Costs and Cautionary Tales: Economic Insights for the Law 9781472563637, 9781841133690

Citation preview

(A) Ogus Prelims

23/2/06

09:29

Page v

For Owens and her cats

(A) Ogus Prelims

23/2/06

09:29

Page vi

(A) Ogus Prelims

23/2/06

09:29

Page vii

Preface

Several publishers have, in recent years, attempted to persuade me to write a textbook on law-and-economics from the perspective of English law. I have always resisted the suggestion. There are some excellent textbooks available in the market and even if most of these are American, that it not an important barrier to their ready appreciation by English law students. In any event, I was less than enthusiastic about the prospect of labouring through a systematic, and highly structured, account of the economic analysis of different branches of the law. Nevertheless, as the thirtieth anniversary of my first encounters with law-and-economics began to approach, I felt the need to celebrate what, for me, has been a period of extraordinarily rich intellectual stimulus, to draw together some of the themes of my recent work, and to reflect on how the sub-discipline has developed, and its current standing. It seemed to me, also, that there was a gap in the literature: a book which attempted to explain why the economic analysis of law was important for lawyers and what insights it had to offer on the law. And this would necessarily involve exploring in a non-dogmatic, and largely non-technical, way some of the more controversial areas of analysis which–at least this side of the Atlantic–have generated criticism and resistance. In particular, I considered it important to address the difficult issues arising from ambiguities in the definition of ‘economic efficiency’ and from conflicts between that goal and other non-economic goals, such as distributional justice and paternalism. The product which has emerged in response to these needs has turned out to be somewhat discursive, though I hope not formless. I have allowed myself, in places, to engage in the anecdotal and even the autobiographical, but such indulgence may help to compensate for other parts which readers may find unrelievedly austere. vii

(A) Ogus Prelims

23/2/06

09:29

Page viii

Preface

I wish to express my gratitude to Carolyn Abbot, Martin Davey, Neil Duxbury, Michael Faure, David Milman, and Niels Phillipsen for their comments on particular chapters, to generations of students who have made me think more carefully about the central themes, and to Richard Hart for his enthusiastic encouragement. Goldsborough December 2005

(B) Ogus Ch1

20/2/06

16:33

Page 1

1 Setting the Scene

Intellectual Inferiority Complex, but not in Chicago I was in my first year as an assistant lecturer in law at the University of Leicester in the late 1960s. One evening, I was introduced by the warden of the hall of residence, where I was a tutor, to a visiting scientist. “He is a lawyer,” the visitor was told, “but not an ordinary lawyer . . .” I was certainly flattered by this latter remark, motivated, I suspect, by the fact that I had tried to impress the warden that I had intellectual interests outside the law. But it also served to reinforce the inferiority complex from which I, and perhaps most of us who were legal academics at the time, suffered. We did not think of ourselves as scholars, unless we wrote about Roman law or legal history; and we were certainly not scientists. So, what were we doing at a university, cohorting with physicists and biologists who were busy advancing human knowledge?1 A decade or so later, the complex may have been somewhat curbed by my employment at the Centre for Socio-Legal Studies, Oxford. During that period I developed a strong interest in the economic analysis of law. I was still not a scientist, but at least I was working with social scientists and learning about how a scientific method could be applied to law.2 Does my 1 This theme is developed in W Twining, Blackstone’s Tower: the English Law School (London, Sweet & Maxwell, 1994). 2 For a useful account of the Centre and its intellectual atmosphere at that time, see K Hawkins, “Prologue: Donald Harris and the Early Years of the Oxford Centre” in K Hawkins (ed), The Human Face of Law: Essays in Honour of Donald Harris (Oxford, Clarendon Press, 1997), 5–14.

1

(B) Ogus Ch1

20/2/06

16:33

Page 2

Setting the Scene

experience help to explain why law-and-economics became so important in the latter part of the 20th century? Was the interest in the approach fuelled by a desire to acquire legitimacy among academic scientific colleagues?3 Before I attempt to answer those questions, I must relate another autobiographical anecdote. When I was a law-and-economics fellow at the University of Chicago Law School, in 1981, my wife and I were offered accommodation in an apartment on 57th Street, belonging to a professor from the History Department. His name was William McNeill. I began to read perhaps his most well-known book, Plagues and People.4 Its theme was relatively simple: epidemics help to explain much of what has happened in world history. I do not know that I was completely convinced by this, but I found it compelling reading and I was most impressed by the skill with which the thesis was advanced. During the day I was, of course, fully engaged in coming to grips with the law-andeconomics writings of the famous Chicago school of “law-andeconomics” and discussing them with William Landes, Frank Easterbrook, Ed Kitch and others, including Richard Posner— he was already a judge but he came to the Law School every Saturday as well as for workshops. It struck me at the time that there was something in common between William McNeill and the Chicago lawyer-economists, although I did not rationalise it until many years later.5 These individuals had made their impact on the world of scholarship by transmitting ideas which were polemical, challenging generally received wisdom. It is no accident that they were American and based in Chicago. The academic world there is highly competitive. Economists tell us that, in such an environment, suppliers will make particularly strenuous efforts to differentiate 3 On a similar theme, see TS Ulen, “The Unexpected Guest: Law and Economics, Law and Other Cognate Disciplines, and the Future of Legal Scholarship” (2004) 79 Chicago-Kent Law Review 403, 411–16. 4 Oxford, Blackwell, 1976; updated edn, New York, Anchor, 1988. 5 A Ogus, “The Power and Peril of Simple Ideas and Simple Rules” (1997) 17 Oxford Journal of Legal Studies 115. See also RA Posner, “Legal Scholarship Today” (2002) 115 Harvard Law Review 1314, 1317.

2

(B) Ogus Ch1

20/2/06

16:33

Page 3

Setting the Scene

their products from others available in the market.6 In most markets, they do so by highlighting a product’s individual qualities. In relation to intellectual ideas, quality is, however, an elusive concept, because opinions differ sharply on what is “good” or “bad”. To meet this problem, the strategy can involve capturing the attention of readers by rendering the ideas unusual, perhaps eccentric; or what Duxbury, in characterising American legal scholarship generally, has called, “faddishness, outlandishness and . . . outspokenness.”7 While it may help if the basic ideas are relatively simple to grasp, readers may rather be impressed if the work reveals complexity and involves sophisticated modelling. As we will see in this chapter, some of the major contributions to the law-and-economics literature, particularly those published when the economic analysis of law was still trying to establish a foothold, fall within this description: they were bold and challenged the accepted orthodoxy. Indeed, they seemed sometimes to take a perverse delight in contradicting conventional legal wisdom on, for example, justice and morality, with the predictable consequence that the work was widely noticed and discussed. There is a certain irony in juxtaposing this explanation for the rapid growth and prominence of law-and-economics scholarship in the USA alongside my own quest for scientific legitimacy—I never met a legal academic at the University of Chicago who suffered from an intellectual inferiority complex. Nevertheless I believe that these complementary stories are important in helping us to understand the character of law-and-economics scholarship, as well as its impact, including criticism and even hostility, particularly outside North America.8 6 J Beath and Y Katsoulacos, The Economic Theory of Product Differentiation (Cambridge, Cambridge Unversity Press, 1991). 7 N Duxbury, “History as Hyperbole” (1995) 15 Oxford Journal of Legal Studies 477, 487. 8 For more conventional accounts of the development of law-and-economics, see N Duxbury, Patterns of American Jurisprudence (Oxford, Oxford University Press, 1995), ch 5 and E Mackaay, “History of Law and Economics” in B Bouckaert and G De Geest (eds), Encyclopedia of Law and Economics (Cheltenham, Edward Elgar, 2000), vol 1, 65–117.

3

(B) Ogus Ch1

20/2/06

16:33

Page 4

Setting the Scene

My aim, in this book, is to demonstrate that the economic analysis of law generates important insights for law and lawyers, without it being necessary to accept all the assumptions on which it is based, nor, having regard to the normative dimension, all the policy implications to which it seems to lead. And we do not need to understand complex mathematical models to benefit from the power of its reasoning. In this chapter I seek to introduce the reader to the main themes I will explore through a brief account of six seminal contributions to the law-and-economics literature. I then deal with those aspects of the economic analysis of law which seem to have been most problematic for lawyers and others coming fresh to the sub-discipline.

Six Landmark Contributions to the Economic Analysis of Law Coase and Transaction Costs Ronald Coase is rightly regarded as the founding father of the economic analysis of law,9 primarily because of his 1960 paper on “social cost”,10 which is the most cited article in legal academic journals11 and which, as my second “landmark”, will be discussed in the next section. Less attention has been given to his earlier 1937 paper on the nature of the firm,12 but, in using economic methodology to understand law, it is perhaps equally important. Coase here explores different legal forms for collaborative effort; in particular he is concerned with predicting, and therefore also explaining, why entrepreneurs will sometimes enter into simple market transactions with those providing inputs (for example products or labour), or rather join with 9 Duxbury, above n 8, 381–91; H Demsetz, “Coase, Ronald Harry” in P Newman (ed), The New Palgrave Dictionary of Economics and the Law (London, Macmillan, 1998), vol 1, 262–70. 10 R Coase, “The Problem of Social Cost” (1960) 3 Journal of Law and Economics 1. 11 FR Shapiro, “The Most-Cited Law Review Articles Revisited” (1996) 71 Chicago-Kent Law Review, 751, 759, referring to Coase as the “runaway citation champion.”

4

(B) Ogus Ch1

20/2/06

16:33

Page 5

Setting the Scene

them to create a single legal entity, a firm. The key to this predictive analysis is the cost of making the relevant transactions. Trading across the market involves, notably, obtaining relevant information as to prices and quality, and negotiating, and then monitoring the performance of, individual contracts. The internal, hierarchical structure of the firm will enable the entrepreneur to economise on some of these costs, but then of course there are other costs associated with the more complex legal form, including those arising from restricting the choice of inputs, and tying them into a long-term relationship. There is nothing startling in this simple idea of exploring and comparing transactions costs, but it is the source of much analysis which brings with it important insights for the law. The way in which individuals will want to select appropriate legal forms to maximise profits and wealth helps us to understand the economic function of those forms and the rules which attach to them; it also provides valuable information for the formulation of rules. Most obviously this line of reasoning has led to the large, and highly influential,13 literature on the economic analysis of company law and corporate governance.14 As the notion of transactions costs is broadened and the identified variables which influence those costs multiply, so of course the analysis becomes increasingly complex. As I will show in subsequent chapters, the reasoning can be applied in a wide range of other, presumptively wealth-generating, contexts. These include the formulation of property rights and the drafting and interpretation of contracts,15 in particular to allocate risks so as to maximise the surplus which the contract generates for the parties to it.16 12

R Coase, “The Nature of the Firm” (1937) 4 Economica (NS) 386. For its use in relation to the reform of British company law, see below, 296–7. 14 The classic text is FH Easterbrook and DR Fischel, The Economic Structure of Corporate Law (Cambridge, Mass, Harvard University Press, 1991). See also B Cheffins, Company Law: Theory, Structure and Operation (Oxford, Clarendon Press, 1997). 15 Ch 2, below, 38–47 and 57–60, respectively. 16 Ch 5, below, 147–51. 13

5

(B) Ogus Ch1

20/2/06

16:33

Page 6

Setting the Scene

Indeed, viewing legal instruments as devices for the minimisation of transaction costs can, as I will attempt to demonstrate in chapter three, facilitate an understanding of the inner structure of the legal system. Wealth-creation may depend, at root, on individuals, within certain limits, formulating contractual terms and amending property rights to meet their preferences; but these are often costly to undertake. The law, by providing standardised sets of obligations as implied default rules, can generate considerable economies and yet not override individual preferences because individuals are free explicitly to adopt alternative sets of obligations if that would better meet their preferences.17 Thus envisaged, many private law obligations can be rationalised as belonging to systems of private governance, but this is not to underestimate the importance of public governance. Policy may dictate the overriding of individual preferences for a variety of reasons18: the preferences were formed on the basis of inadequate information or in an environment in which they are forced upon the individual; or perhaps implementation of the preferences has important effects for parties who are not parties to the private governance arrangements (externalities). Or governments may wish to override preferences on the ground that they are based on irrationality, they are in other respects unwise, or lead to outcomes which offend notions of justice. Sometimes these policies are consistent with wealth-maximising aims; sometimes they are not. Whatever the case, it is still important to know how the policy goals can be fulfilled at lowest cost and that requires an exploration of the costs—in a public governance context we can substitute “administrative costs” for “transactions costs”—incurred by the alternative legal instruments (public and private) which are available.19

17

Below, 57–8. A Ogus, Regulation: Legal Form and Economic Theory (Oxford, Hart Publishing, 2004), ch 3. 19 See the discussion of cost-effectiveness, below, 290–3. 18

6

(B) Ogus Ch1

20/2/06

16:33

Page 7

Setting the Scene

Coase and Reciprocity Coase’s more famous “social cost” paper20 relies on the earlier work on transactions costs but develops it into a more challenging and surprising set of arguments; and, unlike his exploration of the economic nature of the firm, this paper has important normative implications. Hitherto, orthodox welfare economics had treated behaviour which externalised costs to third parties, for example damage to a farmer’s crops from straying cattle belonging to a neighbouring rancher, as giving rise to misallocations of resources, requiring some corrective measures from government. Economists tended to think in terms of a financial charge or tax imposable on the inflictor of the harm, thus internalising the externality.21 The solution suggested by notions of corrective justice, and as such generally adopted by lawyers, that inflictors of harm should compensate victims, reached an equivalent outcome through the law of tort. Ronald Coase challenged both traditional economic and legal analysis by questioning the assumption that requiring the inflictor to pay is invariably the appropriate solution. He perceived the problem not to be that of the rancher imposing costs on the farmer, but rather of a conflict in the demand for the use of a resource. The rancher wants the land to allow the cattle to stray; the farmer wants it free from the cattle so that the crops can grow; the predicament of the two economic agents is reciprocal. That perception led to two further propositions. First, the conflict should be resolved by reference to which of the two conflicting uses has the greater social value. If, for example, the farmer values the damage-free crops higher than the rancher values the roaming capacity of the cattle, then the farmer will be willing to pay the rancher not to damage the crops, a solution which is the exact opposite of traditional legal (and economic) wisdom. 20

Above n 10. Often known as Pigovian taxes after AC Pigou, The Economics of Welfare (London, Macmillan, 4th edn, 1932); and see generally, A Ogus, “Corrective Taxes and Financial Instruments as Regulatory Instruments” (1998) 61 Modern Law Review 767. 21

7

(B) Ogus Ch1

20/2/06

16:33

Page 8

Setting the Scene

Secondly, whatever the law prescribes, the appropriate economic solution can be reached by bargaining between the affected parties, provided that the transaction costs involved in such bargaining are relatively small (the so-called Coase theorem). The reference to transactions costs links the theorem to the earlier work on the nature of the firm, and indeed leads to an important derivative of the theorem: where transaction costs inhibit the bargaining solution, then the law should be formulated in such a way as will create incentives for the parties to reach the economically appropriate solution; and that of course has been the objective of much of the law-and-economics literature. Understandably, commentators22 have tended to focus on the bargaining approach and the transactions costs issue but, as I will argue in chapter six, considerable insights are generated for the law by that part of the reasoning which reinterprets physical invasion in terms of reciprocity. By equating the position of the farmer to that of the rancher, Coase not only rides roughshod over notions of corrective justice; he also undermines fundamental notions of causation. Can it really be said that the presence of the crops is as much a “cause” of their damage as the wanton behaviour of the farmer’s cattle? As lawyers we may be trained to respond to the question with an emphatic negative, but further reflection should lead us to recognise that there are many situations where traditional causation analysis and instinctive notions of corrective justice are insufficient to address the complexity of the issues and interests at stake. The determination of when individuals should be held liable for negligent omissions, that is failures to act, rather than positive acts, provides an excellent, specific example.23 More generally, the world of litigation and the adjudication of particu-

22 For critical evaluations of the large literature on the Coase Theorem, see D de Meza, “Coase Theorem” in Newman, above n 9, vol 1, 270–82, and SG Medema and RO Zerbe, “The Coase Theorem” in Bouckaert and De Geest, above n 8, vol 1, 836–92. 23 A Ogus, “What Legal Scholars Can Learn from Law and Economics” (2004) 79 Chicago-Kent Law Review 383, 396–9 and below, 168–73.

8

(B) Ogus Ch1

20/2/06

16:33

Page 9

Setting the Scene

lar claims tend to favour a narrow perspective of what is, and what is not, relevant to a particular problem; the Coasean vision forces us to expand the parameters. Ackerman makes the point well. Instead of sifting the facts in search of the cause of the trouble, the lawyer-economist urges a conception of causation that recognises how a multiplicity of factors, operating over a lengthy period of time, contribute to our legal discontents . . . Rather than beginning with the moment at which the actors get into some form of obvious trouble, Coasean assumptions force the lawyer to start his story at a much earlier point in time: when the parties could have reorganised their activities in a way that could have avoided the trouble entirely.24

Holmes and Efficient Breach The American judge, Oliver Wendell Holmes, has only an oblique relationship with the economic analysis of law. Although he once famously remarked that, “for the rational study of the law the black-letter man may be the man of the present, but the man of the future is the man of statistics and the master of economics”,25 explicit economic reasoning did not feature significantly in his own judgments.26 Nevertheless some of his insights reflected an intuitive economic approach and none has been more important than his observation that the duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it—and nothing else.27

The idea that a promisor has, effectively, the option either to perform the contract or to pay damages eschews a moral basis to contractual obligations and impliedly authorises the breaking of contracts where it is economically advantageous to do so. As 24 B Ackerman, Reconstructing American Law (Cambridge, Mass, Harvard University Press, 1984), 52–3. 25 OW Holmes, “The Path of the Law” (1897) 10 Harvard Law Review 457, 463. 26 See, generally, RA Posner, “Holmes, Oliver Wendell Jr” in Newman, above n 9, vol 2, 244–6. 27 Above n 25, 462.

9

(B) Ogus Ch1

20/2/06

16:33

Page 10

Setting the Scene

such, the observation was the precursor to the highly influential theory of “efficient breach.”28 As I will show in chapter seven, Holmes’ approach provides a very valuable analytical tool for comparing the various remedies available for breach of contract and for understanding why, for example, specific performance may be appropriate in particular circumstances.29 But it also has a much wider impact on the more general issues which any legal system must address. When an individual’s conduct is characterised as being “unlawful” because it is in breach of some legal obligation, should it be the subject potentially of prevention, in the sense that the police power of the state can be invoked, if necessary, physically to enforce the obligation?30 And if prevention is not practicable because, for example, the legal claim has been brought only after the event, should the damages by the lawbreaker be increased beyond the level required for compensation, to prevent the lawbreaker profiting from the wrong?31 Or will it, as the Holmes observation implies, suffice if any victims of the unlawful conduct are compensated (fully? adequately?) for their losses? And, with regard to these questions, should public law obligations be treated differently from private law obligations, for the very reason that they emanate from the state?32 Indeed, the idea that unlawful conduct should be tolerated provided that the lawbreaker pays appropriate compensation leads to the (for lawyers) novel perception that law primarily

28 For an overview of the theory, see R Craswell, “Contract Remedies, Renegotiation, and the Theory of Efficient Breach” (1988) 61 Southern California Law Review 628. 29 Below, 205–12. 30 The subject of the classic analysis in G Calabresi and D Melamed, “Property Rules, Liability Rules and Inalienability: One View of the Cathedral” (1972) 85 Harvard Law Review 1089, on which see below, 197–201. 31 By an award of exemplary damages designed to punish the defendant (eg Cassell v Broome [1972] AC 1027, below, 189.) or by basing the award on a disgorgement of profits (eg A-G v Blake (Jonathan Cape Ltd Third Party) [2001] AC 268, below 124). 32 Below, 212–6.

10

(B) Ogus Ch1

20/2/06

16:33

Page 11

Setting the Scene

operates as a system of implicit pricing, by adding to the cost of undertaking the relevant activities. Thus if the cost to me of publishing a libel is (say) £50,000 and the damages I will have to pay are £200,000, then, assuming perfect enforcement, the law has raised the cost of the activity to £250,000; and whether I publish will depend on whether the demand for the publication will be sufficient for me to generate a profit. That has important policy implications since, for the legal rules to achieve the desired outcome, the “pricing” of the activity must be set at an appropriate level. The same reasoning applies to the imposition of a criminal sanction, such as a fine, but of course, in relation to both regimes, it is necessary to discount for imperfect enforcement, an issue to which I will return in relation to another “landmark.”33 Posner and the Efficiency of the Common Law The name of Richard Posner will be familiar to anyone who has the slightest knowledge of law-and-economics and, indeed, to many others. He is an extraordinarily prolific author and this notwithstanding the fact that since 1981 he has had a full-time appointment on the bench. From his huge list of publications,34 I select as my “landmark” his monograph Economic Analysis of Law, the first edition of which was published in 1972.35 This provides an economic interpretation of almost all areas of law and, as such, was a “tour de force” given that, at the time, the economic analysis of law was in its infancy. The central theme of the book was (and is) “that the common law exhibits a deep unity that is economic in character.”36 The idea is then elevated into a theory:

33

Below, 15. His curriculum vitae (in 2005) indicates that he has published 34 books (some of them successive editions) and well over 200 articles: http://www.law. uchicago.edu/faculty/posner-r/ppw.html. 35 RA Posner, Economic Analysis of Law (Boston, Little Brown, 1972); now in its 6th edn: (New York, Aspen, 2003). 36 Ibid (1972), 179. 34

11

(B) Ogus Ch1

20/2/06

16:33

Page 12

Setting the Scene What we may call the efficiency theory of the common law is not that every common law doctrine and decision is efficient. The theory is that the common law is best (not perfectly) explained as a system for maximizing the wealth of society.37

Judges are assumed to have some innate, intuitive sense of what outcomes are least costly for society and, over time, this will lead to wealth-maximising principles.38 Statutory law is considered to be different, because legislators are vulnerable to pressure from interest groups to make laws which do not serve wealthmaximising purposes.39 Two preliminary observations should be made on the theory. First, Posner identifies “efficiency” with the maximisation of wealth of society, rather than with the maximisation of welfare, the definition normally given by welfare economists. Secondly, he is not here committing himself to a normative proposition, that the common law ought to maximise wealth; rather, it is a positive statement which is considered to be capable of verification. Later in this chapter, I shall return to the definition of efficiency and also normative assertions made by Posner and others, that the law, particularly the common law, ought to be efficient.40 Here I want to concentrate on the positive statement about wealth maximisation. It is problematic to subject what we may now call the positive theory of the efficiency of the common law to rigorous verification. This is partly because there is often considerable ambiguity concerning what is an efficient rule in relation to a given situation, in the sense of potentially maximising wealth.41 37

Ibid (2003), 25. Ibid (2003), 252. This is to be distinguished from the once-fashionable evolutionary theory of the efficiency of the common law which is based on the idea that inefficient rules are more likely, than efficient rules, to be challenged at an appellate level, and therefore, over time efficient rules will supersede inefficient rules: below, 301, and the references there cited. 39 Posner, n 35 above (2003), 534–7 and see, further, below, 16–21. 40 Below, 25–31. 41 D Friedman, “Posner, Richard Allen” in Newman, above n 9, vol 3, 55, 58–61. 38

12

(B) Ogus Ch1

20/2/06

16:33

Page 13

Setting the Scene

Take, for example, the question whether a bona fide purchaser of goods belonging to a third party should have good title against the latter. As we shall see in chapter two, efficiency justifications can be invoked for both the English rule that the original owner should prevail and for the French rule protecting the bona fide purchaser, depending on which profile of costs affecting the relevant parties is more likely to occur.42 There is, then, a danger of this type of analysis becoming tautologous43: because the courts, in England, have opted for the rule favouring the original owner, it is assumed that the incidence of costs in that jurisdiction lead to this solution, which is therefore efficient. Even if the efficient solution can, unequivocally, be identified, there is still the problem of empirical verification. This would require reference to reliable measures of, or proxies for, wealth44 as well as adequate data which would enable analysis to be made of the impact on wealth of different legal principles, controlling for other variables.45 However, these problematic features of the efficiency of the common law theory should not be allowed to detract from the value of the Posnerian approach to law: it generates important insights for lawyers and makes a major contribution to the critical evaluation of the law. Friedman makes the point well: 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 logic of the problems the law exists to solve.46 42

Below, 45–7. See P Burrows and CG Veljanovski, “Introduction: the Economic Approach to Law” in P Burrows and CG Veljanovski (eds), The Economic Approach to Law (London, Butterworths, 1981), 19–20. 44 M Rizzo, “The Mirage of Efficiency” (1980) 8 Hofstra Law Review 641. 45 For an interesting attempt, see AJ Field, “Do Legal Systems Matter?” (1991) 28 Explorations in Economic History 1; and on the the use of historical studies for this purpose, more generally, see R Harris, “Use of Legal History in Law and Economics” (2003) 4 Theoretical Inquiries in Law, Article 9. 46 Friedman, above n 41, 61. 43

13

(B) Ogus Ch1

20/2/06

16:33

Page 14

Setting the Scene

An investigation of the efficiency characteristics of legal principles leads us to examine the extent to which they create appropriate incentives for the creation of wealth and the reduction of costs, dimensions which I explore in chapters two and four, respectively. And this, as I will argue in the concluding section of this chapter, is valuable information, even if the principal objective of the legal principle in question is something other than wealth-maximisation. Becker and the Economics of Crime The contribution of Gary Becker, another Chicagoan and Nobel prize-winner,47 to the law-and-economics literature has been more controversial than most, because he has chosen to focus on two areas, criminal law48 and family law,49 to which economic analysis is less obviously applicable. If, without undue difficulty, we can accept the economic postulate that the behaviour of those engaging in market-based transactions is motivated by wealth- or utility-maximising intentions, can we say the same of those deciding whether or not to marry? Or to commit a crime? Can the rational calculation of relative costs and benefits plausibly supplant love, and hate, and lots more besides, as impulses prompting such action? I do not know what would be Becker’s answer if the questions were to be framed in this provocative way, but he defends his work with the lesser claim that economic reasoning is applicable to decision-making in areas such as family and criminal law.50 Provided that we are prepared to recognise limits to its applica47 RA Posner, “Gary Becker’s Contribution to Law and Economics” (1993) 22 Journal of Legal Studies 211; WM Landes, “Becker, Gary Stanley” in Newman, above n 9, vol 1, 153–6. 48 See, especially, GS Becker, “Crime and Punishment: an Economic Approach” (1968) 76 Journal of Political Economy 169. 49 Notably in GS Becker, A Treatise on the Family (Cambridge, Mass, Harvard University Press, 1981). 50 GS Becker, The Economic Approach to Human Behavior (Chicago, University of Chicago Press, 1976), 8 (my italics). See also Landes who refers to Becker’s “the relevance of economics” to behaviour in these areas: above n 47, 26 (my italics).

14

(B) Ogus Ch1

20/2/06

16:33

Page 15

Setting the Scene

bility, this analysis can assist in our understanding of the function of the law in these areas, as well as make a significant contribution to a critical evaluation of it. It also generates insights for legal issues of a more general character. To elaborate on these points, I shall take Becker’s well-known economic model on crime and law enforcement.51 The basis of Becker’s model is simple. Compliance with the criminal law is to be predicted only where the utility (or profit) to be derived from committing the offence is exceeded by the sanction which will be imposed on conviction, discounted by the probability of that sanction being imposed. As we shall see in chapter four, this simple prediction can be made more complex, and more realistic, in a number of ways52; notably, account can be taken of costs that are incurred by an offender following apprehension, where a subsequent conviction is not secured, and hence no formal sanction is imposed.53 Now while not every potential offender will trade-off the benefits and costs of crime in this way, many will do so intuitively, particularly in relation to so-called “white-collar” and business crime. Most importantly, differentiating between the two key variables of law enforcement—on the one hand, the probability of apprehension and conviction and, on the other, the severity of sanction—facilitates systematic analysis of enforcement policy. For example, to achieve a given increase in compliance, it might seem necessary to raise the probability of apprehension, involving costly expenditure on more policing. But the model predicts that the same outcome can be achieved by holding the level of policing constant and raising the financial penalty, provided that likely offenders will have the capacity to pay. These few observations provide only a glimpse of the way in which economic reasoning can function as an important 51

Above, n 48. For a survey of economic modelling in this area, see E Eide, “Economics of Criminal Behavior”, Bouckaert and De Geest, above n 8, vol 5, 345–89. 53 A Ogus and C Abbot, “Pollution and Penalties” (2002) 20 Research in Law and Economics 493, 502–6. 52

15

(B) Ogus Ch1

20/2/06

16:33

Page 16

Setting the Scene

analytical tool in the study of criminal law and enforcement.54 I return to the topic in chapter four, where I seek to show that Becker’s framework of analysis is useful in a much wider context. If, as we saw in relation to Holmes and efficient breach, law is characterised essentially as implicit pricing, then, applying the Becker model, and taking account of major differences in sanctions and enforcement, we can compare the effectiveness of a wide variety of legal regimes in inducing behavioural outcomes which are considered desirable. Such regimes include not only criminal sanctions and administrative penalties but also civil law remedies and social norms which have no formal consequences. Indeed, while lawyers are accustomed to the idea that criminal and administrative penalties serve as inducements to behavioural constraints, they would not so readily assume that, for example, tort damagers or a restitutionary remedy should be used for the same purpose. These are traditionally seen as devices for meeting corrective justice goals of compensating ex post the victims of wrongs. Stigler and the Economics of Legislation Mainstream economic reasoning is applied to decisions made by individuals, it being assumed that rationally they seek to maximise their own utility. When decisions are made in relation to collective choice, for example, members of a committee, shareholders or legislators voting for decisions made by the group to which they belong, should those assumptions change? The answer given to that question by the branch of economics known as “public choice” is an emphatic “no.”55 On this view, 54 For a partial survey of the vast literature, see AM Polinsky and S Shavell, “Public Enforcement of Law” in Bouckaert and De Geest, above n 8, vol 5, 307–44. 55 The leading authority is JM Buchanan and G Tullock, The Calculus of Consent: Legal Foundations of Constitutional Democracy (Ann Arbor, University of Michigan Press, 1962). More generally, see L Van den Hauwe, “Public Choice, Constitutional, Political Economy and Law and Economics” in Bouckaert and De Geest, above n 8, vol 1, 603–59; and Ogus, above n 18, 58–75.

16

(B) Ogus Ch1

20/2/06

16:33

Page 17

Setting the Scene

the task is then to explore how individual preferences can be met through the voting rules and other procedures adopted by institutions for collective decision-making and to understand the consequences that these have for social welfare more generally. The analysis provided by the public choice school has broad implications for the law. Here I wish to focus on the contribution it has made to our understanding of legislation and, for that purpose, I select as my final landmark “The Economic Theory of Regulation”56 published in 1971 by George Stigler, yet another Nobel prize laureate and hailing from Chicago, rather than Virginia the acknowledged home of public choice analysis. Although much of Stigler’s work may be considered peripheral to the economic analysis of law,57 this piece is seminal, generating insights which were to prove so influential in the decades which followed. In 1962 Stigler published (with Friedland) the results of an empirical study of the electricity industry which showed that the regulatory system did not, as was its purpose, lead to lower prices.58 According to Telser, the “article created a sensation akin to a major experiment in the natural sciences.”59 Hitherto it had generally been assumed that regulation was introduced for, and served to fulfil, the public interest and not the interests of those, mainly industries and firms, whose power it was designed to curb. In the 1971 paper, Stigler drew on the empirical study to formulate a theory of regulation. Its central hypothesis is simple: the state by means of its coercive power can impose losses and confer benefits on different sectors of the community and it does so through its legislative and regulatory powers. Those exercising power wish to preserve it, for which political support is essential. That political support can be offered as a “price” by groups who benefit by the legislation. In 56

(1971) 2 Bell Journal of Economics and Management Science 3. For a survey of his contribution, see LG Telser, “Stigler, George Joseph” in Newman, above n 9, vol 3, 540–4. 58 GJ Stigler and C Friedland, “What Can Regulators Regulate? the Case of Electricity” (1962) 5 Journal of Law and Economics 1. 59 Above n 57, 543. 57

17

(B) Ogus Ch1

20/2/06

16:33

Page 18

Setting the Scene

short, there is a “market” for legislation in which, like any other market, trade takes place on the basis of supply and demand. As regards demand, while different groups can furnish political support, the “price” necessary to secure the “purchase”, the transaction is most likely to be made by those groups which can co-ordinate their influence at lowest cost. In this category we would expect to find groups which have either or both of two characteristics.60 The first arises from the fact that members of a group are able to benefit from a law whether or not they contribute to the payment of the “price”. Groups which can control free-riding of this kind will thus be more effective. The same applies if the interest with which the group is identified is homogenous, since it will be easier to specify what legislative measure is required to benefit it. All of this leads to the general prediction that legislation will tend to favour professional and industrial groups more than those representing, for example, consumers or taxpayers, whose interests are much more diffuse.61 Although the theory has not gone unchallenged,62 its impact on American economics of law analysis has been immense. There have been a large number of econometric studies, many of them published in the Journal of Law and Economics, purporting to show how legislative, particularly regulatory, measures have increased profits within the regulated industry, often because the legislation which ostensibly controls industrial performance has an anti-competitive dimension, thus protecting incumbent suppliers against entrants. As we shall see in chapter ten,63 the theory has infiltrated the principles of statutory inter60 M Olson, The Logic of Collective Action (Cambridge, Mass, Harvard University Press, 1965). 61 RA Posner, “Theories of Economic Regulation” (1974) 5 Bell Journal of Economics and Management Science 335. 62 See particularly M Kelman, “On Democracy-Bashing: a Skeptical Look at the Theoretical and “Empirical” Practice of the Public Choice Movement” (1988) 74 Virginia Law Review 199; and DA Farber and PP Frickey, Law and Public Choice: A Critical Introduction (Chicago, University of Chicago Press, 1991). 63 Below, 307–10.

18

(B) Ogus Ch1

20/2/06

16:33

Page 19

Setting the Scene

pretation. Some commentators have concluded that, if regard is to be had to the intention of the legislature, then the task of judges is to identify and apply the negotiated deal between the relevant politicians and pressure groups. More positively, as regards promoting a public interest approach to legislation, others have drawn on the theory to argue for constitutional structures which might constrain transactions of this kind.64 Of what value is the theory to lawyers this side of the Atlantic?65 Now many of us may have been naïve, assuming that politicians and therefore the Westminster Parliament were largely concerned with promoting what they considered to be in the public interest, but the ideas of public choice are not wholly alien to English lawyers. Dicey, in his Law and Public Opinion in England,66 attempted to correlate the character of legislation in the late 19th and early 20th centuries with the extension of the franchise; and there have been many statutory provisions which it is difficult to explain other than by reference to pressure from interest groups.67 For example, a provision of the Consumer Protection Act 1987 excludes agricultural products (not undergoing an industrial process) from the new regime of liability for defective products,68 and this was almost certainly the result of pressure from the powerful farmers’ lobby. There have also 64 See, eg, Symposium “Constitutional Law and Economics” (1992) 12 International Review of Law and Economics (June issue). Work of this kind is a response, in particular, to the normative branch of the public choice school which focuses on the fact that the resources spent on efforts to acquire legislative benefits (“rent-seeking”) are, from society’s viewpoint, entirely wasted resources: G Tullock, “The Welfare Costs of Tariffs, Monopolies and Theft” (1967) 5 Western Economic Journal 224. 65 See A Ogus, “Legislation, the Courts and the Demand for Compensation” in RCO Matthews (ed), Economy and Democracy (London, Macmillan, 1985), 151–67, from which some of the following ideas are derived. For the views of prominent public lawyers, see: PP Craig, Public Law and Democracy in the United Kingdom and the United States of America (Oxford, Clarendon Press, 1990), 80–90, and C Harlow, “Changing the Mindset: the Place of Theory in English Administrative Law” (1994) 14 Oxford Journal of Legal Studies 419, 433. 66 (London, Macmillan, 2nd edn, 1914). 67 I provide two further examples in ch 10, below, 309–10. 68 Consumer Protection Act 1987, s 2(4).

19

(B) Ogus Ch1

20/2/06

16:33

Page 20

Setting the Scene

been a number of legislative measures ostensibly designed to protect consumers but which in fact benefit trader groups because of their anti-competitive effect.69 It is certainly arguable that the predictive capacity of the theory is stronger in an American, than a British, context. Legislative deals, of the kind envisaged, tend to take place between lobbyists and individual legislators, with the latter trading their personal votes with other legislators through “log-rolling”: politician X agrees to vote for an amendment sponsored by politician Y, if Y votes for the amendment sponsored by X. This process may regularly take place in the USA, but in Britain is inhibited by party discipline. And then, of course, the different relationship between the executive and the legislature means that in the UK the government of the day effectively controls the legislative programme. These differences are not, however, sufficient to refute the theory; rather it requires some adaptation. Demand for legislative favours must typically be addressed to the governing political party of the day, or to those which may join a future government; and some form of log-rolling can take place within the policy-making processes of those parties.70 The theory might be considered too cynical, as least in its application to legislative behaviour generally. Although politicians may be motivated by self-interest, many are also driven by ideology or altruism which will lead them to outcomes which are inconsistent with self-interest. (Of course, if they maximise utility by advancing such ideological or altruistic outcomes, that is in their self-interest, but then the theory becomes tautologous.) Nevertheless this area of economic analysis of law does make us think more carefully about the antecedents to legislation—the idea that the agricultural exemption from products liability may have resulted from pressure from farmers came as a huge 69 See Ogus, above n 18, for examples of regulation relating to the designation of products (136) and licensing schemes (ch 10). 70 For development of these ideas, and also for the role of civil servants, see Ogus, above n 18, 63–9.

20

(B) Ogus Ch1

20/2/06

16:33

Page 21

Setting the Scene

surprise to students in my torts class. The theory also forces us to think carefully about the impact of the law on different groups within the community: [W]e need to know who wins and who loses and by how much, when thinking about public policy. Not only is this a necessary part of strategic public management, it is crucial to a normative consideration of whether the legislation is in the public interest.71

Mathematics, Science and Plausibility Particularly this side of the Atlantic, the response of lawyers to the economic analysis of law has not always been warm; sometimes it has been met with hostility. Why is this? True, my six landmarks, in their different way all challenge traditional legal assumptions and reasoning. But lawyers should not be particularly perturbed by this: they are accustomed to diverse and contradictory perceptions of phenomena. Practitioners regularly represent clients who present an interpretation of a case that is directly contradicted by their opponents’ interpretation—that is in the nature of an adversarial culture. The problem would seem rather to arise from the abstract, conceptual and often mathematical way in which the analysis is typically presented, the assumptions on which the reasoning proceeds, and the scientific claims made for it. Mathematics and Game Theory Take first mathematics which has increasingly dominated the law-and-economics literature. The development reflects what has happened within economics more generally in the period after the Second World War: “mathematical modelling, a small piece of the subject until the 1940s and 1950s, became the all-encompassing (some would say suffocating) language of the discipline.”72 It is important to understand the nature of 71 JL Mashaw, “The Economics of Politics and the Understanding of Public Law” (1989) 65 Chicago-Kent Law Review 123, 145. I return to this question below, 287–9. 72 DM Krips, “Economics—the Current Position” (1997) 126 Daedalus 59, 62.

21

(B) Ogus Ch1

20/2/06

16:33

Page 22

Setting the Scene

mathematical modelling and why it came to dominate the discipline, in order to appreciate that a mathematical approach is not necessary to gain insights from the economic analysis of law. Economic analysis involves working out the logical implications of certain basic assumptions of human behaviour, for example, that individuals prefer more satisfaction to less. As the application of those assumptions to a variety of hypotheses, and the interaction between them, becomes more complex, so it is helpful to clarify the relationships in a formal model, even though that necessarily involves some oversimplification: “a really good model is one that generates a lot of understanding from focussing on a very small number of causal arrows.”73 Models need not be stated mathematically, even though most economic models adopt this form. The advantage of the mathematical approach is simply that it can communicate complexities of relationships in an efficient way, verbal equivalents being often convoluted and repetitious. In the light of this, it is not difficult to see why mathematical modelling has assumed such prominence in economics.74 As the variety of phenomena being studied has broadened—law is an obvious example—it has become increasingly important to elucidate a limited number of key causal relationships. Then, with developments in information technology, both the amount of data available and the means of analysing them75 advancing spectacularly, the economies of working with mathematic models have increased correspondingly. Of course, we should not forget the ideas advanced in the introduction to this chapter. The intellectual justification for mathematical modelling has been buttressed by a concern to endow economics with the respectability of 73 RM Salow, “How did Economics Get that Way and What Way did it Get?” (1997) 126 Daedalus 39, 45. 74 Ibid, 46–52. 75 Particularly through multiple regression analysis. For an introduction to this, and its application to law, see A Ogus, M Jones-Lee, W Cole and P McCarthy, “Evaluating Alternative Dispute Resolution: Measuring the Impact of Family Conciliation on Costs” (1990) 53 Modern Law Review 57, 67–73.

22

(B) Ogus Ch1

20/2/06

16:33

Page 23

Setting the Scene

natural science methodology,76 and a desire to create barriers for those wishing to enter this particular academic market. Many of these considerations apply also to game theory which in recent years has been an increasingly fashionable instrument of economic analysis of law.77 Game theory complements traditional economic reasoning in that it explores, in greater depth, the way people behave when outcomes depend not only on their own decisions but also on choices made by others, and where therefore “strategy” enters into the reasoning process. The types of situation for which game theory might be useful can be illustrated by a simple example. During the journey to my office this morning I had to make a decision as to what extent, if any, I would exceed the speed limit on a section of the road where I knew speed cameras were in operation. Intuitively I engaged in a utility-maximising calculation, of the kind envisaged in Becker’s model, comparing the costs arising from risk of a photograph being taken of the illegal speeding and proceedings being taken against me against the benefit of arriving at my office a little earlier. At another point in the journey, I had to decide whether it was safe to turn into a main road before the arrival of another vehicle. Now, here, my intuitive assessment of how the best outcome for me could be reached depended not only on my decision, but also on that of the other driver over whom I had no control. On seeing my vehicle, he might slow down to enable me more safely to turn; or he might speed up, to prevent that occurring. Instead of comparing the costs and benefits arising from the simple choice of turning or not turning, I now had to work my way through four possibilities: turning and the driver slowing; turning and the driver accelerating; not turning and the driver slowing; not turning and the driver accelerating. And the other driver’s behavioural choice can be analysed in a similar way. Game theory provides a 76

Solow, above n 73, 56. For an overview of its relevance to law, see D Baird, R Gertner and R Picker, Game Theory and the Law (Cambridge, Mass, Harvard University Press, 1994); and for an introduction designed for British lawyers, see M Hviid, “Games Lawyers Play?” (1997) 17 Oxford Journal of Legal Studies 705. 77

23

(B) Ogus Ch1

20/2/06

16:33

Page 24

Setting the Scene

method for analysing the way we exercise our choices with these additional complexities. One of these complexities is the dilemma (often referred to as the “prisoners” dilemma after an example often used in expositions of the problem78) that if, without coordinating our strategy, we each choose the option that is the least costly, that might not be the cheapest way of solving the problem. Positive Analysis and its Assumptions As we have seen, in relation to the landmark contributions, the economic analysis of law contains both positive and normative dimensions. The positive dimension uses the assumptions, and logical reasoning, of economics to predict how individuals respond to differences in legal rules; the normative dimension involves a critical evaluation of the rules on the basis of what is (economically) best for society. Here I focus on the positive dimension because it is connected to the debate about the “scientific” nature of the discipline; in the next section I turn to the normative dimension. Two criticisms are often made of the positive economic analysis of law, for example, that contained in the Coase and Becker papers. First, people do not always behave in the way that economists assume. Secondly, the predictions are only very rarely subjected to empirical verification, and when such verification is attempted, some of the predictions are shown to be unreliable. Both assertions are correct, but that is not a sufficient reason for rejecting the insights which positive economic analysis of law offers.79 The fact that people do not always behave in the way envisaged in economic theorising does not by itself repudiate the theory if the assumption is plausible for the generality of cases to which it is applied.80 Putting the same point another way, we 78

See B Nalebuff, “prisoners’ dilemma” in Newman, above n 9, 89–94. T Ulen, “Rational Choice Theory in Law and Economics” in De Geest and Bouckaert, above n 8, vol 1, 790–818. 80 Whether the generalisations are “sufficiently good approximations for the purpose in hand”: M Friedman, Essays on Positive Economics (Chicago, University of Chicago Press, 1963), 15; and see G De Geest, “The Debate on the Scientific Status of Law and Economics” (1996) 40 European Economic Review 999. 79

24

(B) Ogus Ch1

20/2/06

16:33

Page 25

Setting the Scene

may recognise that the predictive capacity of the theory is greater in some contexts than in others. For example, we may be more sceptical of the application of the Becker model to a crime of passion than to a decision of a profit-making firm whether to skimp on compliance with health and safety regulations. Then, if and when a standard of plausibility is not met, it may be possible to construct a new predictive model by altering the assumptions. So-called “behavioural law-and-economics” has been developed precisely for this reason. While neo-classical economic analysis is based on an assumption of rational decision-making by individuals, some economists, recognising the problems created by “bounded rationality”, became cautious in applying models in particular contexts.81 Then a group of scholars, drawing on the empirical evidence provided by social psychologists, devised new analytical models, predicting how individuals would respond to legal rules in situations, for example, those involving risk perception, where notoriously many make decisions on an irrational basis.82 In a later chapter, I show how this approach can help in identifying situations where paternalism may be a legitimate legal objective.83

Efficiency and the Normative Dimension The normative economic analysis of law has given rise to two main concerns. The first arises from the tendency of many authors, having subjected certain legal rules to economic analysis, to conclude that they are “efficient” or “inefficient” without any indication of what is meant by these terms and any defence of their usage. The second concern is more fundamental. 81 Building on the pioneering work of H Simon, Administrative Behavior: a Study of Decision-making Processes in Administrative Organization (NewYork, Macmillan, 1948). And see more generally: DM Kreps, “Bounded Rationality” in Newman, above n 9, vol 1, 168–73. 82 CR Sunstein (ed), Behavioral Law and Economics (Cambridge, Cambridge University Press, 2000). 83 Below, 230–40.

25

(B) Ogus Ch1

20/2/06

16:33

Page 26

Setting the Scene

Whatever test is taken as indicating what is, in an economic sense, “good” for society, it cannot be assumed that the law is exclusively, or even predominantly, aimed at economic welfare. The first concern is justified. As I shall show, in different parts of this book, the criteria which have been used by economists to evaluate the law are sometimes ambiguous and sometimes problematic. Where the literature does ignore these difficulties and makes over-bold or dogmatic assertions, this can impair the contribution that the analysis can make to policy-making. In this chapter I explain the economic concepts used for normative purposes, and introduce the reader to their applications and their limitations. These arguments are further developed in subsequent chapters as I apply the criteria to different areas of legal policy-making. Conversely, the second concern is only justified if the “efficient” solution to any issue is regarded as determinative of what is desirable. As I shall show in the last section of this chapter, and elsewhere in this book, particularly chapter ten,84 it is wrong to use economic analysis in this way, because legal policy-making often requires some trade-off between economic and other values, for example distributional justice. It is, nevertheless, valuable for the policy-maker to have information as to the economically appropriate approach even where another value is to prevail. Tools for Normative Analysis of Law Normative economic analysis of the law involves making judgements about what is “good” for society in an economic sense and the word “efficient” is often used to denote legal rules and institutions which satisfy this condition. But “efficiency” has different meanings according to the criterion used and the context in which the judgement is made. In everyday usage, and therefore as a non technical term, “efficient” means maximising output, relative to input, and thereby maximising welfare or wealth for a given individual or 84

26

Below, 301–3.

(B) Ogus Ch1

20/2/06

16:33

Page 27

Setting the Scene

firm. In the economic literature, this is sometimes referred to as “productive efficiency” or “X-efficiency.”85 We can use predictive economic analysis to determine whether a given legal rule is “efficient” in this sense, and most of chapter two is devoted to this theme. Clearly conclusions about the productive efficiency of law, for example, whether the rules governing corporations or other organisations enhance or hinder profit-making,86 can make an important contribution to policy-making, not least because they provide valuable information to firms that want to maximise their profits. But equally clearly what is “best” for one firm or individual is not necessarily best for society as a whole. In most economic contexts, the technical term “efficient” or “allocatively efficient” is used for judgements about what is economically best for aggregate social welfare or, to express this outcome in different language, to indicate situations in which society’s resources are being put to their most valuable use. Two well-known criteria are regularly used to denote efficiency in this sense. A situation (or law) is “Pareto efficient” when it is impossible to make one or more individuals better off by changing the situation (or the law) without making at least one individual worse off. If the aim is to make a “Pareto improvement” in the law, that will therefore involve some change in the law that benefits at least one individual, but imposes losses on no-one. A situation (or law) is “Kaldor-Hicks efficient” when any change to the situation (or law) will, in aggregate, generate more losses than gains. A “Kaldor-Hicks improvement” to the law will therefore involve a change from which, on aggregate, the gains outweigh the losses.87

85 H Leibenstein, “Allocative Efficiency vs. X-Efficiency” (1966) 56 American Economic Review 392. 86 Below, 51–4. 87 For elaboration of these definitions and of their implications, see eg M Trebilcock, “The Value and Limits of Law and Economics” in M Richardson and G Hadfield (eds), The Second Wave of Law and Economics (Sydney, Federation Press, 1999), 17–22.

27

(B) Ogus Ch1

20/2/06

16:33

Page 28

Setting the Scene

Limitations and Controversies “Any kind of normative analysis—economic, libertarian, liberal or communitarian—will be controversial simply because it purports to be judgmental by telling people what is right or wrong.”88 There can be no consensus, even among economists, on what is “good” for society: both of the criteria used for allocative efficiency have their attractions; both have their limitations. The Pareto test has an obvious intuitive appeal as we know from the rhetoric used by governments when enacting welfare-reform measures, opponents being appeased by the promise that “there will be no cash losers.”89 It is also a key determinant of behaviour in the bargaining that takes place in relation to international treaty-making.90 Since, in that context, there is no authority with legal power to impose unwanted outcomes on nation states, no one state will accept provisions which generate, for itself, losses unless there are compensating gains elsewhere in the treaty. On the other hand, those very illustrations indicate why too rigid an adherence to the Pareto “no losses” rule, will stultify sensible decision-making and progress: how could we manage in a world which did not allow the compulsory purchase of property, and in which individual landowners could stipulate what sum was acceptable to them as the price for a consensual sale? Most people are probably likely to accept that some losses are acceptable if major benefits are to result. Nevertheless, that last concession does not legitimise the Kaldor-Hicks test which tolerates any disposition of losses, provided that they are outweighed by the gains. For laws or legal reforms that satisfy the Kaldor-Hicks test, there must therefore be sensitivity to the level and extent of the losses and the section

88

Ibid, 17. A Ogus, “Transitional Protection is Not Just a Technical Problem” (1999) 6 Journal of Social Security Law 111, and below, 224. 90 JB Wiener, “On the Political Economy of Global Environmental Regulation” (1999) 87 Georgetown Law Journal 749. 89

28

(B) Ogus Ch1

20/2/06

16:33

Page 29

Setting the Scene

of the community on whom they fall. I explore this question further in chapter seven where I discuss areas and principles of law which allow losses to be incurred where the relevant activity gives rise to aggregate gains91; and in chapter ten where I discuss the use of cost-benefit analysis as an economic instrument for legal policy-making.92 Another frequently observed problem with economic normative criteria arises from the question as to what we measure when we talk of “gains” and “losses”: do we mean money/wealth or rather utility/welfare? In theory, all economists judge outcomes by reference to utility maximisation—what gives greatest satisfaction—and money is only a means to that end. In practice the goal is problematic because there is no objective way of measuring utility.93 This has major implications for the KaldorHicks criterion of efficiency since that requires a comparison of gains and losses and insofar as those gains and losses comprise non-financial utility, such comparison is a scientific impossibility. For this reason, Kaldor-Hicks efficiency becomes in practice a criterion of wealth-maximisation and this is the normative criterion used for most economic analysis of law. Value of Information on Wealth-Maximising Characteristics Much of what follows in this book involves positive economic analysis: the methodology of economics is used to predict the likely consequences on behaviour of different legal rules and institutions. In parts I also explore the wealth-maximising characteristics of law, thus effectively adopting the Kaldor-Hicks efficiency criterion. I consider the latter exercise to be valuable because wealth-maximisation is, in most contexts, an important goal for legal systems.

91

Below, 196–7. Below, 285–6. 93 As I indicate below, 287–90, observed willingness-to-pay can provide, at best, some indication of how individuals value assets, but is not reliable because it cannot tell us the maximum that they would have been prepared to pay. 92

29

(B) Ogus Ch1

20/2/06

16:33

Page 30

Setting the Scene

Wealth-maximisation is, of course, not the only, or determinative, goal of law. In some situations moral values, such as those associated with human autonomy and dignity, are of great significance. So also the distributional justice of wealthmaximising outcomes may, in some situations, be questioned. This is not only because the increases in wealth resulting from efficient rules may accrue disproportionately—and therefore in the judgement of many, unfairly—on certain groups. It is also because the base-lines from which such increases are calculated, the “starting positions”, are themselves considered by many to be “unfair.”94 The aim of some areas of law, particularly legislation, may then be to redistribute resources in accordance with some notion of what is “fair.” In most areas of law, therefore, policy-makers have to be engaged in some trade-off between economic and noneconomic goals.95 There is no scientific method of determining how such trade-off should be carried out for the very reason that non-economic values are not measurable.96 If, then, the tradeoff is largely intuitive, in what precise ways does the economic reasoning contribute to that process? I explore that question at some depth in chapter ten in relation to both legislative policymaking and judicial decisions. Suffice it here to observe that the role is essentially one of information. In so far as the goal of a given legal regime may be wealth-maximisation, then the economic analysis should be able to provide guidance on the 94 G Calabresi, “The New Economic Analysis of Law: Scholarship, or SelfIndulgence?” (1983) 68 Proceedings of the British Academy 85. 95 A Okun, Equality and Efficiency: the Big Tradeof, (Washington, Brookings Institute, 1975). 96 N Duxbury, “markets and incommensurability” in Newman, above n 9, vol 2, 615–18. The problem cannot be overcome, as is suggested in L Kaplow and S Shavell, Fairness versus Welfare (Cambridge, Mass, Harvard University Press, 2002), by arguing that non-economic values are reflected in the utility-functions of individuals, and that those functions will be maximised if efficient policies are adopted because, as we have already seen, non-financial utility is not measurable and it is therefore impossible to know whether a policy is utility-maximising in the sense claimed: D Farber, “What (If Anything) Can Economics Say About Equity?” (2003) 101 Michigan Law Review 1791.

30

(B) Ogus Ch1

20/2/06

16:33

Page 31

Setting the Scene

formulation of legal principles which can best achieve that end. Where the economic goal competes with other goals, it must certainly help decision-makers to know what legal principle maximises wealth; and, for the purposes of the trade-off, the analysis might be able to reveal what sacrifice must be made, in terms of reduced wealth, to achieve the non-economic objective. We should note, finally, that positive economic analysis may have a key role in relation to the pursuit of non-economic goals. As I will demonstrate in chapter eight,97 for redistributional policies to be effective it is vital to know how individuals and firms will respond to the various legal instruments used for this purpose, and particularly in the context of competitive markets economic analysis may be adept at identifying the predictable behavioural response. So, for example, aiming to redress certain disadvantages of wealth and power, the law may impose heavy contractual and other obligations on traders, landlords and employers, but those aims may be thwarted, at least in part, if the consequences of the legal impositions are substantially to raise the costs of the products or services or to reduce the supply of them; and lawyers and others advocating the measures may not always be sufficiently aware of these consequences.

A Look Forward To achieve notoriety, and thereby success in the academic market, some of the law-and-economics literature may have been, particularly in the earlier years, unduly provocative or extreme and dogmatic in its normative assertions. To acquire scientific legitimacy, some of its exposition may have been excessively mathematical or unnecessarily abstruse. In this chapter I have argued that none of these tendencies inevitably attach to economic reasoning about law and should not be allowed to detract from the value which the exercise has for lawyers and legal policy-making.98 As I will attempt to show in this book, lawyers 97

Below, 225–9. To similar effect, see A Bernstein, “Whatever Happened to Law and Economics?” (2005) 64 Maryland Law Review 101. 98

31

(B) Ogus Ch1

20/2/06

16:33

Page 32

Setting the Scene

may gain considerable insights from the economic reasoning, without being committed to an over-arching criterion of efficiency and without engaging in sophisticated mathematical modelling. In chapter two I begin by focusing on the wealth-generating capacity of the law, in the more limited sense of productive efficiency. Costs, including those incurred in informationgathering, negotiation, and monitoring the conduct of others, affect all forms of entrepreneurial activity. I show how property rights, business organisational forms and contractual default rules of contract can be rationalised as efforts to minimise the costs and thereby enhance profits. In chapter three, I build on these ideas to engage in a mapping exercise of the legal system as a whole. I do so, not because I consider this to be the only, or “correct” way to understand legal structures, but rather because it helps to clarify how the economic and non-economic goals of the law are related; and to identify and classify the legal instruments used for these purposes. Economic reasoning of this kind also enables us to think more clearly about some of the problematic structural issues, such as those arising from the overlap of contract and tort and the relationship between private law and regulatory standards. In chapter four I turn to how the law operates as a set of incentives to induce desired behavioural outcomes. Lawyers tend to associate this idea particularly with the coercive areas of law, the criminal law and command-and-control regulation. I show how economic reasoning can assist in analysing the predicted impact not only of these instruments, but also that of others with less obvious behaviour-inducing characteristics, such as tort liability, contractual invalidity and taxation. By comparing the costs incurred in operationalising and targeting these instruments, the analysis can assist in determining what type of law (or non-law, since I also consider social norms) may be appropriate in different contexts. Much of law is concerned with risks: how to assess and manage risks in widely different environments, including contractual allocations within business settings and tort and regulatory 32

(B) Ogus Ch1

20/2/06

16:33

Page 33

Setting the Scene

obligations for health and safety policies. As I demonstrate in chapter five, economic analysis can make an important contribution to the understanding of these issues and the identification of appropriate legal responses. That importance is enhanced by the fact that the forensic focus of much legal work induces lawyers to adopt a retrospective view of risk which can lead to a skewed vision of how the problems of risk should be addressed. A central feature of legal doctrine, particularly in the law of torts, and in the values which inspire it, is the notion of corrective justice. In chapter six, drawing on Ronald Coase’s radical “reciprocity principle” outlined in relation to my second landmark, I view its applications from an alternative, economic perspective. I believe that that perspective not only clarifies our understanding of the situations to which corrective justice has been applied, but also provides guidelines for appropriate responses where, as with questions of liability for omissions and “coming to a nuisance”, the impact of corrective justice ideas is ambiguous. In chapter seven I enter the heart of the normative debate on allocative efficiency, and its application to legal principles, by exploring the extent to which the legal system does and should tolerate the commission of wrongs in circumstances where such conduct has wealth-maximising characteristics. The language used by the law tends to make us think in dichotomous terms, since conduct is classified as either “lawful” or “unlawful”. I show how economic analysis encourages a more nuanced approach, leading to a better appreciation of when the legal system should lean towards on the one hand prevention or, on the other hand, tolerance (with or without compensation). Enlarging on another of the themes mentioned in this introductory chapter, I then demonstrate the relevance of economic analysis to areas of law which are sharply divergent from traditional economic objectives. Chapter eight, entitled “Protecting the Disadvantaged”, deals with distributional justice and paternalism (the law overriding autonomous individual choice) as legal goals. In relation to the first, I show how the design of appropriate legal instruments must be sensitive to the predictions 33

(B) Ogus Ch1

20/2/06

16:33

Page 34

Setting the Scene

made by positive economic analysis; and, in relation to the second, I draw on “behavioural law and economics” for guidelines as to when a paternalist intervention might be appropriate. In chapter nine, and not just by way of light relief, I view the practice of professional legal work from an economic perspective. In part, this covers the relatively familiar and specific questions of the way lawyers are paid; in part, it strays into larger issues, providing an economic interpretation of the complexity of the law and the peculiarities of legal culture. Finally, in chapter ten, I draw together some of the principal strands of the book by exploring how economic reasoning has been, and can be, used in relation to legal policy-making. That includes most obviously the use of cost-benefit analysis by government departments. It deals also with more controversial questions, for example, the extent to which law reform agencies, such as the Law Commission, should articulate and work to, economic objectives; so, too, though the arguments are strikingly different, in relation to judicial reasoning and decision-making. The chapter reassuringly records how, in Britain, there have been signs of the readier acceptance of economics within legal and law-making circles, but that will have to be countered by one of my most poignant cautionary tales . . .99

99

34

Below, 279–80.

(C) Ogus Ch2

23/3/06

16:02

Page 35

2 Law and Wealth Creation

Introduction: Lawyers as Designers and Disputants During my early years as a law lecturer, I was confronted by a senior, and somewhat intimidating, mathematician who sought to belittle the legal profession, and hence my vocation. “They are mere parasites” he confidently told me, “making money out of other people’s troubles.” I murmured something to the effect that doctors do the same, but was silenced by the retort that “they make people better; who ever heard of lawyers making people better?” Motivated as I was, at that stage of my career, by conceptions of lawyers as champions for the weak, I should at least have held my own by arguing that lawyers help to protect individuals against injustice and wrongdoing, in many cases securing compensation for them. Today I recognise that I could have taken the upper hand by the assertion that law and lawyers play a key role in the entrepreneurial economy, and thus in the creation of wealth. Understandably, the public image of law and lawyers is dominated by the ex post function, the resolution of disputes, since it is typically only when things go wrong that many individuals think about the law; and the attention of the media is captured by the same phenomena. Indeed, the problem of this skewed vision applies not only to the laity: some lawyers derive their knowledge and understanding of the law primarily from the law reports which necessarily largely arise from the existence of disputes. Now, if this perception of law and lawyers represents reality, my mathematician’s comment would seem to have some force. The argument would go something like the following: the existence of the dispute adds nothing to social wealth and, 35

(C) Ogus Ch2

23/3/06

16:02

Page 36

Law and Wealth Creation

though its resolution may reduce the cost of human interaction, it is typically concerned with determining whether a given asset should accrue to one or other of the disputing parties. The resources spent in relation to the dispute are thus largely a deadweight cost to society, in the sense that the expenditure does not add to the aggregate wealth of society. As we will see in chapter nine,1 it should certainly not be assumed that all professional legal activity is conducive to general economic welfare. Nevertheless, at this stage it is important to challenge both the vision of lawyers primarily as disputants and the assertion that such activity is a deadweight cost.2 The bread and butter of the everyday practice of most lawyers consists in the drafting of documents—contracts, wills, company articles and so on—in order to avoid disputes and that is true also of much of the law. Individuals engage in such transactions in order to enhance private utility and wealth. To secure the intended outcome it is usually necessary to create obligations and incentives for those involved in the activity. The law provides the material for this purpose; and lawyers help to fashion it to the desired end and therefore play a key role in the generation of utility and wealth. With good reason, they have been characterised as “transaction cost engineers.”3 What then of their function in relation to disputes? Certainly it is not directly facilitative of socially valuable enterprise, as when applied to the drafting of a will or a contract. However, it is not entirely a deadweight cost.4 The legal fabric required to 1

Below, 256–70. Cf A Ogus, “Lawyers as Designers or Disputants? Some Observations on the Economics of Civil Justice” in J Godard and D Guild (eds), Justice and Money, Hume Papers on Public Policy, vol 7(1) (Edinburgh, Edinburgh University Press, 1999), 28–37. 3 RJ Gilson, “Lawyers as Transaction Cost Engineers” in P Newman (ed), The New Palgrave Dictionary of Economics and the Law (London, Macmillan, 1998), vol 2, 508. See also H Collins, Regulating Contracts (Oxford, Oxford University Press, 1999), 149–53. 4 GL Priest, “Lawyers, Liability and Law Reform: Effects on American Economic Growth and Trade Competitiveness” (1993) 71 Denver University Law Review 115. 2

36

(C) Ogus Ch2

23/3/06

16:02

Page 37

Law and Wealth Creation

achieve desired outcomes includes not only the creation of obligations and other incentives but also their implementation. Thus, if the legal cost of drafting a contract is £x and that of enforcing it is £y, the potential contractor should attribute to the transaction an ex ante legal cost of £(x + py), where p represents the probability of enforcement costs having to be incurred. So also with the enforcement of rights, such as those in tort law, which do not result from voluntary transactions, even though here the legal intervention is only ex post. If, as I shall argue below, such rights operate to generate utility and wealth, then the cost of enforcing them is part of the price to be paid for the beneficial consequences. It is, then, reasonable to assume that much of law, and of the work of lawyers, has an economic function and a significant part of this book is concerned with exploring the function in greater depth. In this chapter, we explore a relatively straightforward and uncontroversial dimension, that in which law is used as a device to augment personal wealth. We are dealing, in other words, with the limited notion of productive efficiency which, as we saw in the last chapter,5 indicates—in relation to a given firm or individual—the highest ratio of output to input, or benefits over costs. The proposition has no necessary normative implications, since the maximisation of wealth of one individual or firm tells us nothing about what is desirable for society as a whole. Nevertheless, its importance is not to be underestimated. This is because, in the first place, the analysis provides us with important information on how law may be used to generate wealth. Secondly, to the extent that particular legal principles succeed in enhancing productive efficiency, we can predict that there will be a demand for their use by individuals and firms and this may lead us to an explanation of why law in this form came to be adopted. To illustrate how legal principles provide devices for wealth generation, I have selected three different areas of general private law: property rights; organisational forms and default rules. 5

Above, 26–7.

37

(C) Ogus Ch2

23/3/06

16:02

Page 38

Law and Wealth Creation

Property Rights Focusing on the bundle of core rights which are comprised in the concept of property6—the rights to consumption, use, control, exclusion (of others) and alienation—we can without difficulty perceive how it facilitates increases to individual wealth. Take, first, some simple productive activity, such as the growing of crops. A farmer has little incentive to realise the development potential of land, if someone else can take the fruits of his labour without his consent. Obviously too, property rights are essential for beneficial trade: if he wants to exchange some of his surplus crops for some of the dairymaid’s surplus milk, each of them wants to exclude third parties from what they receive. Residual Entitlement The fact that a single owner alone enjoys the residual profits and alone incurs the residual costs arising from the property has important implications for value enhancement. If I own a house, I am motivated to take care of it and thus maximise its capital value, since in the long term I will either benefit myself directly, in terms of enhanced quality, or else I will be able to secure a higher price on an eventual sale. Compare my situation with that of a tenant who has a leasehold interest in the property only for 10 years. She will be motivated to extract the maximum shortterm gain from the property, knowing that any longer-term costs arising from her activity will fall not on her but on the individual with the residual estate. The problem of concurrent interests is essentially the same as when interests are held in succession and is exacerbated in relation to depletable resources. Thus if all within a community are allowed freely to hunt within a given territory—the resource is held in common—each individual hunter will be aware that he 6 For other incidents, see AM Honoré, “Ownership” in A Guest (ed), Oxford Essays in Jurisprudence (Oxford, Oxford University Press, 1961), ch 5.

38

(C) Ogus Ch2

23/3/06

16:02

Page 39

Law and Wealth Creation

alone will benefit from what he captures, while the cost of the longer-term consequences—the depletion of the resource—will be shared by all the community. In his paper on the “Tragedy of the Commons,” Hardin famously generalised from this example: individuals matching private benefits to private costs rather than social costs will make decisions harmful for future generations.7 As Demsetz demonstrated, in an equally famous paper,8 creating individual property rights out of the common territory enables the private and social costs to be equated and thus provides a solution. Give the chief, or someone else, the right to exclude others from the hunting territory and the longer-term value of the asset will be assured, on the assumption that she will wish to maximise that value for the purpose either of eventual sale or to benefit her successors in title. While reserving the attributes of ownership to a single individual may thus serve to enhance wealth, they are not costless. Most obviously, resources must be spent on formulating the rules and enforcing them and the costs may exceed the benefits to be acquired. In the hunting example, the benefits of individual ownership arise essentially because of the scarcity and natural depletion of the resource; if there is adequate game to meet the hunters’ needs, the cost of the property system may not be justified. But that might not be the case if the property rights are cheap to ascertain or to enforce. For example, the invention of barbed wire in the second half of the 19th century reduced the cost of controlling straying cattle and, since property rights were now cheaper to enforce, in many cases this tipped the balance in favour of private ownership in the American West.9 Another illustration of how property rights developed to reflect changes in the cost and benefit variables10 is to be found 7

G Hardin, “The Tragedy of the Commons” (1968) 162 Science 1243. H Demsetz, “Towards a Theory of Property Rights” (1967) 57 American Economic Review (Papers and Proceedings) 347. 9 L Anderson and PJ Hill, “The Evolution of Property Rights: a Study of the American West” (1975) 18 Journal of Law and Economics 163. 10 On which see, more, generally, T Eggertsson, Economic Behaviour and Institutions (Cambridge, Cambridge University Press, 1990), ch 8. 8

39

(C) Ogus Ch2

23/3/06

16:02

Page 40

Law and Wealth Creation

in the history of English community land use.11 In the medieval period, the arable land, generally comprising small parcels owned by individuals, and the land for grazing, which was common land, were used predominantly to supply the local community. Although the common land created incentives for over-use, collective controls within the village community by limiting the number of animals per inhabitant were relatively cheap to administer. Changes occurred with the growth of markets and in consequence with production to meet demand for agricultural products from outside the community. The search for comparative cost advantage led to specialisation in agricultural production; and that in turn to the enclosure of common land and to the amalgamation of smaller holdings. The development enhanced the economic benefit of private property rights because the larger the landholding, the cheaper—relative to collective decision-making—were the creation and enforcement of individual property rights. Limited Interests in Land Conferring exclusive property rights on a single individual has costs other than rule-formulation and enforcement. It forecloses on the possibility of granting limited interests in the assets, which may itself enhance productivity.12 I, as landowner of Blackacre, may have entrepreneurial skills and in that capacity acquire information as to what use (for example, agriculture) will maximise its value, both short term and long term. But I may not have the skills in the relevant use and those who do possess them may lack the capital resources to purchase the land. The productivity13 of the land is then enhanced if a 11 CJ Dahlman, The Open Field System and Beyond: Property Rights Analysis of an Economic Institution (Cambridge, Cambridge University Press, 1980). 12 JE Stake, “Decomposition of Property Rights” in B Bouckaert and G De Geest (eds), Encyclopedia of Law and Economics, vol II, Civil Law and Economics (Cheltenham, Edward Elgar, 2000), 32–61. 13 It may also be to our mutual advantage to use this device to share in risktaking: SNS Cheung, “Private Property Rights and Sharecropping” (1968) 76 Journal of Political Economy 1107.

40

(C) Ogus Ch2

23/3/06

16:02

Page 41

Law and Wealth Creation

tenant-farmer is given some short-term property interest, with myself as residual owner. The challenge in cases of joint or successive interests in property—as we shall see14 the same issue arises in relation to corporations and other organisations—for the law is to deal with what we have seen to be the “tragedy of the commons,” the incentive on individuals to extract personal, short-term gains which harm the aggregate, longer-term value to all those with a current or future interest in the property. One obvious tool for the purpose is a contract between the owner and those with the joint or lesser interest, constraining any such undesirable activity. But the transaction costs of this solution may be substantial, particularly where there is an important timedimension, for example, where the arrangement extends over a generation. Let us briefly examine some alternative property devices. The common law doctrine of waste prevented a life tenant from causing permanent and serious harm to those inheriting land.15 This might arise, for example, where the tenant changed the land use, reducing, rather than enhancing, its capital value. The doctrine thus constrained over-use, but did nothing to encourage longer-term investment. Why should the life tenant seek to enhance the capital value of the property, the fruits of which would be enjoyed only by those with residual interests? A modern, legislative solution is to give the tenant certain rights to purchase the residual, freehold estate.16 Another has been to enable the tenant to sell the land, converting the property rights of those residually entitled from interests in the land itself to interests in the proceeds of the sale.17 The legal device used for this conversion, the trust, has proved in a number of 14

Below, 47–56. Jones v Chappell (1875) LR 20 Eq 539. 16 See Landlord and Tenant Act 1987. 17 FH Lawson and B Rudden, The Law of Property, 2nd edn, (Oxford, Clarendon Press, 1982), ch 12. 15

41

(C) Ogus Ch2

23/3/06

16:02

Page 42

Law and Wealth Creation

contexts to be a vital instrument for alleviating the tragedy of the commons.18 When property is held on trust, productive efficiency is induced by the principle that trustees, in exercising their supervisory powers, must act impartially between beneficiaries with interests in income and those with interests in capital. In terms both of investment and management and in default of more specific responsibilities, the trustee should aim at a reasonable balance between maximising income yield and increasing capital value.19 A comparable situation is that of concurrent interests.20 If Blackacre is shared by my nephew and niece, it will normally have a greater value as a single parcel of land than as two separate portions and, unsurprisingly, English law does not allow one co-owner to force on others severance of individual portions of the land. The question whether or not a co-owner should be able to force a sale of the whole parcel, with others having a share in the proceeds of the sale, is however more delicate.21 An unlimited power creates a disincentive to invest resources which are not easily transferable to alternative uses, should the property be sold. On the other hand, major constraints on the power might themselves discourage capital-enhancement projects, because investors might wish to know how and when the assets may be sold. Again English law uses primarily the trust to deal with the dilemma. Trustees, by exercising their power, not only of sale but also of controlling use and occupation,22 can help to provide a satisfactory compromise, since they are bound by their

18 A Ogus, “The Trust as Governance Structure” (1986) 36 University of Toronto Law Journal 186. 19 Re Pauling’s Settlement Trusts (No 2) [1963] Ch 576, 585, per Wilberforce J. 20 ME Tracht, “Co-Ownership and Condominium” in Bouckaert and De Geest, above n 12, vol 2, 62–89. 21 Ogus, above n 18, 193. 22 Under the Trusts of Land and Appointment of Trustees Act 1996, on which see MP Thompson, Modern Land Law, 2nd edn (Oxford, Oxford University Press, 2003), 301–13.

42

(C) Ogus Ch2

23/3/06

16:02

Page 43

Law and Wealth Creation

fiduciary duty to safeguard the interests of all beneficiaries.23 Those powers have, then, to be exercised reasonably which, in many instances, will amount to maximising the aggregate value of the land, in the light of its declared objectives. Disputed Entitlements There are situations in which two (or more) individuals have a plausible claim over a resource and the law must determine which is to prevail. Moral philosophy has played a powerful role in addressing these entitlement issues, for example, in relation to “natural” property rights in an individual’s body or in the fruits of her labour.24 But arguments drawn from this source are sometimes ambivalent or open to challenge. The economic criterion of which allocation of entitlement serves to maximise wealth can in such circumstances provide alternative, helpful guidance on how the property right should be defined. To illustrate this, I consider two entitlement dilemmas arising from simple factual situations, but generating much legal debate. Finder versus Occupier

The first is drawn from the case of Parker v British Airways Board 25 in which a traveller found a valuable bracelet in an airport lounge. The true owner was never discovered and the contest was between the finder and the airline (as occupier of the airport lounge). The Court of Appeal held: 1. that the land occupier had better title in relation to chattels attached to, or in, the land; but 2. that the finder had better title to chattels on, and unattached to, the land, provided that the individual was not a trespasser 23 The trustees may themselves be beneficiairies, but the ultimate power of decision-making lies in the court which, on an application by any interested party, may wield the same power as the trustees: Trusts of Land and Appointment of Trustees Act 1996, ss 14–15. 24 JW Harris, Property and Justice, (Oxford, Oxford University Press, 1996), esp ch 11. 25 [1982] 1 All ER 834.

43

(C) Ogus Ch2

23/3/06

16:02

Page 44

Law and Wealth Creation

and that the land occupier had not manifested an intention to exercise control over things on the land. Now moral considerations seem to play an influential role in relation to (1) since, to acquire possession of the chattel, the finder would normally have to interfere with the land in some way.26 But as regards (2), in moral terms, the claims of the traveller seem to be neither more nor less worthy than those of the airline. What then of economics? We may start with the assumption that the true owner is likely to have a subjective value for the chattel which is equal to, or exceeds, that of other individuals. We can move from that to a second proposition, that the value can be enhanced by a rule which, should the object be lost, creates the best incentive for it to be returned to the true owner. This second proposition could lead, as counsel for the airline suggested,27 to a rule in favour of the occupier of land, because the loser of an article is likely to make inquiries first at the place of the loss. The problem with that rule, as Donaldson LJ observed, is that it would create disincentives for finders to reveal their findings: [T]hey would be tempted to pass by without taking any action or to become concealed keepers of articles which they found.28

The view of the judge seems preferable and can be supported by a little arithmetic reasoning. If, contrary to the ruling in the Parker case, the superior title is in the occupier, the finder has no incentive to hand in the object. He will keep it if the value to him of the object (V ) exceeds the cost to him of keeping the object. That cost may be calculated by reference to the adverse consequences (D) resulting from being apprehended—for example, a prosecution for theft—discounted by the likelihood (p) of being apprehended, 26 Waverley BC v Fletcher [1995] 4 All ER 756, 764, per Auld LJ; C MacMillan, “Finders Keepers, Losers Weepers—But Who are the Losers?” (1995) 58 Modern Law Review 101. 27 Above n 25, 842. 28 Ibid.

44

(C) Ogus Ch2

23/3/06

16:02

Page 45

Law and Wealth Creation

thus pD. We can express p as being a proportion of 1, where 1 represents certainty (thus a one in five chance is 0.2). So, if there is a one in five chance of being apprehended and the finder’s consequent costs are £100, pD is 0.2 ⫻ £100 = £20. If the Parker ruling applies and the finder has superior title to the occupier, the benefit of keeping the object remains V – pD. However, there is also a benefit to be derived from handing in the object. This is V, but that benefit accrues only if the true owner does not claim the object. If the latter contingency is represented by q, the benefit of handing the thing in is therefore qV; and rationally the finder will hand the object in if qV is greater than V – C. Now the value to be given to these variables will differ according to the circumstances, but it is reasonable to assume that in most cases qV will be sufficiently high to motivate the hand-in option under the Parker regime. In any event, if the alternative entitlement is adopted, the real owner’s prospects depend on the occupier (or her employees) finding the object. We can thus reach the tentative conclusion that because the Parker rule creates the better chance of the object being returned to its owner, it adds to the wealth of property-holders. Owner versus bona-fide purchaser29

The second situation may arise in related circumstances, familiar to all law students. One individual purchases a chattel from someone who does not have a good title, perhaps because he is a thief. The true owner seeks return of the thing from the purchaser. Again we have a contest between the claims of two apparently innocent people and again, assuming neither to be at fault, moral considerations do not clearly indicate a solution to the entitlement issue.30 And different rules apply in different 29 This section draws on A Ogus, “What Legal Scholars Can Learn From Law and Economics” (2004) 79 Chicago-Kent Law Review 383, 394–5. 30 In Ingram v Little [1961] 1 QB 31, 73, Devlin LJ proposed that the loss should be apportioned between the parties according to the degree of their respective blameworthiness. The suggestion was not endorsed by the Law Reform Committee: Twelfth Report: Transfer of Title to Chattels (Cmnd 2598, 1966).

45

(C) Ogus Ch2

23/3/06

16:02

Page 46

Law and Wealth Creation

jurisdictions: English law, in general, protects the original owner31; in France a bona fide purchaser typically has better title.32 But through reasoning similar to that used for the Parker case, we can attempt to compare the rules from a wealthmaximising perspective.33 Take the case of the purchase of a jewel. I am willing to pay for it U – pL – qM, where U represents the value to me of the jewel, pL any losses (L) resulting from the risk (p) of the seller not having good title to pass; and qM the losses (M) resulting from the risk (q) that, after purchase, the jewel will be lost or stolen and eventually bought by a third party. As summarised in Table 1, we can expect that in France, pL will be trivial because I am a bona fide purchaser; but qM may give rise to significant losses if the risk materialises, because the third party bona fide purchaser will have superior title to mine. The reverse is true under the traditional English approach and pL will there be the significant risk. Of course, in both jurisdictions, it will make sense for me to take steps to reduce the risks, if the cost of doing so is less than the benefit. In France, this cost (Cf) will be that of my taking care to prevent loss or theft; in England it will be Ce, the cost of making inquiries into the title held by the person who sells it to me. Table 1 principal risk

cheapest risk avoidance method

French law

pL

owner takes care at cost Cf

English law

qM

purchaser investigates title at cost Ce

31 Sale of Goods Act 1979, s 2(1). For exceptions, see R Goode, Commercial Law, 2nd edn (London, Penguin, 1995), 452–85. 32 Code Civil, art 2279(1) and see A Ogus et M Faure, L’Economie du Droit: le Cas Français (Paris, Editions Pantheon-Assas, 2002), 56. 33 Cf R Cooter and T Ulen, Law and Economics, 4th edn, (Boston, AddisonWesley, 2004), 152–4.

46

(C) Ogus Ch2

23/3/06

16:02

Page 47

Law and Wealth Creation

If the aim is to maximise the value of the jewel to the purchaser (U – pL – qM), then, assuming that pL is approximately equivalent to qM,34 we need a law which induces the cheaper of the avoidance methods, Cf or Ce. This will vary according to the circumstances, but in most cases intuition suggests that investigating title will be more expensive than taking care.35 If that is the case, the jewel will have a greater value under the French rule than under the English rule.

Business Organisational Forms In general, and up to a certain point, there are economies of scale in commercial and industrial activity: the joint output of a number of agents typically exceeds the sum of their output if operating individually. A number of legal forms are available to govern the activity of the organisation and here I explore how different combinations of property and contractual arrangements can be designed to maximise output. Legal forms of organisation, it has been said, are like ready to wear clothes: if they fit well, they can be worn without alteration, or they can be modified until they fit better. With the right legal craftsmanship or tailoring, any form can be modified to suit the needs of any group of clients.36

For our present purpose, the crucial dimension of legal rights and obligations is how they can create incentives for productive effort. 34 This might not be the case. See WM Landes and RA Posner, “The Economics of Legal Disputes over the Ownership of Works of Art and Other Collectibles”, in V Ginsburgh and P-M Menger (eds), Economics of the Arts: Selected Essays (Amsterdam, Elsevier, 1996), 177 (noting that the French rule increases the value of the stolen item to the thief and thus also the probability of theft and the owner’s protection costs). 35 The possibility of insuring against the risk should not affect the analysis, because the insurance contract and the premium paid should induce taking action to avoid the risk, if that is cheaper. 36 R Hessen, “The Modern Corporation and Private Property: a Reappraisal” (1983) 26 Journal of Law and Economics 273, 283.

47

(C) Ogus Ch2

23/3/06

16:02

Page 48

Law and Wealth Creation

Market Contracting At its simplest, it is possible to achieve the desired outcome by appropriately drafted contractual obligations. Take an individual, with entrepreneurial skills, who develops an idea for supplying the market with a new product. She can purchase on the market such materials and labour as are necessary, the quantity and quality being specified in the contracts. The entrepreneuse, as residual owner, and therefore sole recipient of the net benefits of the business, certainly has the incentive to maximise profits. But will the contractual obligations be adequate to ensure that she can get the best out of the other inputs? There are at least three potential problematic set of costs which arise: information; contract specification; and monitoring. Take, first, information. Compared with the input supplier, the entrepreneuse may be at a disadvantage as to knowledge of what will constitute, for her, optimal quality and quantity, and therefore what needs to be specified in the contract. Then, even if the information is available, it may be difficult, at low cost, to translate it into enforceable contractual obligations capable of generating the desired outcome (by way of illustration, consider the difficulties of formulating in succinct contractual terms what is expected of a hairdresser). Finally, even if meaningfully specific contractual obligations can be devised, it may be impossible, at low cost, for the behaviour of the input supplier to be monitored by the entrepreneuse to ensure adequate compliance. It would be a mistake to exaggerate these problems because they are a regular feature of ordinary market transactions and the market itself is often able to mitigate the costs. If there is competition between suppliers, most of them will have an incentive to establish and maintain their reputation37 and that should enable either party to terminate the relationship at relatively low cost and, in consequence, constrain the opportunistic possibilities for 37 But obviously not where suppliers seek to make a quick profit from the market and then disappear or become insolvent: see J Boyd and DE Ingberman, “Fly by Night or Face the Music? Premature Dissolution and the Desirability of Extended Liability” (2003) 5 American Journal of Law and Economics 189.

48

(C) Ogus Ch2

23/3/06

16:02

Page 49

Law and Wealth Creation

exploitation created by the three problems. To deal with situations where the market is less adept at performing this role, there are alternative legal arrangements38 which seek to reduce the transactions costs of simple contracting. Relational Contracting The first of these can be envisaged as a hybrid, something between a contractual and a property relationship. “Relational contracting”, as it is known in the literature,39 remains within the legal category of “contract”, but has the special characteristics of involving a long-term relationship, in which the two parties seek to cooperate, rather than remain entirely autonomous and thus potentially and mutually exploitative. One party (the input supplier) is bound to the other (the entrepreneuse) by general, rather than specific, obligations. Examples include a duty of loyalty and an undertaking to make best efforts to reach a certain outcome. To cement the relationship there may be some form of bonding and the input supplier may be entitled to a share in the residual profits. Employment contracts (in traditional legal terminology, a contract of service as opposed to a contract for services—a “one-off” relationship with an independent contractor) are typically relational contracts, as are franchises. The problematic features of market contracting are here overcome by, in the employment case, the authority and power of control and dismissal which the employer exerts over the employee40 and, in the franchise case, by the realignment of incentives consequent upon the franchisee’s becoming entitled to residual profits, on payment of a fee and royalties.41 38 I here consider only private legal forms. The problems may also be used to justify regulatory interventions: cf A Ogus, Regulation: Legal Form and Economic Theory (Oxford, Hart Publishing, 2004), 38–42. 39 IR Macneil, “Contracts: Adjustments of Long-Term Economic Relations under Classical, Neo-Classical and Relational Contract Law” (1978) 72 Northwestern University Law Review 854. 40 JM Malcomson, “Work Incentives, Hierarchy, and Internal Labor Markets” (1984) 92 Journal of Political Economy 486. 41 AW Dnes, “A Case-Study Analysis of Franchise Contracts” (1993) 22 Journal of Legal Studies 367.

49

(C) Ogus Ch2

23/3/06

16:02

Page 50

Law and Wealth Creation

Nevertheless, these legal arrangements generate their own costs. Of course, the initial set-up costs are higher than those incurred in simple market transactions. More important, the locking-in of the input supplier to the entrepreneuse may generate significant opportunity costs—the foregone profits from alternative transactions—and may entail heavy bargaining costs. Being locked in, the parties are effectively in a bilateral monopoly situation, each able to threaten to impose on the other the heavy costs arising from termination of the relationship. We can, then, predict that relational contracting will be preferred only when these set of costs are lower than the three set of costs associated with market transactions. Clearly, the fulfilment of this condition will depend much on the circumstances, but two variables are likely to be particularly significant in influencing adoption of relational contracting.42 Obviously, the more frequent the dealing between the input supplier and the entrepreneuse, the more easily can the costs be contained within a longer-term relationship. Then there is the complexity of specifying and monitoring the quality of performance. As this variable increases, a consequence inter alia of uncertainty affecting the business, so it becomes cheaper to manage the relationship through general, rather than specific, obligations. Integration The second alternative to market contracting is for the supplier and the entrepreneuse to integrate their legal personalities into some form of joint property-holding organisation. As we shall see, a number of options are available (for example, a partnership or a company) offering different productivity-enhancing incentives for different circumstances. But, whichever option is taken, it is evident that the set-up and “lock-in” costs will generally be higher than those associated with relational contracts, because there is a greater degree of mutual commitment and, as a consequence of increased complexity of legal arrangements, 42 OE Williamson, The Economic Institutions of Capitalism (New York, Free Press, 1985), 71–80.

50

(C) Ogus Ch2

23/3/06

16:02

Page 51

Law and Wealth Creation

significantly higher “exit” costs. It follows that, to justify this solution, the savings on the transactions costs arising from ordinary market contracts must be even larger than those leading to relational contracts. It may be that when the size of the two identified variables, frequency of transactions and complexity of specifying and monitoring quality, becomes particularly large, legal organisations become cheaper than relational contracts. Another possibility is the existence of an additional variable, that of transaction-specific investment.43 When, for the purpose of meeting the entrepreneuse’s demand, the input-supplier has to tailor the product or service to particular specifications and, as a result, the product or service has little or no value in other uses, then uncertainty and any divergence of interest between supplier and entrepreneuse may render the relationship even more problematic in terms of transactions costs. Integration enables adaptations to the original specifications to be made without the need to revise the agreement (market transactions) or interpret and apply general obligation clauses (relational contracts) and thus engenders very significant cost savings. Principal Organisational Forms We may readily recognise that, in a given set of circumstances, there are cost advantages in input suppliers amalgamating with the entrepreneuse to form a single legal entity, but there is the further issue of which legal form to adopt. This too becomes an issue of setting appropriate incentive structures to maximise productive efficiency.44 Let us briefly examine the main45 possibilities.

43

Ibid, 52–6. MC Jensen and WH Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure” (1976) 3 Journal of Financial Economics 305; EF Fama and MC Jensen, “Agency Problems and Residual Claims” (1983) 26 Journal of Law and Economics 327. 45 There are many permutations of the basic forms. See HB Hansmann, The Ownership of Enterprise (Cambridge, Mass, Harvard University Press, 1996). 44

51

(C) Ogus Ch2

23/3/06

16:02

Page 52

Law and Wealth Creation

Owner-manager Firm

A single individual is residual owner of the firm and also manages a team of workers. No doubt in many cases the structure results from an entrepreneur hiring a team. But we can also envisage a group of input suppliers recognising that, while there are productive advantages in a joint venture, there is the problem of shirking if they all share in ownership (the “tragedy of the commons” again).46 Therefore they decide that one of them is to be granted managerial authority to monitor and control the others. Since there is no one to manage the manager, it makes sense to make her the residual owner, since she will then be motivated to maximise profits. With such a system in place, there are then productive efficiency incentives operating on both the team and the manager.47 Nevertheless, the organisational form is generally appropriate only for small-scale operations. This is obviously because, as the enterprise becomes larger, management for the owner becomes more costly. Also, since capital investment is more expensive to raise externally,48 the size of the owner-manager’s own wealth constrains expansion. And what an individual, however rich, is prepared to invest into a single enterprise is typically limited because most prefer to diversify risk. Partnership

It follows that, beyond a certain threshold, growth is cheaper by admitting more owner-managers, that is partners, whose share in residual profits is determined by the proportion of their input to the firm’s capital. But this of course leads us straight back into the problems of joint ownership and therefore this form of organisation is likely to be productively efficient only where the scale remains small, so that mutual monitoring by the partners 46

Above, text accompanying n 7. AA Alchian and H Demsetz, “Production, Information Costs, and Economic Organization” (1972) 62 American Economic Review 777. 48 Without an interest in the firm, lenders have high information costs: HB Hansmann, “Ownership of the Firm” (1988) 4 Journal of Law, Economics and Organization 267, 282. 47

52

(C) Ogus Ch2

23/3/06

16:02

Page 53

Law and Wealth Creation

is relatively cheap. The prediction may carry less weight in relation to professional partnerships (for example, firms of architects or lawyers) which are often large, since professional ethics or internal systems of mutual performance evaluation may constrain the possibilities for opportunistic behaviour which arise in this context.49 In any event, since 2000, it has been possible in Britain, as in many other jurisdictions,50 to create limited liability partnerships,51 with the consequence that the personal wealth of individual partners need no longer be jeopardised by the failings of other partners.52 Private Company with Limited Liability

A limited liability private company is, in many respects, similar to a limited liability partnership, but the expectation is here that some of the residual owners will play no part in management. The existence of limited liability may encourage investment and facilitate the raising of capital by such individuals, but the cost to non-active shareholders of information as to productivity is high and they therefore are unlikely to observe and influence managerial performance. Also the fact that the shares are not publicly traded means that entering and leaving the company is a costly business, not the least because the shares have no market value. This organisational form is then most likely to be adopted where the non-active shareholders are related to the owner-manager by ties of family or friendship. Public Company with Limited Liability

This is, of course, the most frequently adopted organisational form for large business. As with private companies, limited liability facilitates capital investment, enabling individuals to diversify 49

Eggertsson, above n 10, 180–1. See WJ Carney, “Limited Liability” in Bouckaert and De Geest, above n 12, vol 3, 660–7. 51 Limited Liability Partnerships Act 2000. 52 For an economic analysis of limited liablity partnerships, see LE Ribstein, “An Applied Theory of Limited Partnership” (1988) 37 Emory Law Journal 837. 50

53

(C) Ogus Ch2

23/3/06

16:02

Page 54

Law and Wealth Creation

their share holdings in enterprises with varying risk characteristics. The critical difference is that the shares are publicly traded. This can be seen to enhance productive efficiency in three different ways. First, and most obviously, it reduces the cost of shares transactions. Secondly, capital markets are able to play an important role in generating incentives for productive effort.53 The market price for the company’s shares will reflect what wellinformed experts judge to be its performance, relative to its potential. Low productivity will thus cause a fall in the price of the shares and render the firm vulnerable to take-over by another organisation which may oust those responsible. Thirdly, and for similar reasons, public trading in shares provides opportunities for friction among the shareholders to be overcome.54 If the market judges a particular project to be efficient, this will be reflected in the share price. If the company were private, a shareholder who was averse to the particular project would be motivated to attempt to block it; in the case of a public company she can, without loss, move her capital to an enterprise whose projects better meet her preferences. Other Ownership Arrangements This brief excursion into the forms of organisation most frequently used suggests that productive efficiency exerts a considerable influence on legal arrangements and in particular the allocation of rights of ownership. Critics have claimed that other values ought to hold sway, arguing in particular that there are precepts of justice or fairness which ought to impact on how issues of ownership and control are decided.55 What may not always be appreciated, and what the economic analysis demonstrates, is that entitlements devised to meet these goals may serve the interests of those intended to be protected less well 53 HG Manne, “Our Two Corporate Systems: Law and Economics” (1969) 53 Virginia Law Review 259. 54 EF Fama and MC Jensen, “Organizational Forms and Investment Decisions” (1985) 14 Journal of Financial Economics 101. 55 A number of such arguments are summarised in J Dine, The Governance of Corporate Groups (Cambridge, Cambridge University Press, 2000).

54

(C) Ogus Ch2

23/3/06

16:02

Page 55

Law and Wealth Creation

than other entitlements, at least in some circumstances. Here I examine the arguments in relation to two groups of potential owners, employees and consumers. The notion that one has a “natural” right to the product of one’s labour has deep roots in moral and political philosophy56 and has led to arguments that employees should have property rights in the output of creative activity undertaken for an employer57 and some mandatory share in the ownership of the firm for which they work.58 If the reasoning continues on the basis that the assignment of ownership is, in part at least, a response to the costs of contracting, then both entitlements have productivity advantages insofar as they generate incentives for creativity and effort; and this can be related to the more general economic proposition that, “if more than one party invests in skills specific to an asset, the asset should be owned by the party whose investment is more important (in terms of generation of surplus).”59 But care must be taken in determining what is “more important.” Although it may be consistent with intuitions, there are no a priori reasons for assuming that technical or creative skills are, for this purpose, “more important” than managerial or financial skills; indeed, there are powerful arguments to the contrary. When deciding which member of an enterprise should be given the residual role of owner, and have managerial control over the others, costs may be reduced by selecting that person whose output it is most difficult, and therefore most expensive, to quantify and monitor.60 Secondly, any 56

Harris, above n 24, ch 11. Eg S Cherensky, “A Penny for Their Thoughts: Employee-Inventors, Preinvention Assignment Agreements, Property and Personhood” (1993) 81 California Law Review 595. 58 Eg JW Singer, “Jobs and Justice: Rethinking the Stakeholder Debate” (1993) 43 University of Toronto Law Journal 475; and, for more general discussion, H Hansmann, “When Does Worker Ownership Work? ESOPs, Law Firms, Codetermination, and Economic Democracy” (1990) 99 Yale Law Journal 1749. 59 O Hart, “Residual Rights of Control” in Newman, above n 3, vol 3, 332. 60 Y Barzel, “The Entrepreneur’s Reward for Self-Policing” (1987) 25 Economic Inquiry 103. 57

55

(C) Ogus Ch2

23/3/06

16:02

Page 56

Law and Wealth Creation

other productivity advantages that employee-ownership may bring are likely to be outweighed by the ability of others to raise and invest capital in the enterprise and to bear the risks of failure, at least in industries which are capital-intensive. Finally, account should be taken of the costs of decision-making by those owning an enterprise. The more heterogeneous the body of shareholders, the more these costs are likely to increase. This suggests that, while confining shareholding to a single group, be it of capital investors or of employees, may be unproblematic, mixing the groups will hinder productive efficiency. The arguments in relation to consumer ownership are not dissimilar. If, according to some consumerist theorists,61 purchasers of products and services are highly disadvantaged by the trading practices of suppliers, why not ensure that their interests are reflected in the ownership of enterprises? And is this not consistent with the notion of reducing the costs of contracting? It may be, but the savings on the costs must be considerable in order to outweigh the costs arising from this form of ownership. In general, consumers are not good residual risk-bearers and they are too distant from the firm and too diverse to be able to control managers. Consumer-owned enterprises, unsurprisingly, are not frequently encountered. It is true that they are to be found in the finance industry, prominent examples being mutual savings banks and mutual life insurance companies. It may be that the ability of customers to withdraw at low cost their residual claims from an organisation, if its performance is disappointing, exerts some degree of control over managers62 and thus serves to enhance productivity. But, except where the nonprofit motive prevails, there has been a very significant decline in the popularity of mutually owned financial organisations63 and this analysis may provide an explanation. 61 RE Hall, The Rational Consumer: Theory and Evidence (Cambridge, Mass, MIT Press, 1990). 62 Fama and Jensen, above n 44, 337–9. 63 See HC Select Committee on the Treasury, Ninth Report: Demutualisation (1999).

56

(C) Ogus Ch2

23/3/06

16:02

Page 57

Law and Wealth Creation

Default Rules Contracts If the choice of legal organisational form has a major impact on productive efficiency, then, even more obviously, so do the terms of individual contracts. While the existence of a contract implies the pursuit of mutual gain, careful choice in the rights and obligations specified can maximise that gain. We need not here go into the huge variety of incentive devices which can be used for that purpose, including, for example, different reward systems in employment contracts to enhance productivity64 and different risk-allocation procedures to deal with contingencies and uncertainty.65 Lawyers play a key role in finding low-cost solutions, but so also does the law itself through the medium of default rules. Default rules provide a set of terms which are incorporated into different types of contracts unless the parties indicate otherwise. They should therefore be distinguished from mandatory terms which the parties cannot vary and which involve some interventionist role by the state. The principal economic function of default rules is clear: they enable the parties to reduce the costs of specifying terms in the contract.66 Contracts are never perfect, since they can never cover all possible future contingencies which may affect performance. In some cases, one or both of the parties may have been aware of a given contingency but considered its occurrence to be insufficiently likely to justify drafting a specific clause to deal with it, the ex post resolution of any dispute by reference to a default rule being, when 64 A-S Vandenberghe, “Labour Contracts” in Bouckaert and De Geest, above n 12, vol 3, 549–53. 65 E Patterson, “The Apportionment of Business Risks Through Legal Devices” (1924) 24 Columbia Law Review 335. 66 CJ Goetz and RE Scott, “The Limits of Expanded Choice: an Analysis of the Interaction between Express and Implied Contract Terms” (1985) 73 California Law Review 261. They extend the idea to include savings on the costs arising from contract formulation errors.

57

(C) Ogus Ch2

23/3/06

16:02

Page 58

Law and Wealth Creation

discounted by the probability of occurrence, cheaper than the ex ante provision. In other cases, they do not foresee the event but, should it occur, they will still require some mutually acceptable outcome.67 In either case, the default rule should normally provide the solution which the parties themselves would have adopted if they had made explicit provision. Over time, judicial interpretation of what the parties would have agreed in regularly recurring contractual situations accumulates and, as a consequence of the doctrine of precedent,68 gives rise to standardised implied terms; in some instances the interpretation finds its way onto the statute book.69 Parties can then rely on the existence of such law to save even modest drafting costs. Of course, in many cases it will not be easy (cheap) for the court to determine ex post what the parties would have agreed ex ante. Judges are therefore likely to adopt what is customary in the trade and should the parties want something more novel, the onus is on them to incorporate their own preferences. There are, nevertheless, persuasive economic arguments that the courts should not necessarily adopt what the parties, or the majority of parties so circumstanced, would have agreed upon as the basis of the default rule. These arguments are rooted in the proposition that, if the goal is to minimise information and drafting costs, then account must be taken of the fact that such costs vary, depending on access to both appropriate information and to drafting skills. Take, first, a situation where, in a given market, the majority of traders are relatively large and sophisticated firms and have a clear set of preferences for particular 67 Which may include the abandonment of the contract under the doctrine of frustration: cf RA Posner and AM Rosenfield, “Impossibility and Related Doctrines in Contract Law: an Economic Analysis” (1977) 6 Journal of Legal Studies 83. 68 In this sense, precedent constitutes a public good, justifying some degree of subsidisation: WM Landes and RA Posner, “Legal Precedent: a Theoretical and Empirical Analysis” (1976) 19 Journal of Law and Economics 249. 69 The classic example is to be found in 19th-century judicial decisions on sale of goods, followed by the Sale of Goods Act 1893. See R Goode, Commercial Law, 2nd edn (London, Penguin, 1995), 191–3.

58

(C) Ogus Ch2

23/3/06

16:02

Page 59

Law and Wealth Creation

contractual outcomes. A court might nevertheless incorporate in the default rule what smaller firms would prefer, given that their information and drafting costs in providing for an alternative outcome are likely to be higher.70 This reasoning can be extended to a situation where there is asymmetry of information between the contracting parties. A party with superior information as to the content of the default rule can opportunistically use it to induce the other party into unexpected and undesired outcomes. Here the courts can adopt in the default rule an outcome which they assume would be preferred, if at all, by the uninformed party. The “stronger” party is induced thereby to make explicit, alternative provision in the contract, thereby alerting the uninformed party to the solution which will prevail.71 A good illustration72 of this approach is provided by the common law contra proferentem rule used in the interpretation of contracts. Exemption clauses and other apparently “harsh” terms are strictly construed against the party relying on them: [T]he more unreasonable the result the more unlikely it is that the parties can have intended it, and if they do intend it the more necessary it is that they shall make that intention abundantly clear.73

Less obviously, it can also help in rationalising cases where judges purport to determine implied terms on the basis of what they consider to be appropriate outcomes. In the leading case of Liverpool City Council v Irwin,74 the House of Lords held that the lease of an apartment in a tower block contained an implied obligation on the local authority lessor to keep the common areas of access in a reasonable state of repairs. It is far from clear 70

Ogus, above n 18, 206–7. I Ayres and R Gertner, “Filling Gaps in Incomplete Contracts: an Economic Theory of Default Rules” (1989) 99 Yale Law Journal 87. 72 For another illustration, see the trustee remuneration rule: text accompanying n 84 below. 73 Lord Reid in Schuler AG v Wickman Machine Tool Sales [1974] AC 235, 251. 74 [1977] AC 239. 71

59

(C) Ogus Ch2

23/3/06

16:02

Page 60

Law and Wealth Creation

that this represents what the parties would have agreed at the time of making the contract but, if it is not in accordance with the council’s preferences, the interpretation forces them to articulate in the lease that they are not responsible for keeping the relevant parts of the premises in repair, and the tenants are then alerted to the fact. Default rules are seen by some lawyers as devices which enable courts to apply ideas of paternalism or distributive justice to incomplete agreements, the implied term providing a model of what is a fair contract; and the Irwin case is often cited as an example.75 But, unless the term is made mandatory by statute, it is difficult to see how this policy will work, since the “stronger” party is always able to provide in the contract an express term to the contrary. Trusts and Fiduciary Duties There are many other areas of default rules which could be explored in terms of savings of transaction costs—significant parts of company law fall into this category.76 I shall limit myself here to a brief look at fiduciary duties, as owed, in particular, by trustees.77 For many lawyers, the inspiration for fiduciary relationships is to be found in ideas of morality or justice, the aim being to redress inequalities between parties to a transaction.78 From an economics perspective, they are, like the legal organisations considered in an earlier part of this chapter, rather a response to what is known as a “principal-agent” problem79 which often 75 Eg H Collins, The Law of Contract (London, Weidenfeld and Nicholson, 1986), 122–4. 76 B Cheffins, Company Law: Theory, Structure and Operation (Oxford, Clarendon Press, 1997), 257–62. 77 Drawing on Ogus, above n 18. 78 Eg S FitzGibbon, “Fiduciary Relationships are Not Contracts” (1999) 82 Marquette Law Review 303. For a vigorous repudiation, see FH Easterbrook and DR Fischel, “Contract and Fiduciary Duty” (1993) 36 Journal of Law and Economics 425. 79 RA Ippolito, Economics for Lawyers (Princeton, Princeton University Press, 2005), 369–74.

60

(C) Ogus Ch2

23/3/06

16:02

Page 61

Law and Wealth Creation

arises from collaborative enterprise.80 A principal-agent problem occurs when one individual, often a property owner, engages a skilled person to undertake some profit-making, or other utilityconferring, activity. Typically, because of the principal’s lack of expertise, a significant degree of discretion is conferred on the agent, with the obvious risk that the latter may opportunistically exercise that discretion in a way which maximises his or her own interests, rather than those of the principal. The risk can be constrained by detailed contractual provisions, but without knowledge and certainty as to the large number of contingencies which may arise, such an endeavour would be both incomplete and very costly. By imposing a fiduciary relationship between the parties, involving general duties of care and loyalty, the common law reduces these costs, thereby enhancing productive efficiency. Fiduciary relationships transcend different legal categories, for example, employment contracts, companies, partnerships and trusts, enabling the strength of these duties to be varied according to the requirements of the context. So, for example, the responsibilities and accountability of the trustee are stricter than those of a company director,81 reflecting the expectation that the latter should engage in commercial risk-taking of a kind which typically the creators of a trust would not desire. The application of our economic interpretation of default rules generally to fiduciary duties can be illustrated by two examples. The first relates to the question whether trustees should be allowed to retain profits made through opportunities arising from trust administration. Here the default rule reflects what the parties would have agreed to, if transactions costs had not inhibited express provision. But formulating what would, in the generality of cases, maximise productive efficiency is not easy.82 A rule 80 R Cooter and BJ Freedman, “The Fiduciary Relationship: Its Economic Character and Legal Consequences” (1991) 66 New York University Law Review 1045. 81 LS Sealy, “The Director as Trustee” [1967] Cambridge Law Journal 83. 82 W Bishop and DD Prentice, “Some Legal and Economic Aspects of Trustee Remuneration” (1983) 46 Modern Law Review 289, 295–309.

61

(C) Ogus Ch2

23/3/06

16:02

Page 62

Law and Wealth Creation

allowing the retention of profits would fail to control opportunistic behaviour; a rule requiring the trustee totally to disgorge profits would create a disincentive to seek out profit-making opportunities. In the leading case of Boardman v Phipps,83 the House of Lords considered that the optimal position involved some sharing of the profits. The default rule requires trustees to account to beneficiaries for profits derived from the use of information acquired in trust activities, but rewards them with payment on a liberal scale for work which substantially increases the value of the trust. The second example concerns the remuneration of trustees more generally and illustrates the argument made above84 for using default rules to force a disclosure of information. In English law, the default rule is that trustees are entitled only to reimbursement of expenses, not payment for services.85 It reflects a historical tradition of trustee altruism within a family context and seems anachronistic in the modern world where there is a market for trust administration, just like any other professional service.86 Of course, the rule can be and generally is displaced by an explicit provision in the trust instrument. Why not change the default rule to accord with the majority practice? The answer given in 1982 by the Law Reform Committee to this question shows that basing the rule on majoritarian practice is not the only approach. We are not in favour of introducing a statutory presumption of a charging clause in every case as it is essential that settlors should be aware that a professional trustee will be remunerated and should know the terms on which the remuneration will be paid. There would be a danger of the settlor being ignorant of the fact that he is required to pay his professional trustee on a professional basis if this were 83

[1967] 2 AC 45. Text accompanying n 67. 85 This appears to be unaffected by the enactment of Trustee Act 2000, s 28, which provides that where there is a provision in the trust authorising payment for the trustee’s services, that should be construed as authorising remuneration for those services. 86 Bishop and Prentice, above n 82, 291–4. 84

62

(C) Ogus Ch2

23/3/06

16:02

Page 63

Law and Wealth Creation done in a way which would not be brought to his attention by an express clause in the trust instrument.87

Conclusions The focus of this chapter has been the impact of legal rules on wealth-creating activities, leading to predictions as to which legal principle or rule-formulation may, in given circumstances, create appropriate incentives for productive efficiency. In relation to property rights, we saw the key role played by residual owners. Since all profits and losses arising from the owned asset directly affect the wealth and income of these persons, they are likely to take such steps as will maximise its value. The fact that, for most productive activities, some form of coordination with others is necessary creates a dilemma. For if those other persons have no stake in the ultimate outcomes they are likely to pursue their own interest to the detriment of the enterprise, while if they are given joint rights of ownership, this will dilute the economic impact of the ownership form, in extreme cases leading to the “tragedy of the commons”. There is a variety of legal devices available to resolve the dilemma, most of them involving some combination of contractual obligations and property rights. We noticed, too, how more generally the law can develop a stock of rules which are available for use by contracting parties in dealing with various contingencies. Whether explicitly adopted or else left to operate as implied terms, these reduce information and drafting costs thereby adding to the value of the transaction. As I made clear in chapter one, productive efficiency, which maximises wealth for a given individual or group, must carefully be distinguished from allocative efficiency, which maximises wealth for society as a whole. The analysis in this chapter carries no implications for the latter. The identification of productively 87

Report on The Powers and Duties of Trustees (1982, Cmnd 8733), para

3.47.

63

(C) Ogus Ch2

23/3/06

16:02

Page 64

Law and Wealth Creation

efficient legal principles and forms nevertheless helps us to understand why they should voluntarily be adopted by individuals and firms and that, in turn, may provide an explanation of how they have involved. In the next chapter, we shall see how the task of providing productively efficient rules relates to other functions of the law; and how that exercise can assist in understanding the structure of the legal system.

64

(D) Ogus Ch3

20/2/06

16:33

Page 65

3 The Structure of the Law

Introduction: Classification is Important In 1983 a Hong Kong bank was sued by one of its clients for wrongfully honouring a forged cheque. In its defence, the bank argued that the client was himself in breach of a duty to exercise reasonable care, that duty arising independently of the contract which otherwise governed the relationship between the parties. The Privy Council rejected the argument that liability in tort arose independently of the contractual relationship. In the words of Lord Scarman: Their Lordships do not believe that there is anything to the advantage of the law’s development in searching for a liability in tort where the parties are in a contractual relationship. This is particularly so in a commercial relationship . . . their Lordships believe it to be correct in principle and necessary for the avoidance of confusion in the law to adhere to the contractual analysis: on principle because it is a relationship in which the parties have, subject to a few exceptions, the right to determine their obligations to each other, and for the avoidance of confusion because different consequences do follow according to whether liability arises from contract or tort. . . .1

Less than a decade later, the House of Lords in Henderson v Merrett Syndicates reached the opposite conclusion.2 It was held that a contract between managing agents and the Names of Lloyds did not preclude a concurrent duty between the parties founded in tort, thereby enabling the plaintiffs to take advantage of what was for them a more favourable limitation rule in tort. 1 2

Tai Hing Cotton Mill Ltd v Liu Chong Hing Bank [1986] AC 80, 107. [1995] 2 AC 145.

65

(D) Ogus Ch3

20/2/06

16:33

Page 66

The Structure of the Law

It is certainly strange that what may appear to be a question of such a fundamental character, relating to the relationship between contract and tort, should lead, at the end of the 20th century, to such a conflict of opinion and consequent uncertainty.3 An explanation is provided by Lord Goff in the Henderson case.4 English law was originally categorised by reference to the ancient forms of action. When these were abolished in 1852: [C]ommon lawyers did at last segregate the law of obligations into contract and tort. . . . Even then there was no systematic reconsideration of the problem of concurrent claims in contract and tort. . . . In a sense we must not be surprised; for no significant law faculties were established at our universities until the late 19th century, and so until then there was no academic opinion available to guide or stimulate the judges. Even so, it is a remarkable fact that there was little consideration of the problem of concurrent remedies in our academic literature until the second half of the 20th century, though in recent years the subject has attracted considerable attention.

It is even more remarkable when account is taken of the importance of classification into contract or tort. Not the least are there practical reasons for clarifying categorisation because there are different rules relating to, for example, limitation periods, bankruptcy, capacity, remoteness of damage and the measure of damages.5 Now those very differences require some rationalisation or explanation. It is not immediately obvious, for example, why those suing in contract should, in comparison with tort victims, be subject to stricter limits on the recoverability of foreseeable harms.6 More than this, there are very basic policy issues at stake. If, for example, the contractual provisions are allowed exclusively to determine the rights and duties of the parties, then consensual governance prevails; if on the other hand tort liabil3 American law seems to be equally uncertain in this area: T Weir, “Complex Liabilities” in International Encyclopedia of Comparative Law (Tübingen, Mohr Siebeck, 1983), ch 12, 37–8. 4 Above n 2, 184–5. 5 See Weir, above n 3, 7–15. 6 The Heron II [1969] 1 AC 350.

66

(D) Ogus Ch3

20/2/06

16:33

Page 67

The Structure of the Law

ity is allowed to supersede what is in the contract, then it is the law and its inherent social values which hold sway. Another issue of basic classification, as to which there had been some uncertainty, arose in Hunter v Canary Wharf.7 A building interfered with the television reception of nearby residents: in order for the interference to be actionable as a private nuisance, did the plaintiffs have to show a proprietary interest in the land affected? In other words, is the tort of nuisance a property right?8 If, again, it is surprising that the law, on such fundamental issues, should be uncertain, at least there had been no reticence on the part of legal academics to express an opinion. The large majority of writers considered that the action in private nuisance had moved away from its source in property rights and were urging that the trend should continue.9 On this occasion, Lord Goff was less appreciative of the contribution of academia to the legal debate. He felt himself driven to say that I found in the academic works which I consulted little more than an assertion of the desirability of extending the right of recovery. . . . I have to say (though I say it in no spirit of criticism, because I know full well the limits within which writers of textbooks on major subjects must work) that I have found no analysis of the problem; and in circumstances such as this, a crumb of analysis is worth a loaf of opinion.10

No doubt, Lord Goff, in the Henderson case, was right to attribute much of the failure of English lawyers to deal adequately with structural questions of this kind to the procedural and pragmatic historical origins of the common law. However, the achievements of our civilian neighbours have not always been superior. As Roscoe Pound once observed,

7

[1997] AC 655. The House of Lords also investigated a related question, though the point did not arise for decision in the case, whether damages for personal injuries resulting from the interference could be claimed in a private nuisance action. 9 See the citations in the speech of Lord Cooke, above n 7, 717. 10 Ibid, 694. 8

67

(D) Ogus Ch3

20/2/06

16:33

Page 68

The Structure of the Law the most successful statements of law in legal history, the Digest of Justinian and the French Civil Code, are notoriously weakest on the side of classification. One might say that they have succeeded in spite of faulty classification.11

At first blush, the “logical” structure of some modern civilian legal systems might seem nevertheless to provide inspiration. That is because private law theorists, particularly in the 19th century,12 strove to lend coherence to their codifications, efforts which enabled them to claim to be legal scientists.13 The obvious analogy was with biology, and its classification into genus, then species and sub-species.14 It may be that such ordering has a certain degree of elegance: if the law of persons is one branch of the law (a genus?), then it may look neat to distinguish between the species of “natural persons” and “legal persons” and introduce company law into the legal structure at this point. The problem is that relating the two areas of law in this way generates no insights into how the content of the law governing natural persons—family law—does or should influence company law, or vice versa. It fails to recognise that the aim of classification is, according to Hall, not merely to pigeon-hole our data so that we can identify them, but, also, to classify them in ways that facilitate the discovery of wider generalisations than those represented in the classification.15

The division of the law of obligations into those arising voluntarily (mainly contracts) and those incurred involuntarily (mainly torts) could have led nineteenth century jurists to the “wider generalisations” that Hall had in mind: for example, by explaining how the voluntary nature of contractual obligations necessarily led to a stricter criterion for the recoverability of 11

R Pound, “Classification of the Law” (1924) 37 Harvard Law Review 933,

939. 12

Ibid, 962–6. J Hall, “Some Basic Questions Regarding Legal Classification for Professional and Scientific Purposes” (1953) 5 Journal of Legal Education 329. 14 Pound, above n 11, 936–7. 15 Hall, above n 13, 330. 13

68

(D) Ogus Ch3

20/2/06

16:33

Page 69

The Structure of the Law

foreseeable losses than that applicable to involuntary, that is, state-imposed, obligations. And generalisations of this kind could have been extended to, and fed back into, other areas of law, including notably company law, where there is major interaction between the underpinning of voluntary obligations and the external state control of mandatory obligations.16 That, in turn, would have facilitated the classification of areas of law such as labour law, environmental law, consumer law, and competition law which, with their mix of private and public obligations, are difficult to place within the older, more traditional legal classifications. Those classifications, as we have seen, were primarily the work of private lawyers. Although the latter did, of course, recognise the existence and importance of public law, for them that meant, in general, either the criminal law17 or constitutional and administrative law, and thus how the powers of law-making and public decision-making are allocated and controlled in the public interest, rather than how the state controls individual conduct; what, today, we should call “regulation”. Indeed, when my book Regulation was first published in 1994,18 it created a problem for librarians who were unsure where it should be shelved. In some libraries it was classified as administrative law; in others as commercial law; and in one library it was to be found under criminal law. The librarian at my own university decided that it did not belong in any particular branch of the law: it was therefore housed in “law general” along with other books on law-and-economics. The problem was (and is) that “regulation” is not a legal category which is familiar from 19th century classifications. As

16 B Cheffins, Company Law: Theory, Structure and Operation (Oxford, Clarendon Press, 1997) well reflects this approach. 17 And then “mainstream” criminal law (ie mala in se) rather than “regulatory” commands and controls (mala prohibia). See, further, on this distinction, below, 213. 18 A Ogus, Regulation: Legal Form and Economic Theory (Oxford, Clarendon Press; reprinted Oxford, Hart Publishing, 2004).

69

(D) Ogus Ch3

20/2/06

16:33

Page 70

The Structure of the Law

defining the content of my book,19 it rather comprises areas of law adopting a particular politico-economic function, that of overriding the individual preferences motivating market transactions which are underpinned by private law. Does it assist creative thinking about the law to have and use a concept such as “regulation”? We may have critical issues to address in selecting appropriate instruments and principles for (say) environmental protection. Is that task facilitated by recognising that these are issues of “regulatory law,” rather than simple “environmental law,” and thus potentially related to analogous policy issues arising in relation to (say) health and safety at work, professional standards or the control of the prices charged for electricity? In this chapter, I attempt to give a (very) positive answer to that question. I argue that we can better resolve the issues by a fuller understanding of the nature of the relevant problems and that fuller understanding is derived from, first, analysing—principally with insights developed from economics—the need for the set of legal principles and institutions; and, secondly, how similar or analogous goals are pursued in other areas of the law. Thinking coherently about “regulation” as a system of public governance arising from the failure of private law/private governance to achieve what is considered desirable facilitates the selection of particular regulatory devices to achieve particular goals in particular contexts. Classifying (some of ) environmental law as “regulation”, for example, facilitates critical evaluation of environmental law as a whole and a readier appreciation of how the various legal instruments involved, public and private, interact; and the same applies to company law.20 As we shall see, towards the end of this chapter, the approach helps us to address what in many legal systems has been highly problematic, the 19 See Ogus, above n 18, 1–3. For other definitions, see BM Mitnick, The Political Economy of Regulation (New York, Columbia University Press, 1980), ch 1 20 See S Deakin and A Hughes, “Economics and Company Law Reform: a Fruitful Partnership?” (1999) 20 Company Lawyer 212.

70

(D) Ogus Ch3

20/2/06

16:33

Page 71

The Structure of the Law

relationship between the standards adopted in private, notably tort, law and those prescribed in public, regulatory law.21 These arguments apply also to the issues of private law classification with which I began this chapter. To understand how contractual obligations relate to tortious obligations, for example, is a necessary preliminary to deciding whether the rules governing remoteness of damage and limitation of actions should be the same or different in the two areas of law. That understanding can be enhanced if, following the framework of analysis adopted in chapter one, we begin by treating contracts presumptively as wealth-creating devices, with torts as default rules, necessitated by substantial transactions costs. Approaching these structural questions in the way proposed requires a mapping of the legal system. In what follows, I extend the analysis in chapter two by showing how the systems of private governance, developed from property and contract, may fail, either because they are too costly to achieve the wealth-generating goal, particularly when set in a broader social context, or else because that goal is supplanted by other, non-economic goals.

Mapping the Legal System Private Governance: Property and Trade To map the legal system from an economic perspective, we need to ask what legal instruments are required to facilitate economic welfare.22 I begin by exploring private governance with its twin pillars of property rights and contracts. An important economic explanation of property rights was offered in chapter two. There we saw that it is necessary to confer on those developing and using resources power to exclude others, thus ensuring that 21 JA Jolowicz, International Encyclopedia of Comparative Law (Tübingen, Mohr Siebeck, 1972), vol XI, ch 13, 4–15. 22 I first explored the subject-matter of this section in Ogus, above n 18, ch 2. See also D Wittman, “General Structure of the Law” in B Bouckaert and G De Geest (eds), Encyclopedia of Law and Economics (Cheltenham, Edward Elgar, 2000), vol I, 1072–89.

71

(D) Ogus Ch3

20/2/06

16:33

Page 72

The Structure of the Law

productive efforts are rewarded. Alongside property rights, laws enforcing contracts are essential, because it is through trade and exchange that resources move to their most highly valued uses. Since the physical exchange of commodities is only rarely feasible, promises have to be made and complied with. Also in chapter two, we saw how contractual variations of basic property rights are used to refine productivity incentives in particular contexts. So, for example, those employed to add value to a resource can be granted a limited interest in the product, thus enabling them to share profits. Explicit contracting is costly and savings on transactions costs are made through the standardisation of the refined property rights, thus in the forms used for joint and limited entitlement to land, leaseholds, licences and trusts, as well as for business organisations, such as partnerships and companies. Although these may emerge as part of customary dealings, in time they are likely to be authenticated by legislative approval, the notoriety of legislative pronouncements adding to the benefits of the transactions costs savings, by rendering the concepts more familiar. The standardised rights are, in terms of the consensual basis of legal concepts here being explored, essentially a set of default rules. Individuals and groups of individuals can “opt in” to the standard forms, when it makes economic sense to do so; but they are free to “opt out” and create their own sets of rules, or indeed vary those within a given set, when that will serve their interests better. The number of property forms which a legal system is prepared to recognise may be finite: the so-called “numerus clausus” principle.23 But this probably reflects the fact that the social marginal costs of creating additional forms begin to rise sharply after a certain threshold is reached, particularly those incurred by third parties who have dealings with, or are affected by, the property-holding.24 23 B Rudden, “Economic Theory v. Property Law: the Numerus Clausus Problem” in J Eeekelaar and J Bell (eds), Oxford Essays in Jurisprudence Third Series (Oxford, Oxford University Press, 1983), ch 11. 24 TW Merrill, “Optimal Standardization in the Law of Property: the Numerus Clausus Principle” (2000) 110 Yale Law Journal 1.

72

(D) Ogus Ch3

20/2/06

16:33

Page 73

The Structure of the Law

Of course, standardisations are also valuable in relation to ordinary contractual dealings which do not involve property rights. In regularly recurring contractual relationships, very significant transaction-cost savings are made by recognising rights and obligations which are likely to meet the preferences of the majority of parties entering into this type of contract.25 Initially, these may be recognised as “implied terms” in judicial decisions, with adherence to precedent serving to consolidate the practice and satisfy parties’ expectations. Here, too, adoption of the terms by legislation, often in the form of codification, is likely to reap benefits, thus leading, to sections on “special contracts” (for example, sale, hire, insurance and employment) alongside the general principles of contract law. By way of contrast, standardised terms can also cut across the distinctions between contract types. The fiduciary relationship, and the duties, including that of loyalty, associated with it, may have originated with the rights conferred on beneficiaries against trustees, but the concept could also be applied to a range of analogous relationships (for example, those between employers and employees, the suppliers of professional services and their clients; company directors and shareholders), lending coherence to the law and with savings to the costs of detailed descriptions of the duties.26 Many, perhaps most, of the general principles of contract law may themselves be treated as standardised, default terms, and therefore, on the consensual approach, subject to variation. So, for example, although in our first week at law school we may have learnt the “rule” in Adams v Lindsell,27 treating an acceptance of an offer by post as binding when it is dispatched, offerors can nevertheless “opt out” of the rule by indicating in the offer that they will consider themselves bound only when the 25 CJ Goetz and RE Scott, “The Limits of Expanded Choice: an Analysis of the Interactions between Express and Implied Contract Terms” (1985) 73 California Law Review 261. 26 See further above, 60–3, and F Easterbrook and D Fischel, “Contract and Fiduciary Duty” (1993) 36 Journal of Law and Economics 425. 27 (1818) 1 B & Ald 681.

73

(D) Ogus Ch3

20/2/06

16:33

Page 74

The Structure of the Law

acceptance is received.28 Also, as regards the enforcement of a contract, although there are strong guidelines indicating when a court should, and should not, order specific performance, in general the parties will be allowed to determine this by an explicit term in the contract.29 The notion of consensual governance can be further extended to explain and classify general obligations, like those arising in tort or restitutionary law. The connection between such obligations and contracts is evident in the case of negligence liability arising from voluntary obligations, as in Hedley Byrne v Heller.30 Indeed, its economic rationalisation31 provides an important explanation of why narrow limits are imposed on this form of liability. It is the very closeness of the relationship between promisor and promisee which enables the former indirectly to internalise the benefit of making the undertaking, just as, in contract, the cost of taking care is reflected in the price. There are other types of obligation which, on the face of it, seem to have little to do with contracts between the relevant parties. Take the principles of tort law which determine the level of care which one individual must exercise towards another. Now, in situations where the parties already have some relationship, for example, that of employee and employee, or of professional consultant and client, it will be relatively easy to make the determination of care by contract and, as we have just seen, that task may be facilitated by standard terms provided by the law for the relevant type of contract. Often, however, there is little realistic possibility of such a contract taking place, or to put it another way, transactions costs would be prohibitively high. The task for the law would then be to prescribe by means of tort law the level of care which the parties presumptively would have agreed if they had been able to make the relevant contract. 28 General Reinsurance Corpn v Forsakringsaktiebolaget Fennia Patria [1983] QB 856. 29 Holwell Securities Ltd v Hughes [1974] 1 WLR 155. 30 [1964] AC 465. 31 See W Bishop, “Negligent Misrepresentation through the Economists’ Eyes” (1980) 96 Law Quarterly Review 360.

74

(D) Ogus Ch3

20/2/06

16:33

Page 75

The Structure of the Law

As between individuals in similar circumstances, say two car drivers, it might be relatively easy to reach a solution, because presumably the hypothetical agreed duty would be a mutual level of care, hence reasonable care as prescribed by the law of negligence. But it is not so obvious that this reasoning should be applied to the relationship between (say) a car driver and a pedestrian or a product manufacturer and a consumer. Here, particularly if the aggregate costs of taking care to avoid harm were, in some way, to be shared between the parties, it would seem appropriate for the law of tort to draft the hypothetical relevant contract so as to minimise those aggregate costs. Thus the standards exacted by the law would reflect the capacities of the parties to avoid harm. That might imply some form of strict liability on the product manufacturer for defects occurring during the manufacturing process, but also some form of contributory negligence defence, or apportionment of liability, for harm which the consumer could more easily have avoided. While tort law may thus deal with hypothetical agreements in relation to harm caused by one party to another, parts of the law of restitution may be seen as performing a similar function for benefits conferred.32 This may apply where agreed work is carried out prior to the drafting of a formal contract and the contract is never made or is void for some reason.33 But it can also apply under the doctrine of “agency of necessity” if a contract was not feasible as where, in an emergency, a person intervening to rescue or protect the person or property of an individual, is not able to obtain instructions from that individual.34 Admittedly, English law is much more reluctant, through restitution, to secure non-agreed payment for benefits than it is to use tort for non-agreed compensation for harms: in general it is opposed to the idea of rewarding “meddlers” or “volunteers.” A plausible explanation for this asymmetrical approach to hypothetical contracting is that too broad a scope to restitutionary 32 33

S Levmore, “Explaining Restitution” (1985) 71 Virginia Law Review 65. Eg Brewer Street Investments Ltd v Barclays Woollen Co Ltd [1954] 1 QB

428. 34

Eg Prager v Blatspiel, Stamp and Heacock [1924] 1 KB 566.

75

(D) Ogus Ch3

20/2/06

16:33

Page 76

The Structure of the Law

recovery would discourage more efficient contract-making, whereas tort law is unlikely to have this effect on arrangements for dealing with accidents.35 Economic Welfare Implications: Competition and Externalities What is agreed, or treated as agreed, between the parties may improve their welfare, but will be assumed to lead to improvements in economic welfare only under certain conditions. One important such condition is that there is adequate competition in the market for the subject-matter of the transaction. In ordinary circumstances,36 competition plays a major role in generating economic welfare: it constrains the prices that suppliers can charge, and therefore their profits; it exerts pressure on them to constrain costs, thereby rendering enterprise productively more efficient; and it induces them to respond to consumer preferences regarding quality. A second condition for increasing economic welfare is that the use of private property and trade should not generate externalities, by impacting on parties not involved in transactions. Negative externalities, where uncompensated costs are imposed on third parties, can lead to the misallocation of resources because the prices that are paid for the activity no longer reflect its full costs: the manufacturer of a product who does not pay for the waste discharged from the factory will be able to charge for the product a price less than the real cost of its production. Positive externalities arise where an activity confers benefits on third parties who do not pay for them. Since actors are thereby under-rewarded for their productive efforts, this situation can also generate misallocations of resources. In theory, it is possible for all of these problems to be solved by means of instruments of private governance. Private law contains a number of principles to constrain anti-competitive behaviour, including the non-enforcement of contracts in 35

Levmore, above n 32, 79–82. The situation is different where the conditions for a natural monopoly exist; on which see R Baldwin and M Cave, Understanding Regulation: Theory, Strategy and Practice (Oxford, Oxford University Press, 1999), ch 15. 36

76

(D) Ogus Ch3

20/2/06

16:33

Page 77

The Structure of the Law

restraint of trade and the economic torts. Negative externalities can be corrected by contracts with all those affected37; in practice, in most situations, the transactions costs are generally too high. The task of the private law, then, as we have already seen, is to imitate what would have been in the contracts. Where the external costs involve an interference with property, then the property rights themselves may provide the means of internalising the costs. The law of private nuisance can, from this perspective, be seen as integrating obligations to avoid imposing such costs and entitlements to enforce those obligations into property interests in land. Where the costs are to the physical integrity of third parties, then the law of tort performs the analogous function. Property rights, most obviously those involving intellectual property, here can also provide a private law solution to positive externalities; and, as we have seen, parts of the law of restitution serve the same purpose. Law for Private Governance What has been described so far is graphically represented in the lower half of diagram 1. Property, contract and the over-arching set of standardised default private law obligations are the legal instruments of private governance. Implicit in these arrangements is a limited role for the state, that of defining and interpreting the relevant principles. Although the rules governing human conduct may emanate from the state, their theoretical base is what the relevant parties would have agreed was appropriate to maximise their joint welfare. It follows that the rules are always subject to variation by those parties—a type of law which in Latin was known as ius dispositivum.38

37 This is the basis of the Coase theorem which asserts that if the cost of making market transactions is ignored, social welfare is maximised by appropriate contracts, however the law allocates rights: R Coase, “The Problem of Social Cost” (1960) 3 Journal of Law and Economics 1. Its impact on legal reasoning is explored in greater depth in ch 6, below. 38 On which see, generally, B Rudden, “Ius Cogens; Ius Dispositivum” (1980) 11 Cambrian Law Review 87.

77

78

Diagram 1

low transaction costs

high transaction costs

implied contract terms explicit contract terms

contract

implied property rights modified property rights property

standardised default private law obligations

paternalist/ distributional goals

low transaction costs

high transaction costs

private regulation

incentive regulation

16:33

modifiable public law obligations

mandatory public law obligations

command and control regulation

20/2/06

competition/ externality problems

information/ rationality problems

criminal law

(D) Ogus Ch3 Page 78

The Structure of the Law

(D) Ogus Ch3

20/2/06

16:33

Page 79

The Structure of the Law

The state has other functions, even under this model: there is a need for institutions and some other areas of law to provide an infrastructure for the operation of rights and their enforcement. Capacity to make decisions regarding property and transactions is determined partly by family law, partly by the law of contract,39 and partly by the procedural or constitutional principles of the law governing legal organisations. Then, the rights and obligations that we have been considering have to be enforced. To a certain extent, self-help may be feasible, but for most situations there are advantages in endowing public institutions with the power ultimately to constrain individuals physically. The principal justification for this may be the scale economies that arise when police powers are concentrated in public officials. But there also arguments that the enforcement of rights should not depend on the physical strength of right-holders and that the accountability of public officials is necessary to constrain the abuse of physical power. The interpretation and enforcement of rights and obligations require institutions—courts and legislatures—which citizens will trust and obey, thus necessitating constitutional law which defines and allocates the powers of the various institutions and also generates principles of accountability; so also procedural law to provide the rules for access to, and the practice of, adjudication.40 From Private Governance to (Modifiable?) Public Governance The upper part of the diagram takes us into the realm of public governance, and thus to an increased role for the state. Systems of public governance may be introduced for a variety of economic reasons. A first, important set of justifications is derived from the relatively high cost of enforcing or co-ordinating 39 Including not only the explicit rules concerned with age and mental capacity, but also those which render transactions unenforceable by reference to the circumstances, for example mistake or duress, in which they were made. 40 G Hadfield, “Contract Law is not Enough: the Many Legal Institutions that Support Contractual Commitments” in C Menard and M Shirley (eds), Handbook of New Intitutional Economics (Norwell, Mass, Kluwer, 2004), ch 8.

79

(D) Ogus Ch3

20/2/06

16:33

Page 80

The Structure of the Law

private rights. It may be difficult for the right-holder to identify the individual committing the unlawful act, a situation which often arises where the infringement is intentional and the defaulter seeks to avoid detection.41 Even if this obstacle is overcome, the right-holder may have insufficient incentive to enforce a claim because the costs of bringing an action will exceed any sums that will be received by way of compensation. This frequently occurs in relation to unlawful activity, such as environmental pollution, the effects of which are thinly spread over a large number of victims. But the problem also arises where, for example, in cases involving complex causal or technological issues, it is very costly for the individual right-holder to obtain the evidence necessary to secure a condemnation. The public enforcement systems can solve these problems, as they enjoy considerable economies of scale; and they are financed independently of outcomes. Account must also be taken of the fact that normally private law rights can be enforced only ex post, that is after an infringement and damage have occurred; courts are generally reluctant to prevent unlawful activity by the issuing of an order such as a quia timet injunction.42 The principal private law remedy, damages, functions as a deterrent, but that may be inadequate to ensure compliance with obligations if the defaulter has insufficient resources to meet judgments. Public law has a wider range of sanctions available; it also has the power to intervene at an earlier stage of the harm-creating process by, for example, attributing unlawfulness to an activity, rather than the infliction of damage; or by requiring prior authorisation for the activity, as when a licence for that activity is required.43

41 G Calabresi and D Melamed, “Property Rules, Liability Rules and Inalienability: One View of the Cathedral” (1972) 85 Harvard Law Review 1089, 1126–7. 42 A Burrows, Remedies for Tort and Breach of Contract, 3rd edn (Oxford, Oxford University Press, 2004), ch 21. 43 Cf A Ogus and Q Zhang, “Licensing East and West” (2005) 25 International Review of Law and Economics 124.

80

(D) Ogus Ch3

20/2/06

16:33

Page 81

The Structure of the Law

Then the costs of co-ordinating individual preferences and activities may be very large. Although, as we have seen, private law obligations such as those arising in tort and restitution may economise on the costs of specific contracting, the complexities of interaction between all relevant individuals may be so great that it is cheaper for public law to provide the appropriate conduct-controlling mechanism. So, for example, rather than relying on a huge network of individual rights and obligations to meet the assumed preferences of all road users, we establish a system of road traffic regulation for the same purpose. A second justification for public governance is that individuals may lack adequate information to determine what activity or set of transactions would best meet their preferences. While, as we have seen, courts and other adjudicatory institutions may provide default rights and obligations based on information to which they have access, that access is itself constrained by the limits of the adjudicatory process44; and centralised, administrative institutions may in this respect be better endowed. Public systems of information dissemination and the regulatory forcing of private actors to disclosure relevant information may help to solve the problem, but in cases where this proves still to be inadequate, regulatory controls of activities, based on centrallyheld information and presumed citizen preferences may be necessary. Related to information deficits is bounded rationality. Individuals have only a limited capacity to digest information, correlate it with their preferences and make rational choices accordingly.45 Governments may then decide to promulgate rules to lead individuals to outcomes which it is assumed they would have adopted if they had reacted with full rationality to the relevant information. 44 LL Fuller, “The Forms and Limits of Adjudication” (1978) 92 Harvard Law Review 353; A Ogus, “Social Costs in a Private Law Setting” (1983) 3 International Review of Law and Economics 27. 45 CR Sunstein (ed), Behavioral Law and Economics (Cambridge, Cambridge University Press, 2000).

81

(D) Ogus Ch3

20/2/06

16:33

Page 82

The Structure of the Law

The law which responds to these problems is public law with the important consequence that it is enforced by public agencies. To what extent, if at all, should individuals be allowed to modify or opt out of its provisions? This is an important question, because although public governance may be justified by reference to a generality of high enforcement costs, significant information deficits or bounded rationality, those conditions do not arise in all cases, and welfare gains may be made by allowing some individuals to make their own choice, where that is appropriate.46 Although it is generally assumed that public law is not modifiable by private citizens,47 the position is not so straightforward. In the first place, there is a judicial canon of statutory interpretation, applied primarily in the 19th century, that where a legislative provision is enacted solely for the benefit of a class of individuals, a member of that class can agree to waive its application.48 The doctrine has apparently fallen out of favour,49 though it has never been formally abrogated. Secondly, even though that doctrine may not now be invoked in practice, it is a feature of many modern regulatory regimes that, while the regulatory goal is prescribed in legislation, the means of achieving it are, to a greater or lesser extent, left to be determined by the individuals or firms subject to the regime. This is sometimes referred to as “co-regulation”50 and, at the polar extreme, where the role

46 TM Palay, “Avoiding Regulatory Constraint: Contracting Safeguards and the Role of Informal Agreement” (1985) 1 Journal of Law, Economics and Organization 155. 47 The principle goes back to Roman law: Rudden, above n 38, 88–9. 48 Graham v Ingleby and Glover (1848) 1 Exch 651; Griffith v Earl of Dudley (1892) LR 9 QBD 357. See also California Civil Code, art 3513: “Anyone may waive the advantage of a law intended solely for his benefit. But a law established for a public reason cannot be contravened by private agreement,” cited in Rudden, above n 38. 49 See Johnson v Moreton [1980] AC 37. 50 I Ayres and J Braithwaite, Responsive Regulation: Transcending the Deregulation Debate (New York, Oxford University Press, 1992), 101–2.

82

(D) Ogus Ch3

20/2/06

16:33

Page 83

The Structure of the Law

of the state is merely residual oversight, it becomes “selfregulation.”51 Mandatory Public Governance and Public Law The shift from a system which allows for some private modification (ius dispositivum) to one allowing for no modification (ius cogens) is, of course, very significant. It may be justified because the welfare gains likely to accrue from private modification may be small, because relatively few of the individuals subjected to the obligation will benefit, or because the cost of determining appropriate modifications is disproportionately large. A more important justification is that any modification would thwart the regulatory objectives which are to override individual choice. Two non-economic goals, in particular, might motivate such an approach. The first is paternalism, where governments assume for themselves power to determine what is best for citizens because the latter cannot be trusted to make decisions in their own best interests. In chapter eight, we shall investigate the implications of this approach for law and how it might be reconciled with traditional concepts of economic welfare. The second, also discussed in chapter eight, is where governments seek to use the law to redistribute resources according to some perception of distributional justice. Turning now to the forms of public governance, we should first identify criminal law as the principal instrument used to overcome the enforcement difficulties of private law mentioned above, particularly those arising from intentional infringements and inadequate sanctions. However, because the criminal law, to achieve its purpose, may have to deploy severe sanctions, and because criminal liability is, in any event, stigmatising, erroneous convictions can impose very large costs on the individual concerned. To reduce such costs, the rules governing procedure in the criminal courts offer defendants a high level of protection, including restrictive rules of evidence and a heavy burden of 51 A Ogus, “Rethinking Self-Regulation” (1995) 15 Oxford Journal of Legal Studies 97.

83

(D) Ogus Ch3

20/2/06

16:33

Page 84

The Structure of the Law

proof.52 This in turn has the consequence that the criminal process is very costly and therefore not obviously suitable for less serious infringements.53 We therefore find systems of regulatory law which, although they may use criminal penalties as a last resort, are mainly enforced through administrative procedures. There are no universally-accepted ways of classifying regulatory regimes and instruments.54 Pursuing the logic of our mapping exercise which has, as its origin, individual autonomy and decision-making, we may nevertheless adopt as discriminator the extent to which those who are governed by the law do, or do not, participate in its formulation and enforcement. As is illustrated in the diagram, this gives us, at the opposite end of the spectrum from property and contract, the criminal law which involves the full authority of the state to control and punish serious infringements. Closest to criminal law, within the regulatory sphere, are command-and-control systems. These may prohibit activities, allow them only with prior authorisation (licensing) or control them by subjecting them to standards or conditions, notably of quality, quantity or price. Whatever the exact nature and purpose of the instrument used, the rules are formulated, interpreted and enforced by public institutions; and are coercive in character in that compliance is secured by the threat, or application, of sanctions. An alternative is for the public authorities to determine the regulatory goal, but create financial and other incentives for individuals and firms to pursue those goals without the use of coercion.55 So, for example, taxes may be raised or lowered for 52 The economic implications of these characteristics are explored in greater depth, below pp 110–1. 53 A Ogus, “Enforcing Regulation: Do We Need the Criminal Law?” in H Sjögren and G Skögh (eds), New Perspectives on Economic Crime (Cheltenham, Edward Elgar, 2004), 42–56. 54 For an elaborate discussion of this, see Mitnick, above n 18, ch 1. 55 D Osborne and T Gaebler, Reinventing Government: How the Entrepreneurial Spirit is Transforming the Public Sector (Reading, Mass, AddisonWesley, 1992); R Howse, “Retrenchment, Reform or Revolution? the Shift to Incentives and the Future of the Regulatory State” (1993) 31 Alberta Law Review 455.

84

(D) Ogus Ch3

20/2/06

16:33

Page 85

The Structure of the Law

those engaged in conduct which is regarded as undesirable or desirable, respectively; and governments may stipulate some behavioural condition for firms engaging in contractual undertakings with them. Mandatory Public Governance and Private Law Hitherto we have assumed private law to be exclusively concerned with private governance, allowing individuals to modify any obligations arising from legislation or case law. But that is not always the case, because public governance can be integrated with private law by means of what may be called “private regulation.”56 Here the public governance goals, which may be economic, to deal with information or externality problems, or non-economic, to implement paternalist or distributional values, are imposed on private law instruments so that they are integrated into the system of private rights and must be enforced by the individual right-holders. However, as a consequence of the principles emanating from public governance, they cannot be abrogated or modified by private agreement. Prominent among techniques of such private regulation are the imposition of mandatory terms in certain types of contract and rules which prescribe that rights in tort or property law are to prevail over any attempt at contractual modification.57 Private regulation typically has its source in legislation, but judges can invoke their own conceptions of what is desirable by way of public governance by not enforcing contracts or other legal entitlements where this would be inconsistent with “public policy.”58 Although the content of these principles may be motivated by similar sets of values to those which inspire legislation, judges tend to focus on constraints which are compatible with political neutrality and which can be accommodated within their 56 Ogus, above n 18, ch 12; H Collins, Regulating Contracts (Oxford, Oxford University Press, 1999). 57 Unfair Contract Terms Act 1977, s 2, is a good example of the latter. 58 PS Atiyah, Introduction to the Law of Contract, 5th edn (Oxford, Clarendon Press, 1995), ch 18; and, more generally, D Lloyd, Public Policy, a Comparative Study in English and French Law (London, Athlone Press, 1953).

85

(D) Ogus Ch3

20/2/06

16:33

Page 86

The Structure of the Law

limited capacity to obtain information on phenomena external to the litigants. So, for example, as regards economic goals, they feel confident to police arrangements which are in restraint of trade59; and, as regards non-economic values, to monitor for compliance with commonly-accepted notions of human rights.60

Contract or Tort Which Set of Obligations to Prevail? To see how this mapping exercise can resolve, or at least illuminate, some of the difficult classification issues that arise, let us first return to the relationship between contract and tort. One important implication from our analysis is that any attempt at rigid demarcation between the two concepts would be inappropriate because, as we have seen, tortious liability may, in many situations, serve as a substitute for explicit contracting. In such situations, the use of contract and tort may be understood as reflecting gradations on a spectrum of private governance, representing different levels of transactions costs, ranging from low costs (justifying contractual arrangements) to high costs (justifying tort default rules).61 On this basis, in terms of private governance, explicit contractual obligations should prevail over implicit tort obligations, because they are more likely to accord with the parties’ actual, as opposed to assumed, preferences.62 Tort liability may, however, arise not for reasons of high transactions costs, but rather because of perceived market failure justifications; in short, when we are in the arena of public 59 M Trebilcock, The Common Law of Restraint of Trade: a Legal and Economic Analysis (Toronto, Carswell, 1986). 60 Lord Woolf, “Human Rights: Have the Public Benefited?” (2002) 121 Proceedings of the British Academy 301. 61 W Bishop, “The Contract-Tort Boundary and the Economics of Insurance” (1983) 12 Journal of Legal Studies 241, 243. 62 An approach which underlies the “non-cumul” principle in French law, that where there is contractual liability, the victim of a breach cannot sue in tort: A Ogus and M Faure, Économie du Droit: Le Cas Français, (Paris, LGDJ, 2002), 103–4.

86

(D) Ogus Ch3

20/2/06

16:33

Page 87

The Structure of the Law

governance, more specifically what I have called private regulation. Here, because they result from public governance, the imposed obligations should prevail over any attempts to modify them by contract. How, then, are judges and others to determine whether a given tort obligation has its origin in private or public governance and therefore whether a purported contractual modification is to succeed or to fail? This might seem to be a problematic task, but it is one which legal systems have to address in certain contexts; and they do so by denying individual autonomy where this conflicts with “public policy.” A classic instance arises in private international law where it has to be decided what limits are to be imposed on the freedom of parties to stipulate what law is to govern their contract. Under the common law, judges did not allow the parties to adopt and give effect to the provisions of a foreign legal system if these were inconsistent with public policy in the domestic law.63 The 1980 Rome Convention64 extends this idea by denying freedom of choice in relation inter alia to regulatory protective provisions in consumer and employment contracts.65 Of course, public policy is well known to be an “unruly horse” allowing for much subjective discretion as to when regulated outcomes are to be preferred.66 This might suggest that the burden of proof should be on those arguing for public governance, although this could be displaced in areas which have traditionally been the subject of private regulation, such as negligently caused personal injuries or death, and consumer and employment contracts. 63

Rousillon v Rousillon (1880) 14 Ch D 351. Convention on the Law applicable to Contractual Obligations (Rome, 19 June 1980; Cmnd 8489), implemented in English law by the Contracts (Applicable Law) Act 1990. 65 Arts 5 and 6, respectively of the Rome Convention; and see H Muir-Watt and LG Radicati di Brozolo, “Party Autonomy and Mandatory Rules in a Global World” (2004) 4 Global Jurist Advances: No 1. 66 W Howarth, “Some Common Law Limitations to the Construction of Contractual Exemption Clauses” (1985) 36 Northern Ireland Legal Quarterly 101, 104–6. 64

87

(D) Ogus Ch3

20/2/06

16:33

Page 88

The Structure of the Law

Which Set of Rules to Apply? Remoteness and Prescription Since contractual and tort liability are to some extent subject to different rules, the question next arises as to which regime should apply in any given case. The position in English law appears to be that, unless the contract specifies otherwise, the claimants can sue under either regime and thus select that cause of action which offers rules most advantageous to them.67 However, the correctness of that approach may be doubted if the rules reflect specific policy objectives and those objectives may be thwarted by the exercise of choice of action. Take, for example, the principles which determine what losses are too remote to be claimed as damages. The question of what different rules (if any) should apply as between contract and tort has been the subject of a lively debate and some uncertainty in the case law.68 The generally-held view is that tort law offers a regime more generous to accident victims: to be relieved from liability the tortfeasor must show that the relevant damage was not reasonably foreseeable,69 whereas the contract-breaker is only liable for losses “not unlikely” to result, a significantly narrower range of possible outcomes.70 Why should this be? Lawyers involving notions of justice and morality have adverted to the fact that tortfeasors tend to be more culpable than contract-breakers who may be strictly liable and that tort, more frequently than breaches of contract, gives rise to physical damage which is more serious than economic loss.71 Indeed, adopting this latter point, Lord Denning once ruled that the tort rule should apply to breaches of contract which cause physical injury.72 67

Lord Goff in Henderson v Merrett Syndicates, above n 2, 194. Bishop, above n 61. 69 The Wagon Mound [1961] AC 388. 70 The Heron II [1969] 1 AC 350. 71 Weir, above n 3, 11. See also E Weinrib, “The Juridical Classification of Obligations” in P Birks (ed), The Classification of Obligations (Oxford, Oxford University Press, 1997), ch 2. 72 Parsons Ltd v Uttley Ingham [1978] QB 791. 68

88

(D) Ogus Ch3

20/2/06

16:33

Page 89

The Structure of the Law

These arguments are not very convincing. Tort liability covers a wide range of moral culpability from torts requiring an intention to cause damage to those of strict liability, but the remoteness doctrine does not reflect these major differences. It is often not easy to distinguish between cases of economic and physical harm73; nor to generalise on the relative severity of the losses which result from either. The economic reasoning which underlies our mapping exercise may prove to be a more fruitful source of rationalisation. An important function of contracts is to allocate risk and, as we shall see in chapter five,74 the less-than-generous contract rule should induce promisees to communicate to promisors, at the time of making the contract, information concerning any unusual losses which they may sustain on breach. Promisors can then take that information into account in deciding how much care they should exert to ensure contractual performance and how that should affect the price that they charge for it. Where, because of high transactions costs, explicit contracting does not take place, and we are thus in the realm of tort law, the possibility to communicate such information hardly exists and tortfeasors, in determining the level of care to be taken, can have regard only to those losses which, to them, are reasonably foreseeable. Let us turn, next, to the rules governing limitations of actions, the period prescribed for those enforcing legal rights to initiate their claim. These rules are very, perhaps excessively, complex.75 Although the same period, six years, or three years in cases of personal injuries or death, applies to both contract and tort, the tort regime in many types of case favours claimants, rather than defendants, because the period begins to run later: while in contract this is from the date of breach, in tort it is, in general, only when there was, or reasonably should have been, 73

See Murphy v Brentwood District Council [1991] 1 AC 398. Below, pp 145–7. 75 See Law Commission Report No 270, Limitation of Actions, (London, Stationery Office, 2000), esp paras 11.7–11.13. The comment applies equally to other jurisdictions, see E Hondius (ed), Extinctive Prescription: On the Limitation of Actions (The Hague, Kluwer, 1996), 16–17. 74

89

(D) Ogus Ch3

20/2/06

16:33

Page 90

The Structure of the Law

knowledge of the facts giving rise to liability.76 It is difficult to find explicit policy justifications for the more generous tort regime, but they would seem to rest on a perception that tort claimants have particular difficulties in obtaining evidence sufficient to vindicate their rights.77 To see how the mapping exercise can assist in an exploration of these issues, we need, first, to identify the basic economic justification for imposing limitation periods.78 This is to reduce the information costs, to the parties and the courts, in obtaining or maintaining “in storage” the relevant evidence, as well as the error costs which result from decisions based on inadequate evidence: both of these costs increase with the passage of time. In addition, the earlier the case is resolved, the less uncertainty there is for both parties. On the other hand, limiting actionability also reduces the incentives to comply with legal obligations, as well as impairing any distributional objective which the law intends to promote. In arriving at an appropriate trade-off between these costs, and therefore determining the optimal limitation period, account should be taken of the possibility that the variables will have different values in different legal contexts.79 So, for example, over time information and error costs are likely to increase at a higher rate in relation to physical damage as compared with financial debts, due to the scientific nature of the evidence often involved. In addition, there are greater losses associated with the uncertainty resulting from delays in personal injury cases, because there are disincentives for injured claimants to recover from 76 Limitation Act 1980 esp s 11; and see, eg, Midland Bank Trust v Hett, Stubbs & Kemp [1979] Ch 384. 77 Law Commission Consultation Paper No 151, Limitations of Actions (London, Stationery Office, 1998), para 1.36. 78 M Baker and T Miceli, “Statutes of Limitations for Accident Cases: Theory and Evidence” (2000) 19 Research in Law and Economics 47; T Miceli, “Deterrence, Litigation Costs, and the Statute of Limitations for Tort Suits” (2000) 20 International Review of Law and Economics 383. 79 Miceli, above n 78, for example, argues that, within tort, negligence regimes require a longer optimal period than those of strict liability.

90

(D) Ogus Ch3

20/2/06

16:33

Page 91

The Structure of the Law

their sickness or injury, given that that will reduce the amount of their compensation.80 Now, these considerations help to explain the shorter timeperiod allowed in personal injury actions, whether in tort or in contract, but not the differences in the rules governing these actions where personal injury is not involved. We need then to investigate how the variables may impact differentially as between the environments of tort and contract. One possible justification for the shorter period in contract law is that contractual liability may be less important than tort liability in generating incentives for compliance with legal obligations. As is well known from empirical studies,81 many promisors are motivated to comply with their contractual obligations because they are concerned to maintain their reputation in the marketplace or with particular customers, rather than because they apprehend the impact of legal sanctions. The same phenomenon may apply to some potential tortfeasors, but it cannot be so widespread. If that is right, it is relatively more important to maintain the incentive effects of tort liability, thus suggesting a longer limitation period. Even more persuasive may be an argument derived from transaction-cost analysis as explored in this chapter. Contracting parties may themselves prescribe the period during which any action must be brought, and subject to overriding public policy considerations, that would be respected by the courts as superseding the period imposed by legislation.82 The fact that the rules prescribed for contract are, effectively default rules, might suggest that a shorter, rather than longer, period is justified. This is because while the benefits of a longer period, preserving the incentives to comply, accrue mainly to the contracting parties themselves, a shorter period generates benefits also for third 80 R Lewis, Structured Settlements: the Law and Practice (London, Sweet & Maxwell, 1993), 26–7. 81 Eg: H Beale and T Dugdale, “Contracts between Businessmen: Planning and the Use of Contractual Remedies” (1975) 2 British Journal of Law and Society 45. 82 Northern and Shell v John Laing [2002] EWHC 2258

91

(D) Ogus Ch3

20/2/06

16:33

Page 92

The Structure of the Law

parties: reductions in the costs of collecting and storing information. So, if the default rule, incorporating a shorter period, is not appropriate for the parties, they can extend it by contractual provision. Summing up, we have seen that transactions-cost analysis can provide substantive justifications for having different remoteness and limitation rules as between contract and tort. Those rationalisations should lead us to the important conclusion that allowing claimants to select their preferred cause of action might defeat the policy objectives of the rules and that it should be for the court to characterise the action and then apply the appropriate rules.

Property Rights and Tort Actions There are differing opinions on the nature of the relationship between tort and property rights and, as we saw in the introduction to this chapter, these came to a head in the case of Hunter v Canary Wharf, which involved the actionability of interference with television reception.83 The view favoured by many academic lawyers is that it is artificial to restrict the action in private nuisance to those with the right to exclusive possession of the land in which the interference occurred.84 The House of Lords held, in contrast, that the action should be so confined. The opposing views effectively reflect the differences between private and public governance and the tension between them. In terms of private governance, the reasoning is relatively straightforward. Property rights offer protection against interference by others, in particular when that interference emanates from neighbouring land. Normally, it is in the interests of all rightholders that there should be some “give and take” between the adjacent properties and therefore a need to define what does and does not constitute an actionable interference. In an ideal world, this would be the subject of an agreement between 83 84

92

Above n 7. See, eg: P Cane, “What a Nuisance!” (1997) 113 Law Quarterly Review 515.

(D) Ogus Ch3

20/2/06

16:33

Page 93

The Structure of the Law

rightholders, thus enabling them to take account of particular circumstances; and any contract could then become a covenant running with the land and thus enforceable by, and against, successors in title.85 Of course, the transactions costs of this contractual approach are likely, in many instances, to be high and the law of private nuisance provides effectively a set of default terms through its definitions of “reasonable user.”86 But since these are default provisions, they can be overridden by consensual arrangements. The consensual modification can operate ex post, as well as ex ante. This can occur, for example, where the victim of an interference obtains an injunction against the interferer, but the termination of the interference is not the optimal outcome, in the sense that both parties are better off if some interference continues, with the defendant paying a sum of money which the victim is willing to accept.87 Given these possibilities, it makes economic sense for the actionability of private nuisances to be limited. As Lord Goff observed in the Hunter case, the efficacy of arrangements such as these depends upon the existence of an identifiable person with whom the creator of the nuisance can deal for this purpose. If anybody who lived in the relevant property as a home had the right to sue, sensible arrangements such as these might in some cases no longer be practicable.88

Channelling legal claims, and any subsequent, negotiation of outcome facilitates appropriate evaluation and reduces administrative costs.89 85 AI Ogus and GM Richardson, “Economics and the Environment: a Study of Private Nuisance” (1977) 36 Cambridge Law Journal 283, 288. 86 On which see, RA Buckley, The Law of Nuisance, 2nd edn (London, Butterworths, 1996), ch 1. 87 Calabresi and Melamed, above n 41; and see further on this, below 197–201. 88 Above n 7, 693. 89 A similar argument has been used to justify the limited duty of care imposed in negligence law for pure economic loss: M Rizzo, “A Theory of Economic Loss in the Law of Torts” (1982) 11 Journal of Legal Studies 281.

93

(D) Ogus Ch3

20/2/06

16:33

Page 94

The Structure of the Law

What then of public governance? As we have seen,90 some, indeed many, cases of nuisance while generating large amounts of damage in aggregate, impose only small amounts on individual rightholders. Such cases are insufficiently contained by the private law, given the costs of enforcing private rights. And there are, of course, vast areas of public, environmental regulatory law which serve to deal with cases of this kind. There is also the action in public nuisance.91 But this is enforceable as a tort by a private individual only where that person sustains “special” damage, different in degree and perhaps kind from that suffered by the general public92; otherwise it is part of the criminal law and therefore regulatory. Here, too, there are economic arguments for not extending actionability to all victims of harm: the very multiplicity of claims would generate significant and excessive administrative costs.

Private Law and Regulatory Standards 93 Most harm-creating activities are controlled by both public (regulatory) and private (primarily tort) legal regimes, yet the relationship between the two systems of governance remains far from clear, both in practice and in theory.94 Two principal policy issues arise: to what extent should private rights be abrogated by regulatory instruments incorporating different standards? And to what extent should regulatory standards be actionable as private rights? 90

Cf above, 80. Which is, admittedly, vague in its contours: see J Spencer, “Public Nuisance: a Critical Examination” (1989) 48 Cambridge Law Journal 55. 92 The Wagon Mound (No 2) [1967] 1 AC 617, 636. 93 Parts of this section draw on an unpublished paper, P Burrows and A Ogus, “Relationships between Private and Public Instruments for Efficiency and Corrective Justice Purposes: Private Rights and Regulatory Contraventions”, presented at the 12th Annual Conference of the European Association of Law and Economics, 1995. 94 CD Kolstad, TS Ulen, and GV Johnson, “Ex Post Liability for Harm vs. Ex Ante Safety Regulation: Substitutes or Complements?” (1990) 80 American Economic Review 888. 91

94

(D) Ogus Ch3

20/2/06

16:33

Page 95

The Structure of the Law

Abrogation of Private Rights Not infrequently, private law and public law obligations differ in their content; for example, a regulatory safety or environmental standard may be higher or lower than that governing the same activity and parties, but arising under contract or tort law. Whether the public standard should prevail over the private standard is, as a matter of law, determined by reference to the intention of the legislature but, since that often is not made explicit, the question of how judges should interpret the legislation raises important policy considerations. The analysis presented in this chapter can assist in addressing this interpretive issue. Whether the public law obligation should be regarded as mandatory or modifiable depends, as we have seen, on the justification for the interventionist measure. If the measure can be characterised as an effort to prescribe what the relevant parties would have agreed to, if not inhibited by transactions costs, then it should be modifiable by those parties. If, however, it was intended to override private governance, then it should be treated as mandatory, and thus prevail. By way of illustration, take, first, a situation where the private law standard is higher than its regulatory equivalent. Paternalist or distributional arguments for public governance here are unlikely, because such arguments would normally give rise to higher environmental and safety standards than those agreed privately. If this is right, it would follow that the higher private standard should be allowed to prevail, on the presumption that this is wealth-maximising between the relevant parties. That presumption may, however, be rebutted where there are externalities, the private high standard adversely affecting third parties who are not able, because of significant transactions costs, to participate in the private standard-setting process. The latter possibility is vividly illustrated by Attorney-General v Birmingham Corporation.95 An injunction was ordered to 95 (1858) 4 K & J 528, on which see L Rosenthal, “Economic Efficiency, Nuisance and Sewage: New Lessons from Attorney-General v Council of the Borough of Birmingham, 1858–95”, Keele Economics Research Papers, 2004/08.

95

(D) Ogus Ch3

20/2/06

16:33

Page 96

The Structure of the Law

enforce a private right to pure water enjoyed by a landowner against a local authority responsible for polluting a watercourse, notwithstanding that compliance with the private obligation would jeopardise the disposal of sewage, with risks to the health of a large population and that the public law obligations were, in consequence, more tolerant. Although the constitutional basis of this decision is understandable—“the court should be slow to acquiesce in the extinction of private rights without compensation”96—it would have been possible, as we will see in chapter seven,97 to have mitigated its adverse impact, by limiting the landowner’s remedy to an action in damages, rather than an injunction. Where the regulatory standard is higher than that which is required by private law, public governance should generally prevail. This is because the public law typically reflects paternalist or distributional objectives. However, where these considerations do not intrude, and information and externality problems do not affect private governance, there are strong economic arguments for allowing private modification of the regulatory standard.98 Actionability of Regulatory Standards I am injured by conduct which is in contravention of a regulatory standard, for example, that applicable under road traffic legislation. Can I use that very contravention as the basis of a private law claim for damages for my injuries; or must I instead show that the conduct giving rise to the convention involved also a breach of the relevant private law standards, in this case negligence law? The diversity of approaches taken in different legal systems to this question is striking.99

96 Wheeler v JJ Saunders [1996] Ch 19, 35, per Peter Gibson LJ. And see, more generally, W Fischel, Regulatory Takings: Law, Economics, and Politics (Cambridge, Mass, Harvard University Press, 1998). 97 Below, 201–5. 98 Palay, above n 46. 99 Jolowicz, above, n 21.

96

(D) Ogus Ch3

20/2/06

16:33

Page 97

The Structure of the Law

In France, for the purposes of establishing fault-based tort liability, the fault condition is satisfied following proof of the commission of a regulatory offence.100 In Germany, civil liability to pay damages arises, in principle, wherever there is a violation of a statutory provision intended for the protection of others.101 In the USA, regulatory contraventions have been accommodated within the general law of negligence.102 On the “negligence per se principle”, the commission of a regulatory offences is automatically treated as negligence, provided that, in the judge’s opinion, the violation was not “excusable”; and that the legislation was intended to lay down a standard appropriate to negligence. On the alternative, “evidence of negligence” principle, the regulatory contravention raises a presumption of negligence, which defendants can rebut if they can prove that they were not in fact negligent. In England, a civil action will lie for breach of statutory duty, whether or not the standard is consistent with negligence, but only if the court finds that it was the intention of the legislature to confer such an action on the victim.103 Judges are reluctant to find such an intention where it is not made explicit in the legislation.104 The analytical framework adopted in this chapter can better explain the American approaches to this problem, than those adopted in the other jurisdictions. That framework suggests that we should focus on whether the public standard was, or was not, intended as an instrument of, or proxy for, private governance, in the sense that it aimed to incorporate the standards which the relevant parties would have agreed upon, if transaction costs had allowed them to do so. Public law standards are likely to operate in this way where they are equivalent to, or compatible with, the principles of private law, as they apply to the particular 100

Code of Criminal Procedure, arts 1–2. Civil Code, para 823, Abs II. 102 C Morris, “The Role of Criminal Statutes in Negligence Actions” (1949) 49 Columbia Law Review 21. 103 Lonrho v Shell Petroleum [1982] AC 173. 104 KM Stanton, “New Forms of the Tort of Breach of Statutory Duty” (2004) 120 Law Quarterly Review 340. 101

97

(D) Ogus Ch3

20/2/06

16:33

Page 98

The Structure of the Law

circumstances. Sometimes, for example in relation to environmental or safety standards, private law imposes a general principle that reasonable care be taken; and standards equivalent to that principle are required in the public law. More frequently, scale economies in relation to acquiring the relevant information and/or formulating legal rules lead to regulatory standards being more specific, but still prescribing behavioural requirements that are consistent with the general standard of private law. In such cases it is appropriate that the regulatory standard is actionable in private law. In situations where the private and public law standards clearly diverge, the American courts would not be receptive to a private right and we can see the advantages of this approach. Take situations where there is a public law obligation, but no corresponding private law right, as for example, in the leading case of X v Bedfordshire CC.105 There officials were under public law obligations to make informed and reasoned decisions in relation to education, health and welfare provision. There were public law instruments for ensuring compliance with these obligations but it was held that those individuals who would have benefited if the obligations had been properly discharged had no private right in tort law to sue for damages. Interventionist measures of this kind may have been inspired by distributional goals and, if this was the case, the denial of a private right can be rationalised on the basis that the institutions and principles of public law are the appropriate means of determining how the redistributional goals should be pursued. This is exclusively a question of public governance because it makes no sense to envisage what the parties would have agreed in a market context. A second possibility is that the divergence reflects the existence of externalities, impacts which would not be adequately reflected in the market relationships which are the basis of the private rights. For example, if in X v Bedfordshire CC taxpayers, rather than the beneficiaries of the welfare services, would have 105

98

[1995] 2 AC 633.

(D) Ogus Ch3

20/2/06

16:33

Page 99

The Structure of the Law

to bear the financial consequences of significantly increased administrative costs engendered by private actionability, then the enforcement of the obligations by private rights would not be justified.106 A third possibility is that, while the public system serves to proxy for what would have been agreed in private, market arrangements, differences occur because, in either private or public law systems, decision-makers may have insufficient information or may make errors of judgement. Regulatory decision-makers may, for example, have readier access to information or greater technological expertise than private law judges. On this hypothesis, rendering breaches of public law standards actionable in private law would be acceptable; and the French and German approaches might be rationalised on this basis.

Conclusions In this chapter I have used economic reasoning not to appraise particular legal principles or doctrines, but rather as a perspective to view the structure of the legal system as a whole, and therefore how its different parts interrelate. To this end, and building on the analysis in chapter one, I started with private governance, individuals using property, contract and tort, as instruments for wealth-maximisation. I then showed how systems of public governance might, for the same purpose, be justified where the costs of private governance were excessive, particularly where information problems or externalities intruded. The law has goals other than wealth-maximisation, in particular, it may be used for distributional or paternalist purposes. Although instruments of public law, notably regulation, are primarily employed for these purposes, public governance can extend into private law territory, imposing non-modifiable private obligations, what I have called “private regulation”. 106 For another illustration of an externality argument, see Richardson v PittStanley [1995] QB 123 where granting a private right to sue on an obligation to take out insurance would have interfered with the system of claiming compensation against assets under insolvency law.

99

(D) Ogus Ch3

20/2/06

16:33

Page 100

The Structure of the Law

Mapping the legal system in this way does, in my view, help to illuminate some of the problematic issues, which judges in particular have to address, arising from tensions or conflicts between different parts of the legal system. To illustrate this, in the second part of the chapter, I deal with several such issues. On the interaction between tort and contract, and the different rules to which they give rise, the transactions-costs justification for moving from explicit (contract) to implicit (tort) private governance provides the key to understanding why the regimes governing remotness of damage and limitation periods should differ. Similar reasoning, in particular the need to accommodate consensual modification, helps to explain why the law of private nuisance is rooted in private property rights. The key to resolving the difficult issues of how regulatory standards should impact on private rights and vice versa is an understanding of the fundamental purpose of the interventionist measures. If they are intended to reflect what the relevant parties would have agreed, if contracting between them were feasible, this would suggest the appropriateness of rendering them actionable in private law, with any privately-agreed modification. If, on the other hand, they were intended to override private governance, because their aims were redistributional or paternalist, or because significant externalities intruded, then regulatory solutions should in general be the subject neither of private modification, nor of enforcement as private rights. Judicial determination of when a public law measure should have these public governance characteristics, to accord with the suggested approach, might not always be easy, but in essence is not different from the familiar task of deciding when, on grounds of public policy, contracts should not be enforced.

100

(E) Ogus Ch4

24/3/06

08:19

Page 101

4 Implicit Pricing and Behavioural Incentives

Introduction: Why Obey the Law? It was five o’clock in the morning and I was driving to the airport along what I thought was a deserted road. I came to some temporary traffic lights installed around road works. I could see that the road ahead was clear and there was therefore no risk of collision with a vehicle coming in the other direction, but because the signal was at red, I waited. While I was doing so, a car came up behind; its driver observed the same phenomenon and decided to proceed, notwithstanding the red light. I think that it can be safely assumed that the other driver knew, as I did, that proceeding through the red light was an unlawful act. Given that fact, how and why did we come to different decisions on whether to proceed? Social scientists, particularly social psychologists, have not been slow to provide explanations of why citizens (generally) obey the law.1 In relation to the incident described, some—including economists— would look to external forces, notably punishment or the threat of punishment for non-compliance or social pressures for compliance. Thus, my docile conduct might have resulted from my intuitive calculation that the costs of the consequences being caught (including the disapprobation of family and friends), even taking account of the unlikelihood of that event, still exceeded the benefits of getting to my destination 60 seconds earlier. The other driver might have reached the opposite 1 TR Tyler, Why People Obey the Law (New Haven, Yale University Press, 1990), ch 3.

101

(E) Ogus Ch4

24/3/06

08:19

Page 102

Implicit Pricing and Behavioural Incentives

conclusion for one, or a combination, of several reasons: the benefit of an earlier arrival at his destination was greater for him; his subjective perception of the probability of getting caught was smaller than mine; the consequences of getting caught would be less costly to him. Other social scientists, notably social psychologists, would focus more on reasons for compliance “internal” to the individual.2 So I, but not the other driver, might have regarded it as morally appropriate always to obey the law, or—an unlikely contingency in this example—always to obey this type of law, perhaps through an acknowledgement of the legitimacy of rulers to impose obligations (in general or this particular type of obligation) on citizens. I do not wish to underestimate the importance of these “internal” explanations.3 But if it be accepted—which typically is the case—that external inducements do play a significant part in motivating behaviour, then, for legal policy purposes, it makes sense to analyse such phenomena in depth, because influencing the mind-set, which makes up the “internal” response, is invariably more costly and more difficult to procure than altering the operation of the external inducements.

External Inducements: The Basic Ideas External inducements can be envisaged as imposing costs or conferring benefits on actors. When integrated into the actors’ cost-benefit appraisal of the different available behavioural options, they may significantly alter preferences, and therefore demand, like any other increase or reduction of price. 2 Eg: P Webley et al, “Studies on Minimal Rule Behaviour: Formal Rules in Public Places” (1998) 4 Psychology Crime & Law 309. The classic jurisprudential exposition of the “internal” reasons for compliance is that in HLA Hart, Concept of Law (Oxford, Clarendon Press, 1960), 55–60. 3 It is, of course, possible to translate these and indeed any other “internal” perceptions into a cost-benefit utility calculus and thus not different from the response to “external” factors, but the analysis then becomes tautologous: R Korobkin, “A Multi-Disciplinary Approach to Legal Scholarship: Economics, Behavioral Economics and Evolutionary Economics” (2001) 51 Jurimetrics 319.

102

(E) Ogus Ch4

24/3/06

08:19

Page 103

Implicit Pricing and Behavioural Incentives

To see how law, as an external inducement, interacts with other price variables, take the following example. I must decide whether to drive to the city centre to do my weekly shop there, or else to travel by bus. In the absence of a government policy instrument to influence my decision, I might prefer to go by car on the grounds that the additional financial cost of car travel (petrol, depreciation and parking, less the bus fare) is exceeded by the non-financial utility it provides me (primarily comfort and absence of waiting time). Now of course my decision might be reversed by changes to my costs resulting from ordinary market developments, for example, an increase in the (private) car park fee or the price of oil. But, equally, a government concerned to reduce traffic congestion in the city might induce the same decision by a legal or fiscal device. The main possibilities of raising the cost of car travel are:4 prohibiting the entry of private cars into the city central zone without a permit; levying a charge for entry; and imposing a tax on car parking. Alternatively the cost of bus travel might be reduced by subsidies which either lower the fare or ensure a greater frequency of service. The additional cost to actors arising from a legal intervention is assessed by reference to two principal variables: D, the losses which they will incur from the law being enforced, discounted by p, the probability of such enforcement activity.5 Thus the illegality of the act raises its ex ante price by pD. The complexities arising in calculating pD are of course considerable.6 First, the p and D variables reflect the potential offender’s subjective perception of the probability of apprehension and of the associated level of costs respectively, rather than their objective values; and the accuracy of such perceptions will of course depend inter alia 4 KJ Button and ET Verhoef (eds), Road Pricing, Traffic Congestion and the Environment: Issues of Efficiency and Social Feasability (Cheltenham, Edward Elgar, 1998). 5 For an introductory explanation to this form of analysis, see above, 44–5. 6 The following section draws on A Ogus and C Abbot, “Sanctions for Pollution: Do We Have the Right Regime?” (2002) 14 Journal of Environmental Law 283.

103

(E) Ogus Ch4

24/3/06

08:19

Page 104

Implicit Pricing and Behavioural Incentives

on the information available to the offender on enforcement practice. Further, some people are known to dislike taking risks and therefore will be more easily deterred than others. Thus pD should be weighted to reflect the degree of such “risk aversion”.7 Secondly, since p refers to apprehension by the public agency and not, more narrowly, to a formal determination of liability (or guilt) by the court or agency with power to impose a penalty, D covers a far wider range of costs than a simple formal sanction, such as a fine. It thus includes the “hassle” and personal inconvenience costs arising from apprehension by a policeman or other public official, legal and other defence expenditures and any stigma or loss of reputation resulting from such apprehension and subsequent events.8 Because not all cases reach the ultimate stage of conviction or condemnation, involving the imposition of the formal sanction, it is helpful to rewrite the ex ante additional cost arising from rendering the act illegal as: qE + pD where qE represents the probability and the associated costs of the relevant act being detected by an enforcement agent, and pD the probability of a formal condemnation or conviction and its associated costs, including notably the prescribed sanction. Whether a particular external inducement will, in a given set of circumstances, operate effectively to modify behaviour in the desired way is dependent on yet a further variable, the opportunity cost to the actor of compliance, that is the utility/benefit that is derived from the undesirable act (U). In accordance with the standard economic model,9 for compliance to be achieved, the 7 There is empirical evidence to suggest that those committing small offences are more sensitive to changes in p, whereas those committing more serious offences are more averse to changes in D: A Witte, “Estimating the Economic Model of Crime with Individual Data” (1980) 94 Quarterly Journal of Economics 57. 8 E Eide, “Economics of Criminal Behavior” in B Bouckaert and G De Geest (eds), Encyclopedia of Law and Economics (Cheltenham, Edward Elgar, 2000), vol V, 351. 9 G Becker, “Crime and Punishment: an Economic Approach” (1968) 76 Journal of Political Economy 161.

104

(E) Ogus Ch4

24/3/06

08:19

Page 105

Implicit Pricing and Behavioural Incentives

costs associated with the inducement, and assessed on the above basis, must exceed the benefit which will be foregone if the relevant act is not performed: U < qE + pD. The subjective content of U makes estimation of it highly problematic, but actors will not have to ascribe to it a particular value; it is a question of perceiving—if only intuitively—that it is, or is not, greater than the costs arising from commission of the act. And policy-makers, in designing external inducements, might be expected to attribute some average value to U. There are, nevertheless, some characteristics to this cost-benefit appraisal which vary significantly as between different classes of individuals. Take, first, the question of elasticity and inelasticity: some individuals may be more responsive to changes in the costs imposed by sanctions, than others.10 This may be because satisfactory substitutes for the act are particularly easy (or difficult) to find. For example, it is likely to require a substantial increase in the cost (including taxation) of cigarettes before someone addicted to smoking them will significantly reduce consumption. Risk aversion may have the opposite effect. If I do not like taking risks, particularly in relation to behaviour which might generate investigation by the police, then I am likely to be particularly responsive to an increase in the probability of my being caught while engaged in an illegal activity (q). It should be observed, too, that the wealth of an individual may also have an impact. It might affect the value attributed to the act (U). Stealing a loaf of bread or a £10 note will be worth more to a starving person than to someone not in such a desperate need; and therefore to deter, the sanction must be correspondingly higher. Conversely, since the time of a poor person is typically less valuable than that of a rich person, because earnings are generally lower, the utility of exceeding the speed limit and getting to a destination earlier will be higher for the latter.11 10 S Levitt “Why do Increased Arrest Rates Appear to Reduce Crime: Deterrence, Incapacitation or Measurement Error?” (1998) 36 Economic Inquiry 353. 11 D Friedman, Law’s Order: What Economics has to Do with Law and Why it Matters (Princeton, Princeton University Press, 2000), 232–4.

105

(E) Ogus Ch4

24/3/06

08:19

Page 106

Implicit Pricing and Behavioural Incentives

A Taxonomy of External Inducements Analysis of the kind described above has given rise to a huge literature within the economics of criminal justice and law enforcement, exploring in particular the potential efficiency of different strategies in relation to penal sanctions (D) and enforcement policies (p).12 It has rarely been used to compare the wide range of legal and non-legal inducements which exist Table 2 sanction

area of law

enforcer

how assessed

fine

criminal

punishment

imprisonment

criminal

community service confiscation

criminal

police/§ public agent police/ public agent police/ public agent police/ public agent victim victim victim victim affected party

tort damages punitive damages injunction restitution contractual invalidity administrative penalty tax/charge

criminal/civil* civil civil civil civil civil administrative administrative

market exclusion administrative name & shame administrative social norm

n/a

punishment rehabilitation actor’s profits

victim’s loss punishment cessation actor’s profits actors’ investment and expected profit public agent deterrence?

public agent deterrence/revenue raising public agent cessation public agent actor’s expected profits/moral costs citizens moral costs

12 The literature is reviewed in Eide, above n 8, 345–89, and AM Polinsky and S Shavell, “Public Enforcement of Law” in Bouckaert and De Geest, above n 8, vol V, 307–44. * Civil proceedings for confiscation may be taken under the Proceeds of Crime Act 2002, pt V: see below, 123.

106

(E) Ogus Ch4

24/3/06

08:19

Page 107

Implicit Pricing and Behavioural Incentives

in most societies.13 I attempt to provide a taxonomy of the principal instruments in table 2. The nature of some of the instruments may require explanation. An administrative penalty is imposed by a public agency for a regulatory contravention without a criminal justice process: for example, when a traveller is caught riding on public transport without a valid ticket. It is thus to be contrasted with an administrative charge or tax which is levied on certain types of otherwise lawful conduct, such as the purchase of cigarettes. Regulatory authorities may also have the power, though normally only after judicial proceedings, to exclude actors from lawfully operating in the market by, for example, depriving them of a licence or permit. In some situations they may be able to give adverse publicity to firms and individuals who contravene the law, in the expectation that such “naming and shaming” will adversely affect market reputations and thus diminish profits. Included also, for purposes of comparison, is social disapproval which arises from the contravention of social, but not legal, norms. “Contractual invalidity” refers to situations in which the actor’s endeavours to achieve an intended outcome are frustrated when the contract used for that purpose is declared, as a consequence of intervention by some affected party, to be without legal effect, since it is contrary to some public policy or standard. The primary function of tort liability is generally assumed to be the compensation of victims; restitution to deprive the actor of unjustified enrichment; and that of taxes to raise revenue. However it is often the case that these instruments are used to regulate conduct and thus it is important for policy purposes to understand and compare their capacity to influence the actor’s behavioural choice.14 13 A valuable analysis of the choice between moral and legal sanctions is contained in S Shavell, “Law Versus Morality as Regulators of Conduct” (2002) 4 American Law and Economics Review 227, but comparisons between different legal regimes are not included. 14 Cf H Collins, Regulating Contracts (Oxford, Oxford University Press, 1999), ch 4. His analysis is concerned particularly with the regulatory capacity of contract law.

107

(E) Ogus Ch4

24/3/06

08:19

Page 108

Implicit Pricing and Behavioural Incentives

To appreciate how effectively the sanctions listed in table 2 can operate as inducements to behavioural change in particular contexts, we need to determine and compare the cost of adapting them to the conditions of the economic model. For this purpose, I identify four key cost variables: the enforcement of the sanction; the targeting of the sanction; the presence (or absence) of informal costs; and the information available to the actor. I also consider how the analysis differs, if it all, when the activity occurs within a corporate setting.15

Enforcement Costs The costs of enforcing the different inducement systems vary considerably. The matter is significant not only because, other things being equal, low cost inducements are preferable to high cost inducements, but also because the higher the cost, the less likely it is to be invoked, and therefore the lower the probability of apprehension (q). Enforcement normally has three dimensions: monitoring the actor’s conduct; once apprehension of the relevant conduct has occurred, engaging in the processes necessary for determining contravention and the appropriate sanction; and, finally, imposing the chosen sanction. Monitoring The costs of monitoring compliance with social norms will typically be small, because of the large numbers of potential “enforcers.” As regards formal legal sanctions, there are clearly economies of scale associated with systems using a public enforcement agency, thus typically criminal and administrative inducements. This advantage may be partly offset, however, by the fact that civil law claimants typically gain personally from the remedy, notably damages, which the law confers on them and

15 The analysis develops and refines that presented in A Ogus, “What Legal Scholars can Learn from Law and Economics” (2004) 79 Chicago-Kent Law Review 383, 385–8.

108

(E) Ogus Ch4

24/3/06

08:19

Page 109

Implicit Pricing and Behavioural Incentives

the “carrot” may render them more diligent enforcers.16 Of course, for such an incentive to be operative, the benefits, financial and non-financial, must exceed the costs of making legal claims, a condition which in some contexts may justify the award of punitive, rather than compensatory, damages. Account has also to be taken of the generality of the environment in which the relevant activity takes place—the larger the haystack, the more costly it is to discover the pin. This factor may reduce the enforcement expenditure of parties who are engaged in some continuing relationship, for example, contractual, with the actor, compared with that of general agents, for example, the police, who have a large population to monitor. A related point is that if the inducement can be integrated into an administrative system which already requires routine monitoring, then the marginal cost of any additional monitoring may be relatively small; so, for example, with a pollution tax element incorporated into the VAT system.17 Sanction Processes Processes leading to sanctions generate highly differentiated costs. We may begin by observing that no formal processes occur in relation to social norms and that administrative taxes and charges are normally routinely applied without any institutional investigation. Civil law damages claims can in general be settled without court adjudication, although the claimant’s settlement payment will invariably be less than what the court would have awarded if the process had been completed.18 This is in sharp contrast to criminal penalties and the administrative sanction of exclusion from the market which can only be 16 WM Landes and RA Posner, “The Private Enforcement of Law” (1975) 4 Journal of Legal Studies 1. 17 S Smith, “Green” Taxes and Charges: Policy and Practice in Britain and Germany (London, Institute for Fiscal Studies, 1995), 19–20. 18 H Genn, Hard Bargaining: Out of Court Settlement in Personal Injury Actions (Oxford, Clarendon Press, 1987); for economic analysis, see RD Cooter and DL Rubinfeld, “Economic Analysis of Legal Disputes and Their Resolution” (1989) 27 Journal of Economic Literature 1067, 1075–82.

109

(E) Ogus Ch4

24/3/06

08:19

Page 110

Implicit Pricing and Behavioural Incentives

imposed after a formal hearing. However, the significance of the distinction is somewhat reduced by the fact that the enforcement authorities and the actors can effectively negotiate a compromise on the basis of which a reduced, and informal, sanction is imposed as the price of the authority exercising its discretion not to take formal proceedings.19 A perhaps more significant cost feature of the criminal justice process is a consequence of the enforcement agency having to marshal sufficient evidence to obtain a conviction, notwithstanding the exacting rules of criminal procedure including, notably, the high burden of proof (“beyond all reasonable doubt”), the restrictive rules of evidence and (in serious cases) the requirement of a jury trial.20 These requirements contrast markedly with what is involved in civil law21 and administrative processes, thus leading to a significantly lower cost of securing the formal sanction. An economic analysis of the justification for the differences between criminal justice procedure on the one hand, and civil justice and administrative procedure on the other, is illuminating. The higher protection offered to criminal justice defendants may be explained by a desire to avoid the conviction of innocent people22 and thus, in economic terms, the high costs of such erroneous decisions.23 But in endeavouring to reduce these 19 Plea-bargaining, where it exists, performs a similar function. On this, see BH Kobayashi and JR Lott, “Low Probability-High Penalty Enforcement Strategies and the Efficient Operation of the Plea Bargaining System” (1992) 12 International Review of Law and Economics 69. 20 J Rowan-Robinson, P Watchman, P and C Barker, Crime and Regulation: a Study of the Enforcement of Regulatory Codes, (Edinburgh, T & T Clark 1990), 255–63. 21 The civil law burden of proof is “on the balance of probabilities”; and jury trials are highly exceptional. 22 G Williams, The Proof of Guilt: Study of the English Criminal Trial (London, Stevens, 1955), 154–8. 23 R Posner, “An Economic Approach to Legal Procedure and Judicial Administration” (1973) 2 Journal of Legal Studies, 399, 410–17. For another interpretation, see KN Hylton and VS Khanna, “Toward an Economic Theory of ProDefendant Criminal Procedure” (2001) available at http://papers.ssrn.com/ paper.taf?abstract_id=265795.

110

(E) Ogus Ch4

24/3/06

08:19

Page 111

Implicit Pricing and Behavioural Incentives

costs, others are increased: not only the institutional costs in meeting the more extensive procedural requirements but also the losses arising from the increased chance of failing to convict, and therefore also failing to deter, the guilty—if the costs of enforcement rise, the probability of incurring the sanction (p) falls.24 There are evident difficulties in quantifying and therefore comparing these various costs. Sir William Blackstone famously asserted that it was “better that ten guilty persons escape, than one innocent suffer”.25 The assessment was, presumably, intuitive. In modern times, Hylton and Khanna have estimated that, for the criminal (“beyond all reasonable doubt”) burden of proof to be preferable, on economic grounds, to the “balance of probabilities” standard used in civil law cases, the costs arising from the wrongful conviction of the innocent must, in the given area, be at least 2.64 times those arising from erroneous acquittal of the guilty.26 Sanction Impositions Discussion of the costs of imposing sanctions can be kept short, since the differences are relatively clear. Most obviously, sanctions requiring protracted administration, notably imprisonment but also community service, are the most costly. While not leading to costs on the same scale, the exclusion of actors from the market requires on-going monitoring and hence falls into the same category. So also with the imposition of a civil law injunction, although here a negotiated release by the claimant will significantly reduce the administrative costs.27 Declarations that contracts, or some of their terms, are illegal and therefore unenforceable, might involve relatively low administrative costs, but here account must be taken also of the external costs which may be incurred by third parties in relying on the validity of the 24

Ogus and Abbot, above n 6, 293. W Blackstone, Commentaries vol IV, 19th edn (London, Sweet and Maxwell, 1836), 358. 26 Above n 23. They assume the “beyond reasonable doubt” test to imply a probability of accuracy of 95%. 27 See further on this, below, 197–201. 25

111

(E) Ogus Ch4

24/3/06

08:19

Page 112

Implicit Pricing and Behavioural Incentives

contract.28 The infringement of social norms does not lead to any formal administrative action, and the cost to any individual in manifesting disapproval might be small, but for this regime to constitute an effective inducement, the disapproval must be widespread and, presumably continuing to some degree.29 In aggregate, such costs may therefore not be trivial. Sanctions involving a single transaction or other event generate low administrative costs, most obviously where seized assets are confiscated. Securing financial payments by actors is not always easy, but the lower the amount (relative to the actor’s wealth) the more likely this is to occur at low cost. Scale economies suggest that public law financial sanctions (fines, taxes, charges, administrative penalties) will be cheaper to impose than private law damages.

Costs of Targeting the Sanction The next variable to be investigated is that of the sanction. To compare the capacity of the different inducements to meet the requirements of the economic model, we need to know how easily the cost that the instrument imposes on the actor can be fashioned to induce that person to make the relevant behavioural change. Simple Deterrence: Reference to Actor’s Utility I begin with the straightforward case in which the policy objective of the inducement is a given: the relevant act is assumed to be socially undesirable. Here, as we have already seen, the condition for the inducement to be operative is U < qE + pD It follows that, for this inequality to be satisfied, the amounts selected for D and E should have reference both to the proba28 A Griffiths, Contracting With Companies (Oxford, Hart Publishing, 2005), 58–60. 29 Shavell, above n 13, 241.

112

(E) Ogus Ch4

24/3/06

08:19

Page 113

Implicit Pricing and Behavioural Incentives

bility of that loss being incurred by the actor (p and q respectively) and the utility/profit (U) which the actor is likely to derive from the socially undesirable activity. In particular, for the formal sanction to create the appropriate incentive for the actor ex ante, the condition is D>

U – qE p

Now this formula might appear to impose substantial information problems on those responsible for setting the formal sanctions: they may have some knowledge regarding enforcement policy sufficient to make a reasonable estimate of p and qE, but establishing a value for U is likely to involve much guesswork. The difficulty is partially alleviated by the fact that, if the value of D exceeds (but is not less than) that prescribed by the above formula, the incentive on the actor will not change: if I am induced to obey a red light signal by a threat of £x, my response will not be different if the threat is £x + y. However, this reasoning is subject to important qualifications. The wealth of an actor is clearly a constraint. If there will be insufficient assets (which include the profits, if realisable, of the act in question) to meet a prescribed financial sanction, nonfinancial alternatives, such as imprisonment, have to be imposed and this significantly increases administrative costs. This has led to the proposition that D should be maximised within the wealth constraint, on the ground that that would enable the value of p to be reduced, with savings of enforcement costs.30 But the higher the financial penalty, the more difficult, and the more costly, it is to extract from offenders. There is also the possibility that an excessive penalty may create a perverse incentive for the actor to increase the amount of law-breaking on the basis that “you might as well be hung for a sheep as a lamb”.31 30

Becker, above n 9, 193–8. D Friedman and W Sjostrom, “Hanged for a Sheep: the Economics of Marginal Deterrence” (1993) 22 Journal of Legal Studies 345. In any event, such an approach is wholly incompatible with the principle of retributive justice (or 31

113

(E) Ogus Ch4

24/3/06

08:19

Page 114

Implicit Pricing and Behavioural Incentives

The conclusion to be drawn from these arguments is that levying too large a sanction will not, in general, impair the inducement on the actor to abstain from the undesired activity, but that the further removed the sanction (when discounted for p) is from U, the larger the costs, administrative and social, which will result.

The Normative Alternative: Reference to the Harmfulness of the Activity Those responsible for setting the amount of the sanction can adopt an alternative strategy which does not involve any reference to U but is based, rather, on the harmfulness of the activity. Suppose that D is assessed by reference to (H) the amount of harm generated by the undesired act, so that D=

H – qE p

Actors will here be deterred from performing the act, but only if the social cost (H) arising from it, as reflected in the combination of pD + qE, exceeds the increase the act generates to their utility/profit (U). Suppose that I value proceeding through a red traffic light in a given set of circumstances at £20 and that the cost to society in my taking that risk, primarily the average harm I am likely to cause if I collide with another road user (say £1,800) discounted by the risk of such an accident (say 0.01), is £18. Assume, for the sake of simplicity, that qE is trivially small. If p is 0.1, and the sanction for the act is determined by reference to £18, that is £180, I will cross the light because 20 > 180  0.1. “just deserts”) which dominates modern sentencing policy (A Ashworth, Sentencing and Criminal Justice, 3rd edn (London, Butterworths, 2000), 72–4) and notions of distributive justice which suggest that it is unfair to impose draconian measures on the small minority of offenders who happen to be caught as a consequence of the policy.

114

(E) Ogus Ch4

24/3/06

08:19

Page 115

Implicit Pricing and Behavioural Incentives

The reference to social costs means that the formula can serve a different and more ambitious function. Instead of being concerned simply to induce what has already been determined to be socially-desirable behaviour, it now itself furnishes the criterion of what is socially desirable,32 by forcing a comparison between the utility of the actor’s behaviour with its social costs. We have moved, in other words, from the plane of positive analysis to that of normative analysis; and, as such, the approach is, in some contexts at least, controversial. If, for example, the act envisaged by the agent is one of rape or murder, application of the revised formula would imply that the utility which the perpetrator acquires from such an act can be legitimately set off against its social costs because it is all part of what makes society better off, in other words, the social welfare function. We might therefore expect to see the simple deterrence model used in cases of mainstream crime, where policy-makers would be reluctant to include the actor’s utility in the social welfare function and the normative model used for situations within the regulatory sphere of government, where there is generally some social utility in the activity to be deterred.33 Indeed, it is precisely within the latter area that economists have for long advocated the use of taxing devices which seek to internalise to the actor the social harm created by the activity, rather than prescribing particular forms of conduct and enforcing them by the simple deterrence model.34 One of their arguments is that the taxation approach obviates the need for regulators and other 32 See, eg: Polinsky and Shavell, above n 12, 309. The Australian Law Reform Commission in its report, Principled Regulation: Federal Civil and Administrative Penalties in Australia (2003), 783, refer to this as “optimal deterrence”; what is described above 112 as “simple deterrence”, they call “absolute deterrence”. 33 “Regulation” has been defined as “a sustained and focused control exercised by a public agency over activities that are valued by the community” (my italics): P Selznick, “Focusing Organizational Research on Regulation” in R Noll (ed), Regulatory Policy and the Social Sciences (Berkeley, University of California Press, 1985), 363. 34 WJ Baumol, “On Taxation and the Control of Externalities” (1972) 67 American Economic Review 307.

115

(E) Ogus Ch4

24/3/06

08:19

Page 116

Implicit Pricing and Behavioural Incentives

law-makers to determine what behaviour is socially desirable; instead, place the full cost of the activity on agents (often firms) and, in the light of their profit-making objectives, they should— given access to appropriate information—determine what is optimal. Take the following simple example. A given activity generates profits to the actor (U ) of £8,000 but at the same time causes harm (H ) assessed at £10,000. The harm can be eliminated by a specific precaution costing £1,000 or by another precaution costing £2,000. Clearly the optimal solution is for the actor to take the first precaution. The simple deterrence model would require the law-makers to be aware of the cheaper precaution, and then to impose a sanction for failing to take that precaution, such that pD + qE would exceed £8,000. Under the normative alternative, knowledge by the law-maker of the cheaper solution is not required: a “charge”, calculated on the basis that pD + qE would approximately equal £10,000, is levied if the harm occurs, and it is for the actor to choose the cheapest way of avoiding paying it. In many situations, this characteristic of the normative approach should lead, in comparison with the simple deterrence model, to a significant savings in administrative costs, but the approach also has a countervailing cost disadvantage.35 In the application of the simple deterrence model, we noted that raising the discounted sanction (pD) above the actor’s utility would not generally affect the inducement. In contrast, setting the sanction above (or below) that required to reflect H, will, normatively, send the wrong signal to the actor, and may induce behaviour which is not desired.36 Suppose, to adapt the last example, there was no measure available to the actor to avoid the harm of £10,000. The activity will then be undertaken only if the amount of profits exceeds that sum. If, however, the sanc35 For more detailed comparison on these points, see: R Cooter, “Prices and Sanctions” (1984) 84 Columbia Law Review 1523; A Ogus, “Corrective Taxes and Financial Impositions as Regulatory Instruments” (1998) 61 Modern Law Review 767. 36 Cooter, above n 35, 1532.

116

(E) Ogus Ch4

24/3/06

08:19

Page 117

Implicit Pricing and Behavioural Incentives

tion is erroneously set so that the actor faces an ex ante cost of (say) £20,000, an activity generating profits of (say) £18,000 will not be undertaken—and the normative objective will be defeated. In short, the normative approach requires that those setting the sanction are able to make a reasonably approximate assessment of the harm caused. Fixed and Discretionary Sanctions The first implication of the above analysis is that regimes which impose fixed sanctions will perform poorly as external inducements, except where the probability of enforcement and the level of utility/profit or social harm are reasonably predictable and in consequence are reflected in the sanction. The only regimes which involve fixed sanctions are administrative penalties and tax/charges. Fixed penalties have typically been used in the UK37 only for relatively minor contraventions, such as travelling on public transport without a valid ticket, creating litter and certain road traffic offences.38 Information regarding the probability of apprehension is presumably available to those determining the sum payable and the level of utility/profit (or social harm) can be assumed to be relatively small. In such circumstances, and provided that the stipulated sum is not so high that actors consider it worthwhile to challenge the imposition in formal proceedings,39 the inducement can be achieved at low administrative cost. 37 Administrative penalties are more widely used in foreign jurisdictions: for common law countries, see Australian Law Reform Commission, Securing Compliance: Civil and Administrative Penalties in Australian Federal Regulation, Discussion Paper 65 (2002); for European countries, see European Commission, The System of Administrative and Penal Sanctions in the Member States of the European Communities (Brussels, Office for Official Publications of the European Communities, 1994). 38 Home Office Consultation Paper, Reducing Public Disorder: the Role of Fixed Penalty Notices (2000), paras 4–6. More controversially, there has recently been a proposal to extend them to 16 and 17-year-olds responsible for antisocial behaviour: White Paper, Respect and Responsibility—Taking a Stand against Anti-Social Behaviour (Cm 5778, 2003). 39 Cf Reducing Public Disorder, above n 38, para 11.

117

(E) Ogus Ch4

24/3/06

08:19

Page 118

Implicit Pricing and Behavioural Incentives

Administrative taxes/charges are also typically fixed but sometimes calculated by reference to measurable dimensions of the activity, such as time (eg a parking charge) or the amount of waste (eg pollution tax). As such, they have often been regarded, potentially at least, as examples of the normative approach, the amount levied per unit (of time or waste) reflecting the harm created by the activity; congestion and pollution, respectively.40 In practice, the use of administrative taxes for this purpose has been hindered by two major obstacles.41 In the first place, there are the huge informational demands, not only of assessing H, but also of determining the marginal impact on H of each of the taxable units (in the case of the pollution tax, the concentration of particular pollutants). In the light of such demands, theorists have argued that a tax based on imperfect information can achieve the desired effect, but only by iterative means.42 An initial rate is set, based on policy-makers’ best guess of what would be appropriate; its effect on behaviour is monitored; it is then fine-tuned until the desired outcome is achieved. The second difficulty due to the fact that governments benefit from the revenue raised by these regulatory instruments and there is an inherent conflict between the inducement and the revenue-raising functions due to differences in the price elasticity of the relevant activity.43 The more reluctant individuals are to change their behaviour, the more they will pay by way of tax. It follows that the more successful a tax is in raising revenue, the less successful it will be in inducing behavioural change; and vice versa. There is, therefore, a risk that the design of any given tax or charge will tend to reflect its revenue-raising potential rather than its behaviour-inducement capacity. 40 Ogus, above n 35, 768–9. For a formal demonstration of the economic advantages, see L Kaplow and S Shavell, “On the Superiority of Corrective Taxes to Quantity Regulation” (2002) 4 American Journal of Law and Economics 1. 41 A Ogus, “Nudging and Rectifying: the Use of Fiscal Instruments for Regulatory Purposes” (1999) 19 Legal Studies 245. 42 WJ Baumol and WE Oates, “The Use of Standards and Prices for Protection of the Environment” (1971) 73 Swedish Journal of Economics 42. 43 Ogus, above n 41, 258.

118

(E) Ogus Ch4

24/3/06

08:19

Page 119

Implicit Pricing and Behavioural Incentives

Most regimes enable publicly-authorised decision-makers some discretion in assessing the amount of the sanction at the time of the process, albeit within parameters and principles laid down by the law. As regards sentencing within the criminal justice process, there is a vibrant debate on the appropriate degree of control which the legislature or executive should exercise over judges.44 Our analysis suggests that discretion is economically advantageous as it allows the judge or other officials to adapt the ex post “price” to the actor’s circumstances.45 Punishment The existence of a discretion in the quantification of the sanction does not, of course, necessarily mean that decision-makers will attempt to tailor it to what is required by the economic model. With or without the constraints of legislative principles, they may be pursuing other objectives. The task is then to identify, for each type of external inducement, the relevant alternative objectives and ascertain the extent to which they can be reconciled with the economic goals of behavioural incentives. We may start with punishments which are largely administered by the criminal justice process, although account must also be taken of the power of the court to award exemplary or punitive damages for civil wrongs. On the face of it, criminal justice sanctions correlate with the inducement function more easily than other sanction systems, because it has readily been acknowledged from the time of Bentham46 that deterrence is one of the main purposes of the criminal law.47 True, in modern times, retribution, based on the 44

Ashworth, above n 31, 46–8. In FH Easterbrook, “Criminal Procedure as a Market System” (1983) 12 Journal of Legal Studies 292, the author hypothesises that the state “purchases” illegal activity from the offender. As such, “there is no “right” price of crime any more than there is a “right” price of apples” (295) and judicial discretion is therefore desirable (322–30). 46 “First Rule:—The evil of the punishment must be made to exceed the advantage of the offence”: J Bentham, The Theory of Legislation (ed CK Ogden) (London, Kegan Paul, 1931), 325. 47 Ashworth, above n 31, 64–8. 45

119

(E) Ogus Ch4

24/3/06

08:19

Page 120

Implicit Pricing and Behavioural Incentives

notion of “just deserts,”48 seems to have taken precedence, but the two approaches may be largely compatible. Take the leading statutory principles that, the amount of any fine fixed by a court shall be such as, in the opinion of the court, reflects the seriousness of the offence

and in fixing the amount . . . a court shall take into account the circumstances of the case including, among other things, the financial circumstances of the offender . . .49

The first provision begs the question of how “seriousness of the offence” is to be determined, but criminologists typically base this on both the amount of harm caused or risked by the act, and the degree of “culpability”, involving factors of intent and motive.50 The harm variable, of course, corresponds to H, and therefore is particularly apt for the normative approach. It will also serve for simple deterrence purposes, provided that when discounted by p, it is sufficient—account being taken also —to exceed U. The culpabilof additional costs arising from qE— ity variable is typically justified by reference to moral considerations but may serve an important economic function in relation to U, since it provides a reasonably reliable indicator of those individuals who have an inelastic response to inducements. It can be surmised that the more deliberate or intentional the act, the higher the benefit to be derived from it (U); and therefore the larger the sanction needed to deter it.51 And the reference to the financial circumstances of the offender correlates well with the recognition in our previous discussion that wealth may be an important variable in relation to U 52 as well as a necessary constraint on the amount of a financial sanction.53 48 A Von Hirsch, Censure and Sanctions (Oxford, Oxford University Press, 1993). 49 Powers of Criminal Courts (Sentencing) Act 2000, s 128(2)–(3). 50 A Von Hirsch and N Jareborg, “Gauging Criminal Harm: a LivingStandard Analysis” (1991) 11 Oxford Journal of Legal Studies 1, 2–3. 51 Cooter, above n 35, 1537. 52 Above, 105. 53 Above, 113.

120

(E) Ogus Ch4

24/3/06

08:19

Page 121

Implicit Pricing and Behavioural Incentives

Other criminal law sanctions may be dealt with briefly. Where U is relatively large but there cannot be a matching increase in the amount of a fine, because of the constraint of the actors’ wealth, the policy choice is between raising p, the marginal costs of which rise steeply, or imposing another form of sanction which creates non-financial disutility to the actor.54 Imprisonment may be assumed to impose a very heavy non-financial cost on the offender and is therefore an effective deterrent. It also serves to incapacitate the offender from committing further offences during the period of incarceration, thus generating further social benefits which, particularly in the case of violent offenders, may be considerable; but it is very costly to administer. Community service is somewhat less costly and may also increase social welfare, by educating or socially reintegrating the offender, but from a deterrence perspective it may not impose sufficient disutility. Although sanctions, designed as punishments, may, in accordance with this analysis, perform well as inducements, there is also a general recognition that they are intended to do something more than this, particularly if they are part of the criminal justice system. Use of the criminal law implies for most people some form of moral denunciation.55 This dimension has been used as an argument for denying the predictive ability of economic models of criminal behaviour56; but without distortion it can be incorporated into the model as part of the cost variable.57 Decision-makers may recognise that for many (most?) individuals there is a moral force attaching to the notion of criminal liability. This will, by itself, create some inducement to obey the law, irrespective of the size of the sanction, thus implying 54 AM Polinsky and S Shavell, “Enforcement Costs and the Optimal Magntiude and Probability of Fines” (1992) 35 Journal of Law and Economics 133 55 J Braithwaite, Crime, Shame and Reintegration (Cambridge, Cambridge University Press, 1989). 56 T Gibbons, “The Utility of Economic Analysis of Crime” (1982) 2 International Review of Law and Economics 173. 57 Ogus, above n 35, 783.

121

(E) Ogus Ch4

24/3/06

08:19

Page 122

Implicit Pricing and Behavioural Incentives

some addition to D and E where criminal liability is involved. Alternatively, the phenomenon may be treated as part of the informal costs, notably stigma, which are linked to, but not part of, the formal sanction. Outside the criminal law, these considerations may not apply but there are instances where sanctions are viewed primarily in terms of punishment. Administrative action taken in respect of serious regulatory contraventions sometimes takes this form. Enforcement agencies operating in areas of corporate and economic regulation are increasingly being given powers to impose heavy financial penalties.58 Of particular interest, here, are the explicit efforts that have been made in some jurisdictions to relate these directly to U. So, in Australian competition law, judges relate the amount of the penalty to estimates of profits derived from the breach.59 Of course, by itself this constitutes imperfect deterrence because it takes no account of p. One solution is to have reference to some multiple of U, an approach adopted in New Zealand where the administrative penalty for insider trading is three times the gain made by trading in the securities.60 Finally, we should note that punitive (or exemplary) damages, available for the enforcement of some private rights, are easily reconcilable with the simple deterrence model.61 In English law the sanction is explicitly to be used in cases of wrongful conduct which has been calculated by the defendant to make a profit for himself which may well exceed the compensation payable. . . . To mark their disapproval of such conduct and to deter him from repeating it, then it [the jury] can award some larger sum.62

58

See, eg, Competition Act 1998, s 36. Australian Law Reform Commission, above n 32, pp. 815–16. 60 Securities Amendment Act 1988. 61 For a more detailed appraisal, see A Ogus, “Exemplary Damages and Economic Analysis” in K Hawkins (ed), The Human Face of Law: Essays in Honour of Don Harris (Oxford, Oxford University Press, 1997), ch 4. 62 Rookes v Barnard [1964] AC 1129, 1127–8, per Lord Devlin. 59

122

(E) Ogus Ch4

24/3/06

08:19

Page 123

Implicit Pricing and Behavioural Incentives

Clearly the assessment is expected to be related to U; judicial guidelines also suggest that the defendant’s wealth is a relevant consideration.63 Confiscation and Restitution Confiscation of the proceeds of, or property connected to, crime has become an increasingly important part of criminal justice policy in recent years, particularly to confront drug-trafficking and money-laundering.64 In relation to the model of simple deterrence, one can see the attractions of the device for this particular type of undesirable activity.65 The probability of detection of drug-trafficking (q) is surmised to be relatively small. Deterrence thus requires an increased value to D (and/or E). No doubt the wealth of many offenders is quite large, thus allowing in principle a high financial penalty, but too often the wealth will be hidden or not available for law enforcement purposes. For some time, legislation has authorised the confiscation of any payments or property received in connection with drugtrafficking.66 With such a broad ambit to what may be confiscated, and when combined with conventional criminal penalties, the effect has been to render the financial sanction more sensitive to the offender’s available wealth.67 It thus has served to enhance the simple deterrence model. Recent reforms have significantly extended the range of this sanction, thus rendering it even more efficacious. So, to raise p,, where there is evidence that an individual is living off the proceeds of crime, but there is insufficient evidence to secure a criminal conviction, a government agency can confiscate assets using civil procedure; and thus subject to a lower standard of proof.68 63

Ibid, 1228. N Dorn, J Sepson and E Savona, European Drug Policies and Enforcement (London, Macmillan, 1996). 65 R Bowles, M Faure and N Garoupa, “Economic Analysis on the Removal of Illegal Gains” (2000) 20 International Review of Law and Economics 537. 66 Drug Trafficking Act 1994, s 4. 67 Bowles et al, above n 65, 546. 68 Proceeds of Crime Act 2002, pt V. 64

123

(E) Ogus Ch4

24/3/06

08:19

Page 124

Implicit Pricing and Behavioural Incentives

Different considerations apply to restitutionary remedies available in the civil law, generally in cases of unjust enrichment. These may take the form of tracing assets which have been wrongfully appropriated or making a defendant disgorge profits derived from an unlawful act. Remedies of this kind have been used particularly to compensate for infringement of property rights where the claimant has suffered little or no financial loss or where damages are difficult to calculate.69 More controversially70 in the case of Attorney-General v Blake the House of Lords extended the remedy to breach of contract, because it was considered unfair that an ex-spy should benefit from publications involving a breach of obligations of confidentiality.71 Interestingly, the decision was also justified on the basis that “neither he, nor any other member of the service, should have a financial incentive to break his undertaking”.72 To what extent, then, can this approach also serve as inducement to abstain from the wrongful act?73 At first glance, the remedy might seem to be particularly apt for this purpose since it is assessed by reference to U and indeed serves to deprive the actor of the whole or much of the amount in question. The problem is that it cannot be increased above that amount, to take account of variations in enforcement policy (p).74 The condition of effective enforcement, then, is qE + pV > (1 – p)U

69 These justifications are reviewed in A-G v Blake (Jonathan Cape Ltd Third Party) [2001] AC 268, 278–81, per Lord Nicholls. 70 See D Campbell and D Harris, “In Defence of Breach: a Critique of Restitution and the Performance Interest” (2002) 22 Legal Studies 208. 71 Above n 69. 72 Ibid, 287, per Lord Nicholls. 73 See S Levmore, “Probalistic Recoveries, Restitution and Recurring Wrongs” (1990) 19 Journal of Legal Studies 691. 74 Levmore, above n 73, 710–15, makes the different, but connected, point that if an activity creates only a risk of harm, assessing a victim’s recovery on the basis of the amount the defendant profited by not taking care to avoid the risk will not generate an adequate incentive to take care.

124

(E) Ogus Ch4

24/3/06

08:19

Page 125

Implicit Pricing and Behavioural Incentives

where V represents that part of U which will be disgorged in a successful restitutionary claim. Unless p has a relatively high value, this condition is unlikely to be fulfilled although, as with confiscation orders, the restitutionary device may usefully be combined with another sanction. Compensation Most successful civil law claims give rise to damages awards and they are usually assessed by reference to the claimant’s loss. The principal intended function may be compensation, according to some notion of corrective justice, but the sanction can also operate as an inducement. Most obviously, being based on the harmfulness of the relevant act, it correlates well with the normative approach. However, for the purpose of this approach, to be an effective discriminator between desirable and undesirable conduct, and therefore to deter only the latter, the combination of pD and qE, as we have already seen, should reflect the totality of the harm caused. There are important reasons why it may fail to do this.75 Not all harms give rise to actionable claims; for example, the value of the life to the person killed by the act is not itself reflected in damages payable in the fatal accident action, since these are based on the value of life to that person’s dependants—a consequence of course of the fact that the action is primarily viewed as being for compensation, rather than deterrence. And the amount of harm sustained by the victim may be insufficiently large to outweigh the costs of bringing, or threatening to bring, a legal action. In such situations, therefore, unless the deficit is offset by qE, the damages award is unlikely to supply the correct inducement.76 Using compensatory damages awards for the simple deterrence model might appear to be even more problematic, because there is no obvious correlation between D and U. This is certainly true in cases of intentional infliction of harm, where U 75

Ogus, above n 61, 89–91. For the implications of this, see KN Hylton and TJ Miceli, “Should Tort Damages Be Multiplied?” (2005) 21 Journal of Law, Economics, and Organization 388. 76

125

(E) Ogus Ch4

24/3/06

08:19

Page 126

Implicit Pricing and Behavioural Incentives

is likely to be particularly high and it is therefore not surprising that for such cases criminal law sanctions, and punitive damages, are often available in addition to private rights. But where the harm is unintentional, U may comprise no more than what the actor has saved in failing to take the precaution sufficient to avoid the harm. If the amount of damages is sufficiently large to entice the claimant to bring a legal action, then it is reasonably likely that qE + pD will exceed the cost of taking the accidentavoiding precaution. Such reasoning has led many commentators to the view that the damages payable for the tort of negligence induce actors to take the level of care prescribed by that law.77 Cessation In respect of unlawful activities which operate on a continuing basis, the civil law often provides, in addition to damages for past losses, an injunction, compelling the actor to cease the activity. The probability of enforcement (p) should here have the same value as in an ordinary damages claim, but D will differ. Once the order is in effect, the actor is deprived of U, thus relating well to the simple deterrence model. However, since it is a civil claim, it is also normally possible for the victim to agree to release the actor from the order. Rationally, this will be done only if the actor agrees to pay an amount which exceeds the harm which the activity will predictably inflict on the victim. Subject to the usual proviso regarding p, this outcome satisfies the requirement of the normative model particularly well: since it depends on the agreement of the victim, the amount payable as compensation necessarily captures subjective elements in the harm, which may not be present in a court award of damages.78 Administrative orders requiring the cessation of an unlawful activity have the same effect as an injunction which is fully 77

Eg Cooter, above n 35, 1538–9. G Calabresi and AD Melamed, “Property Rules, Liability Rules and Inalienability—One View of the Cathedral” (1972) 85 Harvard Law Review 1089, 1116–19. 78

126

(E) Ogus Ch4

24/3/06

08:19

Page 127

Implicit Pricing and Behavioural Incentives

implemented. A related, but more draconian, sanction is the suspension or revocation of a licence. This has the effect of foreclosing profit-making activities, lawful as well as unlawful, and through its impact on individual livelihoods can play a very significant deterrent role. It costs relatively little to administer and therefore is an attractive alternative to a fine, where wealth constraints render that sanction insufficiently effective.79 Of course, it normally presupposes that the activity is subject to some system of licensing or prior approval, but in some situations enforcement agencies have powers to deprive an individual of the right to practise a profession or trading activity which is not governed by such a system.80 Contractual Invalidity A contract to undertake an unlawful act is normally unenforceable. It has been widely accepted that this legal consequence has the function, inter alia, of deterring commission of the unlawful act.81 In a case concerning an attempt to defraud an insurance company, Lord Millett said: [I]t is time that a clear message was sent to the commercial community. Let it be clearly understood if a builder or garage or other supplier agrees to provide a false estimate for work in order to enable its customer to obtain payment from his insurers to which he is not entitled, then it will be unable to recover payment from its customers and the customer will be unable to claim on his insurers even if he has paid for the work.82

Clearly, an inability to achieve the outcome intended in a transaction constitutes some disincentive to engage in the unlawful

79

Ogus and Abbot, above n 6, 294–5. Sometimes referred to as “negative licensing”. These sanctions are available to bar from future activity eg estate agents (Estate Agents Act 1979) and company directors (Company Directors Disqualification Act 1986). See, generally, Australian Law Reform Commission, above n 32, 848–9. 81 Law Commission Report No 154, Illegal Transactions: the Effect of Illegality on Contracts and Trusts (1999), 88–9. 82 Taylor v Bhail [1996] CLC 377, 383–4. 80

127

(E) Ogus Ch4

24/3/06

08:19

Page 128

Implicit Pricing and Behavioural Incentives

activity, but how effective the sanction is as an external inducement requires further investigation.83 In the first place, we should note that the legal consequences for those involved in illegal transactions vary. The complexity of English law defies easy summary, but in general neither party will normally be able to secure the gain expected under the contract and only those parties who are innocent of any knowledge of the illegality may claim restitution of property or money passed to the other party.84 In deterrence terms, this last principle is easily understood: ex hypothesi only “guilty” parties will be in a position to alter their conduct. Assuming in relation to the latter that there is no restitutionary remedy, it is to be noted that the amount of the sanction will depend not only on the amount of profit (U) but also, and crucially, the amount of resources which illegal actors have invested in the transaction (say I ). In some contracts, for example those involving loans, I has a high value, substantially exceeding that of U, and in such cases the invalidity of the contract will constitute most effective deterrence.85 If I is relatively small, and in consequence deprivation of U is the main cost imposed on the actor, the deterrent function of the approach becomes problematic because of p, the probability that the sanction will be incurred.86 In the criminal justice and regulatory systems, there is an expectation that a reasonable level of enforcement will be undertaken by the public agencies involved. As regards civil law, victims have an obvious incentive to enforce damages claims. But the only individuals with an interest in 83 On which see also JP Kostritsky, “Illegal Contracts and Efficient Deterrence: a Study in Modern Contract Theory” (1988) 74 Iowa Law Review 115. 84 For details, see GH Treitel, The Law of Contract (London, Sweet & Maxwell, 10th edn, 1999), ch 11. 85 This is presumably why Atiyah uses the example of consumer credit to illustrate his argument that, at least in some circumstances, contractual invalidity will be a more effective deterrent than the criminal law: PS Atiyah, Introduction to the Law of Contract (Oxford, Clarendon Press, 5th edn 1995), 342–3. 86 This point seems to have been overlooked in Kostritsky, above n 83.

128

(E) Ogus Ch4

24/3/06

08:19

Page 129

Implicit Pricing and Behavioural Incentives

asserting the invalidity of a contract are normally the parties to the contract, and then only if the contract is, or turns out to be, disadvantageous to them and they stand to benefit from some restitutionary remedy. In consequence, p is likely to be highly speculative and, in cases where there is cooperation between the parties regarding the illegal dimension, it will be quite small.

Informal Costs We have already seen that informal costs arising in some way from the undesirable activity may play a significant role as an inducement. This aspect needs now to be examined in more detail: in what circumstances do informal costs arise? How might we expect them to impact on the actor’s behaviour? And how do they interact with other sanctions? Informal costs arise in different ways. Let us first see how they operate as an adjunct to other sanction systems. If the commission of the act is observed and that leads to some form of complaint or process by an official or some other party, the actor will incur some costs including loss of profits or utility from the time spent in dealing with that person or the process and the “psychic” costs of the pressure that may be involved (what we have already designated as E ). These costs may be assumed to increase as more steps are taken towards formal procedure, and to rise steeply if court appearances arise, thus constituting an important addition to D. Enforcement agencies may exploit these costs to negotiate compliance without executing the threat of a formal prosecution.87 In addition to what is likely to be perceived as a high value to D,88 actors will be aware that, since they have already been apprehended, the value of p will rise 87 I Ayres and J Braithwaite, Responsive Regulation: Transcending the Deregulation Debate (New York, Oxford University Press, 1992), 20–35. 88 There is strong empirical evidence indicating that some enforcement agencies in their dealings with offenders exaggerate the amount of the sanction likely to be imposed by a court: K Hawkins, “Bargain and Bluff: Compliance Strategy and Deterrence in the Enforcement of Regulation” (1983) 5 Law and Policy Quarterly 35.

129

(E) Ogus Ch4

24/3/06

08:19

Page 130

Implicit Pricing and Behavioural Incentives

significantly, should they continue the activity: compliance then becomes the cheaper option.89 Moreover, the very fact of a formal finding of liability may give rise to substantial costs independently of the sanction imposed. These may be characterised either as stigma costs, where the publicity consequent on the finding affects primarily the social reputation of the actor; or as market costs, if commercial reputation is damaged and demand for the actor’s products or services is reduced. The former depends critically, of course, on the social standing and network of the individual concerned. Commercial reputation plays a key role in certain industrial sectors, particularly if traders have an interest in maintaining an ongoing relationship with customers and thereby acquiring and retaining their goodwill.90 In consequence, informal costs may, in some contexts at least, be more important than formal costs.91 Reputational costs do not normally give rise to additional administrative expenditure and, for this reason, may be regarded as particularly efficacious inducements. However, it should be recalled92 that the criminal justice process, which presumably gives rise to higher informal costs of this kind than other legal regimes,93 for this very reason offers additional procedural protection to the accused, thus raising the cost of proceedings and lowering the probabilities of conviction. We may note, too, that at relatively low administrative cost some enforcement agencies 89 P Fenn and CG Veljanovski, “A Positive Economic Theory of Regulatory Enforcement” (1988) 98 Economic Journal 1055. 90 C Shapiro, “Consumer Information, Product Quality, and Seller Reputation” (1982) 13 Bell Journal of Economics 20. 91 JM Karpoff and JR Lott, “The Reputational Penalty Firms Bear from Committing Criminal Fraud” (1993) 36 Journal of Law and Economics 757. In relation to invididuals and their social reputation, see D Teichman, “Sex, Shame, and the Law: an Economic Perspective on Megan’s Laws” (2006) 42 Harvard Journal on Legislation (forthcoming). 92 See above, 121–2. 93 Hence the perception that for the same type of unlawful conduct, deterrence requires a higher civil penalty than criminal penalty: Australian Law Reform Commission, above n 32, 809.

130

(E) Ogus Ch4

24/3/06

08:19

Page 131

Implicit Pricing and Behavioural Incentives

seek deliberately to enhance informal reputational costs by policies of “naming and shaming” offenders.94 Informal costs will alone be incurred where the undesirable activity does not give rise to any legal intervention but is the subject solely of social or moral norms.95 How does the incidence of such costs compare with that arising in cases of illegality?96 It is difficult to generalise on how the size of the costs may differ since so much depends on the character and context of the norm. The probability of incurring disapproval consequent on contravention of the norm will also vary enormously, but since there are likely to be more individuals interested in observing compliance with the norms than those with a direct role in the enforcement of legal rules, we can perhaps attribute a higher value to p in the former case. In any event, the costs of enforcement are significantly lower, since by definition no formal proceedings are involved. To counter such advantages, it should be noted that a significant degree of uncertainty typically exists as to the content of the social or moral norms, thus creating ambiguity regarding their application to specific situations.97

Corporate Actors Much of the analysis hitherto has assumed that the actor is an individual. In this section, we need to investigate considerations which arise when it is applied to firms. An obvious starting-point is the fact that though some acts may be done in the name, or under the auspices of, a firm, they are always done by individuals. How will a sanction imposed on the firm affect those individuals’ willingness to undertake the act?

94

Australian Law Reform Commission, above n 32, 870–2. In recent years a large literature has developed on this topic: for a survey, see Symposium, “Social Norms, Social Meaning, and the Economic Analysis of Law” (1998) 27 Journal of Legal Studies 537–823. 96 See S Shavell, “Law Versus Morality as Regulators of Conduct” (2002) 4 American Journal of Law and Economics 227. 97 Shavell, above n 96, 234–6. 95

131

(E) Ogus Ch4

24/3/06

08:19

Page 132

Implicit Pricing and Behavioural Incentives

The conventional answer is that since most firms are in the business of making profits, and the success of management is measured by reference to profits, managers will be motivated to reduce costs, including those incurred as a consequence of socially undesirable activities undertaken by employees. Indeed, where an employee’s wealth is insufficient to pay a fine or damages, redirecting that sanction to the firm is a good (and cheap) alternative, because the firm has a variety of sanctions not available to law enforcers (for example, reducing wage increases or prospects of promotion; less attractive work conditions; at the last resort, dismissal) and which are not sensitive to the wealth constraint.98 This argument is based on the assumption that the sanction and associated costs will impact on those, mainly shareholders, who will exert pressure on the management of the firm in the way suggested. In most cases, this assumption will be justified, but in some circumstances, it may be possible to pass on the cost to another group, less able to influence managerial decisions, for example, consumers or employees.99 To meet this contingency, and thus to preserve the deterrence impact of corporate liability, it has been suggested that the device of an “equity fine” should be available for law enforcement purposes.100 This would authorise transfer of a certain number of the firm’s shares to, and for eventual disposal from, a publicly-held fund, and in

98 For this justification in relation to civil liability, see A Sykes, “The Economics of Vicarious Liability” (1984) 93 Yale Law Journal 1231; and for criminal law, AM Polinsky and S Shavell, “Should Employees be Subject to Fines and Imprisonment Given the Existence of Corporate Liability” (1997) 17 International Review of Law and Economics 203. In the latter area, imposing liability on the employer may, nevertheless, create disincentives to report wrongdoing and thus reduce the level of p: J Arlen, “The Potentially Perverse Effects of Corporate Criminal Liability” (1994) 23 Journal of Legal Studies 833. 99 I deal with this issue at greater length in ch 8, below, 228–9. 100 JC Coffee, “No Soul to Damn; No Body to Kick: an Unscandalised Inquiry into the Problem of Corporate Punishment” (1981) 79 Michigan Law Review 386. The idea appears not yet to have been accepted in any jurisdiction: cf Australian Law Reform Commission, above n 32, 860.

132

(E) Ogus Ch4

24/3/06

08:19

Page 133

Implicit Pricing and Behavioural Incentives

consequence reduce the value of the stock held by other shareholders, thus channelling the impact of the sanction primarily on them. If it be assumed that applying a sanction to the firm does induce a behavioural response from the individual actor, is it well designed for the deterrence function? In addressing this question, we can identify two important differences from sanctions applied directly to individuals. First, for the purposes of the simple deterrence model, it is easier to target the sanction on U, because the problematic non-financial dimension to the utility derived from the activity does not typically exist in relation to firms. Also, the accounting requirements imposed on most firms should mean that information on profits are readily available. Some enforcement regimes, indeed, calculate the sanction by reference to a certain percentage of a firm’s turnover.101 The second difference is that some non-financial sanctions, notably imprisonment, cannot be imposed on firms. Now, although the wealth of firms will, in most cases, be greater than that of individuals, it is still an important constraint on penalty assessment. Of course, those managing firms will sustain losses in the event of insolvency, but, when discounted by p, these may be small relative to U. The dilemma involved in the so-called “deterrence trap”, fixing penalties high enough so as to deter firms, but not so high as to induce insolvency, has prompted some authors to doubt the efficacy of corporate liability in some contexts and to offer solutions “piercing the corporate veil” and attaching responsibility to relevant individuals.102

101 In exercise of powers under the Competition Act 1998, s 38, the DirectorGeneral of Fair Trading has published guidelines which indicate that “the starting point for determining the level of financial penalty which will be imposed on an undertaking is calculated by applying a percentage rate to the ‘relevant turnover’ of the undertaking, up to a maximum of 10%” (OFT 423, para 2.1, available from www.oft.gov.uk). 102 See, eg: Coffee, above n 100.

133

(E) Ogus Ch4

24/3/06

08:19

Page 134

Implicit Pricing and Behavioural Incentives

Information Costs For an external inducement to be effective, actors must have sufficient information relating to pD + qE, and thus on the practice of enforcement and the typical costs arising from the sanctions regime, to enable them to perceive the alteration to the cost-benefit configuration which arises in consequence. It is not easy to generalise on the extent to which such information is acquired, since much will depend on the individual and the circumstances. However, there clearly are major differences between regimes. At one extreme, there is an administrative charge or tax which is routinely levied: here both the probability of the cost being incurred and its amount will be known to most who are subject to it.103 Contrast that with, at the other extreme, a sanction, such as punitive damages, which is both highly discretionary in its amount and dependent on a civil claim being enforced which is itself relatively unpredictable. Into the same category may be placed contractual invalidity (p here largely reflecting the likelihood of the other party’s willingness to defect from the deal) and market exclusion which, because it is such a severe sanction, enforcement agencies are very reluctant to pursue.104 As regards the remaining sanctions, one might expect individuals to be relatively well informed about the likelihood of breaches of social norms being detected and the likely response of families and friends to such detection.105 It is also reasonable to assume that most individuals contemplating law-breaking will be moderately well informed as to criminal sanctions and the levels of policing, and that may be enhanced by media attention and government efforts at publicity. The same is probably true of administrative penalties. It is to be assumed that there is much 103

Ogus, above n 35, 782. As regards revocation of a licence, “it is politically impossible and morally unacceptable to use it with any but the most extraordinary offences”: Ayres and Braithwaite, above n 87, 36. 105 Shavell, above n 96, 238 104

134

(E) Ogus Ch4

24/3/06

08:19

Page 135

Implicit Pricing and Behavioural Incentives

less awareness among individuals of the systems of civil law remedies and the variables, notably the probability of enforcement, relevant to them, although those involved in the management of firms may have a greater knowledge.106

Conclusions With the aid of the standard economic model of law enforcement, I have in this chapter explored the way in which law affects the costs of undertaking particular acts and therefore the willingness of individuals to engage in them. This has enabled me to compare the likely effectiveness of different legal regimes as instruments for inducing behavioural change. Central to the analysis has been not only the identification of the costs arising from any formal sanction which the law may impose on the actor, but also a recognition of the importance of the probabilities of detection and therefore enforcement, and indeed the incidence of informal costs which arise as a consequence of these processes. Why should this approach be of value to lawyers? We should note, in the first place, that in thinking about deterrence, they certainly pay heed to the level of sanctions and problems of inadequate enforcement, but often fail to recognise the interplay between the two variables which lies at the heart of the economic model. So also there is a tendency to focus excessively on the criminal law, thereby overlooking, or at least undervaluing, the incentive effects generated by other legal instruments. The neglect is unfortunate because in terms of administrative costs the criminal justice process is particularly expensive. A second, and related, point is that insufficient attention is typically given to what has been referred to in this chapter as “informal costs”, particularly those arising from the need of most firms to maintain a market reputation.

106 D Dewees, D Duff and M Trebilcock, Exploring the Domain of Accident Law (Oxford, Oxford University Press, 1996), 283.

135

(E) Ogus Ch4

24/3/06

08:19

Page 136

Implicit Pricing and Behavioural Incentives

If, then, comparison between different legal (and non-legal) regimes in relation to their capacity to induce behavioural change is relatively novel, what has it revealed? In applying the economic model, I have explored four principal variables: the costs of enforcement; the costs of targeting of the sanction; the role of “informal costs”; and the cost to actors of acquiring information as to the likely costs of the activity. In table 3 I attempt to summarise how these variables operate in relation to the different sanction regimes, drawing on the analysis in the relevant sections of this chapter. In relation to each of the sanctions listed in my taxonomy (table 2), I first indicate the typical level of enforcement costs, distinguishing between those arising from: monitoring behaviour; the processes of determining liability and the appropriate sanction; and imposing the sanction. The following column provides some estimate of the difficulty, hence the cost, of adapting the sanction to meet the requirements of the economic model—at its simplest, when discounted by the likely incidence of enforcement, to exceed the profit the actor will derive from the activity. In some regimes, problems of imposing an appropriate formal sanction for this purpose may be overcome, in part at least, by the existence of significant informal sanction costs. In the penultimate column, I therefore indicate the likelihood of these costs being incurred. For inducements to be effective, it is important that actors have adequate information on the incidence of the sanctions regime and the final column contains an indication of the likely level of costs of obtaining such information. Of course, the generality involved in these classifications, as well as the subjectivity involved in the judgements, reduces their usefulness. Nor is it possible directly to compare the levels of costs across the different variables. Nevertheless, subject to these qualifications, some general conclusions can be drawn from the analysis. We may first observe that the traditional criminal justice regimes serve well as deterrents (low targeting costs plus additional informal sanctions) but, because of procedural requirements, have heavy process costs. The reduction in these costs in relation to confiscation, as a consequence of recent 136

c

b

medium medium high low medium

low medium low medium high

low low medium medium medium low medium high mediumc

targeting costs

rarely rarely generally always always

generally generally generally generally sometimes generally sometimes rarely rarely

additional informal sanction

medium low high medium low

medium medium medium medium medium high medium medium high

actors’ information costs

08:19

Includes settlement of claims. Medium if there is negotiated release. When significant investment in transaction.

low low high medium low

medium low medium medium low

low high high low medium medium high/mediumb low low

sanction costs

24/3/06

a

high high high medium mediuma high high medium medium

medium medium medium medium high medium high medium medium

fine imprisonment community confiscation tort damages punitive damages injunction restitution contractual invalidity administrative penalty tax/charge market exclusion name and shame social norm

process costs

monitoring costs

sanction

Table 3

(E) Ogus Ch4 Page 137

Implicit Pricing and Behavioural Incentives

137

(E) Ogus Ch4

24/3/06

08:19

Page 138

Implicit Pricing and Behavioural Incentives

reforms, while preserving most of the features of criminal sanctions, points to the advantages of this instrument. Noteworthy, too, are the findings relating to the administrative sanctions of penalties and taxes/charges. Although they do not normally give rise to additional informal sanctions, they combine a reasonably low level of targeting costs with low process and imposition costs. Economists have, for some time, been preaching the virtues of taxes and charges as inducement devices,107 and their enthusiasm seems to be matched by government policy statements.108 But notwithstanding the rhetoric, the actual use of fiscal instruments for this purpose has been relatively modest.109 Administrative penalties are widely available in American and continental European jurisdictions and their relative neglect in the UK is difficult to explain.110 Social norms involve almost no administrative costs and their deterrent effect may, in some contexts, be powerful, but in general—as explained above—their lack of specificity renders them operable only in relation to broad categories of behaviour.

107 Eg W Baumol, “On Taxation and the Control of Externalities” (1972) 62 American Economic Review 307. 108 See the references collected in Ogus, above n 41, 246. 109 Ogus, above n 41. 110 Cf Ogus and Abbot, above n 6.

138

(F) Ogus Ch5

24/3/06

14:32

Page 139

5 Risk Allocation and Risk Management

Introduction: Railways, Rings and Russia In March 1998 the railway company, Thames Trains, commissioned a cost-benefit analysis on whether they should install a device, Automatic Train Protection (ATP), which would provide for the automatic halting of a train encountering a red signal.1 The analysis suggested that it would cost the company £8.22 million to install the system on the relevant route. The principal benefit was that it would prevent a relatively small risk of fatal accidents which might otherwise occur. Over a 20-year period it was estimated that ATP would save approximately one statistical life. Assuming the value of a human life to be £2.45 million, the analysis therefore concluded that the costs significantly exceeded the benefits. In October 1999, a crash occurred as the result of a Thames train proceeding through a red light, leading to the loss of 31 lives. A year or so later, as a coursework assignment, I asked students registered on my undergraduate law-and-economics course to review the use of cost-benefit analysis in this case. I was particularly interested in their views on how risks are assessed, what levels of safety they consider to be desirable, and how (if at all) human life should be valued. As I hope to show in this chapter, these are matters on which economics has much to offer; and in general the students revealed a reasonable understanding of the subject. I was, however, dismayed by the fact 1 See Lord Cullen, The Ladbroke Grove Rail Inquiry (London, HSE Books, 2001), ch 8.

139

(F) Ogus Ch5

24/3/06

14:32

Page 140

Risks Allocation and Risk Management

that nearly a half of them assumed that because an accident killing 31 people had happened, the risk estimate of one life being lost over a 20-year period had been shown to be wrong. In the 1980s I was involved in a comparative law project which brought together teams of contract lawyers from England and France. One theme which we discussed was the extent to which contractual obligations should be affected by unexpected events occurring after the agreement.2 One of our French colleagues expressed the view that, if a trader sells a good (say a ring) to a consumer and it turns out to have a poorer quality than either party expected at the time of the sale, the trader should be liable to compensate the consumer for the difference between the actual quality and the expected quality. I think that he was somewhat taken aback when I asked whether, if the ring turned out to have a higher quality than that expected, the consumer should be required to pay compensation, or an increased price, to the trader. At the end of the 20th century, a team of European company law experts went to Russia under the aegis of the EU TACIS programme to assist a group of Russian lawyers in the drafting of a new law governing the restructuring of enterprises. Two of the participants drew on their experience to generalise on the difficulties of transplanting legal concepts to so-called transitional economies.3 They described how the Russian lawyers had problems in understanding that the restructuring of companies was essentially about deciding how the risk of business failure was to be confronted; in particular, the Russians seemed to assume that creditors should invariably be granted protection. What have my three anecdotes in common? They show that risk analysis does not sit easily with the intuitions of even experienced lawyers. My students were admittedly not that experienced, but if they had been well taught on my course, they 2 See the book resulting from the project, D Harris and D Tallon (eds), Contract Law Today (Oxford, Oxford University Press, 1989), ch 5. 3 See F Dahan and J Dine, “Transplantation for Transition—Discussion on a Concept around Russian Reform of the Law on Reorganisation” (2003) 23 Legal Studies 284.

140

(F) Ogus Ch5

24/3/06

14:32

Page 141

Risks Allocation and Risk Management

should have known better. Exhibiting what is known in the social psychology literature as “hindsight bias”,4 they allowed what happened ex post to distort the appraisal of the risk ex ante. In arguing that the trader should be liable for inferior quality in the ring, my French colleague might, of course, have been right, but his surprise at my retort suggests that either he did not perceive the issue in terms of risk allocation; or, even if he did, for him the risk was unidirectional and the role of contract law was predominantly to protect the “weaker” party against its consequences. As for the Russian lawyers, they had failed to grasp that it is the very essence of a competitive market economy that parties to transactions and entrepreneural activity take risks and one of the principal functions of the law is to determine how those risks should be allocated. The language of risk is becoming all pervasive in today’s society. We have recently become obsessed by it, at least as it affects health and happiness and the environment.5 This is, no doubt, a consequence of significant growth, both in the technological means of generating serious risks and in citizen expectations that governments can and should control them. On a less elevated plane, “risk assessment” is part of the everyday work of corporate actors6 and public sector officials7 as a management tool, for the systematic appraisal of how organisations should respond to different contingencies in an uncertain environment. Lawyers are, of course, deeply involved in all of this, since they must convert the outcomes of the analysis into workable concepts capable of delimiting the obligations of individuals and groups and, if necessary, enforcing them. Much takes place in 4 JJ Rachlinksi, “A Positive Psychological Theory of Judging in Hindsight” in CR Sunstein (ed), Behavioral Law and Economics (Cambridge, Cambridge University Press, 2000), ch 3. 5 U Beck, The Risk Society, Towards a New Modernity (London, Sage, 1992). 6 J Savirimuthu, “The Entrepreneur, Business Failures and Corporate Law Ideology” in R Baldwin (ed), Law and Uncertainty: Risks and Legal Processes (London, Kluwer Law International, 1997), ch 7. 7 R Baldwin, C Hood and H Rothstein, The Government of Risk— Understanding Risk Regulation Regimes (Oxford, Oxford University Press, 2001).

141

(F) Ogus Ch5

24/3/06

14:32

Page 142

Risks Allocation and Risk Management

the regulatory sphere, as it has to be decided what legal instruments are appropriate for dealing with particular risks, and how those instruments should incorporate the standards of risk control which are deemed desirable.8 And it goes without saying that economic analysis can facilitate these functions.9 But this close relationship between risk management and legal work is far from new. For centuries, lawyers have been arguing or making decisions about civil or criminal liability for risks generated by individuals or firms. So also they have been drafting contracts, wills or corporate arrangements to implement the express or implied wishes of their clients as to how certain risks are to be allocated; or giving advice as to whether a specific risk was covered by these allocatory devices. Familiar doctrines of private, as well as public law, have been developed to meet these needs, but sometimes the sharpness of the analysis, particularly such as emerges through its economic content, becomes blurred or lost under the pressure of legal rhetoric and efforts to infuse corrective or distributional justice into the outcomes. In this chapter, I attempt to show how exposure of the economic content can serve to clarify the legal doctrines we use to deal with risks and help to avoid some of the problematic features of policy-making to which intuitive responses to risks have given rise.

Limiting Liability: Foreseeability An important part of the law for both generally imposed obligations (torts) and voluntarily incurred obligations (contract) is concerned with defining what risks are to come within the scope of liability. Over-simplifying somewhat, it may be said that English law places much reliance on the criterion of reasonable foreseeability for this purpose. A non-exhaustive list of how the concept is used would include the following: 8

See the various contributions to Baldwin, above n 6. A Ogus, “Risk Management from an Economic Perspective” in E Vos and G van Calster (eds), Risico en Voorzorg in de Rechtsmaatschappij (Antwerp, Intersentia, 2004), 229–38. 9

142

(F) Ogus Ch5

24/3/06

14:32

Page 143

Risks Allocation and Risk Management

(1) to establish a duty of care, for the purposes of an action in negligence, the injury to the victim must be reasonably foreseeable10; (2) for the purposes of proving a breach of that duty, the harm suffered must be reasonably foreseeable11; (3) as a general test of remoteness throughout the law of tort, liability will not be imposed for types of damage which, at the time of the tortious act, were not reasonably foreseeable12; (4) promisors are liable for breach of contract only for those losses which were reasonably foreseeable (or not unlikely to occur) at the time of making the contract13; (5) promisors may be relieved from contractual obligations by the doctrine of frustration when a subsequent, unforeseeable, event renders performance impossible.14 Confronted by the ubiquity of the foreseeability concept, judges have sometimes stressed that it cannot provide a single, determinative criterion for imposing, or exonerating from, liability.15 Indeed, it is clear that its meaning and application differ as between the four cited principles: in (1) it is combined with a policy test of whether it is “fair” to impose a duty of care16; for the purposes of (2), the degree of probability of harm is weighed against other factors17; and its use in (4) is regarded as requiring a higher degree of probability than that in (3) and (5).18 Even with these qualifications, reliance on the foreseeability test has been the source of much confusion, not the least 10

Donoghue v Stevenson [1932] AC 562. Roe v Minister of Health [1954] 2 QB 66. 12 The Wagon Mound (No 1) [1961] AC 388; Cambridge Water Co v Eastern Counties Leather plc [1994] 2 AC 264. 13 Koufos v C Czarnikow Ltd [1969] 1 AC 350. 14 Salmon LJ in Denmark Productions v Boscobel Productions [1969] 1 QB 699, 725. 15 Eg Lord Goff in Smith v Littlewoods Organisation [1987] AC 241, 280. 16 Caparo Industries plc v Dickman [1990] 2 AC 605. 17 Bolton v Stone [1951] AC 850. 18 Koufos v C Czarnikow Ltd [1969] 1 AC 350. 11

143

(F) Ogus Ch5

24/3/06

14:32

Page 144

Risks Allocation and Risk Management

because what is “foreseeable” can cover a large range of contingencies, from those which are “a very remote possibility” to others which are simply “improbable.”19 Economic reasoning can help to give the notion some precision, as well as to unravel the relevant issues and clarify how and why the foreseeability concept is used. Let us take, first, tort law, the economic justification for which is to encourage actors to take optimal care in relation to the risks of damage which they create. Here, to evaluate the significance of the risk, we estimate the probability of its occurrence (p), and the amount of damage it will generate if it occurs (D). The cost to society of the uncontrolled risk is then pD.20 Care exercised by the risk-creator will reduce the value of p or D, or both of them. If the cost of taking such care is C, then the economic goal of optimal21 safety is where the marginal increase to C is approximately equal to the marginal reduction in pD which care at that level causes. To illustrate this, take the familiar case of Bolton v Stone,22 in which a pedestrian injured by a cricket ball failed in her negligence claim against the club from whose ground the ball had been hit. The House of Lords held that the club was not liable in negligence to the victim. The evidence revealed that a ball had been hit out of the ground, clearing a seven-foot high fence, on average once every three years. If we assume that the chance of such a ball striking an individual was about one in 100, then the annual risk of such an accident (p) was 0.3 ⫻ 0.01 = 0.003. Let us also assume that in 1947, when the accident occurred, the average amount of harm (D) from being struck by a cricket ball was £150. The evidence suggested that the cheapest way of averting the risk was to add to the height of the fence. The cost of doing this, amortised to an annual sum, would have had to be 19 P Cane, Atiyah’s Accidents Compensation and the Law, 6th edn (London, Butterworths, 6th edn, 1999), 38–9. 20 For an introduction to analysis of this kind, see above 44–5. 21 Defined by the Kaldor-Hicks test of allocative efficiency: above, 27. 22 Above n 17.

144

(F) Ogus Ch5

24/3/06

14:32

Page 145

Risks Allocation and Risk Management

less than £0.45 (0.003 ⫻ £150) for that safety measure to be justified economically. The law of negligence can thus be seen as imposing a standard approximating to that of optimal care and inducing the defendant to take that amount of care by imposing liability to pay damages should the requisite standard not be met. Reverting now to the list of applications of the foreseeability concept, we can see that the issue in Bolton v Stone was the standard of care relevant for breach of duty (2), and that the degree of probability of the harm (p) was the key variable. Foreseeability in uses (1) and (2) are irrelevant to this analysis. Foreseeability in use (3) is nevertheless relevant to the economic approach. The import of the law here is that the defendant should be relieved of liability when p does not exceed a minimum threshold, that is, where the loss to the victim arises from freak or very unusual events. There are two economic justifications for this. First, if the event could not have been foreseen by the actor, then ex hypothesi the prospect of a tort sanction will not influence pre-accident behaviour and permitting liability would generate costs in dispute resolution without achieving any reduction in the cost of accidents.23 Secondly, liability for very unusual events would induce actors to spend resources acquiring information both as to their incidence and as to how to constrain them, an expenditure which is not justified, given the smallness of the risk.24 These justifications can usefully be compared with those when foreseeability is used to limit liability for breach of contract. Here the famous rule in Hadley v Baxendale 25 permits recovery only of losses “not unlikely” to occur, as viewed at the 23 WM Landes and RA Posner, “Causation in Tort Law: an Economic Approach” (1983) 12 Journal of Legal Studies 109, 125–9. It may, of course, be argued that the purpose of imposing liability is distributional (shifting the loss from victim to defendant) rather than economic, but in the case of unforeseeable accidents the moral justification for this outcome is unclear. 24 M Grady, “Proximate Cause and the Law of Negligence” (1984) 69 Iowa Law Review 363, 385–90. 25 (1854) 9 Exch 341, as interpreted in Koufos v Czernikow, above n 13.

145

(F) Ogus Ch5

24/3/06

14:32

Page 146

Risks Allocation and Risk Management

time of making the contract. To understand the economic function of this principle in this context, we need to see how the contract acts as a risk allocation device. The promisor undertakes certain obligations and the price she charges will reflect the cost of the undertakings. That cost includes not only necessary outlays for performing the contract but also any liabilities which will attach to risks for which the promisor is responsible. Take the following example. I deliver a film for the development of photographs. The firm undertaking this service will charge me a price which includes not only the cost (say C1 which = £1.00) of labour and materials etc, but also that (C2) arising should my film be lost or damaged.26 Suppose the chance of that occurring is one in 100 (p = 0.01) and that my average loss in such circumstances is small (say £10.00), then C2 = £10 ⫻ 0.01 = £0.10; and the price, to cover these costs, will be £1.10. If the risk can be avoided by taking a little extra care costing (say) £0.08, then it will be cheaper for the firm to take this care and the total price will be £1.08. If the extra care necessary to avoid the risk costs more than £0.10, it will not be taken. Now suppose that the film contains photographs of particular sentimental value to me, say the wedding of my niece; and the subjective loss I sustain if the film is lost or damaged is £200. If full liability were to be imposed for that loss, C2 becomes £2 (0.01 ⫻ £200). But if I do not inform the firm of the unusual value of contractual performance to me, when I deliver the film, the firm will be unable to modify the price to take account of the increased cost, nor decide whether the taking of extra care is justified. It therefore makes economic sense to limit contractual liability to normal losses, that is losses foreseeable at the time of making the contract, or those of which the promisor has information at that time; and that is the conventional interpretation of the Hadley v Baxendale principle.

26 The price will also include a small component of profit; to simplify exposition I ignore this.

146

(F) Ogus Ch5

24/3/06

14:32

Page 147

Risks Allocation and Risk Management

Foreseeability in this context, then, serves principally as an incentive for the appropriate communication of information between promisee and promisor.27 It is not surprising, therefore, that the degree of probability of the relevant losses should be higher than those sufficient to exclude liability in tort (use (3)), which must be freak or very unusual events. The equivalent of the latter within contract doctrine is, rather, frustration (use (5)).28 In relation to all unexpected events occurring after the contract was made,29 the question of what impact they should have on contractual obligations is to be resolved by an inquiry into how the risk was, or should have been, allocated.30 Economic reasoning suggests that if the event was foreseeable, it should be allocated to that party who could have dealt with it at lower cost, for example by taking precautions or insurance cover. The effect of such rulings will be to create incentives for the relevant party to take cost-reducing measures. Parity with the reasoning for remoteness in tort suggests that neither party should be allocated the risk of freak, or very abnormal, events— hence frustration as the outcome—because imposition of the risk will not induce the cost-reducing behaviour and may lead to an inefficient level of information gathering.

Contractual Risk Allocation: Individual Autonomy or “Fair Shares”? The above discussion leads us to an overview of risk allocation in contracts and of how the economic approach can facilitate an understanding of the court’s interpretative role. The starting 27 For an attempt to verify empirically that contracting parties would voluntarily adopt the limitation, thus justifying it as a default rule, see GS Geis, “Empirically Assessing Hadley v. Baxendale” (2005) 32 Florida State University Law Review (forthcoming). 28 W Bishop, “The Contract-Tort Boundary and the Economics of Insurance” (1983) 12 Journal of Legal Studies 241, 252. 29 The same reasoning can be applied to events occurring before the contract: see McRae v Commonwealth Disposals Commission (1951) 84 CLR 377. 30 RA Posner and AM Rosenfield, “Impossibility and Related Doctrines in Contract Law: an Economic Analysis” (1977) 6 Journal of Legal Studies 83.

147

(F) Ogus Ch5

24/3/06

14:32

Page 148

Risks Allocation and Risk Management

point is the recognition that individuals enter into contracts in order to improve their welfare. In normal circumstances, then, a contract will satisfy the Pareto test of allocative efficiency31: neither party will be made worse off and at least one party will gain. The aggregate gain to the parties is often referred to as the contract surplus and how that is shared between them will depend, among other circumstances, on their bargaining skill. Suppose, to revert to the necklace example mentioned in the introduction, the jeweller values it at £1,000 because that is the price he expects to obtain through a market sale, and the purchaser attributes to it a subjective value of £1,200. If the necklace is sold for any price between those two amounts, there is a Pareto-efficient contract, the surplus being £200. The higher the price (up to £1,200—the purchaser will not be willing to pay more), the greater the proportion of the surplus which accrues to the jeweller. Conversely, the closer the price to £1,000 (the minimum the jeweller is willing to accept), the greater the proportion to the purchaser. It may be reasonable to assume that each party will attempt to secure as large a portion of the surplus as he and she can, but it is very difficult for a third party, such as a judge, to predict where, within the relevant range, the price will be agreed. However, since normally there is clear evidence on this aspect of the sale, judicial interpretation of the agreed price is rarely needed. Let us now extend the example to incorporate the dimension of risk. Suppose that there is a possibility (assessed at one in 10, ie 0.1) that one or more of the stones in the necklace are not well encased and will come loose, with an average consequential loss to the purchaser of £300. The risk is to be valued ex ante at £30 (0.1 ⫻ £300) and has then to be set off against the surplus of £200, which is now reduced to £170. We might expect a hardhearted seller to leave that risk with the purchaser, but in that case the maximum the latter will be prepared to pay, assuming knowledge of the risk, is £1,170. Suppose, alternatively, that the jeweller can eliminate the risk by spending time (at a cost say of 31

148

Above, 27.

(F) Ogus Ch5

24/3/06

14:32

Page 149

Risks Allocation and Risk Management

£20) on a careful inspection of the necklace (the purchaser being insufficiently expert to be able to do this at the time of purchase). If the risk is assigned to the jeweller, that will then increase the contract surplus from £170 to £180. If there is no cheaper way of dealing with the risk, then the efficient contract (that which maximises the surplus) will indeed assign the risk to the jeweller. Will the parties achieve this outcome through explicit risk allocation? In a competitive market, where the relevant information is available, they should do so. In circumstances where it is cheaper for traders to deal with the given risk than customers, those traders who voluntarily agree to accept the risk should get a better price for the sale; and competition should then push other traders in the same direction. If the contract is silent or ambiguous on the point, then judicial interpretation can reach the same result. The theory of implied terms has moved from a test of what did the parties intend to what it would be reasonable to expect that the parties would have intended, had they been fully appraised of the relevant facts.32 In the given example, an implied term allocating the risk of the badly encased stone to the jeweller would have the effect of protecting the consumer and, as such, would have satisfied my French colleague who was concerned that the law should protect the “weaker” parties in contractual environments. But let us now apply the same analysis to a case where the customer can deal with the risk more cheaply than the trader. A good illlustration is provided by Levison v Patent Steam Carpet Cleaning Co.33 Mr Levison delivered to the defendants a valuable Chinese carpet to be cleaned. A clause in the standard-form contract purported to exclude the liability of the defendants should the article be lost; and the customer was advised to ensure that he had insurance cover against loss. The carpet was lost (probably stolen) and relying on the contract clause, the defendants denied liability when an action was brought by the claimant (in effect 32 See the remarks of Lord Bridge in Scally v Southern Health and Social Services Board [1991] 4 All ER 563, 571. 33 [1978] QB 69.

149

(F) Ogus Ch5

24/3/06

14:32

Page 150

Risks Allocation and Risk Management

his insurers, because he had complied with the advice given). The Court of Appeal held that the clause was ineffective to exclude liability because a “fundamental breach” of the contract had occurred, a common law doctrine which has since been doubted or at least narrowed.34 Lord Denning MR provided another justification: it was the case of a standard-form contract, the terms of which had been dictated by the party with the stronger bargaining power. Such terms should, therefore, be subject to a test of reasonableness which, in the instant case, could not be satisfied.35 Was this an appropriate judicial intervention? We should first investigate why the contract assigned the risk to the customer.36 Lord Denning assumed that it was the consequence of superior bargaining power.37 But there is no evidence in the law report of any cartel or other impediment to competition and there is a quite different, and perhaps more plausible, explanation. It was less costly for the owner, rather than the cleaner, to have insurance cover. Although obviously both parties could have purchased insurance cover, it would have been cheaper for the owner because he alone could provide information to the insurer as to the (subjective) value to be placed on the carpet.38 Let us invent some plausible figures on the latter assumption. Suppose that the price charged by the cleaners was £50, that the insurance cover secured by Mr Levison cost him £5, but that cover would have cost the defendants £10. With the risk of loss assigned, as in the case, to Mr Levison, his total cost was £55. If, as the Court of Appeal decided, the contractual clause is unenforceable, the cleaners have to insure and the surplus on the contract is reduced, Mr Levison now having to pay £60 for the carpet to be cleaned (what the defendants will demand to cover their costs). So that an attempt by the judges to correct explicit 34

R Halson, Contract Law (Harlow, Longman, 2001), 306–7. Above n 33, 79. 36 See GL Priest, “A Theory of the Consumer Product Warranty” (1981) 90 Yale Law Journal 1297. 37 Above n 33, 78–80. 38 Priest, above n 36, 1314–19. 35

150

(F) Ogus Ch5

24/3/06

14:32

Page 151

Risks Allocation and Risk Management

risk allocation on the grounds of “justice” or “reasonableness” has in fact backfired—ironically also, the insurers who were paid by Mr Levison to cover the risk have been allowed to escape from their responsibilities.

Ex Post Adjudication and Ex Ante Analysis Risk allocation is essentially an ex ante process in the sense that those engaged in the allocation assess the risk prior to its possible occurrence and determine the appropriate way of dealing with the contingency. A dilemma sometimes occurs because adjudication and judicial rule-making almost always take place in relation to a given dispute after the event. That tends to force attention away from the generality of the issues involved, in particular, the likely impact of the decision or rule on future behaviour, to the merits of the opposing claims in the individual case. Viewing the dispute from an ex ante perspective can provide a valuable corrective on how the dispute should be resolved and on what legal rules may be appropriate.39 An example can be taken from insolvency law. Judges and policy-makers have struggled to formulate rules and procedures for bankruptcy which are, on the one hand, “just” to creditors and, on the other hand, reduce the costs to the various stakeholders involved in financial distress.40 Critical also, but often ignored in the analysis, is the impact the arrangements have on corporate behaviour ex ante: if they are too lenient, managers may be encouraged to engage in unduly risky ventures; creditors may demand higher rates of interest, or be unwilling to lend; and investment patterns may change.41 39 MJ Trebilcock, “A Conceptual Overview of the Economic Perspective on Law” in R Devlin (ed), Canadian Perspectives on Legal Theory (Toronto, Emond Montgomery, 1991), 100–3; A Ogus, “What Legal Scholars Can Learn From Law and Economics” (2004) 79 Chicago-Kent Law Review 383, 388–92, from which some of the following is derived. 40 See, eg, R Goode, Principles of Corporate Insolvency Law, 2nd edn (London, Sweet & Maxwell, 1997). 41 RE Rasmussen, “The Ex Ante Effects of Bankruptcy Reform on Investment Incentives” (1994) 72 Washington University Law Quarterly 1159.

151

(F) Ogus Ch5

24/3/06

14:32

Page 152

Risks Allocation and Risk Management

Take, next, contract law and the well-known case of Williams v Roffey Bros.42 A carpenter who had contracted with builders to undertake certain work for them found that, because of financial difficulties, he was unable to complete it at the agreed price and he negotiated an increase. The builders subsequently argued that the agreement to pay the increase was not enforceable because it was not supported by consideration: they had sustained no benefit from paying more (in economic terms, it was not a Pareto-efficient contract). The court disagreed. By enabling the work to be finished on time, and without the hassle of enforcing the original contract, the builders had secured a benefit. Now, whatever be the merits of this decision in terms of a “just” outcome for the parties to the dispute, the judges failed to ask the question which would have been at the heart of an economic analysis43: what incentive effects would the suggested interpretation of principle have on contracting behaviour generally? The evident problem is that, if contract modifications are too readily enforceable, then individuals may be led to believe that there is little risk in underpricing in order to attract custom, and thus the approach can encourage behaviour of this kind. We should then note that, though the subsequent modification may be in the interest of both parties, it is not Pareto efficient, because of the negative externalities generated. Another example, taken from contract law, involves an issue relating to remedies which has created somewhat of a puzzle for lawyers.44 A buyer of goods repudiates the sale. Should the seller’s damages be based on the profit that she would have made on this sale, on the ground that the number of profitable sales has been reduced (the “lost volume” measure)? Or should 42

[1990] 1 All ER 512. Cf AW Dnes, “The Law and Economics of Contract Modifications: the Case of Williams v. Roffey” (1995) 15 International Review of Law and Economics 225. 44 C Goetz and RE Scott, “Measuring Sellers’ Damages: the Lost Profits Puzzle” (1979) 31 Stanford Law Review 323; VP Goldberg, “An Economic Analysis of the Lost-Volume Retail Seller” (1984) 57 Southern California Law Review 283. 43

152

(F) Ogus Ch5

24/3/06

14:32

Page 153

Risks Allocation and Risk Management

it be assumed that the seller would, or should, have been able to substitute a buyer in the market, and therefore be entitled only to the difference between the contract price and the market price (at the time of breach) plus incidental expenses (the “market” measure)? One plausible way of addressing this issue is to have regard to the state of the market at the time of breach: if supply exceeds demand, then the seller would have been able to meet all potential demand and thus should recover for loss of profits.45 If, conversely, demand exceeds supply, then a subsequent sale should be treated as an alternative to that which is the subject of the claim, and no additional loss of profits will accrue.46 However, determining the conditions of the market in respect of particular sellers at the time of breach is not always easy and can render the operation of this approach unpredictable, thus hindering the easy resolution of contractual disputes. What can an ex ante perspective contribute to this issue? We should first remember 47 that rules on contractual remedies can be treated as default rules, in the sense that, subject to overriding policy dictates, such as those that prevent the enforcement of penalty clauses, the parties to a contract may specify what remedies are to apply. Adopting the ex ante perspective, the question then becomes, not what losses in fact occurred, but rather how the parties did, or would have, allocated the risks relating to market conditions. One possibility is that sellers would prefer not to respond to buyers’ defaults by mitigating the loss and finding an alternative sale. If buyers would be prepared to accept this, and the higher price to which it would give rise, given the increase in potential liability costs, that would suggest the appropriateness of the “lost volume” measure. But, of course, many buyers would not accept this, particularly since the amount of the sellers’ profit on the transaction is unlikely to be known to them. Another possibility 45 46 47

Thompson v Robinson [1955] Ch 177. Charter v Sullivan [1957] 2 QB 117. Above, 57–8.

153

(F) Ogus Ch5

24/3/06

14:32

Page 154

Risks Allocation and Risk Management

is that both parties treat the transaction primarily as an allocation in the risk of fluctuations in the price of the goods.48 The executory contract fixes the price in advance of the date of payment. If, on that date, the market price is lower than the contract price, sellers are protected against the buyer defaulting, while if the price is higher buyers are protected against sellers defaulting. If both parties would have agreed to this characterisation of the contract, then the “market” measure would be appropriate. In many transactions, particularly in well-functioning markets, this latter interpretation would seem to be the more likely approximations to the parties’ preferences, not the least because information on market prices is more readily available, and thus potential liability costs can be more easily predicted. But the analysis here has not been designed to show that the “lost volume” measure is necessarily wrong. My concern has been, rather, to indicate how the ex ante perspective on risk allocation can contribute to an understanding of the issue.

Subjectivity and Risk Management In the earlier discussion of foreseeability, we saw how risk assessment plays a key role in the law of tort, the economic goal of which is to induce the optimal level of care, the point at which a marginal increase to the resources spent on care (C) approximately equals the consequential marginal reduction in the risk (pD). The same economic goal applies to regulatory interventions intended to protect health, safety and the environment.49 So far I have treated the variables involved as if their values were unproblematic. Obviously this is not always so. Decision-makers may not have the necessary information to make the evaluation; or the information that is available may be uncertain. And there may be important differences as to how the information is interpreted, say, as between experts and lay people. These issues 48 Cf RE Scott, “The Case for Market Damages: Revisiting the Lost Profits Puzzle” (1990) 57 University of Chicago Law Review 1155. 49 A Ogus, Regulation: Legal Form and Economic Theory (Oxford, Hart Publishing, 2004), 153–4.

154

(F) Ogus Ch5

24/3/06

14:32

Page 155

Risks Allocation and Risk Management

have important implications for the legal arrangements for risk allocation and management. Take first the problems created by popular attitudes to risk. People generally do not always respond to risks in ways which are rational or well informed. One phenomenon well documented by social psychologists50 is “hindsight bias”: awareness of what has happened ex post distorts the ex ante perception of what might happen. My students’ attitude to the evidence given at the rail accident inquiry illustrates this. Equally familiar is the “availability heuristic”, the over-estimation of risks identical, or analogous, to those which are readily brought to mind, typically because of their prominence in the media and other fora for public discussion. A single accident causing the death of 20 people may be no more harmful to society than the same number of fatalities occurring in regular road accidents, but the focus of attention makes it seem worse. Mention can also be made of “status quo bias”, over-valuing the benefit of preventing (or reducing) risks from new activities or technologies. What we are familiar with (say a conventional ferryboat) may be more dangerous than an invention which emerges to compete with it (say a hovercraft), but the very novelty of the latter may create apprehensions which, objectively, are not justified. At first glance, it might seem that economic analysis should lead policy-makers to allow such lay perceptions of risk to override those based on expert opinion, leading to generally higher levels of protection. This is because, in analysing the welfare functions of individuals—what gives them satisfaction and therefore indicates their preferences—economists recognise that attitudes to risks differ. Some individuals, for example, derive utility from taking risks (“risk-preferring”); others dislike risks (“risk averse”); while a third group come somewhere between 50 See, esp: RG Noll. and JE Krier, “Some Implications of Cognitive Psychology for Risk Regulation” in C Sunstein (ed), Behavioral Law and Economics (Cambridge, Cambridge University Press, 2000), ch 13; P Slovic, B Fischhoff and S Lichtenstein, “Rating the Risks: the Structure of Expert and Lay Perceptions” in C Hohenemser and JX Kasperson (eds), Risk in the Technologiocal Society (Bowker, 1982), ch 10.

155

(F) Ogus Ch5

24/3/06

14:32

Page 156

Risks Allocation and Risk Management

the two (“risk-neutral”). It follows that to achieve the same degree of happiness, those who are risk-averse will be willing to pay more than those who are risk-neutral to reduce a risk, and those who are risk-preferring to pay less. The simple case of householders (who are risk-averse) transferring to insurance companies (who are risk-neutral) the risk of flooding or destruction by fire is an example of this. Since the ultimate objective of economic decision-making is to maximise utility, risk-aversion, where it exists, must be taken into account as an important part of individual preferences. Even if the lay perceptions of risk resulting from the phenomena described above are “irrational”, they cause disutility and therefore the analysis suggests that there is a justification in making safety policy meet standards higher than those required by expert assessments.51 Irrespective of this theoretical argument, politicians seeking to maximise their popularity are likely to proceed in the same direction. They will gain esteem by being seen to respond to public anxiety, while the cost of meeting the additional precautions will generally be spread widely and often hidden from public view.52 However, intuition suggests that such a policy is likely to be misguided. A literal application of the risk-aversion criterion constitutes a disproportionate response to flawed and irrational risk perceptions and will seriously inhibit technological development.53 Nor does economic reasoning ineluctably lead to such a conclusion. As we have seen in chapter one, the seminal work of Ronald Coase teaches us to be sceptical of normative propositions that the active creators of risks should always be expected to modify their conduct.54 In some situations, it is

51 EA Posner, “Fear and the Regulatory Model of Counterterrorism” (2002) 25 Harvard Journal of Law and Public Policy 681; R Howse, “Decomcracy, Science and Free Trade: Risk Regulation on Trial at the World Trade Organisation” (2000) 98 Michigan Law Review 2329. 52 Ogus, above n 49, 75. 53 WK Viscusi, Rational Risk Policy (Oxford, Clarendon Press, 1998), 17. 54 Above, 7–9. See also below, 166–8.

156

(F) Ogus Ch5

24/3/06

14:32

Page 157

Risks Allocation and Risk Management

cheaper for the victim to avoid harm by taking appropriate action. So, for example, although a negligent car driver will in general be responsible for personal injuries consequent on the active creation of the risk, a passenger failing to wear a seat belt will not be able to recover for a serious head injury, if wearing the belt, at a relatively trivial cost, would have prevented that injury.55 By analogous reasoning, if individuals attribute an inappropriately high value to a given risk and in consequence sustain psychic losses if that risk is not prevented, we can surely expect them to take advantage of information available demonstrating that the risk is much smaller than they perceive it to be. Another line of reasoning which points in the same direction can be derived from the concept of “moral hazard”, familiar in the context of insurance. Insurers are generally unwilling to cover risks that arise from the unilateral actions of the insured person. For example, I cannot easily obtain cover against selfinflicted injuries.56 The reason is that I can, by my own actions, largely define (and increase!) the magnitude of the risk; and with insurance cover, I have no incentive to restrain the losses. So also if policy-makers were to respond to all instances of phobia generated by risks, it generates disincentives to master such phenomena. It may also exacerbate the problem by “legitimising” irrational public reactions and thereby adding to the anxiety.57 In short, if, and to the extent that, attitudes to risk are based on inadequate information or fallacious understanding, it can be argued that the disutility to which these give rise may more easily and cheaply be contained by the better informing and educating of public opinion.58

55

Froom v Butcher [1976] QB 286. See eg: Dhak v Insurance Co of North America [1996] 2 All ER 609. 57 HF Chang, “Risk Regulation, Endogenous Public Concerns, and the Hormones Dispute: Nothing to Fear but Fear Itself?” (2004) 77 Southern California Law Review 743. 58 Sunstein, Risk and Reason: Safety, Law, and the Environment (Cambridge, Cambridge University Press, 2002), 112–13. 56

157

(F) Ogus Ch5

24/3/06

14:32

Page 158

Risks Allocation and Risk Management

Uncertainty of Risks and the Precautionary Principle We are becoming increasingly aware, through such phenomena as global warming and the BSE crisis, that much scientific knowledge is subject to uncertainty. Because an insufficient degree of protection against some of these risks can generate huge welfare losses, there is much public anxiety and pressure on governments to take preventative action. One reponse has been the articulation of a “precautionary principle” and its endorsement in a number of international and national instruments, and the principle appears to have made a major impact on regulatory and legal policy-making.59 Unfortunately, it has also led to some loose reasoning about uncertain risks with, potentially at least, socially harmful results.60 From the various meanings attributed to the “precautionary principle” we can pass quickly over those which simply indicate that [W]here there are threats of serious or irreversible damage, lack of full scientific certainty shall not be used as a reason for postponing cost-effective measures to prevent environmental degradation.61

This is a banal statement because policy-makers are very often faced with a “lack of full scientific uncertainty” and obviously should not use that, by itself, as a justification for failing to take appropriate risk management measures. Another version involves the transfer, in cases of risks of serious or irreversible damage, of the burden of proof from those claiming that protection is necessary to those claiming that it is not necessary.62 Insofar as this interpretation simply implies 59 N de Sadeleer, Environmental Principles: From Political Slogans to Legal Rules (Oxford, Oxford University Press, 2002), ch 3. 60 A Ogus, above n 9, from which some of this sections is derived. 61 United Nations (Rio) Conference on Environment and Development, Agenda 21. 62 The so-called Wingfield Declaration, quoted in CR Sunstein, “Beyond the Precautionary Principle” (2003) 151 University of Pennsylvania Law Review 1003, 1006.

158

(F) Ogus Ch5

24/3/06

14:32

Page 159

Risks Allocation and Risk Management

that regulators should err on the side of caution, it is entirely reasonable, but taken literally it is meaningless, since, in a situation of scientific uncertainty, it is impossible to prove that intervention is unnecessary. Indeed, this interpretation can easily slide into a stricter, and more harmful, version, requiring preventative action wherever there is perceived risk of very serious harm, and whatever the cost of prevention.63 Now, this interpretation cannot be applied literally wherever there is a perceived risk of very serious harm. Perceptions must have at least some degree of plausibility: clearly we cannot inhibit all technological process simply because some speculative predictions of catastrophe have been made. Even with this qualification, the principle is untenable insofar as it implies that, in a given set of circumstances, protection should be undertaken whatever the economic cost.64 It is untenable because “there is no escape from evaluation: whatever rule we adopt it will imply an economic value”65; and it cannot be the case that society is prepared to devote an infinite amount of resources to prevent the materialisation of any given risk, let alone a speculative risk. One reason why some non-economists seem to fail to grasp this fundamental point is that they do not understand sufficiently the economic method of valuing resources in terms of “opportunity cost.”66 This notion tells us that we should value what we do, not by reference to what we spend to achieve a desired outcome—generally referred to as “accounting costs”—but by reference to what we sacrifice for this purpose, in 63 This is related to another, often-quoted, maximin approach, which requires policy-makers to search for a strategy which would give rise to the best outcome in the worst possible scenario: see G Majone, “What Price Safety? The Precautionary Principle and its Policy Implications” (2002) 40 Journal of Common Market Studies 89. 64 Such a position appears to have been taken by the European Court of Justice in Case T–13/99 Pfizer Animal Health v Council, 2002, para 456. 65 D Pearce, “The Precautionary Principle and Economic Analysis” in T O’Riordan and J Cameron (eds), Interpreting the Precautionary Principle (London, Earthscan Publicatioons, 1994), 145. 66 Majone, above n 63, 100.

159

(F) Ogus Ch5

24/3/06

14:32

Page 160

Risks Allocation and Risk Management

other words the value we attribute to our next most-preferred alternative to the course of action we have taken.67 So, if we use resources in protection against risks, the cost to society is the best alternative use that could have been made of those resources. Viewing the matter from this perspective should make us aware that efforts to prevent certain risks may lead to worse outcomes, because less resources are then available to deal with other risks. If we spend large amounts on removing from hospitals minute risks of salmonella, we have less money available to use elsewhere in health care, leading to a loss of lives more serious than that posed by the risk of salmonella. Another, striking illustration is provided by the Hatfield railway disaster of 200068 which led to popular demands for an improvement in the safety of the railway lines. The government response was to insist on emergency work which created considerable delays on train services and induced many potential passengers to travel by road rather than by rail. However, since the risks of death or serious injury from a road accident were significantly higher than those arising from railway travel even on the unrepaired lines, this probably resulted in a net loss to social welfare.69 Examples such as these can lead us to the conclusion that the precautionary principle can be indeterminate, as well as flawed.70 If the principle compels us to eliminate an uncertain risk of very serious harm, and the measures necessary to elimin67

Above, 50. See The Guardian, October 30, 2000. 69 “Over the past month, the railways are estimated to have lost nearly a third of their passengers. The resulting growth in road traffic is likely, according to road-safety experts, to result in five additional deaths-nearly as many as broken rails have caused over the past 30 years”: The Economist, 25 November 2000, 65. See also the report on the Paddington crash submitted to the Rail Safety and Standards Board by Chris Elliott and Tony Taig in July 2003 which asserted that since it cost taxpayers £10m to save each life with the new train warning system TPWS, but as little as £100,000 to save a life with safety measures on the roads, the public might, if properly informed, prefer to invest money on safety differently. The report is available at www.rssb.co.uk/pdf/complete_ethical.pdf. 70 Sunstein, above n 62, 1020–8. 68

160

(F) Ogus Ch5

24/3/06

14:32

Page 161

Risks Allocation and Risk Management

ate that risk themselves generate a risk of very serious harm, in what direction should the policy proceed? Apparently, we should neither allow the risk to materialise nor take the measures necessary to abate the risk! It is, of course, true that scientific uncertainty creates dilemmas for risk management, but unnecessary difficulties are imposed on policy-makers if particular risks are singled out for particular treatment, relying on the existence of uncertainty. It is wrong artificially to distinguish between those risks as to which we have sufficient information to undertake a cost-benefit justified risk management and those risks where we do not have such information: “in reality, these are two points on a knowledge-ignorance continuum rather than two qualitatively distinct situations”.71 Scientific uncertainty indeed attaches to all risks and we must do the best we can in the face of it.

Conclusion Risk plays a major role in many areas of law and yet the approach of lawyers to issues of risk allocation and risk management appears sometimes to be flawed, or at least confused. In one section of this chapter, we saw how a search for the economic rationale of the different rules in which the “foreseeability” of a risk is required can help to clarify the usage of this ambiguous concept. More generally, problems arise because much legal work consists of dispute resolution which involves an ex post perspective on events. The perspective not only leads those focusing on these events to treat them as having been more probable than scientifically was the case—what we have referred to as “hindsight bias”; it also tends to divert attention away from the impact which judicial decisions are likely to have on future conduct. As the Levison case shows, this can be particularly unfortunate when judges seek to impose “just” outcomes on contractual relationships, without taking adequate account of how their rulings will affect others in circumstances 71

Majone, above n 63, 104.

161

(F) Ogus Ch5

24/3/06

14:32

Page 162

Risks Allocation and Risk Management

similar to those of the individuals they were attempting to protect. Economic reasoning predominantly applies an ex ante perspective to legal rules and the process of inquiring how parties to a contract might have allocated particular risks facilitates the formulation of the many legal principles which effectively operate as default rules. The determination of what damages should be awarded to a seller of goods when the buyer defaults provides a good example. A rational approach to risk management assumes great importance in areas of regulation protecting health, safety and environment, particularly as there is often public demand for higher levels or protection based on distorted perceptions of risk. The same applies where the risks in question are subject to a significant degree of scientific uncertainty and where too heavy an insistence on the apparent benefits of precautionary measures can fail to take account of the high opportunity costs to which those measures give rise.

162

(G) Ogus Ch6

20/2/06

16:34

Page 163

6 Corrective Justice: Damage, Causation and Responsibility

Introduction: The Puddle and the Sauna I am sure that you have known the situation, particularly if you live in, or have been to, Manchester. You are standing on the pavement waiting for a bus or a taxi. It has been raining heavily and unfortunately the road is not well drained so that there is a puddle. A mischievous motorist drives straight through the puddle and you are sprayed; those nice trousers must go to the cleaners again. You are angry, but of course there is nothing you can do. The car is already far in the distance and even if you had had time to make a mental note of the registration number, it is not worth your while to do anything about it. However few would dispute the moral judgment that the motorist has been at fault, the fact that he has caused damage to you, and the conclusion that he ought to pay for the cleaners’ bill. For what it is worth—unfortunately not much—the claims would be endorsed by the law, were the case to be brought before a court. Let us switch to another situation, this one even more within my personal experience. I used to enjoy having a sauna bath. The pleasure I derived from it was not only the sense of refreshment and cleanliness which ensued from the experience but also the tranquillity and relaxation of the experience itself. On one occasion, while (with others) I was sitting in a commercial sauna, such pleasure was seriously prejudiced by pop music issuing from a loudspeaker. I complained afterwards and the proprietor assured me that next time there would be a quiet environment. There was; but on subsequent occasions the noise 163

(G) Ogus Ch6

20/2/06

16:34

Page 164

Corrective Justice: Damage, Causation and Responsibility

returned and, eventually, I ceased to complain, but did not return to that sauna. To what extent is my predicament in the sauna analogous to that of the hapless, showered pedestrian? The legal situation is clearly very different: the question in the first case is whether there is an implied term in my contract with the sauna owner that quiet should prevail. But suppose that I had to formulate a moral argument to uphold my desire for freedom from noise, what would I say? The language of culpability is difficult to apply here, at least if there was no intention to irritate me. Nevertheless, at some risk of artificiality, I could contend that there had been damage to my senses caused by another, or perhaps that peace and quiet was the “natural” condition of this particular part of the environment and that I was entitled to restrain the “pollution” of it. For some legal writers, entitlements in civil law, principally those governed by the law of tort, are presumed to reflect basic precepts of morality, collectively referred to as corrective justice.1 As a matter of history, the influence of morality on the development of tort law cannot be denied.2 But how well do these ideas serve as guidelines when difficult decisions have to be made in what may be described as the peripheral or “grey” areas of tort law? We may have no problem in determining the appropriate outcome in the puddle case, because the moral content is unambiguous. But suppose that there had been no deliberate attempt to splash the pedestrian; rather, the motorist could not avoid driving through the puddle. Suppose that the pedestrian’s aims of hailing a cab or bus could have been equally as well fulfilled by standing a few yards back, out of range. With either or both of these changes to the facts, the moral implications of the situation become far less obvious. And the moral 1 See particularly, EJ Weinrib (ed), Tort Law (Aldershot, Dartmouth, 1991) and EJ Weinrib, The Idea of Private Law (Cambridge, Mass, Harvard University Press, 1995). 2 As can be evidenced by the dicta of Lord Atkin and Viscount Simonds in the leading cases of Donoghue v Stevenson [1932] AC 562, 580, and The Wagon Mound [1961] AC 388, 422–3.

164

(G) Ogus Ch6

20/2/06

16:34

Page 165

Corrective Justice: Damage, Causation and Responsibility

content of my sauna experience is even more problematic. Is peace and quiet invariably a “good” thing? Suppose—which is likely to have been the case if the sauna manager was adept at business—that a majority of clients preferred pop music to silence? In attempting to generalise on the features in the two cases which render the moral content uncertain, we can fasten on to the question of causation. Now any particular event, such as the pedestrian’s wet trousers, can be attributed to a vast number of causes and conditions, including the heavy rainfall, the inadequacy of the drains, as well as my decision to stand near to the puddle. The moral perspective, and often the law, requires the decision-maker to select from the causes those which are deemed to be the most significant and thus justify some degree of responsibility, typically because they involve some characteristics of abnormality, or some voluntary and deliberate behaviour.3 The absence of these characteristics renders the moral test of responsibility somewhat ambiguous, as where the motorist could not avoid driving through the puddle or where it is argued that noise rather peace and quiet is “normal” in a sauna. The economic approach to these issues is significantly different. Not only does it involve a shift from the moral focus to an inquiry into what is the least-cost solution to the problem. It also, primarily as a consequence of the writings of Ronald Coase,4 cuts across traditional legal reasoning on causation. I therefore begin with a short account of the relevant part of Coasean reasoning and how it impacts on causation theory; I then apply the theoretical framework to three problematic areas of tort liability where it seems to me that traditional legal notions of responsibility based on corrective justice ideas are largely indeterminate and, where (I argue), economic reasoning can provide a better explanation of how the law has evolved: 3 HLA Hart and AM Honoré, Causation in the Law (Oxford, Clarendon Press, 1959), 30–41. 4 R Coase, “The Problem of Social Cost” (1960) 3 Journal of Law and Economics 1.

165

(G) Ogus Ch6

20/2/06

16:34

Page 166

Corrective Justice: Damage, Causation and Responsibility

negligent omissions, coming to a nuisance, the requirement of damage and different types of damage.5

Causation and Coasean Reasoning Principles of corrective justice ascribe responsibility primarily to those who inflict harm on others. Thus, in the puddle example, it is the physical interference with my property which first attracts our attention; and were we able to solve the sauna problem by corrective justice ideas, we would identify the intrusion on my senses as the significant factor. Interestingly, while the aim of welfare economics is very different—to correct the misallocation of resources—in its traditional form of analysis, it adopted a perspective which could easily be correlated with the legal approach. The imposition of unwanted and uncompensated costs on others distorts the price structure and leads to inefficiency. A simple example is that of a manufacturing process which pollutes the environment. The pollution costs are part of the costs of production and if they are not reflected in the price which the manufacturer charges for the products, the latter will be cheaper and production will be higher, relative to what is economically desirable. This is, of course, the familiar concept of a negative externality.6 As I indicated in chapter one,7 the most radical, and perhaps for lawyers still insufficiently appreciated,8 aspect of Ronald Coase’s Social Costs paper9 was the overturning of this theoretical framework. For him, the misallocation, if any, arises not as 5 A Ogus, “Inglaterra sin pescado y patatas fritas, o qué más deberíamos haber descubierto en el ensayo de Coase sobre costos sociales” (“England Without Fish-and-Chips, or What More Should We Have Discovered in Coase’s Social Cost Paper?”) (2002) 3 (June issue) Revista Argentina de Teoría Jurídica (available at http://www.utdt.edu/departamentos/derecho/publicaciones/ rtj1/pdf/TraduccionOgusfinal.PDF) from which this chapter has been developed. 6 Cf above, 76. 7 Above, 7–9. 8 Ogus, above n 5. 9 Above n 4.

166

(G) Ogus Ch6

20/2/06

16:34

Page 167

Corrective Justice: Damage, Causation and Responsibility

a result of the unilateral infliction of costs by one economic actor on another, but rather from the friction which occurs when two or more actors compete for the same resource. While the pollution clearly harms neighbouring landowners, so also, if less obviously, those landowners “harm” the manufacturer if through the exercise of their property rights they prevent her disposing of the waste as she would wish. Coase considers that the position of polluters and pollutees is symmetrical and reciprocal: each wishes to use the environment in ways which are utility-maximising. There is no a priori reason for assuming that, because the polluter’s activity involves a physical interference, her claim on the environment is less valuable than that of the pollutees. The normative (economic) proposition which flows from this is not necessarily that the interference be abated or paid for by the inflictor, bur rather that the friction between the conflicting resource uses be relieved at lowest cost, taking account both of the value of the resource uses and the costs of adapting behaviour. Let us now examine the implications of this for our two examples. In the puddle case, the outcome is likely to hinge on whether it is less costly for the motorist to avoid driving through the water, or for the pedestrian to stand out of range of being splashed. The calculation would take account of the cost of being made aware of the problem and its solution—it is probably easier for the pedestrian to spot the danger—and also of any risks to which the avoidance behaviour might give rise—the motorist swerving might create hazards for other road users. The sauna case may perhaps be more easily resolved. By reference to known demand for the commodity, a sauna with pop music may (sadly) have a higher social value than one which is quiet. Lawyers may have no difficulty in coming to terms with the outcomes signalled in these cases, but we should note that the reasoning cannot always be easily accommodated within normal legal discourse.10 So, for example, the language of the law makes 10 B Ackerman, Reconstructing American Law, (Cambridge, Mass, Harvard University Press, 1984), ch 4; and see above 8–9.

167

(G) Ogus Ch6

20/2/06

16:34

Page 168

Corrective Justice: Damage, Causation and Responsibility

it difficult to translate Coase’s notion of reciprocity into principles of tort liability.11 If it is held that the risk of splashing is to be borne by the pedestrian, the legal argument cannot be articulated by the proposition that the latter should be “liable” for the motorist’s “loss” in not being able to drive through the puddle.12 More than this, Coase’s reciprocity principle asks us to be suspicious of the over-simple selection of causes based on “abnormality” or “voluntary and deliberate” behaviour and examine the broader context in which the conflict arises. In the following pages, I shall attempt to show how this approach, when combined with an inquiry into efficiency considerations, can generate major insights for understanding how the law can resolve some problematic areas of liability. I begin with the question of liability for negligent omissions.

Liability for Negligent Omissions For the purpose of negligence or fault-based tortious liability, most legal systems draw a distinction between acts (malfeasance) and omissions (nonfeasance) and reveal some caution in imposing responsibility for the latter. The strength of the reluctance to impose positive duties to act nevertheless varies significantly between jurisdictions.13 If corrective justice ideas are the basis of the law, this is not surprising since moral values are unlikely to be homogenous. So, for example, the traditional common law, with its emphasis on individual liberty, has a 11 N Duxbury, “Ronald’s Way”, in SG Medema (ed), Coasean Economics: Law and Economics and the New Institutional Economics (Deventer, Kluwer, 1998), 187. 12 I recall many years ago being struck by a remark of Tony Jolowicz that, in tort law, rules of no liability were as important as rules of liability: see JA Jolowicz, “The Law of Tort and Non-Physical Loss” (1972) 12 Journal of Society of Public Teachers of Law (NS) 91, 91–2. In their seminal analysis, Calabresi and Melamed sensibly use the concept of entitlement to overcome the problem: “Property Rules, Liability Rules and Inalienability: One View of the Cathedral” (1972) 85 Harvard Law Review 1089. 13 JM Smits, The Good Samaritan in European Private Law (Deventer, Kluwer, 2000).

168

(G) Ogus Ch6

20/2/06

16:34

Page 169

Corrective Justice: Damage, Causation and Responsibility

narrower range of liability for omissions14 than (say) French law, with its more collectivist approach.15 But the question of where to draw the line to accord with presumed moral values has proved to be problematic. Take English law, for which the fundamental principle is that a failure to act is not in general actionable. This is qualified by recognising situations in which there is a positive duty to prevent harm, notably where there exists some form of pre-tort relationship between the parties, such as that between employers and employees,16 professionals and their clients17 or that of adjacent landowners,18 and the defendant has knowledge adequate to meet the contingency. But commentators have found it difficult to formulate the principle of corrective justice on which this distinction is based; still more to prescribe how cases in the grey area outside familiar categories should be determined.19 A useful illustration is Stovin v Wise.20 Stovin was injured at a road junction when his motor cycle collided with Wise’s car, which emerged from a side road. Stovin’s view of that road was impeded by an earth bank. The highway authority was aware of the potential danger but had not exercised its statutory power to remove the bank and Wise sought to render it liable for Stovin’s injuries. The House of Lords held by a majority of three to two that the authority was not liable for its failure to act. In the leading dissenting opinion, Lord Nicholls attempted to identify the key considerations in applying the corrective justive test of whether it was “fair and reasonable” to impose a positive duty on the highway authority. These included foreseeability of 14 BS Markesinis, “Negligence, Nuisance and Affirmative Duties of Action” (1989) 105 Law Quarterly Review 104. 15 J Carbonnier, Droit Civil (Tome 4) Les Obligations, 21st edn (Paris, PUF, 1998), 392–7. 16 Costello v Chief Constable of Northumbria Police [1991] 1 All ER 550. 17 Carr-Glynn v Frearsons [1998] 4 All ER 225. 18 Goldman v Hargrave [1967] 1 AC 645. 19 See eg AM Honoré, “Are Omissions Less Culpable?” in P Cane and J Stapleton (eds), Essays for Patrick Atiyah (Oxford, Oxford University Press, 1991), 33. 20 [1996] 3 All ER 801.

169

(G) Ogus Ch6

20/2/06

16:34

Page 170

Corrective Justice: Damage, Causation and Responsibility

the harm caused and whether “it was out of all proportion to the preventive steps required”, control of the situation by the defendant, and vulnerability or dependence of the victim.21 Interestingly, Lord Hoffmann, giving the leading opinion of the majority, invoked economic analysis as part of his justification for not imposing liability. He said: In economic terms, the efficient allocation of resources usually requires an activity should bear its own costs. If it benefits from being able to impose some of its costs on other people (what economists call “externalities”) the market is distorted because the activity appears cheaper than it really is. So liability to pay compensation for loss caused by negligent conduct acts as a deterrent against increasing the cost of the activity to the community and reduces externalities. But there is no similar justification for requiring a person who is not doing anything to spend money on behalf of someone else.22

It is not too often that there is explicit reference to economic analysis in English tort cases,23 and ironically the learned judge here adopts the language of pre-Coasian welfare economics. Coasean reasoning can indeed provide us with a more surefooted way to resolve a case like this than either the notions of corrective justice implicit in the “fair and reasonable” criterion or traditional externality analysis. The reasoning invites us to reject any distinction between misfeasance and nonfeasance. Taken to its logical conclusion that might seem to lead to the absurdity that any single accident can be attributed to an infinite number of passive agents, any one of whom could have prevented it and therefore who could potentially be made liable. But we do not have to travel so far to arrive at meaningful insights. We start indeed from the proposition that there is no a priori reason to ignore omissions but that is then combined with an inquiry as to how the efficient solution might have been reached by market transactions. Approaching the problem in this way, we can see how one party might be willing to provide the level 21 22 23

170

[1996] 3 All ER at 807. Ibid at 819. See more generally, below, 280–1.

(G) Ogus Ch6

20/2/06

16:34

Page 171

Corrective Justice: Damage, Causation and Responsibility

of precaution which meets the preferences of the other party— the potential victim—at a price which the latter is prepared to pay. There might be an explicit agreement to deal with the risk, for example, if someone is employed to act as lifeguard and is paid a fee reflecting the cost to that individual of providing the level of safety desired by the potential victim. But more often it will function within a broader-based contractual setting. An employer assumes responsibility for positive steps to secure the health and safety of employees, the cost (in part, at least) being offset against wages and other benefits provided. We can see now why there is a tendency to impose liability for omissions on the employer, and others involved in a pre-tort relationship with the victim. Even if there was no explicit assumption of the responsibility, the existence of the relationship and the relevant knowledge of the defendant would suggest this was likely to be the cheapest way of dealing with the risk. The law performs the useful economic function of imposing the solution which the parties themselves would rationally have reached if they had been able to make an appropriate contract. Reasoning of this kind can be extended beyond parties in a contractual, or potentially contractual, situation. In Stovin v Wise, the cost to the highway authority in removing the bank might have been lower than the aggregate cost to all motorists at the junction taking the additional care rendered necessary by the presence of the bank. If so, it would have been rational for the users to have paid the authority to undertake this task. Of course, such a transaction could not realistically have been made. Nevertheless, the authority could have financed the undertaking by raising taxes on local residents, who would have constituted a reasonable proportion of junction-users; and this would have been some equivalent to an efficient contract. Let us now turn to the position of the Good Samaritan, that is, the casual bystander.24 The person in distress may have the 24 For full discussion, see WM Landes and RA Posner, “Salvors, Finders, Good Samaritans, and Other Rescuers: an Economic Study of Law and Altruism” (1978) 7 Journal of Legal Studies 83.

171

(G) Ogus Ch6

20/2/06

16:34

Page 172

Corrective Justice: Damage, Causation and Responsibility

opportunity to make a contract with a potential rescuer. If the victim had no alternative recourse, the terms of the agreement should be reviewed to ensure that the rescuer has not exploited the monopoly situation25; otherwise the contractual solution is appropriate. Suppose, however, that a contract is not feasible because, for example, the victim is unconscious or, to prevent harm, an act of assistance is necessary before the victim becomes aware of her plight. Consistent with the reasoning above, we should here expect the law to imitate the efficient contract that would have been made if it had been possible. Especially if the assistance could have been effected at low cost, that would seem to imply imposing a duty to rescue, a solution not accepted by English law. Further consideration may nevertheless furnish arguments against such a duty. We should first note that there may be a technical legal problem in the rescuer obtaining compensation from the victim for the cost of rescue.26 If there is little prospect of payment, that will reduce the supply of potential rescuers not motivated by altruism.27 A second point is that the duty imposed on the rescuer may reduce the incentive on the victim to take care.28 Next, in identifying what, in the circumstances, would have been the efficient contract, we must be careful to adopt a sufficiently broad perspective of the relevant costs and benefits. In particular, there is a danger of under-estimating the costs of imposing a positive duty to act. Take, first, the costs to an individual. In general, it is cheaper for someone already engaged in an activity to take steps to constrain risks arising from it than for a passive agent to respond to a risk created by 25 Under the doctrine of economic duress. See Pao On v Lau Yiu Long [1980] AC 614. 26 The doctrine of agency of necessity is relatively limited in English law: Lord Goff of Chieveley and G Jones, The Law of Restitution, 4th edn (London, Sweet and Maxwell, 1998), 363–99. 27 Landes and Posner, above n 24, 119–27. 28 D Wittman, “Optimal Pricing of Sequential Inputs: Last Clear Chance, Mitigation of Damages and Related Doctrines in Law” (1981) 10 Journal of Legal Studies 65.

172

(G) Ogus Ch6

20/2/06

16:34

Page 173

Corrective Justice: Damage, Causation and Responsibility

another. This is because the active agent has already selected that activity which presumptively generates for herself the greatest utility: the added cost of taking care in that activity might be relatively small. In contrast, the passive agent, to engage in the risk-controlling activity, must sacrifice all other profitable activities—in short her opportunity costs may be considerable. Secondly, in a situation where any one of a number of individuals could have controlled the risk, account must be taken of the non-trivial psychic costs which would be incurred by all those subject to a legal duty to act; and in aggregate such costs might be relatively large.29 To summarise. Articulating principles of corrective justice in relation to omissions has proved to be difficult. Coasean reasoning is hostile to formulating principles of liability by reference to crude distinctions between misfeasance and nonfeasance. Some caution in relation to omissions liability is justifiable because the costs of requiring passive agents to engage in a particular activity may be significantly high. But there are also cases where the cost of intervention to a particular passive agent would be small relative even to active agents. By identifying situations in which the parties would, if transactions costs had not inhibited them, reasonably have entered into a transaction to deal with a given risk, the analysis lends coherence to the determination of the liability issue.

Coming to a Nuisance In a situation where one party’s activity physically impacts on another’s, as in the puddle example, we cannot envisage creating a legal right for the active agent (the motorist) against the passive agent (the pedestrian), notwithstanding Coase’s notion of reciprocity. Nevertheless, if it is economically appropriate for the activity to prevail, because, for example, the victim could have avoided the loss more cheaply than the actor, legally we can 29 Liability here also creates problems of distributional justice: the “why pick on me?” objection. See Stovin v Wise, above n 20 at 819, per Lord Hoffmann.

173

(G) Ogus Ch6

20/2/06

16:34

Page 174

Corrective Justice: Damage, Causation and Responsibility

allow the latter to plead some causal defence, should the victim bring an action. For many torts, contributory negligence is the relevant legal concept and in the English law of nuisance we find the defence of “hypersensitivity”: a man who carries on an exceptionally delicate trade cannot complain because it is injured by his neighbour doing something which would not injure anything but an exceptionally delicate trade.30

A related situation is that in which an existing activity causes harm only when an individual subsequently arrives on the scene, within range of the activity. For example, the noise from a factory bothers no-one until an adjacent landowner decides to build residential accommodation there. Here, by analogy with the hypersensitivity doctrine, there may be arguments for a defence to be available to the factory owner. However, the literature31 informs us that there is considerable diversity and uncertainty in how courts approach the entitlements issue, some refusing to allow priority to first users, others effectively allowing a defence of “coming to nuisance”, at least to prevent second users enforcing their rights by an injunction. Once again we find that notions of corrective justice are not determinative. On the one hand, there is the idea that the fact of first use should not entitle polluters physically to invade the property of others. According to the judge in one 19th-century case, the Plaintiff came to the house he occupies with all the rights which the common law affords, and one of them is a right to wholesome air.32 30

Robinson v Kilvert (1889) 41 Ch D 88, 97, per Lopes LJ. See, for England, AI Ogus and GM Richardson, “Economics and the Environment: a Study of Private Nuisance” (1977) 36 Cambridge Law Journal 284, 302–3; for the USA, D Wittman, “First Come, First Served: an Economic Analysis of ‘Coming to Nuisance’” (1980) 9 Journal of Legal Studies 557; for Belgium and the Netherlands, M Faure, “Eerstingebruikneming in het milieurecht: een rechtseconomische analyse” in K Raes and H Willekens (eds), Economische Verklaringen van het Recht, (The Hague, VUGA, 1994), 147; for Norway, E Stavang, “Tolerance Limits and Temporal Priority in Environmental Civil Liability” (1997) 17 International Review of Law and Economics 553. 32 Tindal CJ in Bliss v Hall, (1838) 4 Bing NC 183, 186. 31

174

(G) Ogus Ch6

20/2/06

16:34

Page 175

Corrective Justice: Damage, Causation and Responsibility

On the other hand, the causal significance of the claimant’s act sometimes suggests that corrective justice should protect the first user. In Miller v Jackson, balls struck from a pitch, where cricket had been played for many years, landed in an adjacent, but recently-built, property. Lord Denning MR was receptive to the idea that “coming to a nuisance” should be a defence, at least to prevent the granting of an injunction. He argued that if and insofar as any damage is caused to the house or anyone in it, it is because of the position in which it was built.33

To what extent can economic analysis, derived from Coasean reasoning, rescue us from these ambiguities of corrective justice? Interestingly, Coase in his Social Costs paper discusses at some length the leading English authority denying the defence of “coming to a nuisance”, Sturges v Bridgman.34 There a doctor decided to build a consulting-room in his garden, a part of his property which was affected by noise and vibration from the adjacent works of a confectioner. The Court of Appeal held that the doctor was entitled to an injunction. For Coase, the decision (and the reasoning which led to it) was relatively insignificant: it was a platform for any subsequent bargaining. If the loss to the doctor caused by the confectioner’s noise was greater than the profit it generated for the latter, then there was no need to disturb the verdict. But [T]he doctor would have been willing to waive his right and allow the machinery to continue in operation if the confectioner would have paid him a sum of money which was greater than the loss of income which he would suffer from having to move to a more costly or less convenient location, from having to curtail his activities at this location, abandon his operation, or . . . from having to build a separate wall which would deaden the noise and vibration. The confectioner would have been willing to do this if the amount he would have to pay the doctor was less than the fall in income he would suffer if he had to change his mode of operation at this

33 34

[1977] QB 966, 981. (1879) 11 Ch D 852.

175

(G) Ogus Ch6

20/2/06

16:34

Page 176

Corrective Justice: Damage, Causation and Responsibility location, abandon his operation, or move his confectionery business to some other location.35

In short, Coase uses Sturges v Bridgman simply to illustrate his thesis that, if transaction costs are negligible, the parties will negotiate themselves to the efficient outcome; the legal principles simply provide the starting position for such negotiation. The judges in the case, as Coase notes, did not appreciate this: “it was of course [their] view that they were affecting the working of the economic system—and in a desirable direction”;36 and they invoked an economic policy of flexible land use to justify their decision. If, they argued, the first user’s activity were to be protected, that would for ever restrict the use and value of the adjacent land.37 But suppose that we are not in a situation of low transaction costs. There might, for example, be several landowners whose residence is built within range of an existing nuisance, thus rendering a bargaining solution difficult.38 Here the legal principle does affect “the working of the economic system”. The economic policy of flexible land use adopted by the Court of Appeal in Sturges v Bridgman may seem to take it in a “desirable direction”, but to alight on an appropriate legal principle we need to explore the matter further. The problem may be resolved by asking how relevant parties could have reduced (or can reduce) the conflict of land use by adapting their activity at lowest cost. We cannot expect to be efficient either a rule which always protects the first user (coming to a nuisance is always a defence) or a rule which always protects the second user (coming to a nuisance is never a defence). Since this is a problem of resource allocation over time, the inquiry as to the least-cost solution must be made within an extended time-frame and, if we are in a multi-party situation, with reference to the character of the neighbourhood. 35

Coase, above n 4, 9. Ibid, 10. 37 Above n 34, 865. 38 See, eg, the well-known American case Spur Industries v Webb Development Co 494 P 2d 700 (1972). 36

176

(G) Ogus Ch6

20/2/06

16:34

Page 177

Corrective Justice: Damage, Causation and Responsibility

We might begin by viewing the matter as it appears at the time when the conflict of land use has already occurred. Then we would ask whether it would be cheaper for the polluter to abate or rather for the victims to tolerate the disamenity or relocate.39 Such information is important but may not be decisive. This is because regard has also to be had to the impact of rulings on decisions made ex ante: protection of second users may encourage inefficient decision-making on where to locate more vulnerable, for example residential, uses. And this perverse incentive would be exacerbated if the price of the land used for the latter purpose were to reflect the existing level of pollution. The inquiry would then need to be expanded to cover other existing or potential users and thus the character of the neighbourhood.40 If an area has, and has consistently had, a predominant character (for example, industrial or residential), that strengthens the argument for protecting the activity which is more consistent with the character against an inconsistent activity, whichever was first in time. Too rigid an application of this guideline would, however, lead to the freezing of land-use, and encourage over-investment in that use.41 So, if the first use has gradually been superseded by second and subsequent users (for example, an industrial plant may survive in an otherwise derelict area which is then gradually converted to residential use), the least-cost solution may be for the first user to relocate.42 The discussion could be prolonged, not the least to incorporate the impact of zoning principles of public law.43 It is nevertheless sufficient for my present purposes, since, in accordance with Coasean reasoning, it reveals the importance of taking a 39

Faure, above n 31, 152–4. Wittman, above n 31, 559–60. 41 R Pitchford and CM Snyder, “Coming to the Nuisance: an Economic Analysis from an Incomplete Contracts Perspective” (2003) 19 Journal of Law, Economics and Organization 491. 42 It may be deemed appropriate (on distributional grounds) for the second user to compensate the first user of the costs of relocation. See the Spur Industries case, above n 38. 43 See Faure, above n 31, 169–72. 40

177

(G) Ogus Ch6

20/2/06

16:34

Page 178

Corrective Justice: Damage, Causation and Responsibility

broad approach to the causal factors operating on a particular issue of dispute. It shows again that traditional legal doctrines which tend too readily to attribute responsibility on the basis of wrongdoing or notions of causal potency can underestimate the significance of “innocent” or “passive” agents.

Requirement of “Damage” An important element in determining the boundaries of tortious liability is the existence and type of “damage” which the claimant must have suffered. There has been considerable discussion in the literature of the question why, in certain contexts, physical harm, whether to the person or to property, must be proved. Less attention has been given to an equally problematic issue, “what damage is or could be recognised as constituting the minimum for an actionable claim”.44 I believe that Coasean reasoning can shed light on both issues; I begin with the second. In applying the corrective justice idea of A being required to compensate B if A causes harm to B, we generally have no difficulty in identifying the harm which triggers liability. That is because it is typically a “palpable and deleterious physical change”,45 attributable to the defendant’s act, from a state of physical integrity; so, for example, a physically fit person’s leg is broken. Of course, in some cases, it has to be recognised that the claimant’s person or property might in any event have deteriorated as a consequence of internal, or other external, causes. The law then has the complex task of determining the appropriate extent of liability in the light of such concurrent or consecutive causes. If my back is physically injured in an accident for which the defendant is responsible but it is shown that, due to a latent condition, I would in any event have suffered the same consequences, I can recover from the defendant for my disability only up to the time when the latent condition would have mani44

J Stapleton, “The Gist of Negligence” (1988) 104 Law Quarterly Review

213. 45

178

Ibid.

(G) Ogus Ch6

20/2/06

16:34

Page 179

Corrective Justice: Damage, Causation and Responsibility

fested itself.46 The baseline is defined by reference to what would have occurred “naturally” or by ordinary and reasonable usage. The concept of “damage” which emerges may operate unproblematically in many areas to which it applies. I nevertheless believe that it hinders clarity of analysis in more complex situations, of which environmental pollution is a primary example. Here an understanding of the basis of the problem is assisted by Coasean analysis, for which the notion of “damage” is otiose. To approach this matter and, in particular, to see how Coasean analysis impacts on it, we should return to the sauna example given earlier in the chapter. My problem with the pop music can be characterised in corrective justice terms. The noise is an infliction on my senses and therefore “damage”: (with some stretching of language) we can describe it as “a palpable and deleterious change.” If asked to identify the baseline (the “change from what”), we could argue that the “natural” condition—that which would have occurred if there had been no intervention—is one of peace and quiet, and my attempt to derive an entitlement would be based on that. In Coasean terms, the situation is quite different. The character of the environment (noisy or quiet) should be determined according to its social value: if (in general) clients at the sauna prefer pop music to silence, then it has a higher social value in that use, and my preferences must succumb to those of others who, by reference to what they are willing to pay, can outbid me. Presumably, the sauna owner tested the hypothesis in the market; that is why noise was reinstated. Many, perhaps most, would accept that my preferences regarding the sauna should not prevail over those of other customers. If so, what is the weakness in the corrective justice argument? I suspect that the answer lies in the concept of “damage” and more particularly with the identification of peace and quiet as the appropriate baseline from which to measure the change in my circumstances. Peace and quiet may not be considered as “natural” in a sauna. Just as: 46

Jobling v Associated Dairies [1982] AC 794.

179

(G) Ogus Ch6

20/2/06

16:34

Page 180

Corrective Justice: Damage, Causation and Responsibility There would be little sympathy with a man who complained of the yelling by fans at a football match, or of the noise and smoke inside a pub, or of indecent exposure in a brothel. Such features are customarily associated with such places, and they can obviously and easily be avoided.47

Although the author of this passage is an economist he regards the issue as one of reasonable expectations based on “ethical consensus”; and that might enable us more readily to identify the baseline with corrective justice ideals. In contrast, Coasean reasoning uses market evaluation as the exclusive determinant. One can see the advantage of the latter approach in a situation where, as in the sauna, it may be difficult to identify an “ethical consensus.” It is also a situation where the market evaluation may be observed at relatively low cost, because all users of the sauna pay for the product. Shifting the focus of discussion to the environment more generally, where it is not enclosed and available only to those paying for it, raises the same question—what is pollution?—but the answers are more complex. We begin with a typical definition: [T]he introduction into the environment of substances or emissions that either damage, or carry the risk of damaging, human health or well-being, the built environment or the natural environment.48

Here pollution is identified with the merest disturbance from a baseline of environmental purity. By itself that is not a matter of concern; but it becomes so when it is part of a normative proposition. One such proposition, calling for the “elimination” of “pollution”, can be regarded as economic nonsense, once it is appreciated that pollution generates benefits as well as costs. Considerable currency is given to an apparently milder proposition, the “polluter-pay-principle”. This has featured in international treaties since the early 1970s, most notably in the 47 EJ Mishan, “Pangloss on Pollution”, in P Bohm and AV Kneese (eds), The Economics of Environment, (London, Macmillan, 1971) 72, n 1. 48 A Weale, The New Politics of Pollution, (Manchester, Manchester University Press, 1992), 3.

180

(G) Ogus Ch6

20/2/06

16:34

Page 181

Corrective Justice: Damage, Causation and Responsibility

Single European Act of 1986.49 It indicates that while pollution is not to be eliminated, the sources responsible should pay for it, apparently applying notions of corrective justice.50 However articulated, the principle remains incoherent because it is impossible to give “pollution” a workable meaning. This is not just a scientific problem of attributing responsibility for environmental conditions; it is also because “pollution” is a relative concept. It depends partly on individuals’ perceptions of what is harmful, and this clearly may vary according to time, place and individual sensitivity.51 And since pollution abatement is costly, it also reflects individual and community preferences as to resource allocation: in certain areas or countries, citizens may prefer lower standards of environmental amenity if that is consistent with, for example, higher prospects of employment. In determining nuisance claims, judges have recognised this through an application of the so-called neighbourhood test: “that may be a nuisance in Grosvenor Square which is none in Smithfield Market”.52 The test seems to be consistent with Coasean reasoning. Bruce Ackerman puts it well: Law-and-economics is sceptical of the very idea that actions are intrinsically right or wrong. So far as it is concerned, the same act may count as “pollution” in one relational setting but count as “desirable” in another setting that is only slightly different.53

49 HC Bugge, “The Principle of ‘Polluter-Pays’ in Economics and Law” in E Eide and R Van den Bergh (eds), Law and Economics of the Environment (Oslo, Juridisk Forlag, 1996), 53. 50 Although it is sometimes formulated in the language of externalities: “national authorities should endeavour to promote the internalization of environmental costs . . . taking into account the approach that the polluter should, in principle, bear the cost of pollution”: Principle 16 of the Rio Declaration on Environment and Development (1992). 51 JH Dales, Pollution, Property and Prices: an Essay in Policy-Making and Economics (Toronto, University of Toronto Press, 1968), 18–19. 52 Bamford v Turnley (1862) 3 B & S 66, 79, per Pollock CB. 53 Ackerman, above n 10, 86.

181

(G) Ogus Ch6

20/2/06

16:34

Page 182

Corrective Justice: Damage, Causation and Responsibility

We have reached the point of equating the problem of pollution with my problem in the sauna. In relation to the latter, I argued, in accordance with Coasean reasoning that, since the existence of “damage” was inextricably linked to resource allocation and individual preferences, the problem should be exclusively determined by market evaluation. There are manifest difficulties in treating the problems as entirely analogous. Conditions in the sauna have an effect only on customers who also pay for the experience. Environmental pollution is not so confined and it is almost impossible to relate its level to payments, whether by way of general taxes, or for goods the production of which involves pollution. Moreover, it may also affect future generations who do not participate in current market or political decision-making. Noise as an amenity, or disamenity, is readily “understood” by those entering the sauna. The ordinary citizen may know little about pollutants and their effects, thus rendering articulated preferences unreliable. These are important considerations which suggest caution in following through the implications of Coasean analysis. They do not, however, undermine the main thrust of my argument. Conventional notions of “damage” in corrective justice ideas cannot help us in determining appropriate levels of environmental protection. Analysing the problem in terms of conflicting uses establishes an appropriate framework for decision-making. We cannot generally rely on the market to provide the evaluations. The public good aspects may require some public institutions to conjecture on what levels of environmental amenity are likely to conform to citizens’ preferences, and some weighting may be necessary to cope with the problems of information deficits and future generations. Thereby we can hope that the “right” questions are being asked, even if we are not confident that the “right” answers will be secured.

Types of Damage We saw earlier in the chapter how in nuisance cases the existence of “damage” has been related to the character of the 182

(G) Ogus Ch6

20/2/06

16:34

Page 183

Corrective Justice: Damage, Causation and Responsibility

neighbourhood and by implication to citizen preferences. Nevertheless, the approach is by no means universally adopted. In a famous 19th-century case, the House of Lords drew a distinction between “nuisance . . . productive of personal discomfort . . . anything which discomposes or injuriously affects the senses or the nerves,” for which the neighbourhood test was applicable, and “material injury to property” which was actionable wherever it occurred.54 “Material injury” must clearly involve physical damage and thus is distinguishable from, for example, noises and smells. This distinction can be related to a broader range of legal doctrine that offers greater protection against physical damage, to the person or to property, than against non-physical damage.55 In English law, for example, liability has been imposed where a negligently caused loss of power resulted in the physical alteration of an iron smelt in a furnace, and hence for consequential loss of profits, but not for the inability to process another smelt, also leading to a loss of profits.56 So also if, as a result of a negligent survey, a building collapses and damages adjacent property, but not if the negligence results simply in the building being in a defective condition, and not creating a risk to life or limb.57 Liability for physical injury to a person can extend, in some circumstances, to psychiatric illness but not to mere grief or emotional stress.58 Reinterpreting, and necessarily over-simplifying a huge area of case law and legislation, we can reach the generalisation that the law of tort lays down a set of standards by reference to types of damage. In attempting to rationalise, for corrective justice purposes, some of the awkward distinctions resulting from “type of damage” rules, legal scholars often try to establish a hierarchy of interests protected by the law. Inflictions of personal injury 54 St Helen’s Smelting Co v Tipping (1865) 11 HL Cas 642, 651, per Lord Westbury LC. 55 P Cane, The Anatomy of Tort Law (Oxford, Hart Publishing, 1997), ch 5. 56 Spartan Steel v Martin [1973] 1 QB 27. 57 Murphy v Brentwood District Council [1991] 1 AC 398. 58 White v Chief Constable of the South Yorkshire Police [1999] 1 All ER 1.

183

(G) Ogus Ch6

20/2/06

16:34

Page 184

Corrective Justice: Damage, Causation and Responsibility

are more “reprehensible” than the causing of mere emotional distress; and the same can be said of physical damage to property, relative to pure economic loss. It is readily acknowledged that arbitrariness sometimes sets in when the distinctions are rigidly applied, particularly where the amount of physical harm inflicted is small.59 But greater difficulties arise from identifying the moral values underlying the ranking. One approach is to elevate tangible property entitlements to a special sphere of protection because they are considered essential for individual liberty and autonomy. The problem with appeals to “reification” of this kind is that they involve a circularity of argument, since what we define as a property entitlement reflects what assets we wish to be the subject of individual entitlement.60 A second set of arguments contains several interrelated themes. We may be sceptical of the ability of individuals to make wise decisions for themselves in relation to assets which are central to their welfare; hence, on paternalist grounds, we may deny them the opportunity of trading assets such as liberty and personal integrity, at least on the basis of personal evaluation.61 This justification is related to, but distinct from, another which focuses on the problem that individuals may have in acquiring adequate and comprehensible information on which to make an appropriate decision. Whatever weight is given to these considerations—and that is a matter of some controversy—it is unclear how they can assist in rationalising the special treatment of physical damage. It is true that bounded rationality and the like may 59 KM Stanton, “The Recovery of Pure Economic Loss in Tort: the Current Issues of Debate” in M Furmston (ed), The Law of Tort: Policies and Trends in Liability for Damage to Property and Economic Loss, (London, Duckworth, 1986), ch 1; and for a particularly valuable judicial contribution, see McLachlin J in Canadian National Railway Co v Norsk Pacific Steamship Co (1992) 91 DLR (4th) 289, 365–7. 60 DH Gjerdingen, “The Coase Theorem and the Psychology of CommonLaw Thought” (1983) 56 Southern California Law Review 711. 61 A Ogus, Regulation: Legal Form and Economic Theory (Oxford, Hart Publishing, 2004), 51–3.

184

(G) Ogus Ch6

20/2/06

16:34

Page 185

Corrective Justice: Damage, Causation and Responsibility

operate with particular force in relation to personal injuries and death, especially where these result from a complex web of risk-generating phenomena. But why, for this purpose, should physical damage to property be equated with personal injury? Coasean reasoning seems to suggest that distinctions between types of damage are irrelevant. The question is, how do the individuals concerned value freedom from the specific interference? At first blush, it might seem that there is nothing inherent in the different forms of interests justifying different treatment. I might be willing to pay more to avoid certain instances of emotional distress than I would to avoid, for example, a broken leg. And noise from an adjacent student apartment may reduce the (subjective) value I put on my house more than damage to the plants in my garden.62 We should, nevertheless, recognise that subjective evaluation of this kind is necessarily subject to a discounting for risks and this, consistent with Coasean reasoning, may help to explain the legal categorisation of types of damage. If a future, albeit uncertain, event is taken into account when making behavioural decisions, notably in relation to prices, there is less need for the law to make ex post corrections if and when the event occurs. Now it may be that most individuals engage in such discounting in relation to many instances of non-physical harm, for example, emotional distress or loss of profitability due to power cuts. So also when land or buildings are being purchased, the buyer may take account of the presence of noise and smells, and in consequence offer a lower price for the property. These are regular, on-going phenomena and may be different from physical harm which tends to result from less predictable events. And this reasoning can be extended to embrace loss-avoidance considerations. It may be (though this is necessarily a gross oversimplification) that, in general, the victims of non-physical loss can avoid that loss more cheaply63 than can the inflicters. If so, 62

Ogus and Richardson, above n 31, 299–300. Eg by insurance: DR Harris and CG Veljanovski, “Liability for Economic Loss in Tort”, in Furmston, above n 59, 56. 63

185

(G) Ogus Ch6

20/2/06

16:34

Page 186

Corrective Justice: Damage, Causation and Responsibility

whether or not ex ante discounting occurs, the denial of liability may encourage such loss-avoidance to take place. The possibility of ex ante reasoning is but one of several modes of economic reasoning which can be used to explain principles of law distinguishing between different types of damage.64 My purpose here has not been to explore this literature, nor to provide a definitive explanation of the ranking of interests for the purposes of tort liability. Rather, it has been to demonstrate how a progression from basic aspects of Coasean reasoning can assist in understanding the essential properties of the legal problem.

Conclusion The approach of Ronald Coase to conflicts of resource use may startle lawyers with its unorthodox treatment of causation. In this chapter I have attempted to show how, by forcing us to expand our vision on the interaction of phenomena, it generates insights essential for understanding how legal principles can be formulated to deal adequately with problematic liability issues. This seems to me to be as important as the more familiar, socalled “Coase theorem”, that when transactions costs are zero, bargaining between the relevant parties will ensure the efficient outcome, whatever their legal entitlements. A common failing among lawyers is to alight on the Coase theorem as a conclusion and argue that it has relevance to normative legal analysis only when transactions costs are insignificant.65 64 There is a fertile literature on liability for pure economic loss. See esp: MJ Rizzo, “A Theory of Economic Loss in the Law of Torts” (1982) 11 Journal of Legal Studies 281; Harris and Veljanovski, above n 63; VP Goldberg, “Recovery for Economic Loss following the Exxon Valdez Oil Spill” (1994) 23 Journal of Legal Studies 1; G Dari-Mattiacci, “The Economics of Pure Economic Loss and the Internalization of Multiple Externalities” in W van Boom, H Koziol and C Witting (eds), Tort and Insurance Law, vol 9: Pure Economic Loss (New York, Springer, 2004), 167–90. 65 See eg the way Coase is presented in a book on general legal theory: B Bix, Jurisprudence: Theory and Context (London, Sweet and Maxwell, 1996), 166–71.

186

(G) Ogus Ch6

20/2/06

16:34

Page 187

Corrective Justice: Damage, Causation and Responsibility

The reasoning inherent in the “reciprocity principle” penetrates to the very core of legal notions of responsibility and, as such, provides an alternative, and often more sensitive vision than that offered by conventional corrective justice. As I have sought to demonstrate in my brief examination of some problematic liability issues, this fresh perspective might not lead us to abandon moral criteria for determining entitlements, but when—as frequently occurs—these criteria remain insufficiently precise for “hard” decision-making, Coasean-inspired cost analysis can help us, both to explain the case law and to arrive at satisfying outcomes.

187

(G) Ogus Ch6

20/2/06

16:34

Page 188

(H) Ogus Ch7

24/3/06

08:20

Page 189

7 Wrongdoing and Welfare Maximisation

Introduction: Publishers Punished and Developers Disgorged Sadly we live in a world where people enjoy reading tittle-tattle, not the least if it involves the reputation of leading public figures. Sometimes what is read is truthful, thus justifying the tarnished reputation. Sometimes it is false and the innocent suffer. The famous case of Cassell v Broome1 was concerned with the defamation of Captain Broome in The Destruction of Convoy PQ17, a book describing a wartime naval disaster. The evidence revealed that, at an early stage in the preparation of the publication, both the author and the publishers knew that Captain Broome regarded some of the material as defamatory. They nevertheless proceeded to publish it with only minor modifications. Aware, no doubt, of the commercial implications of that decision, the jury (in 1970) awarded Captain Broome, in addition to £15,000 compensatory damages, £25,000 exemplary damages to punish the defendants. The award was upheld in the House of Lords: it was “intended to teach the defendant and others that ‘tort does not pay’.”2 The context of Wrotham Park Estate v Parkside Home3 was more homely. Here a property developer built houses on an estate in breach of a restrictive covenant. The adjacent landowners, in whose favour the covenant had been created, sought to 1 2 3

[1972] 1 All ER 801. Ibid, 826 (Lord Hailsham). [1974] 2 All ER 321.

189

(H) Ogus Ch7

24/3/06

08:20

Page 190

Wrongdoing and Welfare Maximisation

enforce that covenant against the property developer and those who had purchased and occupied the offending houses. Brightman J who heard the case found himself in a dilemma. He was not prepared to issue a mandatory injunction to have the offending development demolished: that “would be an unpardonable waste of much needed houses”. So compensation alone should be awarded. But this too was problematic. The defendants had argued that only a nominal award should be made, since the judge had found as a fact that “[n]o damage of a financial nature has been done to the plaintiffs by the breach of the lay-out stipulation”.4 “Is it just” he asked rhetorically, that the plaintiffs should receive no compensation and that the defendants should be left in undisturbed possession of the fruits of their wrongdoing? Common sense would seem to demand a negative answer to this question.

So, in the end a compromise was reached: the award of a sum of money exceeding the plaintiffs’ loss and based on what the defendants might have paid them to relax the covenant. There is a factor common to these two cases. A wrong had been committed—a tort in Cassell v Broome; a breach of contract in the Wrotham Park case—and the sum of money which would be payable, as assessed in accordance with the normal principle of compensating the victim of the wrong, was regarded by the judges as inadequate. Some ambiguity existed as to exactly what set of values motivated this view.5 The concern may have been that the damages award failed to deter the wrongful conduct; or it may have been that the defendants should not have been allowed to profit from wrongful acts. In either case, the argument has a moral basis, derived essentially from the wrongfulness of the conduct. Most lawyers would probably share the concerns of the judges, particularly if the contravention of legal obligations is 4

[1974] 2 All ER 337. See Law Commission Report No 247, Aggravated, Exemplary and Restitutionary Damages (1997), 53–9. 5

190

(H) Ogus Ch7

24/3/06

08:20

Page 191

Wrongdoing and Welfare Maximisation

blatant. Nevertheless, too dogmatic an insistence on the sanctity of legal obligations will have adverse economic consequences. Legal obligations, whether derived from a general principle, as in tort law, or from voluntary, consensual, arrangements, as in contract law, are often imperfect instruments for defining and achieving their specific goals; and the same applies to public, regulatory obligations. Obviously the decision-makers, legislators, judges, regulators or the individuals involved, may not possess the information necessary to determine and formulate what should be done; and, even if they do, circumstances may change between the time the obligation was formulated and the time of its execution, rendering performance of the obligation no longer desirable. Let me illustrate this.6 The principal hobby of my friend, Michael Faure, is the collection of exotic fish. Suppose that he desires to purchase a particular and rare specimen, for which he is prepared to pay €480. Verkoper is a Belgian dealer specialising in this trade. He expects to pay €400 for the fish to his supplier in Uganda, but he has to obtain from that country an export licence. If the licence is not granted, he must go to a dealer in another country and it will cost him €2000 to obtain the fish. When negotiating the deal with Faure, he does not know if he will get the licence but estimates that there is a 90% probability of doing so. Now suppose that the contract of sale would be governed by a law under which Faure could obtain specific performance if Verkoper failed to deliver the fish. How then would the latter price the contract ex ante? He must at least cover his purchase costs which would be: 0.9 (the probability of obtaining the licence) ⫻ €400 (what he pays the Uganda dealer) = €360; plus 0.1 (the probability of not obtaining the licence) ⫻ €2000 (what he pays the alternative dealer) = €200, therefore a minimum price of €560. Faure is not interested in paying a sum as high as €560 and therefore a contract will not be made. 6 Drawn from A Ogus et M Faure, Economie du droit: le cas français (LCDJ, Paris, 2002), 106.

191

(H) Ogus Ch7

24/3/06

08:20

Page 192

Wrongdoing and Welfare Maximisation

Next, suppose instead that the governing law allowed Verkoper, in the event of not obtaining the licence, to break the contract and pay Faure compensation, based on the value of the contract to him. The minimum price would now be calculated ex ante as: 0.9 ⫻ €400 (as before the cost if the licence is obtained) = €360, plus 0.1 ⫻ €480 (the value of the contract to Faure and thus the amount of compensation Verkoper must pay him if he breaks the contract) = €48; thus a minimum price of €408. Since €480 exceeds €408, Faure will be prepared to enter the contract. Of course, there are other legal routes which could have been taken: they could have an inserted an exemption, limitation, or liquidated damages clause, to govern the contingency that an export licence is not obtained. But the importance of the reasoning remains undiminished. The welfare of the two parties is enhanced by enabling the contract to be made, while accepting that, in some circumstances, breach rather than performance is preferable. The key question is then whether the apparatus of law enforcement is sufficiently flexible to accommodate “wrongdoing” when, in this sense, it turns out to be beneficial. In relation to breach of contract, Oliver Wendell Holmes famously wrote: The only universal consequence of a legally binding promise is that the law makes the promisor pay damages if the promised event does not come to pass. In every case it leaves him free from interference until the time for fulfilment has gone by, and therefore free to break his contract if he chooses.7

An Israeli jurist, antagonist to this notion, has responded with the rhetorical question: Why not generalize the proposition so that every person has the “option” to transgress another’s rights and to violate the law, so long as he is willing to suffer the consequences?8 7 OW Holmes, “The Path of Law” in OW Holmes, Collected Papers (Boston, Harcourt, 1920), 167, 175. 8 D Friedmann, “The Efficient Breach Fallacy” (1989) 18 Journal of Legal Studies 1, 1.

192

(H) Ogus Ch7

24/3/06

08:20

Page 193

Wrongdoing and Welfare Maximisation

Why not, indeed? In exploring that question in this chapter, we shall find that the economic approach, while not providing definitive answers, generates valuable insights on these issues for the very reason that it abstracts the moral dimension from the analysis. I begin with the normative question: when should we treat wrongdoing as generating welfare gains? Having shown how legal entitlements can be classified to conform with different answers to that question, I deal with three prominent areas where the issues have arisen: interference with the property rights in land; breach of contract; and regulatory contraventions.

When Should Wrongdoing be Treated as Generating Welfare Gains? Clearly, if we are to use economic reasoning to decide when and how wrongdoing is to be tolerated, that must be on the assumption that the wrongdoing in question is treated as generating gains to social welfare. Now, as should be clear from chapter one, unfortunately it is not possible to find a single test, which commands universal respect, for determining the existence of improvements to social welfare. We saw that, in practice, economists use either the Pareto test, according to which no one should lose, or the Kaldor-Hicks test, according to which it is sufficient if the aggregate gains outweigh the aggregate losses. The choice between the tests—or indeed the adoption of any other test—has a major impact on the policy determination of when the law should accept and perhaps even encourage the commission of wrongs. In Cassell v Broome, application of the Kaldor-Hicks test would require us to tolerate/encourage publication of the book, if the benefits to the readers, as measured by what they are willing to pay the publishers, and therefore the latters’ profits, exceed the losses to Captain Broome. For many, that would be an unattractive outcome and intuitively we might wish to draw a distinction between the benefits to readers of truthful information and false information respectively. However, that would involve making moral judgments as to what should and should 193

(H) Ogus Ch7

24/3/06

08:20

Page 194

Wrongdoing and Welfare Maximisation

not confer utility on individuals, and becomes highly problematic.9 Not unconnected with this last point is a possible distributional objection: some might argue that whatever the economic merits of the activity, those deliberately publishing false information should not profit at the expense of those who suffer by the revelation. Application of the Pareto test would not lead to these criticisms, but, to be satisfied, that test requires that the money payable to Captain Broome should perfectly compensate his losses, that is, he would be indifferent between, on the one hand, remaining undefamed and, on the other, being defamed but receiving the damages. The difficulty then becomes a more practical one: how would a court (or any third party) be able to determine what would be sufficient to compensate him, judged by this criterion? Only Captain Broome himself can provide information on this, and, if asked, he has every motivation to exaggerate or lie. The best the court can do is to arrive at a figure which, in its estimation, would be adequate for most people in Captain Broome’s circumstances. But since that might not be perfect compensation for Captain Broome, the Pareto test is not satisfied. Objections to the Kaldor-Hicks test, as well as difficulties in applying the notion of “perfect compensation”, may also help to explain why sensibilities are worried by another famous case, that of the Ford Pinto.10 Ford, the American car manufacturers, had become aware that the design of the fuel system in one of their models was defective. The company decided not to change the design, since this would have cost $11 per car, even though their analysis suggested that it would result in 180 fewer deaths. In aggregate, they calculated that the losses (deaths, injuries ands car damage) from the existing design would be about $49.5 9 D Friedman, Law’s Order (Princeton, Princeton University Press, 2000), 229–31. 10 Grimshaw v Ford Motor Co 19 Cal App 3d 757 (1981), and see GT Schwartz, “The Myth of the Ford Pinto Case” (1991) 43 Rutgers Law Review 1013.

194

(H) Ogus Ch7

24/3/06

08:20

Page 195

Wrongdoing and Welfare Maximisation

million which would be significantly less than the cost to them ($137 million) of changing the design. Assuming Ford made appropriate estimates of the gains and losses, their decision not to change the design would have satisfied the Kaldor-Hicks test, but would nevertheless be subject to criticisms analogous to those made of the Broome case. Ford’s knowledge of the consequences of the faulty design might be considered to be morally equivalent to knowingly publishing a false statement. And it would be of little comfort to those injured or killed to be informed that aggregate social welfare had increased, whether gains had accrued to Ford’s shareowners (through increased dividends) or other purchasers of the Pinto model (through reduced prices). For the purposes of the Pareto test, perfect compensation is here even more problematic, because of the statistical probability of fatalities. Clearly, since the victims of fatal accidents do not themselves receive the damages, they cannot be adequately compensated for their loss (unless life for them has a negative value). It might thus appear that activities causing death can never satisfy the Pareto test. This is, however, not the case, unless death is a certain consequence of the activity. Individuals regularly, in their everyday lives, confront risks of death, even though such risks may be tiny, for example, when crossing a road. To eliminate or reduce the risk, they have to decide what they are willing to pay. This is typically the foregoing of a benefit, for example, in getting across the road more quickly. Provided that adequate information relating to the risk is provided, in principle it therefore becomes possible for each individual to quantify what for him or her is perfect compensation for being confronted with a given risk of death.11 If, then, purchasers of the Ford Pinto were to be informed of the risk and a reduction was made to the price of the car equal to or exceeding what for them was perfect compensation for taking the risk, 11 The hypotheis is often used for decisions on safety in public policy contexts to attribute a value to a statistical life: see MW Jones-Lee, Economics of Safety and Physical Risk (Oxford, Blackwell, 1989).

195

(H) Ogus Ch7

24/3/06

08:20

Page 196

Wrongdoing and Welfare Maximisation

the Pareto test would be satisfied. Of course, like the value of Captain Broome’s reputation, what constitutes such compensation cannot be known by persons other than the potential risk victims. What emerges from this discussion is the realisation that economics cannot provide a universally acceptable answer to the question when wrongdoing should be treated as generating welfare gains. Many people would object to the notion implicit in the Kaldor-Hicks test, that individuals can be sacrificed for the purpose of generating aggregate welfare. They would probably find acceptable the Pareto idea, that wrongdoing should be tolerated, even encouraged, if losers are perfectly compensated. At the same time, most people might also accept that to insist rigidly, in every case, on perfect compensation would block too many activities which, in general, are to be regarded as desirable. We could attempt to speculate on what compromise between the Pareto and Kaldor-Hicks criteria might prove to be politically acceptable. Such compromise would have to be based on broad, and necessarily vague, concepts. Elsewhere,12 I have suggested that in determining the features of the compromise, account should be taken of the following considerations. First, the size of the aggregate costs relative to the aggregate benefits: the smaller the former, the more acceptable the outcome. Secondly, identification of the groups within the community which benefit and lose respectively from the activity which imposes the costs. The more that these groups overlap, the more acceptable the outcome. Thirdly, the extent to which the costs are spread over the community at large: the more narrowly focused, and identifiable, the losers, the more unacceptable the outcome. However my purpose here is not to reach definitive conclusions on normative questions of this kind; it is rather to see how the economic approach can increase our understanding of how the law grapples with the issues. In the next section, 12 A Ogus, “Risk Management from an Economic Perspective” in E Vos and G van Calster (eds), Risico en Voorzorg in de Rechtsmaatschappij (Antwerp, Intersentia, 2004), 232.

196

(H) Ogus Ch7

24/3/06

08:20

Page 197

Wrongdoing and Welfare Maximisation

we see how legal rights and remedies can be classified for this purpose.

Classification of Legal Entitlements In their classic and hugely influential 1972 paper, Calabresi and Melamed provided a method of classifying entitlements according to the degree of protection afforded by the law to the rightholder.13 If a right is protected by a “liability rule” the only legal remedy available for its infringement is that of compensation. The involvement of the state is limited to the assessment of damages and the enforcement of the damages award. The important implication of this is that the law tolerates infringement, provided that the infringer subsequently compensates the right-holder for the loss sustained. If the entitlement is instead protected by a “property rule”, then the police power of the state can be invoked by the right-holder physically to prevent invasion by others, notably by the issuing of an injunction. However, the right-holder can voluntarily accept interference for a price paid by the infringer, or on other conditions considered appropriate. If, thirdly, the entitlement is protected by a “rule of inalienability”, the power of the state is also used physically to prevent infringement but, crucially, the right-holder is not allowed voluntarily to accept the interference; any release from the obligation of non-interference is controlled by the state and may not be permitted at all.14 Which rule is selected, by the legislature or the judiciary, for a particular type of asset or infringement may obviously involve moral judgements. This is particularly evident in relation to rules of inalienability. I am not allowed to sell myself into slavery and, in most jurisdictions, there are strict state controls on transactions involving prostitution and bodily parts. To justify these 13 G Calabresi and D Melamed, “Property Rules, Liability Rules and Inalienability: One View of the Cathedral” (1972) 85 Harvard Law Review 1089. 14 Calabresi and Melamed, above n 13, did not explore inalienable rules in depth. For a more sustained analysis, see S Rose-Ackerman, “Inalienability and the Theory of Property” (1985) 85 Columbia Law Review 931.

197

(H) Ogus Ch7

24/3/06

08:20

Page 198

Wrongdoing and Welfare Maximisation

rules, we may use the language of human rights, invoke notions of paternalism or simply acknowledge ethical or moral reasons why certain commodities should not be the subject of market transactions.15 Non-economic justifications may also be identified for decisions to protect an entitlement by a property, rather than a liability, rule. Clearly the property rule confers much greater power on victims of the infringement which can be exploited to their advantage, an outcome which some may argue is inherent in certain types of property rights, whatever their financial value.16 And an analogous argument can be made for the use of specific performance to enforce contractual obligations on the moral ground that promises ought to be performed.17 From an economic perspective, the Calabresi and Melamed classification relates well to our focus on efficient wrongdoing.18 Clearly a liability rule is wholly consistent with the idea that legal wrongs should be tolerated/encouraged. If wrongdoers are sufficiently aware of the profit to be derived from the wrong and know also that the amount so gained is likely to exceed any damages payable under the liability rule, the rule will not deter them from engaging in the activity. Assuming, in the Wrotham Park case, that the gains to the land developers and the subsequent purchasers of the newly-built properties significantly exceeded the losses to the plaintiffs, damages payable for the latter would not have induced the developers to abstain from the unlawful development. However, we should note at once that liability rules do not guarantee Pareto or even Kaldor-Hicks efficiency. In the first 15 There is a large literature on these issues. See, esp, MJ Radin, “Market Inalienability” (1987) 100 Harvard Law Review 1849; N Duxbury, “Do Markets Degrade?” (1996) 59 Modern Law Review 331. 16 See, eg, Goodson v Richardson (1874) LR 9 Ch App 221, 224, per Lord Selbourne LC. 17 A Ogus, “Remedies: English Report” in D Harris and D Tallon (eds), Contract Law Today: Anglo-French Comparisons (Oxford, Clarendon Press, 1989), 256–8. 18 See also L Kaplow and S Shavell, “Property Rules Versus Liability Rules: an Economic Analysis” (1995) 109 Harvard Law Review 713.

198

(H) Ogus Ch7

24/3/06

08:20

Page 199

Wrongdoing and Welfare Maximisation

place, liability rules are limited in scope and cannot capture all the adverse effects resulting from a given activity. Secondly, some of those entitled in accordance with the rules will not in practice enforce them, because the cost of doing so will exceed the benefits which would be generated. Thirdly, even when liability rules are effectively enforced, damages awards do not cover all the losses and in practice may fall well short of the perfect compensation necessary for Pareto efficiency. This may be because the principles of law for assessing damages omit important categories of loss19 or consistently underestimate losses20; or simply because, as in Captain Broome’s case, given the subjective character of the loss, there is no means to evaluate it accurately. Perfect compensation to a given individual can, in contrast, be secured by a property rule. Suppose that Captain Broome had taken legal action earlier and had secured an injunction prohibiting publication. If the author and publishers had then approached him offering a sum of money to be released from that injunction, we are entitled to assume that the minimum sum which he would have been prepared to accept for such a purpose would, for him, have constituted perfect compensation for the defamation. Provided that there are no significant thirdparty effects arising from such a transaction, we can therefore treat property rules leading to such outcomes as paradigm examples of wrongdoing generating welfare gains, judged by the Pareto test. Property rules enjoy the important advantage that they guarantee perfect compensation, and thus help to ensure that wrongdoing takes place only when the conditions of the Pareto test are satisfied, but in many instances they will be unsuitable to protect entitlements. Most obviously this will be the case 19 For example, non-financial loss in breach of contract cases: Halson, Contract Law (Harlow, Longman, 2001), 483. 20 As may be the case for loss of earnings awards in personal injury cases: R Lewis, R McNab, H Robinson and V Wass, “Loss of Earnings Following Personal Injury: Do the Courts Adequately Compensate Injured Parties?” (2003) 113 Economic Journal F568.

199

(H) Ogus Ch7

24/3/06

08:20

Page 200

Wrongdoing and Welfare Maximisation

where ex ante prevention of the wrong is impossible or impracticable. All of the examples discussed so far in this chapter involve deliberate wrongdoing which it is relatively easy to prevent or correct; that would not apply to most wrongs involving accidents or where the wrong is an incidental consequence of an activity having another principal purpose. Driving cars may generate some wrongs, for example, negligent driving injuring other road users, but to revoke my licence to drive would be a wholly disproportionate response to the mere risk that such a wrong might take place. If the ultimate goal is for the wrongdoing to take place, but with perfect compensation to be negotiated by the victim as the price for accepting the interference, then property rules are also likely to be inappropriate where negotiations between infringers and the right-holders are very costly or difficult. A paradigm example is where the activity infringes rights belonging to a number of individuals, particularly where their interests are not homogeneous. Here, not only are there very significant costs arising from multiple transactions, particularly from coordinating bargaining between the parties; there is also the risk that some of the right-holders will exploit the power of veto inherent in the situation and attempt to “hold out” for a sum which exceeds their personal loss.21 Even when only two parties are involved, bargaining may not be straightforward because either or both engages in strategic behaviour, attempting to extract the maximum from the deal. This may render bargaining very costly and, in the worst scenario, inhibit a mutually beneficial outcome.22 In short, for these or other reasons, perfect compensation may be achievable only at great cost. Adherents of the Pareto criterion will argue that that cost must be incurred, if the wrongdoing is to be tolerated. Others may be 21 JE Krier and ST Schwab, “Property Rules and Liability Rules: the Cathedral in Another Light” (1995) 70 New York University Law Review 440, 460–1. 22 J Farrell, “Information and the Coase Theorem” (1987) 1 Journal of Economic Perspectives 113.

200

(H) Ogus Ch7

24/3/06

08:20

Page 201

Wrongdoing and Welfare Maximisation

happy with a compromise which would allow substantial, but imperfect, compensation to be payable under a liability rule.23 With these considerations in mind, we can now examine some areas of law where questions frequently arise as to the degree of protection which the law should provide for entitlements. We begin with the use of injunctions to protect property rights in land, turning thereafter to contractual expectations and regulatory interventions.

Injunctions and Interference with Property Rights in Land A striking feature of English law is the primacy of injunctive relief in the protection of property rights in land. The presumption that an injunction will be awarded to prevent or terminate a direct physical interference, for example a trespass, is particularly strong.24 There may be non-economic reasons for this. The general notion of sanctity of property, and the fact that a direct interference violates its integrity, may provide a strong moral justification.25 In normative economic terms, that moral dictate may feed into a preference for the Pareto efficiency test, and the consequence will be considerable difficulty for the court in satisfying the condition of perfect compensation. In addition to the problem of valuing an asset like land, which because of its unique character often contains a significant subjective dimension,26 there is what may be characterised as the psychological losses resulting from the blatancy of the invasion, which cannot feature in any market-value basis of assessment.27 Direct 23

See esp, Kaplow and Shavell, above n 18, 757–60. D Harris, D Campbell and RL Halson, Remedies in Contract and Tort, 2nd edn (London, Butterworths, 2002), ch 26. 25 R Epstein, Takings: Private Property and the Eminent Domain (Cambridge, Mass, Harvard University Press, 1990). 26 D Harris, A Ogus, J Philips, “Contractual Remedies and the Consumer Surplus” (1979) 95 Law Quarterly Review 581, 587–8. 27 Sometimes referred to as “demoralisation costs”: FI Michelman, “Property, Utility, and Fairness: Comments on the Ethical Foundations of ‘Just Compensation’ Law” (1967) 80 Harvard Law Review 1165, 1214–15. 24

201

(H) Ogus Ch7

24/3/06

08:20

Page 202

Wrongdoing and Welfare Maximisation

interferences often, though not always, involve small numbers, thus rendering feasible a bargained outcome by means of which the parties are able to agree on a price, reflecting the subjective losses.28 It is quite clear from the case law that judges frequently impose injunctions not because they desire or expect the wrongdoing to cease, but because such an order will enable the property-holder to negotiate an acceptable price to tolerate the interference.29 The injunction nevertheless creates the potential for a stubborn right-holder to extract an extortionate price and, as we have seen, this means that bargaining will not always lead cheaply to the efficient outcome. The judiciary are also alive to the possibility and may be reluctant to grant an injunction for this reason.30 The Wrotham Park case may have been an example of this. The granting of a mandatory injunction to dismantle the housing which offended the restrictive covenant might have enticed the plaintiffs to demand a price which would have milked almost all the profits which the defendants gained by the development. Hence the next best solution: the award of “such a sum of money as might reasonably have been demanded by the plaintiffs . . . as a quid pro quo for relaxing the covenant”.31 The arguments so far considered can be used to interpret the classic rule in Shelfer’s case,32 that damages in lieu of an injunction should only be awarded: 28 For other economic arguments for preferring property rules in cases of direct interference, see Kaplow and Shavell, above n 18, 757–72. 29 Eg Goodson v Richardson, above n 16, per Lord Selbourne LC at 224; and see R Sharpe and S Waddams, “Damages for Lost Opportunity to Bargain” (1982) 2 Oxford Journal of Legal Studies 290. 30 “I do not think I ought to make a decree which would enable an extortionate price to be obtained for the injury sustained by the plaintiff”: Senior v Pawson (1866) LR 3 Eq 330, 336, per Page Wood VC. 31 Above n 3, 341, per Brightman J, my italics. 32 Shelfer v City of London Electric Lighting [1895] 1 Ch 287, 322–3, per AL Smith LJ, on which see A Ogus and G Richardson, “Economics and the Environment: a Study of Private Nuisance” (1977) 36 Cambridge Law Journal 284, 308–11.

202

(H) Ogus Ch7

24/3/06

08:20

Page 203

Wrongdoing and Welfare Maximisation (1) if the injury to the plaintiff’s legal right is small, (2) And is one which is capable of being estimated in money, (3) And is one which can be adequately compensated by a small money payment, (4) And the case is one in which it would be oppressive to the defendant to grant an injunction.

The first three conditions point to cases in which the assessment of adequate (if not perfect) compensation is relatively easy for the courts, subjective factors not intruding. The fourth condition is more ambiguous. We can see why attempts by the rightholder to extort an excessive price from the defendant may be characterised as “oppressive.” A more delicate question is whether it should encompass cases where the benefit to the defendant from the wrongdoing greatly exceeds the loss to the right-holder, in short where there are potentially large KaldorHicks efficiency gains to be acquired. In cases of direct interference, the English judiciary have been reluctant to engage in balancing cost and benefit in this way, unless the interference is technical and temporary, as where defendants require access to neighbouring land in order to complete developments on their own land.33 Of course, where interference is by a public authority and the social benefit may be assumed generally to be large, legislatively-granted compulsory purchase powers have to be invoked. And here, it should be noted, particular measures have been taken for the compensation to cover subjective losses.34 When we turn to actions for private nuisance, we find that the traditional approach of English judges has been equivalent to that taken in cases of direct interference. In the protection of private property rights, they have been disinclined to take account

33 See, eg Woollerton & Wilson v Richard Costain [1970] 1 WLR 411 and other cases cited in Harris et al, above n 24, 521–2. Indeed it was thought necessary for legislation (the Access to Neighbouring Land Act 1992) to be passed to deal with such cases. 34 In addition to basic compensation, assessed by reference to the market value of the property acquired, “home loss payments” (to a current maximum of £31,000) are made, equivalent to 10% of that market value: Land Compensation Act 1973, s 29.

203

(H) Ogus Ch7

24/3/06

08:20

Page 204

Wrongdoing and Welfare Maximisation

of the social costs of granting an injunction.35 In the USA and Canada, courts have shown a greater readiness to engage in balancing the (social) benefits and costs, thus adopting a Kaldor-Hicks strategy on property protection.36 In the late 20th century, the English judiciary appeared to have moved towards this position. In Miller v Jackson,37 for example, the Court of Appeal (by a majority) was not prepared to order the cessation of cricket on a village green, because occasionally balls landed in neighbouring gardens: “the public interest should prevail over the private interest.”38 Equally important was the decision in Kennaway v Thompson.39 Here the peace of a rural landowner was disturbed by a club organising the racing of power boats on adjacent property. The Court of Appeal was not prepared to accede to the landowner’s demand for an injunction prohibiting the racing; rather, the injunction allowed for a limited number of days of racing during the year, and a maximum noise level at other times. How are these developments in nuisance law, and particularly the outcome in the Kennaway case, to be explained? We should begin by identifying what appears to be an important difference between direct interference and nuisance.40 Direct interference generally involves small numbers, thus rendering feasible bargaining in relation to the injunction. Although, as we have seen, there may be a concern not to allow right-holders to exploit their 35 In a case of water pollution, the defendant local authority claimed that the granting of an injunction would prejudice waste disposal for a large population in Birmingham. Page Wood VC famously retorted: “it is a matter of almost absolute indifference whether the decision will affect a population of 250,000 or a single individual carrying on a manufactory for his own benefit”: Att-Gen v Birmingham Borough Council (1858) 4 K & J 528, 539–40. 36 See, eg, Boomer v Atlantic Cement 257 NE 2d 870 (1970) (USA) and Canada Paper v Brown (1921) 66 DLR 287 (Canada); and SM Waddams, Dimensions of Private Law: Categories and Concepts in Anglo-American Legal Reasoning (Cambridge, Cambridge University Press, 2003), 143–5. 37 [1977] QB 966. 38 Ibid, per Lord Denning MR at 987. 39 [1981] QB 88. 40 Cf Kaplow and Shavell, above n 18, 716–17.

204

(H) Ogus Ch7

24/3/06

08:20

Page 205

Wrongdoing and Welfare Maximisation

bargaining power, in general the Pareto outcome of perfect compensation can be achieved at relatively low cost. Nuisance in contrast often involves large numbers. Where that is the case, bargained solutions are not to be envisaged. Given also that activities generating nuisances often involve substantial investments, a rigid adherence to the Pareto test would generate significant social costs, typically exceeding by far the losses sustained by right-holders after the imperfect compensation resulting from a damages action is received. Contrary to first impressions, Kennaway v Thompson was not a case involving large numbers which would have inhibited bargaining. True there would be many, participants as well as spectators, with an interest in the racing of power boats, but it is reasonable to assume that their demand would have been channelled through the club, as a consequence of contracts made between them and the club. The case appears to have been one in which strategic behaviour by either or both of the parties inhibited the bargained outcome.41 The court therefore boldly attempted to mimic the outcome which would have been reached by reasonably behaving bargainers, a compromise level of wrongful interference which would—when account was taken of the damages also payable—presumptively have maximised the welfare of both parties.

Efficient Breaches of Contract When we turn to the world of contract to consider cases where breaches of promises may generate welfare gains, we encounter some interesting differences. In the first place, the question of the extent to which the legal system should tolerate and facilitate the breaking of contractual undertakings has acquired a prominence in the academic literature, not matched by other areas treated in this chapter: the succinct term “efficient breach” is 41 This is suggested by the trial judge’s remark that granting the injunction claimed “would only lead to further litigation almost certainly”: quoted by Lawton LJ, above n 39, 92.

205

(H) Ogus Ch7

24/3/06

08:20

Page 206

Wrongdoing and Welfare Maximisation

familiar to, and widely discussed by, contract scholars not known for their adherence to an economic approach to law.42 But, secondly, there is also evident a hostility to the idea, based usually on moral grounds43; and the strength of the opposition may be attributable to the fact that contracts, unlike tort and property rights, arise from obligations specifically and voluntarily undertaken in relation to others.44 Within the common law, however, a number of features point in the direction of the economic, rather than moral, approach, suggesting that “breach” is not to be equated with “wrong.”45 Although Holmes’ famous observation, quoted at the beginning of this chapter,46 stressing the equivalence of contractual performance and the payment of damages for breach, is sometimes regarded as simplistic,47 judges have traditionally been reluctant to order specific performance. Moreover, their long-standing aversion to the enforcement of penalty clauses,48 as well as their insistence that breach victims mitigate their losses, is hardly consistent with a deference to the moral sanctity of promises. That “efficient breach” is not simply a theoretical notion devised by jurists and remote from the realities of everyday com42 See, eg: PS Atiyah, “Executory Contracts, Expectation Damages, and the Economic Analysis of Contract” in PS Atiyah, Essays on Contract (Oxford, Clarendon Press, 1986), ch 7; H Collins, Regulating Contracts (Oxford, Oxford University Press, 1999), 118–22; B Rudden and P Juilhard, “La théorie de la violation efficace” (1986) 38 Revue International de Droit Comparé 1016. The phrase “efficient breach” has entered judicial language in the USA (eg Giampapa v American Family Mut Ins Co 64 P3d 230 (2003)) and in Canada (eg Bank of America Canada v Mutual Trust Co (2002) 211 DLR (4th) 285), but not yet apparently in the UK. 43 Eg C Fried, Contract as Promise, a Theory of Contractual Obligation (Cambridge, Mass, Harvard University Press, 1981), 113–23; Harris and Tallon, above n 17, 385–6. 44 An argument central to Fried’s analysis: above n 43. 45 Harris et al, above n 24, 18. 46 Above, n 7. 47 Fried, above n 43, 117–18. 48 In marked contrast to the approach taken in civil law jurisdictions: GH Treitel, International Encyclopedia of Comparative Law (Tübingen, JCB Mohr, 1976), vol VII, ch 16, 90–109.

206

(H) Ogus Ch7

24/3/06

08:20

Page 207

Wrongdoing and Welfare Maximisation

merce can be readily demonstrated. A few years ago I had a reservation on an Alitalia flight from Milan to Marseilles. Since it was a one-way journey, I had paid a substantial sum (about £200) for the ticket. When I arrived at Milan airport, to my horror I was informed that my flight was overbooked and that I would have to take a plane to Paris, connecting there to another flight to Marseilles, and arriving at that destination some five hours later than the flight on which I had the reservation. My protests (in three different languages) were in vain. I was paid some £80 by way of compensation, the amount stipulated in my standard form contract with the airline. A year or so later I had a reservation on an American Airlines flight from Chicago to Manchester. The aircraft had technical problems and had to be replaced. Unfortunately, the only substitute available was smaller, with the consequence that there was a surplus of passengers with reservations. Over the public address system, the airline sought passengers to volunteer to fly ChicagoLondon-Manchester: they would arrive at Manchester four hours later than the direct flight, but would travel first class (instead of economy class). After 15 minutes another announcement was made: there had been an insufficient number of volunteers accepting the offer; the airline now proposed to add to it a payment of $200. The ploy succeeded; no further offers were made because the surplus of passengers had been eliminated. Let us assume that both airlines were in breach of contract to the passengers with reservations.49 We must assume that Alitalia had adopted a deliberate policy of overbooking to counter the familiar problem of passengers with reservations cancelling at a late stage, thus leaving empty seats on planes. The American Airlines problem was not, in this instance, the consequence of overbooking; but it could have been, since airlines there had adopted such a policy—and the system of dealing with surplus passengers—since the late 1970s.50 The questions arise, were 49 In practice in either or both cases there may have been exculpatory clauses in the contract. 50 J Simon, “The Airline Oversales Auction Plan: the Results” (1994) 28 Journal of Transport Economics and Policy 319.

207

(H) Ogus Ch7

24/3/06

08:20

Page 208

Wrongdoing and Welfare Maximisation

these breaches efficient? And how are the different approaches taken by Alitalia and American Airlines to be evaluated? To address the first question, suppose that an airline finds that on a given flight each week, on average, 20 reserved seats are unoccupied, the fare paid on these being substantially refundable; and that this leads to an average weekly loss of £80 ⫻ 20 = £1600. That loss is avoided by a given level of overbooking. Suppose that, with that level of overbooking, the probability of a surplus of passengers presenting themselves, in any given week, is denoted by p; and that, in the latter contingency, D represents the weekly average costs to disappointed passengers and to any third parties from the inability to take the particular flights. If, then, 1 – p (the probability of there being no surplus) ⫻ £1600 exceeds pD there are welfare gains (ie the outcome is Kaldor-Hicks efficient). And this is the case even if no compensation is paid to the unlucky passengers. In contrast, the policy will be Pareto-efficient only if there is perfect compensation of the losers. The American Airlines auctioneering solution gets as close as is perhaps practicable to a Pareto-efficient solution, because the voluntary acceptance of the breach implies perfect compensation for the victim, although some third-party uncompensated losses cannot be ruled out. It is true that the Alitalia solution could in principle be regarded as providing me with full compensation, since it involved a payment stipulated in the contract and I was free not to accept these terms. However, the facts that the agreed sum was in practice not negotiable and that Alitalia had a monopoly on the Milan-Marseilles route are sufficient to refute the argument.51 My subjective losses were not covered and the solution falls well short of Pareto efficiency. It is not easy to generalise on what is to be regarded as an acceptable outcome, but it is reasonable to assume that most people would not tolerate a policy which encouraged breach of 51 From February 2005, EU law has required that airlines provide compensation of €250 for cancellation of flights of less than 1500 km, €400 for flights between 1500 and 3500 km, and €600 for longer flights: Reg 261/2004.

208

(H) Ogus Ch7

24/3/06

08:20

Page 209

Wrongdoing and Welfare Maximisation

contract simply because the aggregate gains exceeded the aggregate losses, and that the opposition would be particularly strong if the gains accrued principally to the contract-breaker and the losses to the victim. We may therefore conjecture that the “efficient breach” doctrine is likely to be acceptable only where the outcome approaches the Pareto-efficiency criterion of perfect compensation Addressing the issues in this way may also help us to appreciate the significance of specific performance as a remedy for breach of contract. In most respects, the reasoning is parallel to that used in relation to injunctions: where specific performance is ordered, beneficiaries of contractual expectation are protected by a Pareto-efficiency inspired property rule which enables them to extract what compensation is acceptable to them as the price for releasing the promisor from the court order. It is, therefore, unsurprising that specific performance has been routinely ordered on sellers’ breach of the sale of land. In the words of an early 19th-century judge, “damages . . . may not be a complete remedy to the purchaser, to whom the land may have a peculiar and special value.”52 And similar considerations have been used to justify the same remedy in sale of goods cases where there is no easily available substitute to what has been purchased and therefore the objective value of the loss is difficult to determine.53 Account must necessarily be taken of the difficulties and costs of reaching mutually acceptable outcomes through the bargaining process. The multi-party problem encountered in relation to injunctions is less likely to arise in a contractual context but, as with injunctions, there is a risk that opportunistic or strategic behaviour by the promisee might inhibit the efficient outcome. Take, first, a case where the cost of performance has substantially increased since the time the contract was formed. In negotiating a price to release promisors, the promisees may be 52

Adderley v Dixon (1824) 1 Sim & St 607, 610, per Sir John Leach VC. Eg Behnke v Bede [1927] 1 KB 649, 661 (“of peculiar and practically unique value to the plaintiff”), per Wright J. The situation can arise in a commercial context: see Sky Petroleum v VIP Petrol [1974] 1 All ER 954. 53

209

(H) Ogus Ch7

24/3/06

08:20

Page 210

Wrongdoing and Welfare Maximisation

tempted to hold out for a sum which gets as close as possible to that cost, and far exceeding their own subjective loss arising from non-performance. Here a court might legitimately award damages rather than order specific performance,54 thus adopting a Kaldor-Hicks solution. They can do so in accordance with the discretionary nature of the specific performance remedy and the principle that it should not be used as an instrument of oppression.55 Somewhat different is the situation where the promisor will secure a larger profit by breaking the contract, perhaps because a third party has been found who offers an increased price for what has been sold to the promisee. The effect of aggressive bargaining by the promisee in this situation will, of course, be to disgorge most of the promisor’s profits. In economic terms it might be argued that allowing promisors to retain the greater part of the profits generates appropriate incentives for them to engage in efficient breaches, particularly where they assist in identifying and dealing with third parties who ascribe a higher value to the subject-matter of the contract. This consideration, added to the bargaining problem, might indicate that in the specified context specific performance should normally be refused. Traditional distributional arguments—that the wrongdoer should not be allowed unduly to benefit from breach— point in the opposite direction, because a specific performance order enables the promisee to take a major share in the profits. It should be noted that that outcome can also be achieved by damages awards which are assessed by reference to a disgorgement of the defendant’s profits, rather than compensation of the claimant’s losses.56 This section cannot be concluded without some reference to the market context in which the contract takes place because this critically affects the promisee’s loss and therefore the question of 54

Harris et al, above n 24, 223–6. See the dissenting judgment of Millett LJ in Co-operative Insurance Society v Argyll Stores [1996] 3 All ER 934, 948–50 which explicitly invokes economic considerations. 56 See A-G v Blake [2001] AC 268. 55

210

(H) Ogus Ch7

24/3/06

08:20

Page 211

Wrongdoing and Welfare Maximisation

what is appropriate compensation. Hitherto we have assumed that the loss that should be compensated is the diminution in profits or utility arising from the breach, but that is clearly not appropriate where the promisee has purchased a substitute in the market; and arguably the position is the same where such a substitute could have been purchased. The law recognises this by, in general, computing damages on the basis of the difference between the contract price and the price of the substitute at the date of breach (plus the expenditure of obtaining the substitute in the market).57 It is not difficult to reconcile this approach with notions of efficiency since, for the latter goal, remedies should be designed to minimise losses resulting from breach, whether the necessary action should be taken by the defaulter or the victim of the breach. A damages remedy, limited to the cost of obtaining a substitute, effectively imposes the obligation to minimise the loss on the promisee; following a specific performance order, it is the promisor who has the duty. One way of determining which costreducing action should be taken is by asking what the parties would have agreed to ex ante, as the cheapest way of dealing with the contingency of non-performance.58 Where an exact equivalent is easily available on the market and one of the two parties is likely to have cheaper access to the market than the other, there is a ready answer to the question. Other situations are, however, not so easy to resolve.59 The degree of substitutability of near-equivalents is something which can be answered only by reference to the promisee’s subjective preferences. The promisee may wish to spend some resources in locating a near-equivalent to what was promised. Thus, if a vintner failed to deliver a particular vintage, I might be keen to 57

A Ogus, Law of Damages (London, Butterworths, 1973), 322–3. CJ Goetz and RE Scott, “The Mitigation Principle” (1983) 69 Virginia Law Review 967. 59 See the discussions in A Kronman, “Specific Performance” (1978) 45 University of Chicago Law Review 351; A Schwartz, “The Case for Specific Performance” (1979) 89 Yale Law Journal 271; and E Yorio, “In Defence of Money Damages for Breach of Contract” (1982) 82 Columbia Law Review 1365. 58

211

(H) Ogus Ch7

24/3/06

08:20

Page 212

Wrongdoing and Welfare Maximisation

find the same product from a different source. But, with certain commodities and services, for example a specific jewel, the prospect of finding this might be impossible or too remote and the loss would be best compensated by purchasing some substitute which would provide alternative satisfaction or profit. In the first case, the damages remedy might be regarded as appropriate, because I will be induced to seek out the near-equivalent which I regard as satisfactory and then charge the cost to the promisor. The court’s control on what may be awarded would, then, serve to restrain me from opportunistic excesses. In the case of the jewel, an order for specific performance, would— subject to the risk of exploitative bargaining—enable me to negotiate a sum which would provide me with an equivalent amount of utility derived from a different form of expenditure.

Regulatory Contraventions Hitherto we have considered only private wrongs, that is breaches of private law obligations. We must now apply the analysis to public wrongs: to what extent does and should the law tolerate the infringement of public law obligations when such activity is deemed to generate welfare gains? Now, we should recognise at the outset that some important areas of public law will fall outside this category. We have already seen,60 that there are some rights (“inalienable rights”) which the law will not allow to be compromised through trading, and these rights are often protected by the criminal law. Indeed, some would argue that certain forms of activity are treated as crimes, precisely because they are presupposed to generate little or no social utility.61 The assumption is, then, that such activity should always be deterred.62 These crimes are sometimes 60

Above, 197. See, eg: JC Coffee, “Paradigms Lost: the Blurring of the Criminal and Civil Law Models—and What Can Be Done About It” (1992) 101 Yale Law Journal 1875. 62 But not necessarily eliminated since the costs of enforcement may substantially exceed the benefits accruing from reducing the activity. 61

212

(H) Ogus Ch7

24/3/06

08:20

Page 213

Wrongdoing and Welfare Maximisation

referred to as mala in se, to indicate conduct which is regarded as intolerable in a wide variety of societies with different social and economic values. They are to be contrasted with mala prohibita, activities which do not fall into this category, and which therefore are the subject of specific proscription.63 Here we need to focus on mala prohibita—which may be largely identified with regulatory contraventions64—on the assumption that such activity can enhance social welfare. Traditional regulation, involving specific rules supported by penal or administrative sactions, is notoriously prone to poor targeting.65 This is not surprising: the more specific the law, the less it will be able to accommodate the variety of circumstances to which it must be applied.66 A speed limit of 30 miles per hour in urban areas may be optimal for motor vehicles on streets during normal traffic conditions, but it is likely to be too high for icy roads and too low for periods when there is little traffic and no pedestrians. There are different methods, formal and informal, of facilitating efficient regulatory contraventions; some—as with private wrongs—involving transactions with affected parties, some involving action by or with public officials. Most obviously, legislation can adopt a more general formulation of what is required, for example, imposing an obligation that vehicles be driven at a “reasonable” speed. It is then left to adjudicators to adapt the requirement to what is optimal in the circumstances,

63 The distinction tends to be discredited by contemporary authors on criminal justice (eg, C Wells, Corporations and Criminal Responsibility, 2nd edn (Oxford, Clarendon Press, 1993), 7) but has been well established since Blackstone and Bentham: JS Wiley, “Not Guilty By Reason of Blameworthiness: Culpability in Federal Criminal Interpretation” (1998) 85 Virginia Law Review 1021, 1074. 64 A Ogus, Regulation: Legal Form and Economic Theory (Oxford, Hart Publishing, 2004), 79. 65 C Sunstein, After the Rights Revolution: Reconceiving the Regulatory State (Cambridge, Mass, Harvard University Press, 1990), ch 3. 66 I Ehrlich and RA Posner, “An Economic Analysis of Legal Rulemaking” (1974) 3 Journal of Legal Studies 257.

213

(H) Ogus Ch7

24/3/06

08:20

Page 214

Wrongdoing and Welfare Maximisation

although of course the socially beneficial activity is not then to be categorised as “wrongdoing”. Alternatively, the ill-targeted rule can remain in place, but the discretion of enforcement agents will be exercised in such a way that efficient wrongdoing will be permitted in practice: no action will be taken against wrongdoers in such circumstances.67 More germane to the themes of this chapter, we can ask how consensual bargaining may also be used to achieve the desired outcome. The idea can be illustrated by emissions trading, such as that used in the UK Greenhouse Gas Emissions Scheme.68 Traders are set specific limits for their discharges, but those discharging below their limits can sell the surplus to other traders who wish to discharge above their limits. To appreciate the economic merits of this approach, we should note first that the limits will be increased for the traders whose abatement costs are higher, thus leading to better targeting. These traders will of course have to pay the price for the relaxed standard and they thus have a strong incentive to reduce, or to develop technology to reduce, the harmful discharges. In theory, the same outcome can be achieved by traditional regulatory standards which are differentiated according to the varying cost-abatement functions, but such an approach imposes substantial information demands on regulators which they are unlikely to meet. The characteristic of pollution which lends itself to approaches of this kind is the fact that it is a common harm to which a number of firms contribute. If the total amount of harm which is, or which approximates to what is, optimal is known, then that amount of harm can be allocated among the firms according to willingness to pay. There are not many forms of

67 In Ogus, above n 64, 96–7, I accordingly distinguished between de jure and de facto standards. 68 Made under the Pollution Prevention and Control (England and Wales) Regulations 2000, SI 2000/1973. For theoretical discussion of different possibilities, see TH Tietenberg, “Transferable Discharge Permits and the Control of Stationary Source Air Pollution: a Survey and Synthesis” (1980) 56 Land Economics 391.

214

(H) Ogus Ch7

24/3/06

08:20

Page 215

Wrongdoing and Welfare Maximisation

wrongdoing which can be so characterised, although congestion furnishes another example.69 For a closer analogy to our treatment of private wrongs, we should explore private contracting around regulatory requirements. Particularly for the purpose of Pareto efficiency, the regulatee who gains from the contravention should compensate those who would have benefited from strict adherence to the requirements. No doubt, in comparison with private wrongs, there is less scope for this device, because the regulatory beneficiaries are likely to be more numerous, more difficult to identify and (if necessary) transact with. Nevertheless, it is potentially applicable to situations in which there is regulation of contractual relationships, such as those between employers and employees, or landlords and tenants. It is, therefore, rather surprising that the subject has been relatively neglected in the literature,70 perhaps because it is assumed that the practice is always unlawful. This is not always the case and, in any event, we should consider the effect of unlawful contracting. The question of whether a legislative obligation is mandatory, or may be the subject of contractual variation, and therefore in effect only a default rule, is a question of statutory interpretation.71 Interestingly, 19th-century judges, inspired by freedom of contract ideals, were inclined to tolerate contracting around regulatory obligations, on the basis that where a statutory intervention was for the benefit of a particular class of individuals, members of that class were free to waive the benefit unless there 69 Thus justifying the trading of, for example, taxi licences ( J Fingleton, The Dublin Taxi Market: Re-regulate or Stay Queuing (Dublin, Policy Institute, 1998) and parking authorisations (RA Epstein, “Allocation of the Commons: Parking on Public Roads” (2002) 31 Journal of Legal Studies 515). 70 For papers which relate to the issue, see I Ayres, “Empire or Residue: Competing Visions of the Contractual Canon” (1999) 26 Florida State University Law Review 897 and some of the contributions to FH Buckley (ed), The Fall and Rise of Freedom of Contract (Durham NC, Duke University Press, 1999). See also H Collins, Regulating Contracts (Oxford, Oxford University Press, 1999), esp ch 4. 71 Ogus, above n 64, 259–60.

215

(H) Ogus Ch7

24/3/06

08:20

Page 216

Wrongdoing and Welfare Maximisation

was an explicit legislative provision to the contrary.72 Modern English73 judges take a different view74; and the burden of proof is effectively on those contracting out to show that the legislature intended to allow the practice. In resolving the issue, they have spoken of balancing the “public interest” in the regulation against that of freedom of contract.75 However, there is little evidence that the courts examine the terms of the agreement to ascertain the price agreed for the waiver, and whether the arrangement might be (Pareto) efficient because the price is to be regarded as reasonable compensation. Even where contractual modifications to regulatory requirements are unlawful, they may still take place and, so long as the parties to the agreement mutually benefit from them, the modifications will be effective unless and until public enforcement agents intervene. An interesting study of the American trucking industry has shown how informally and legally unenforceable contracts between carriers and those shipping goods were often used to “fine-tune” relevant regulations which were unduly restrictive.76

Conclusions From a traditional legal perspective, there is a fundamental distinction between lawful and unlawful conduct. The language associated with legal wrongs suggests that the latter should be eliminated, at least up to the point where the costs of enforcement are treated as being excessive. An economics perspective 72

See, eg: Graham v Ingleby and Glover (1838) 1 Exch 651. In the USA, some reversal to the 19th-century view seems to have occurred: see the Supreme Court case Gilmer v Interstate Securities 500 US 20 (1991), discussed in WE Kovacic, “Economic Regulation and the Courts: Ten Cases That Made a Dffference” (2002) 21 Journal of Regulatory Economics 23, 26–7. 74 The leading case is Johnson v Moreton [1980] AC 37. 75 National Trust for Scotland v MacRae [2000] SLT (Land Court) 27, 29. 76 TM Palay, “Avoiding Regulatory Constraint: Contracting Safeguards and the Role of Informal Agreements” (1985) 1 Journal of Law, Economics and Organization 155. 73

216

(H) Ogus Ch7

24/3/06

08:20

Page 217

Wrongdoing and Welfare Maximisation

invites us to adopt a more nuanced approach. There are likely to be welfare gains from many forms of wrongdoing, often because those formulating legal obligations are not able, or do not have the necessary information, to target the rules precisely on what is, and what is not, desirable. In this chapter, we have recognised the major task for legal systems in determining the extent to which legal wrongdoing should be permitted and even encouraged, so that the envisaged welfare gains can be realised. We have examined the principal devices for pursuing this policy, notably paying compensation to the victims of the wrong and contracting around imposed obligations. There remains, however, the fundamental difficulty of characterising what are welfare gains for this purpose; and, in relation to this, mainstream economic reasoning can supply us with possible tests, but none which normatively can be regarded as universally acceptable. In our analysis, and the account of prevailing legal doctrines, we have seen that neither of the familiar criteria for allocative efficiency, the Pareto and the KaldorHicks tests, emerges as satisfactory; the former, because it takes too restrictive a view of welfare gains, and the latter because it can lead to large, uncompensated losses. The examples selected from property, contract and regulatory law suggest that legal policy-makers tend to accept as desirable notions of compensation which provide full, but not perfect compensation. Their position, therefore, comes close, but is not equivalent, to Pareto efficiency.

217

(H) Ogus Ch7

24/3/06

08:20

Page 218

(I) Ogus Ch8

20/2/06

16:35

Page 219

8 Protecting the Disadvantaged

Introduction: Crossing the Road Safely? Near the University of Manchester there is a road junction with traffic lights, where pedestrians can also cross. The rotation in authorisation by green light is: vehicles travelling east and west; vehicles travelling north and south; pedestrians crossing all four streets. Casual observation of the system in operation reveals that the large majority of pedestrians do not wait for the signals in their favour but cross whenever it is safe to do so. During rush hours, when there is considerable traffic entering and leaving the university, there is significant congestion on both south-north and east-west roads. Impressionistically, we might guess that the inclusion in rotation of authorisation for pedestrians to cross adds 90 seconds to the journey of the average vehicles using the junction (and during the rush hours, this might be in excess of five minutes). If so, is this form of traffic regulation justified? That is a difficult question to answer because it depends on many variables, including the traffic and pedestrian flows and the benefits of accident avoidance which the system is ostensibly designed to achieve. Intuitively, I would expect the costs significantly to outweigh the benefits and that intuition primarily rests on the assumption that, at much lower cost, most pedestrians could themselves always make the decision when it is safe to cross.1 And the intuition is strengthened by the fact that so many pedestrians do not wait for the protected period, but cross when they think it safe to do so. 1 Normally north-south pedestrians would cross when the red light prevents the east-west traffic flow. Of course, some of the north-south traffic will want to turn east or west, and these vehicles must then be avoided.

219

(I) Ogus Ch8

20/2/06

16:35

Page 220

Protecting the Disadvantaged

If I am right, and it is difficult to justify the regulatory arrangements in cost-benefit terms—they are therefore not Kaldor-Hicks efficient—how should we explain their existence? One possibility2 is that the policy-makers might have considered that the need to protect some pedestrians who are particularly vulnerable outweighed the efficiency goal. Another possibility, independent but linked, is paternalism. The policy-makers might wish to deprive pedestrians of the freedom of choice when to cross the road, because there is insufficient confidence that that choice will be exercised wisely. Distributive justice and paternalism have undoubtedly had a major influence on the law, particularly in the second half of the 20th century. Economics has, wrongly, been treated as having little to say about these two goals. It is true that the appropriateness of the policies call for moral judgements and therefore fall outside the range of mainstream economic reasoning. But, as I hope to demonstrate in this chapter, that reasoning can play an important role in the understanding and critical evaluation of the policies, in particular by shedding important light on two questions which policy-makers adopting redistributive and paternalist policies should certainly address: what legal institutions are most likely to achieve the desired outcomes? And what legal instruments can do so at lowest cost?

Distributive Justice Law for the Rich and Law for the Poor Back in the 1970s, there was much talk and some action to redress what was conceived by many to be an unhealthy bias in the law towards helping rich people become richer. If “justice” is a central goal of the legal system, then surely, it was argued, law and the skills of lawyers should serve to help the disadvan-

2 Others include a general aim of adding to the delays of urban traffic, thus encouraging greater use of public transport and reduced traffic congestion.

220

(I) Ogus Ch8

20/2/06

16:35

Page 221

Protecting the Disadvantaged

taged members of the community. The movement combined several different dimensions. There were, in the first place, movements to establish and sustain a higher level of transfers through the combination of taxation and welfare law, and a call for the greater involvement of academic lawyers and practitioners in the “new” field of “welfare rights”.3 Advocates of distributional justice were equally active in the fields of labour law, housing law and consumer law, arguing for more interventionist measures overriding contractual arrangements which (it was assumed) were exploited by, respectively, powerful employers, landlords and traders to the disadvantage of employees, tenants and consumers. Even more interesting, though somewhat less prominent, were the energetic attempts—many of them successful—to incorporate distributional goals into the general principles of private law.4 Within contract law, for example, there were calls for traders to be required to warrant the quality of the goods or services that they supplied. Judges were urged to be more generous in protecting “weaker” parties against contractual oppression by resorting to formation defences such as mistake or undue influence,5 and restraining “unconscionable” terms or behaviour.6 In due course, general legislation was passed in response to this demand.7

3 Cf TM Partington and JL Jowell (eds), Welfare Law and Policy: Studies in Teaching, Practice and Research (London, Frances Pinter, 1979). My own coauthored work AI Ogus and EM Barendt, Law of Social Security, 1st edn (London, Butterworths, 1978) was inspired by this ideology: see the preface, vii. 4 Two particularly influential papers were: AT Kronman, “Contract Law and Distributive Justice” (1980) 89 Yale Law Journal ; and D Kennedy, “Distributive and Paternalist Motives in Contract and Tort Law, with Special Reference to Compulsory Terms and Unequal Bargaining Power” (1982) 41 Maryland Law Review 563. 5 Lloyds Bank v Bundy [1975] QB 326. 6 See notably Schroeder Music Publishing Co Ltd v Macaulay [1974] 3 All ER 616. 7 Unfair Contract Terms Act 1977.

221

(I) Ogus Ch8

20/2/06

16:35

Page 222

Protecting the Disadvantaged

Lessons were also given in the “socialisation” of tort law.8 There were here, on the one hand, arguments for facilitating the ability of accident victims, almost by definition a disadvantaged group, to bring successful actions against tortfeasors, by altering the burden of proof, broadening the scope of strict liability, or reducing the impact of defences such as contributory negligence. And, on the other hand, there were theoretical justifications for such policies, of particular interest in the present context because they have an economic content. Accidents, it was said, were the inevitable consequence of (capitalist) enterprise; and the community which in general benefits from such enterprise should, rather than the accident victims, bear the cost. Tort law could be developed away from the mere shifting of losses from the victim to the tortfeasor to the more ambitious social distribution of such losses. Liability insurance, for example, would enable the loss to be shared by all those paying premiums of the same kind; and firms, held liable in damages, could through the prices of their products and services pass on the loss to consumers, and thereby to the community at large.9 The strength of the rhetoric used in relation to these arguments seems, in recent years, to have weakened,10 but the arguments are still used and the policies remain largely intact, so how can economic reasoning increase our understanding of the issues and what can it tell us about the effectiveness of redistributional policies in achieving their goals and the cost involved? Relevance of Economics to Redistributional Goals From an early point in this book we have been treating “allocative efficiency” (or general economic welfare) and “distributional justice” as potentially conflicting goals of the law. The first concept is concerned with the amount of welfare within a given 8 Highlighted in the very influential work of the French jurist, G Viney, Le Declin de la Responsabilité Civile (Paris, LGDJ, 1964). 9 For an influential exposition of the argument, see W Friedmann, Law in a Changing Society, 2nd edn (London, Stevens, 1972), ch 5. 10 N Duxbury, Patterns of American Jurisprudence (Oxford, Clarendon Press, 1995), 467–70.

222

(I) Ogus Ch8

20/2/06

16:35

Page 223

Protecting the Disadvantaged

society and, fundamentally, an “efficient” policy is one which maximises that amount. Distributional justice, on the other hand, is concerned with the fairness of how a given amount of welfare is divided up between different individuals and groups within society. However, although what is “fair” in this context is a moral, not an economic question, economic efficiency is still relevant to the policy. First, consider a policy which involves the pursuit of a redistributional goal, moving welfare from one group to another. To appreciate the impact of such a policy on aggregate welfare, let us first take the case of a simple, voluntary gift. Suppose that I, an individual with a reasonable level of means, wish to give money to my poor nephew. The transaction will satisfy the Pareto test of efficiency, provided that the increase in utility which I derive from the gift exceeds that which I could obtain from spending that amount of money in another way, as well as any cost of the transaction itself. Voluntary redistribution of wealth is, therefore, in economic terms, generally unproblematic, although there are interesting questions as to the legal means of effecting such transfers (for example, by private trusts or registered charities) at lowest cost.11 Involuntary transfers are another matter. Since ex hypothesi the donor sustains a loss, the transaction cannot satisfy the Pareto test. Application of the Kaldor-Hicks criterion requires that the value of the resources transferred to the beneficiaries exceeds the loss to the donors. Given the diminishing marginal utility of money (a pound is worth more to my impoverished nephew than to me), that condition will usually be satisfied. However, the resulting gain in welfare has also to exceed the administrative and other costs resulting from the transfer process. The task of economics is, then, to explore and compare the cost implications of different legal instruments for distributional transfers and, by that process, to ascertain what level of 11 See, eg: J Phillips, B Chapman and D Stevens (eds), Between State and Market: Essays on Charities Law and Policy in Canada (Toronto, McGillQueen’s University Press, 2001).

223

(I) Ogus Ch8

20/2/06

16:35

Page 224

Protecting the Disadvantaged

welfare must be sacrificed, and how that can be minimised. And, as we shall see, of particular interest here is the question whether tax and welfare systems are more efficient than legal rules in effecting such transfers.12 An interesting, but less well noticed, issue is how criteria of allocative efficiency are sometimes implicitly used as concepts of distributional justice to block changes to redistributional programmes,13 with costly consequences. As a member of a UK advisory committee on social security, I have been struck by how governments find it politically difficult to effect reforms of welfare benefit systems which involve some losers.14 To avoid what might be technically referred to as a Pareto-inefficient outcome,15 they therefore have recourse to “transitional protection,” a system which preserves entitlement for those in receipt of the benefit at the time of reform. The consequence is that in some welfare programmes, at any one time, there are two or more sets of parallel rules of entitlement, dependent on the date on which entitlement first accrued, leading to huge complexity and therefore large administrative costs. 12 On which there is a significant literature. See esp: L Kaplow and S Shavell, “Why the Legal System is Less Efficient than Income Tax in Redistributing Income” (1994) 23 Journal of Legal Studies 667; C Sanchirico, “Taxes versus Legal Rules as Instruments for Equity: a More Equitable View” (2000) 29 Journal of Legal Studies 797; NL Georgakopoulos, “Solutions to the Intractability of Distributional Concerns” (2002) 33 Rutgers Law Journal 279; DA Weisbach, “Taxes and Torts in the Redistribution of Income” (2002) 70 Chicago Law Review 493; K Logue and R Avraham, “Redistributing Optimally: of Tax Rules, Legal Rules and Insurance” (2003) 56 Tax Law Review 157. 13 For economic analaysis on the problem in a broader, constitutional context, see L Kaplow, “Economic Analysis of Legal Transitions” (1986) 99 Harvard Law Review 509. 14 See A Ogus, “Transitional Protection in Social Security” in Twelfth Report of the Social Security Advisory Committee (Leeds, Corporate Document Services, 1999), ch 4, later expanded into A Ogus, “Transitional Protection is not just a Technical Problem” (1999) 6 Journal of Social Security Law 111. 15 In practice, the outcomes are often only imperfectly Pareto efficient because the value of the benefits within transitional protection is frozen at the date of the reform. Inflation can therefore impose losses on this group of beneficiaries, but politicians can still be heard to say that are no “cash losers”! See, ibid, 121.

224

(I) Ogus Ch8

20/2/06

16:35

Page 225

Protecting the Disadvantaged

Welfare Costs of Wealth Redistributional Programmes Among a number of government-administered schemes for redistributional transfers, the most important are those which combine raising money through general taxation and conferring financial benefits (social security). However, only those parts of these schemes which tax according to capital or income and assess benefits according to (the lack of) capital and income are normally intended as genuinely progressive redistributional transfers of wealth, therefore most significantly, income tax and social security contributions and the income-related benefits and tax credits.16 The tax and welfare systems are, therefore, well targeted to the wealth redistributional goals; they also potentially apply to all individuals within the defined categories of capital and income.17 But, of course, that targeting comes at a high cost. The administrative structures necessary for the operation of these systems—assessing income and capital on an individual, and sometimes, household basis, collecting and enforcing tax liabilities, applying complex rules for entitlements and their delivery, adjudicating disputes—are huge and expensive. And account should be taken also of indirect costs, arising from rules linked to income and capital. First, the taxation of earnings predictably affects work-incentives: the less take-home pay individual receive for their efforts, the more they are inclined to substitute leisure for work.18 Secondly, and subject to the increasingly complex efforts to contain the problem,19 the 16 On which see N Wikeley, A Ogus and EM Barendt, Law of Social Security, 5th edn (London, Butterworths, 2002). 17 It has been argued, ironically, that the explicit design and transparency of these redistributional processes are disadvantages, rather than advantages, since it may become too difficult politically to secure what “right-thinking” individuals might regard as desirable distributional outcomes: Logue and Avraham, above n 12, 255–6. 18 J Bankman and T Griffith, “Social Welfare and the Rate Structure: a New Look at Progressive Taxation” (1987) 75 California Law Review 1905, 1919–21. 19 M Taylor, The Modernisation of Britain’s Tax and Benefit Systems, Report No 2: Work Incentives (London, HM Treasury, 1998).

225

(I) Ogus Ch8

20/2/06

16:35

Page 226

Protecting the Disadvantaged

receipt of financial benefits also generates disincentives, not only to work but also to save.20 As we have already seen, many modern legal rules, including those operating in private law,21 aim to redistribute wealth, and some may have that effect even when not intended. However, there are some striking contrasts with the tax and welfare systems. First, and most obviously, there is the question of targeting. While tax and welfare systems can and do identify precisely the levels of wealth which should render individuals liable to pay and receive, respectively, legal rules do not operate in this way. They may be formulated in terms of categories which, to some extent, correlate with the absence of wealth (thus tenants, consumers, employees, tort victims), but such categories are over-inclusive and under-inclusive.22 There are tort victims who are wealthy and, even more obviously, there are many poor people who are not tort victims (of course, as we shall see, the legal characterisation may be more appropriate for distributional goals other than wealth). Targeting and costs are closely related. The costs of administering the regulatory and private law rules which are effectively used for redistribution of wealth are not, in aggregate, as high as those incurred by the tax and welfare systems, but that is because they do not purport to cover all individuals within the relevant wealth categories. Some regulatory systems, for example, those controlling terms in consumer contracts, may be reasonably cheap to administer; others, for example, rent controls are more expensive. Redistributing through the tort system is, relative to the amount of money actually transferred, administratively perhaps the most costly.23

20 T Clark, Rewarding Saving and Alleviating Poverty? The Final Pension Credit Proposals (London, Institute of Fiscal Studies, 2002). 21 H Collins, “Distributive Justice Through Contracts” (1992) 45 Current Legal Problems 49. 22 Weisbach, above n 12. 23 P Cane, Atiyah’s Accidents, Compensation and the Law, 6th edn (Cambridge, Cambridge University Press, 1999), ch 21.

226

(I) Ogus Ch8

20/2/06

16:35

Page 227

Protecting the Disadvantaged

Because legal rules are not defined by reference to income and capital, they do not lead to the incentive problems identified for tax and welfare systems. But they too have indirect costs insofar as the distributional goals may render them economically inefficient, leading to welfare losses. There are many ways in which such losses can arise but two short examples should suffice. Take, first, a situation where it is much easier (and less costly) for a potential victim of an accident, rather than the creator of the risk, to take care to avoid it. If, for distributional purposes, the risk-creator is held liable to pay compensation, that may dull the incentive on the accident victim to take the less costly safety measure. So, also, if courts attempt to extend the doctrines of mistake or undue influence, in order to protect individuals who have entered into disadvantageous contracts, this may adversely affect the security of transactions generally and reduce the number of welfare-generating transactions. Equally important is the fact that the redistributional goal of some legal rules may be thwarted by market transactions. True, legislation can prohibit any attempt explicitly to vary by contract the redistributional rule: for example, traders and consumers cannot contract out of the provision imposing a warranty on the quality of goods sold.24 Judges may also refuse to allow parties artificially to avoid regulated terms, in for example, a contract of employment or a lease, by disguising the agreement as a different type of contract, such as a contract for services or a licence.25 But it is difficult to prevent the intended financial gain to the “poorer” individual being overridden by price mechanisms. If, as a consequence of a mandatory warranty of quality, sellers of goods incur increased costs—whether the costs arise from taking greater care, securing insurance cover or from liability to consumers—they will need in a competitive market to recover those costs from consumers by an increase in the price 24 Sale of Goods Act 1979, s 14, as amended by the Sale and Supply of Goods Act 1994, s 1. 25 Ready Mixed Concrete v Minister of Pensions and National Insurance [1968] 2 QB 497 and Street v Mountford [1985] AC 809 are, respectively, leading authorities on these two types of contract.

227

(I) Ogus Ch8

20/2/06

16:35

Page 228

Protecting the Disadvantaged

of the product. By way of another example, take the situation discussed in an earlier chapter,26 where the consumer can deal with a risk more cheaply than the trader. If, on wealth redistributional grounds, an exemption clause transferring the risk to the consumer is rendered unenforceable and the trader has to cover the risk at higher cost, passing that cost on to the consumer in the price of the good or service will mean that the real cost of the latter to the consumer is higher than if the redistributional rule did not apply. Indeed, the impact of legal rules on costs and prices is a complex question which needs to be addressed more generally, if we are to understand why those rules designed to redistribute wealth may, or may not, achieve their purpose. Take a rule of tort law, such as that arising from the Consumer Protection Act 1987, enhancing the liability of suppliers and others towards those injured by defective products. Assuming, as a consequence of the legislation, that firms which are potentially liable take greater care, increase insurance cover, or pay more compensation to accident victims, what will happen to the costs so incurred? Oversimplifying somewhat, we can recognise three different ways in which the firms might deal with them. First, they may simply accept a lower level of profits from selling the product, in which case the cost will effectively be borne by shareholders who will receive a reduced dividend on their capital investment. Secondly, they may attempt to reduce the wages of their employees. Thirdly, they may increase the price of their products, the ultimate cost then being borne by consumers. It is important to appreciate that it is only the first of these outcomes which would satisfy conventional aims of wealth redistribution: shareholders as a class are likely, on average, to be wealthier than the victims of product accidents, but the same cannot be said of employees and other consumers. Note, too, that if the cost can be passed to consumers in the form of higher prices, the third outcome, then the redistribution is effectively between two different groups of consumers, from those who are 26

228

Above, 149–151.

(I) Ogus Ch8

20/2/06

16:35

Page 229

Protecting the Disadvantaged

not injured to those that are injured; in short, the legal rule creates a form of mutual insurance for the product consumers.27 Economic reasoning tells us that the extent to which the firm will in fact be able to pass on the cost in the three mentioned ways depends on the relative elasticity of supply in the capital market (by shareholders) and in the labour market (by employees); and of demand in the product market (by consumers).28 In less technical terms, the firm will be unable to pass on the cost to shareholders and/or employees if the consequent reduction in dividends and/or wages will lead to an insufficient supply of investment/labour. Analogously, the firm may find competition in the product market to be such that even a small rise in price will substantially reduce demand. Generalisations are not easy on the likely degree of elasticity in particular markets, since these may vary significantly according to the context; and that, by itself, suggests that policy-makers ought to be cautious in using legal rules for redistributional purposes. The conviction that judges should be able to refine legal rules to meet distributional concerns29 is, on this basis, equally suspect. Other Redistributional Policies Economists tend to use the term “distributional justice” to relate exclusively to wealth (capital or income, or both); in consequence a policy of redistribution (more correctly “progressive redistribution”) involves transferring resources from richer to poorer individuals. But, we could clearly extend the concepts to other attributes, thus, for example, physical capacities and endowments. So understood, a redistributional policy would then involve transfers from the physically stronger to the physically weaker, notably disabled individuals; and a similar policy could be applied to, for example, the less well-educated. Under 27

Logue and Avraham, above n 12, 255–6. R Craswell, “Passing on the Cost of Legal Rules: Efficiency and Distribution in Buyer-Seller Relationships” (1991) 43 Stanford Law Review 361, 366–8. 29 Logue and Avraham, above n 12, 254. 28

229

(I) Ogus Ch8

20/2/06

16:35

Page 230

Protecting the Disadvantaged

such systems, the categorisation serves not as a proxy for poverty but rather because current social values treat the differences between those who pay and those who receive as, in some sense, “unfair” and thus justifying the transfer.30 How will the economic arguments used in the last section be affected? Note, first, that the economic argument associating social welfare gains with progressive redistribution and relying on the diminishing marginal utility of money, may here not apply, since recipients may be as wealthy as the sources of the transfer. What, then, of other costs? Schemes directly raising finance for these purposes by taxation will have the problem of workincentives, already noted. The complexities of measuring the income and capital of beneficiaries will disappear, but there still may be significant difficulties and costs in formulating and applying definitions of entitlement. This is well recognised in relation to physical disability and is even more marked for the mentally disabled.31 Moreover, as qualitative indicators tend to supplant quantitative criteria—as is perhaps inevitable given that social values on what is “unfair” are likely to be vague—so subjectivity plays an increasing important role in decision-making, leading to higher grievance and dispute costs. Recipients of these forms of redistribution do not have disincentives to earn or to save, but potential loss of the benefit may affect any motivation to remove themselves from the categorisation of entitlement. Studies have shown how, for example, efforts at physical rehabilitation are affected by disability welfare programmes.32

Paternalism Should the pedestrians near the Law School at the University of Manchester be forced to wait until there is an appropriate green 30

Logue and Avraham, above n 12, 207–8. G Zarb, “Social Security and Mental Health: Defining the Issues” in G Zarb (ed), Social Security and Mental Health (London, HMSO, 1996) 3–10. 32 J Hogeland, In Search of Effective Disability Policy (Amsterdam, Amsterdam University Press, 2003). 31

230

(I) Ogus Ch8

20/2/06

16:35

Page 231

Protecting the Disadvantaged

signal before they are allowed legally to cross the road? To what extent, and in what circumstances, should motor cyclists (or pedal cyclists) be obliged to wear safety helmets? Should those purchasing on the doorstep be protected against making rash decisions? Should the law be used to deter individuals from smoking? These are important legal policy questions but far from easy to address. Although a positive answer appears to have been given to most of them in most jurisdictions, the reasons for the interventions tend not to be fully debated or analysed. One explanation for this may be that the justifications tend to be intertwined and difficult to disentangle. For example, requiring safety helmets to be worn may be in cyclists’ own interest (whether they think so or not); but it may be defended also by reference to savings of public expenditure on accident treatment costs. Notice, too, that at least in policy debates there may be inhibitions, derived from political correctness, in openly discussing paternalism (or maternalism?): politicians are reluctant to be heard to say that they (or bureaucrats) know better than ordinary citizens what is good for them. Economics may be helpful in dealing with accident treatment costs, but, on the face of it, has little to offer to the paternalist debate. It treats the autonomous individual as the only decisionmaker capable of knowing his or her own preferences and therefore able to maximise individual welfare. Yet, as with distributional justice, economic reasoning can do much both to clarify the issues and to indicate the cost of pursuing paternalist policies. More than that, we can draw on the relatively recent work in behavioural law and economics,33 to formulate hypotheses as to when paternalist intervention may be appropriate.34

33 See especially CR Sunstein (ed), Behavioral Law and Economics (Cambridge, Cambridge University Press, 2000). 34 A Ogus, “Regulatory Paternalism: When is it Justified?” in K Hopt, E Wymeersch, H Kanda and H Baum (eds), Corporate Governance in Context: Corporations, States and Markets in Europe, Japan and the US (Oxford, Oxford University Press, 2005), ch 16, from which this part of the chapter is derived.

231

(I) Ogus Ch8

20/2/06

16:35

Page 232

Protecting the Disadvantaged

Economic and Paternalist Reasons for Overriding Individual Preferences Many apparently interventionist measures, overriding individual preferences, can be rationalised economically without reference to paternalist arguments. Most obviously and importantly, some unwise individual decisions generate negative externalities, that is, impose costs on third parties. Regulating the individual’s conduct may, then, constrain or internalise those costs.35 Thus, insistence that a safety helmet or an equivalent protective device be worn by those at risk may reduce the accident rate and thus also the health-care costs borne by taxpayers and healthinsurance contributors. And in relation to measures designed to inhibit personal financial losses, for example, by doorstepselling, the analogous justification is that social security and other welfare provision might come to the rescue of the impoverished individual. But care must be taken when invoking externality justifications. The mere infliction of third-party costs cannot, of course, by itself justify intervention. In some circumstances, the benefit to third parties from the individual activity may exceed the costs. Paradoxically, this may be the case with cigarettesmoking if that activity accelerates death, such that there is a net36 saving on the medical and other costs which taxpayers bear. Admittedly, account must also be taken of the financial and non-financial losses which the early death may generate for third parties, including families and other dependants. But the calculation should not take account of the cost to the smokers themselves of their lives being shortened, because that is not an externality. For the legal intervention to be justified on this basis normally implies a paternalist approach, if the individuals’ preferences, with adequate information on the impact on life expectancy, are to smoke. 35

See, above, 76–7. Taking account of any increase to health care and analogous costs during the abbreviated lifetime. 36

232

(I) Ogus Ch8

20/2/06

16:35

Page 233

Protecting the Disadvantaged

More generally, what society gains from reducing negative externalities by a relevant legal instrument has to be compared with the costs of that intervention. That latter figure should include not only the costs of compliance of all those subject to the legal requirement, but also the administrative costs of the legal and other machinery necessary to achieve this end. Another economic justification for overriding individual preferences may be related to information. Economists do indeed recognise that since many individuals do not have the appropriate information to form preferences, or proceed on the basis of false information, there is no reason to suppose that meeting their expressed preferences will always maximise their welfare. So if, as a cyclist, I do not have adequate information of the risk of a serious head-injury and of how the wearing of a helmet might reduce that risk, then my decision whether or not to wear a helmet cannot be assumed to be an efficient one. But here again some caution in invoking the justification is necessary: the costs of requiring me to wear the helmet may outweigh the benefits and even if they do not, a cheaper solution may be to furnish me with the relevant information, leaving the choice to me. Mainstream economists draw a distinction between inadequate information, the consequences of which they are willing to investigate, and an individual’s inability to respond rationally to adequate information. The notion of “bounded rationality” is recognised37 but mainly as an indicator of the parameters beyond which traditional analysis cannot go.38 If remedial interventions are based on some anti-individualist approach to welfare, holding that society, or more particularly, certain “experts” in society, should make decisions for individuals, that clearly cannot be reconciled with economic reasoning based on individual autonomy. However, as we shall now see, a paternalist 37 For example, in the seminal work of O Williamson, The Economic Institutions of Capitalism (New York, Free Press, 1985), 45–6. 38 DM Kreps, “bounded rationality” in P Newman (ed), The New Palgrave Dictionary of Economics and the Law (London, Macmillan, 1998), vol 1, 168–73.

233

(I) Ogus Ch8

20/2/06

16:35

Page 234

Protecting the Disadvantaged

policy does not necessarily involve abandoning an individualist approach to welfare. We may first explore the notion of rational delegation.39 Individuals can recognise that they will be subject to temptations, for example, drug consumption or a gambling urge, which they will find difficult to resist. To succumb may generate short-term utility gains which will be substantially outweighed by the longer-term costs of addiction, ill health, or penury. In such circumstances, the utility of individuals is enhanced if they agree ex ante to submit to an external control depriving them of the temptation.40 It is then possible to extend this reasoning to situations where individuals can recognise ex ante that they may behave irrationally or make errors of judgement. If, in such circumstances, they would hypothetically consent to being deprived of freedom of choice, then a paternalist intervention may be legitimised on individualist grounds. On the basis of the above arguments, the paternalist goal of increasing social welfare becomes that of meeting what it is assumed would have been the preferences of individuals if they had responded rationally to full information. And particular paternalist measures can then be justified if the benefits of the intervention exceed the costs. However, determining when individuals are likely to act irrationally and when the cost-benefit condition is met is, of course, not easy. I address both of these issues in turn.

39 J Kleinig, Paternalism (Manchester, Manchester University Press, 1983), 55–67. 40 For the economic basis to this reasoning, see G Loomes and R Sugden, “Regret Theory: An Alternative Theory of Rational Choice under Uncertainty” (1982) 92 Economic Journal 805. The same idea is present in the contention that paternalism may be justified where individuals’ second-order preferences conflict with their first-order preferences: C Sunstein, “Legal Interference with Private Preferences” (1986) 53 University of Chicago Law Review 1129. For an empirical study, purporting to show that cigarette taxes make people happier, see JH Gruber and S Mullainathan, “Do Cigarette Taxes Make Smokers Happier?” (2005) 5(1) Advances in Economic Analysis & Policy, Article 4.

234

(I) Ogus Ch8

20/2/06

16:35

Page 235

Protecting the Disadvantaged

Individual Decision-Making and Irrationality It is generally assumed, uncontroversially, that the law should protect children below a certain age and individuals below a certain level of mental capacity, on the ground that their expressed preferences may not be consistent with their long-term welfare maximisation. Difficulties obviously arise in determining to what extent the assumption of rationality should be relaxed for other individuals. But social psychologists have done much in recent years to enlarge our knowledge concerning the way people make decisions and how the latter diverge from what may be regarded as rational decision-making.41 From this work, we can highlight certain key phenomena which relate to situations where paternalist motives seem to have inspired legal interventions. Status Quo Bias and Inertia

Individuals systematically undervalue the costs, and risks, arising from choices they are accustomed to make, and undervalue the benefits to be derived from different, or new, options.42 Others things being equal, they will therefore tend to opt for status quo outcomes. Examples include behaviour such as smoking or alcohol consumption which individuals have engaged in for a number of years apparently without significant adverse effects. This will typically distort their perception of the risks involved in continuing the activity, notwithstanding the flows of information generated by greater scientific knowledge of the risks. Status quo bias is closely related to problems of inertia. Individuals may not be prepared to incur the costs, even when trivial, of exploring beneficial alternatives to familiar choices.43 The phenomenon is familiar to those promoting competition in hitherto monopolistic markets: a significant proportion of 41

For a useful survey, see Sunstein above n 33. R Noll and JE Krier, “Some Implications of Cognitive Psychology for Risk Regulation” (1990) 19 Journal of Legal Studies 747, 765–7. 43 R Korobkin, “Inertia and Preference in Contract Negotiations: the Psychological Power of Default Rules and Form Terms” (1998) 51 Vanderbilt Law Review 1583. 42

235

(I) Ogus Ch8

20/2/06

16:35

Page 236

Protecting the Disadvantaged

purchasers remain faithful to the dominant supplier, even though the price and quality offered by newcomers apparently better meet their preferences.44 This in turn leads to a further proposition: other things being equal, individuals will typically prefer doing nothing (omission) to doing something (commission). This has implications for a wide range of paternalistically motivated measures. For example, individuals—if pressed—may recognise the advantages of insuring themselves against future contingencies but might err on the side of doing nothing. Availability Heuristic

The easier a phenomenon is brought to mind, the greater the influence it will have in the formulation of preferences.45 Advertisers and others seeking to influence purchasing behaviour exploit individuals’ vulnerability in this respect by emphasising the advantages of particular products. Again, other things being equal, people will in consequence tend to overestimate the benefits and under-estimate the costs of the product. The availability heuristic applies equally to the risks of detrimental occurrences. If media coverage has given prominence to a given contingency, say an accident, individuals will attribute a greater probability to the contingency recurring than is objectively justified. Now, of course, that is likely to lead individuals to take excessive, rather than insufficient, precautions, relative to how they would have behaved if responding rationally to the risk, and—as such—might lead to the exact opposite of what we observed in relation to status quo bias: detrimental action, as opposed to beneficial inaction. That might seem to preclude the possibility of paternalist intervention but there is no theoretical reason to limit paternalism to precautionary measures and we might envisage paternalistically forestalling the taking of excessive safety measures. 44 A Fishman and R Rob, “Consumer Inertia, Firm Growth and Industry Dynamics” (2003) 109 Journal of Economic Theory 24. 45 T Kuran and CR Sunstein, “Availability Cascades and Risk Regulation” (1999) 51 Stanford Law Review 683.

236

(I) Ogus Ch8

20/2/06

16:35

Page 237

Protecting the Disadvantaged

Excessive Discounting

Individuals often discount future costs and benefits to a greater degree than is objectively justified.46 In other words, the shorterterm consequences of a particular choice unduly influence decision-making, relative to the longer-term consequences. Not unexpectedly, individuals with addictions have a very rapid discount rate for benefits which accrue only after some time,47 but there is evidence of the same, if less drastic, phenomenon applying in a wide range of activities including career and investment choices.48 Among several policy consequences which may be derived from this phenomenon, mandatory retirement pension programmes constitute an obvious example.49 Selective Optimism and Control

Individuals are not always good at reasoning on the basis of representative sources of information; rather they tend to generalise from highly selective examples.50 That can lead them to becoming excessively optimistic regarding the unlikelihood of a risk materialising,51 The fact that they exert a degree of control over the circumstances may exacerbate the problem.52 Thus drivers, including those whose judgement is affected by alcohol, tend to under-estimate the probabilities of being involved in an accident, compared with those who are driven by others; and one 46 M Eisenberg, “The Limits of Cognition and the Limits of Contract” (1995) 47 Stanford Law Review 211, 222. 47 NM Petry and T Casarella, “Excessive Discounting of Delayed Rewards in Substance Abusers with Gambling Problems” (1999) 56 Drug and Alcohol Dependence 25. 48 J Myerson and L Green, “Discounting of Delayed Rewards: Models of Individual Choice” (1994) 64 Journal of Experimental Analysis of Behavior 263. 49 M Feldstein, “The Optimal Level of Social Security Benefits” (1985) 100 Quarterly Journal of Economics 303. 50 A Tversky and D Kahneman, “Belief in the Law of Small Numbers” in D Kahneman, P Slovic and A Tversky (eds), Judgement under Uncertainty: Heuristics and Biases (Cambridge, Cambridge University Press, 1982), 23–5. 51 DM DeJoy, “The Optimisim Bias and Traffic Accident Risk Perception” (1998) 21 Accident Analysis and Prevention 333. 52 Ibid, 336.

237

(I) Ogus Ch8

20/2/06

16:35

Page 238

Protecting the Disadvantaged

study showed that 90 per cent of drivers thought that they drove more safely than the average driver!53 Social Pressure

Choices made in purchasing and other activities are often highly imitative of those made by other individuals. This might, of course, be rational if the individual reasonably assumes that the relevant preferences are shared with those that take the lead in decision-making and that the latter have better information on which to make choices.54 But individuals may rather come under direct or indirect social pressure to make purchases which imitate the behaviour of others.55 Although it may enable them to gain esteem, and thus increase their welfare in this respect, the behavioural trait often distorts preferences.56 It may also lure individuals into levels of expenditure which they are unable to sustain and to which otherwise they would not have committed themselves. The Benefits and Costs of Paternalist Interventions Let us assume that, with the aid of the psychological evidence described above, we can identify situations in which many, perhaps most, individual decision-makers select options which would not reflect their preferences if they had been responding rationally to the information available. The benefit of a legal intervention forcing an individual to adopt the rational choice may then be expressed as the difference between the utility she has gained from complying with the legal requirement and the utility she would have gained from her own preferred option. The social benefit of the measure would then be the aggregate 53 O Svenson, “Are We All Less Risky and Skilful than Our Fellow Drivers Are?” (1981) 47 Acta Psychologica 143, 146. 54 J Bjönerstadt and KH Schlag, “On the Evolution of Imitative Behaviour” SFB 303, Universität Bonn, Discussion Paper No B-378 (1999). 55 T Tassier, “A Model of Fads, Fashions, and Group Formation” (2004) 9 Complexity 51. 56 G Duffield and P Grabosky, The Psychology of Fraud (Canberra, Australian Institute of Criminology, 2001).

238

(I) Ogus Ch8

20/2/06

16:35

Page 239

Protecting the Disadvantaged

of such increases in utility for all those subject to the requirement, though some deduction would have to be made for imperfect enforcement of the law.57 Of course, the variables cannot be quantified with any precision but it is helpful to proceed to examine the broad profile of costs likely to be incurred and speculate on whether they are likely to be disproportionate to the benefits.58 In doing so, we should distinguish between different forms of paternalist intervention, because some are significantly more costly than others. We may start with administrative and institutional costs which, in the case of regulatory interventions, are largely born by public agencies. They include the costs of acquiring relevant information, formulating relevant standards or other controls, monitoring behaviour and enforcing compliance. Another possibility is to use principles of private law, for example, those giving rise to entitlement to damages or contractual invalidity, although account has to be taken here of the fact that the beneficiary of the entitlement might not have the means to enforce it or be competent to reap the advantages of legal invalidity. The costs may be reduced, or avoided, if the paternalist measure—regulatory or private law—is formulated and/or administered as a default rule, applying only to those who have manifestly not adopted the required, or some analogous but equally effective, course of conduct.59 The device renders the law more complicated but it helps to reduce the (not trivial) “frustration” costs of imposing controls on individuals whose behaviour does not justify paternalist intervention.60

57 For a more sophisticated model based on the same idea, see E Zamir, “The Efficiency of Paternalism” (1998) 84 Virginia Law Review 229. 58 For another approach to the assessment of the benefits and costs of paternalist intervention, see C Camerer et al, “Regulation for Conservatives: Behavioral Economics and the Case for ‘Asymmetric Paternalism’ ” (2003) 151 University of Pennsylvania Law Review 1211. 59 Cf Camerer et al, above n 58, 1224–30. 60 See Zamir, above n 57, 260.

239

(I) Ogus Ch8

20/2/06

16:35

Page 240

Protecting the Disadvantaged

Paternalist intervention controls sometimes the intended beneficiary, for example, requiring the wearing of safety equipment, but sometimes third parties, such as employers or traders who must do, or abstain from, some act, in order to protect the beneficiary. Clearly the subjects of the control, in whatever category, incur the cost of being informed as to its existence and content. What then of compliance costs? Here we can assume that if the intervention is well targeted, in the sense of compelling a beneficiary to do what he or she would have done if responding rationally to the information available, then those costs would, in any event, have been incurred, as part of the utility-maximising behaviour. That does not apply to third parties and their compliance costs may be substantial. The indirect costs of paternalist intervention, for example externalities, may be important. Paternalism may prevent individuals learning from the consequences of their own decisions, pushing them into a vicious circle where they become more and more dependent on governments.61 Regulation of any kind can also artificially generate demand for particular products, for example, safety equipment conforming to certain specifications which can advantage the suppliers of those products, to the detriment of others supplying equally effective products but not conforming to the specifications. This not only undermines the competitiveness of markets; it also creates perverse incentives for suppliers to spend resources convincing politicians and others of the need to prescribe those particular products—a significant deadweight loss to social welfare.62 The Pedestrian Crossing Near Manchester University

Let us now see how this analysis can be applied to situations where paternalism seeems to have influenced the law. Take, first, the example of the pedestrian-crossing near the University of Manchester, given at the beginning of the chapter. Although 61 BJ Winick, “On Autonomy: Legal and Psychological Perspectives” (1992) 37 Villanova Law Review 1705, 1756 et seq. 62 G Tullock, “The Welfare Costs of Tariffs, Monopolies and Theft” (1967) 5 Western Economic Journal 224.

240

(I) Ogus Ch8

20/2/06

16:35

Page 241

Protecting the Disadvantaged

there are possible externality justifications arising from the fact that some of the damage costs, should an accident materialise, fall on third parties—particularly the health-care costs incurred by taxpayers funding the National Health Service—we may plausibly assume that paternalist reasoning featured significantly in the policy adopted. In relation to the paternalist justification, we should note that children sometimes cross the road at this point; also I have a visually-handicapped colleague who might occasionally benefit from the protection (and there may be others in this category). But these cases apart, I would be very surprised if evidence could be produced showing that pedestrians systematically misperceive the risks of crossing the road when “unprotected” and in consequence fail to take optimal care. Even if I am wrong, the fact that so many of them ignore the protected period and cross when it is not lawful to do so suggests that the arrangements as currently implemented do not generate significant benefits for this group. That might change if the police were to alter their apparent current policy of non-enforcement; but that would of course massively increase the costs of this measure—and not only enforcement costs but also frustration costs, those incurred by individuals who feel perfectly safe in crossing the road without protection. We may thus reach the conclusion that the paternalist justification can be sustained only in relation to children and visually-handicapped pedestrians; and, as regards these individuals, there may be cheaper means of achieving the safety goal, for example, by enabling them to cross with the aid of fullysighted adults. Other Health and Safety Measures

From the vast array of other health and safety measures for which paternalist arguments, as well as externality justifications, can be made out, I select two: seat-belts in cars; and beef possibly affected by BSE. The wearing of seat-belts in private motor-vehicles has been mandatory in many countries for a number of years and the 241

(I) Ogus Ch8

20/2/06

16:35

Page 242

Protecting the Disadvantaged

evidence is overwhelming that this reduces the incidence of serious injuries and fatalities resulting from road accidents.63 It seems too that, notwithstanding this evidence which has been widely disseminated, there has been a reluctance on the part of some classes of drivers and passengers to use the belts. This may have been particularly marked when seat-belts were novel, thus displaying the status quo bias; and, insofar as it applies to drivers, reflects the selective optimism and control phenomenon. It does not seem unreasonable therefore to conclude that the wearing of seat-belts would represent the preferences of the large majority of car travellers, if not constrained by bounded rationality, and that there are very significant welfare gains to accrue from interventionist measures securing this outcome. There are at least three types of intervention which have been used in this context: the manufacturers of vehicles are obliged to install seat-belts64; the failure to wear a seat-belt can reduce the amount of compensation payable to a road accident victim in private law65; and criminal sanctions are available to punish such failures even if no accident occurs.66 The cost of the first two measures may be assumed to be rather small: it is easy to monitor compliance by car manufacturers; and although the second may give rise to additional litigation and other dispute costs, these may not be large. The third does potentially involve significant enforcement costs—behaviour must be sufficiently well monitored for the sanction regime to be an effective deterrent.67 The measure may also be regarded by some as a non-trivial interference with liberty, and thus give rise to frustration costs. But the effectiveness of the first two options to secure the desired outcome may be doubted and, impressionis63 D Dewees, D Duff and M Trebilcock, Exploring the Domain of Accident Law (Oxford University Press, 1996), 44–5. 64 Road Vehicles (Construction and Use) Regulations 1986, SI 1986/1078, reg 47. 65 Froom v Butcher [1976] QB 286. 66 Motor Vehicles (Wearing of Seat Belts) Regulations 1993, SI 1993/176. 67 See generally on this, A Ogus, “Enforcing Regulation: Do We Need the Criminal Law?” in H Sjögren and G Skögh (eds), New Perspectives on Economic Crime (Cheltenham, Edward Elgar, 2004), 42–56.

242

(I) Ogus Ch8

20/2/06

16:35

Page 243

Protecting the Disadvantaged

tically, it would seem that the costs associated with the third measure are still small, relative to the benefits to be obtained. The conclusion is, then, that this instance of paternalist regulation is justified. The scenario of how BSE (“mad cow disease”) was identified in certain cattle herds, and was (and still is) thought by some to create the risk of humans contracting Creutzfeld Jakob Disease (CJD) is reasonably well known.68 A number of regulatory measures were taken in consequence, notably—following a decision of the EU Veterinary Committee—the prohibition of export of British beef within the EU; and it was several years before this ban was lifted. It may be possible to justify these measures on the basis that consumers had inadequate information on which to make rational purchases of meat. The problem with this justification is that considerable publicity had been given to the possibility that serious risks to human health might arise from BSE. Given the scientific uncertainty, individuals with this information could have been left to make the choice whether or not to subject themselves to the possible risks.69 The decision to deprive them of that choice thus suggests paternalism. Now it may be that the very characteristic of uncertainty renders problematic appraisal of the benefits of intervention, particularly where potential fatalities are involved. Definitive conclusions on whether the paternalist measures were justifiable are therefore difficult. However, there are three features of the BSE case which merit our attention because, taken together, they suggest that the case for paternalist intervention was not as strong as it was made to appear. First, the costs to the agriculture industry, to dependent industries and to taxpayers consequent on the ban, were colossal.70 68 Cf A Dnes, “An Economic Analysis of the BSE Scare” (1996) 43 Scottish Journal of Political Economy 343. 69 For the impact of scientific uncertainty on risk assessment, and its policy implications, see above 158–161. 70 See the OECD Report: The Incidence and Costs of Foodborne Disease (OECD, 2003), 56–7.

243

(I) Ogus Ch8

20/2/06

16:35

Page 244

Protecting the Disadvantaged

Care must be taken in invoking these figures because presumably a significant proportion of the costs would in any event have been incurred if there had been a non-paternalist response: if governments had simply provided information to consumers on the nature and evidence of the risk, we must assume that demand for the product would have fallen substantially. Nevertheless, the difference between the costs that did occur and those which would have occurred in this latter contingency must still have been very large. Secondly, there were groups of private interests, notably the suppliers of non-British beef, who benefited from the ban and may well have exerted their influence on the decisionmakers.71 Thirdly, this is a case where the evidence from social psychology undermines, rather than strengthens, the arguments for paternalist intervention. The massive media coverage of the BSE phenomena would, according to the availability heuristic, have led many individuals to exaggerate the risk. Doorstep- and Distance-Selling

Doorstep-selling and distance-selling are two practices which are widely considered to be prejudicial to some consumers, thus justifying interventionist measures.72 At the heart of this concern is the suspicion that in the given circumstances many consumers will agree to purchases which, because they may later be regretted, do not reflect their longer-term preferences, or at least are not in their longer-term interests. With regard to both, there are certainly information problems: consumers will often be unable to draw inferences regarding the reputation and reliability of the trader when the transaction takes place away from business premises; and, in the case of distance-selling, there is the additional problem of inability to inspect products being sold. Paternalist arguments would seem to be particularly apt in rela71 This was certainly the case in France (the agricultural lobby being particularly strong there) where the ban was, in defiance of EU law, extended beyond the period required by the Veterinary Committee: The Guardian, 2 October 2002. 72 C Scott and J Black, Cranston’s Consumers and the Law, 3rd edn (London, Butterworths, 2000), 427–33.

244

(I) Ogus Ch8

20/2/06

16:35

Page 245

Protecting the Disadvantaged

tion to doorstep-selling and perhaps to distance-selling where this takes place by telephone. This is because of the availability heuristic: traders should have little difficulty in getting customers to focus attention on the advantages, rather than the disadvantages, of a particular transaction. These phenomena have led to different regulatory responses in different countries. In some jurisdictions, doorstep-selling is prohibited unless there is a prior request by a customer; in other jurisdictions it is allowed only with a licence authorising the practice.73 Application of our analytical framework raises doubts whether these measures can be justified. Prohibiting the practice is very costly, insofar as it deprives individuals who are less mobile of the opportunity of purchasing on the doorstep; and a licensing system generates very high administrative costs. Much more cost effective would seem to be the mandatory imposition of a cooling-off period, as now required by European law74: customers may without penalty cancel the agreement within seven days of entering the transaction. Admittedly, there are here non-trivial costs to be considered, particularly those arising from any exercising of the right to cancel, as well as from the monitoring required to ensure that customers are being adequately notified of the right. But the benefits of the measure are likely to be secured not so much from the exercise of the right as from the chilling effect the existence of the right is likely to have on behaviour; both that of traders in not over-selling the product and that of consumers in getting to think twice about whether they really wish to purchase.75 73

Netherlands is an example of the first; Italy of the second: ibid, 428–9. Council Dir 85/577/EEC, implemented in the UK by the Consumer Protection (Cancellation of Contracts Concluded Away from Business Premises) Regulations 1987, SI 1987/2117. For distance-selling, see Council Dir 97/7/EC, implemented in the UK by the Consumer Protection (Distance Selling) Regulations 2000, SI 2000/2334. 75 Camerer et al, above n 58, 1239. “Those who complain about ‘cooling-off’ provisions are not buyers fearful that their decision will be undermined, but sellers fearful that what has been extracted through virtuosity may be less captivating the following day”: Kleinig, above n 39, 195–6. 74

245

(I) Ogus Ch8

20/2/06

16:35

Page 246

Protecting the Disadvantaged

Consumer Credit

The supply of consumer credit has, for some time, been one of the most regulated areas of commerce.76 Much of this can doubtless be justified on traditional market-failure grounds. Those entering into consumer-credit transactions often face major information problems, particularly regarding the rate of interest that will be charged and the consequences of failing to meet their repayment obligations. So also there are assumed to be significant externalities resulting from over-indebtedness, including the costs of administering bankruptcies, welfare payments for impoverished people and, in extreme cases, increased crime and health care costs.77 Nevertheless, paternalism appears also to have played an important role in motivating the legislation.78 There are several features of the circumstances surrounding the obtaining of consumer credit which suggest that the transactions might often fail to match the assumed longer-term preferences of individuals. We may note, in the first place, that consumer credit is particularly associated with socio-economic groups of lower educational attainment79 and that these groups may be particularly prone to errors in the discounting of future costs and benefits. So, too, there is evidence that social pressure—the “keeping-up-with-the-Jones’s” phenomenon—lures many people into unwise levels and cycles of indebtedness from which it is difficult to escape80; although their selective optimism may suggest otherwise. 76

Scott and Black, above n 72, 229–32. RP Hill, “Stalking the Poverty Consumer: a Retrospective Examination of Modern Ethical Dilemmas” (2002) 37 Journal of Business Ethics 209. 78 The word “paternalist” is of course absent from policy statements but the concept is not far from the surface. See, eg: the speech of the UK DirectorGeneral of Fair Trading on “Credit, Consumers and Codes of Practice” (2001) available at http://www.oft.gov.uk/nr/rdonlyres/5076b62e-0f1c-4b15-b76b80232691c4a0/0/spe0301.pdf. 79 I Ramsay, Access to Credit in the Alternative Consumer Credit Market (Office of Consumer Affairs, 2000), 1–3. 80 UN Development Programme, Human Development Report 1998, ch 3, available at: http://hdr.undp.org/reports/global/1998/en/. 77

246

(I) Ogus Ch8

20/2/06

16:35

Page 247

Protecting the Disadvantaged

Many of the regulatory controls on consumer credit trading are designed to enhance the information available to consumers and, as such, should not be regarded as paternalist measures. Although the licensing of consumer-credit suppliers81 might be considered to be intended primarily to overcome the inability of consumers to judge the reliability of suppliers and therefore an information measure, it is clear that the process is intended also to screen out creditors extending credit unwisely (ie to those already in bad debt) and therefore, presumably, with a paternalist motive.82 However, the administrative costs of operating such a system are very large and are likely to be disproportionate to any paternalist benefits,83 given, in particular, the difficulty of identifying suppliers who exploit debtors in this way. Among the other instruments which can be characterised as paternalist, we can highlight the imposition of cooling-off periods84 and the control of other contractual terms. There is little to add to what was said about the former in relation to doorstepselling: the arguments for the cost-effectiveness of the measure would seem to be equally applicable here. As regards controls on other terms, some jurisdictions85 have rendered unenforceable rates of interest exceeding the current rate by more than a certain percentage; and Canada has used the criminal law to prohibit such practice.86 Legislative provisions of this kind 81

Consumer Credit Act 1974, ss 21 and 145. See the Report of the [Crowther] Committee on Consumer Credit (Cmnd 4596, 1971) which instigated the system, esp at 150. 83 Cf A Ogus and CK Rowley, “The Costs and Benefits of Part III of the Fair Trading Act 1973 and Licensing under the Consumer Credit Act 1974”, (unpublished study commissioned by the Office of Fair Trading, 1981). 84 Consumer Credit Act 1974, s 67: the period is 12 days, compared to the seven imposed for non-credit doorstep and distance transactions: above n 74. 85 Eg France and Germany: G Howells, “Controlling Unjust Credit Transactions” in G Howells, I Crow, and M Moroney (eds), Aspects of Credit and Debt (Sweet & Maxwell, 1993), 92–108. The British legislation enables a court to review the terms of a contract if the payment terms are “grossly extortionate” (Consumer Credit Act 1974, ss 137–40) but the device is apparently little used: Scott and Black, above n 72,, 256. 86 Criminal Code, s 347. See Ramsay, above n 79, 31–3. 82

247

(I) Ogus Ch8

20/2/06

16:35

Page 248

Protecting the Disadvantaged

might constrain the supply of credit to higher-risk borrowers, and therefore paternalistically protect some of the more vulnerable consumers, because lenders will not be able to charge rates of interest sufficient to meet the greater risk of default; and these measures are not particularly costly to administer. On the other hand, if they succeed in this objective, they impose frustration costs on those who wish to engage in higher-risk transactions and who do not need protection. It may also force some of the more vulnerable consumers to obtain loans in the black market, with even greater potential losses. The paternalist justification for such controls is, therefore, more contentious. Listing of Securities

My final example is drawn from corporate law and securities regulation; it concerns controls exerted over the listing of securities on the stock exchange. Traditionally such controls have focused on disclosure requirements, ensuring thereby that potential investors have the appropriate level of information on which to make decisions. However, in some jurisdictions, there is what is sometimes called “merit regulation,” the authorities having power to exclude from the market firms which, in their view, constitute a risk of such dimensions that individuals should not be allowed to invest in them.87 In the UK, for example, the listing authority can reject an application on the ground that “it considers that the applicant’s situation is such that admission of the securities would be detrimental to the interests of investors.”88 In this area, it is not always easy to differentiate between disclosure regulation, responding to information asymmetry, 87 DF Vagts, “Securities Regulation” in K Zweigert and U Drobnig (eds), International Encyclopedia of Comparative Law (The Hague, Nijhoff, 2000), vol XIII, 10–16. For an excellent, if dated, description of systems in US state, not federal, law, see ABA Subcommittee Report on State Merit Regulation of Securities Offerings, reprinted in (1986) 41 Business Lawyer 85. 88 Financial Services and Markets Act 2000, s 75(5). For further details, see The Financial Services and Markets Act 2000 (Official Listing of Securities) Regulations 2001, SI 2001/2956; and for policy discussion, The Listing Review and Prospectus Directive, FSA Consultation Paper 05/07 (2005).

248

(I) Ogus Ch8

20/2/06

16:35

Page 249

Protecting the Disadvantaged

and merit regulation involving paternalist intervention: an adverse decision on the latter basis may in fact result from insufficient information and be remedied by more information.89 Nevertheless, some “merit” scrutiny clearly involves substantive evaluation of risk by reference to what the regulatory agency considers to be a tolerable level of risk. Although the agency’s function in this respect can be analogised to that of a (private) financial adviser, the fact that the investor is not allowed to ignore the advice, because the investment may, following an adverse review, be withdrawn from the market, means that there is a strong paternalist content to the arrangement. That some individual investors are unsophisticated and will make poor evaluations of risk even when they have full information is, of course, clear.90 Nor is it difficult to relate such behaviour to the social psychological phenomena of excessive discounting and selective optimism. The availability heuristic, too, may be relevant insofar as the information supplied with public offers typically highlights positive, rather than negative, characteristics of the firm. It is also the case that many unwise investments involve sums of money which are large, relative to the individual’s wealth. There are, therefore, potentially substantial benefits to be gained from interventions where investments do not conform to the preferences which individuals would have had if responding rationally to the information provided. However, the situation is very different from the doorstepselling problem. In the first place, the proportion of the total population of investors for whom paternalist protection might be justified is much smaller. Institutional investors and experienced brokers now play such a major role in relation to the floating of the securities that to deprive them of the choice of purchasing when typically they have much greater knowledge and expertise than the regulators approaches the absurd; and 89

ABA Subcommittee Report, above n 87, 823. BR Cheffins, Company Law: Theory, Structure and Operation (Oxford, Oxford University Press, 1997), 134–8. 90

249

(I) Ogus Ch8

20/2/06

16:35

Page 250

Protecting the Disadvantaged

gives rise to substantial frustration costs.91 Indeed, the regulatory strategy may also be criticised for inhibiting one of the basic functions of public trading in shares, that of investors diversifying risk in their portfolios and thereby enabling riskier ventures to make their contribution to the productive economy.92 As a regulatory instrument, the ex ante imposition of minimum standards of investment risk by the agency can be classified as a form of licensing and, as such, involves very large administrative costs. In the present context, if the aims of the system are to be adequately met, those costs may be particularly high, because of the complexity of the decisions that have to be made.93 And the uncertainty, and possible inconsistency, to which such complexity gives rise, impose costs on firms seeking to list their securities, adding to the, in any event, serious costs arising from the delay in listing. In short, in the light of very large costs and questionable benefits, it is very difficult to justify this form of paternalist regulation.

Conclusions As I indicated in chapter one,94 the economic analysis of law has been treated with scepticism by some traditional lawyers. Prominent among their criticisms are the assertions, first, that the law is concerned with “justice,” rather than, or as well as, efficiency; secondly, that many people do not behave rationally in the way envisaged in economic models. Such commentators are not always explicit on what they mean by “justice.” Sometimes they have in mind a notion of corrective justice, 91 R Romano, “Empowering Investors: a Market Approach to Securities Regulation” in K Hopt, H Kanda, M Roe, E Wymeersch and and S Prigge (eds), Comparative Corporate Governance: the State of the Art and Emerging Research (Oxford, Oxford University Press, 1998), 163. 92 EW Kitch, “Regulation of the Securities Market” in B Bouckaert and G De Geest (eds), Encyclopedia of Law and Economics (Cheltenham, Edward Elgar, 2000), vol 3, 821–2. 93 ABA Subcommittee Report, above n 87, 832–3. 94 Above, 21.

250

(I) Ogus Ch8

20/2/06

16:35

Page 251

Protecting the Disadvantaged

which I dealt with in chapter six; sometimes they are referring to distributional justice which I have considered in this chapter. My discussion of distributional justice begins with an account of how it relates to, but is also distinct from, the economic goals of Pareto and Kaldor-Hicks efficiency. That in some areas of law, law-makers may be pursuing distributional justice, rather than efficiency, is clear; but that does not imply that economic reasoning is irrelevant. Invariably there must be a trade-off between non-economic and economic goals, and for this reason it is important to be aware of the costs of implementing distributive justice goals. Put another way, legal policy-makers might wish to know how to implement those goals at lowest cost. In the first part of this chapter I have highlighted some key factors relevant for this purpose. I have also shown that the redistributional aims of some laws are thwarted because insufficient consideration is given to the market context in which the laws are made and therefore to the indirect effects which the laws have on behaviour within that context. In the second part of the chapter I consider paternalism which, in part at least, can be seen as a response to the fact that, as the critics of economic analysis have argued, many individuals do not always act rationally. It is assumed in most economic models that individuals do act rationally. For that reason, paternalism has been infrequently explored in the law-and-economics literature. I attempt to show why this neglect is not justified. There are risks that governments, while not admitting to adopting paternalism, because it is not politically-correct language, will arrogate to themselves extensive powers to override individual choice, to the benefit neither of those individuals nor of society at large. But I here argue that it is, in appropriate circumstances, a legitimate and important objective for legal policy-making and that it is not necessarily incompatible with economic reasoning. The evidence derived from social psychology studies can help in identifying commonly occurring flaws in reasoning about preferences and choices and therefore circumstances in which meeting expressed preferences may generate significant welfare losses. But it does not, of course, follow that systematically 251

(I) Ogus Ch8

20/2/06

16:35

Page 252

Protecting the Disadvantaged

replacing those preferences with others, determined by third parties, will alleviate the losses. We need to explore carefully the costs involved in intervening paternalistically, particularly where such intervention frustrates those who do not need the protection. The analytical framework which I have used is by no means robust and, at best, can establish an impressionistic profile for a given paternalistically-justified measure, thereby giving some indication of whether the costs involved are likely to be disproportionate to the prospective benefits. To illustrate the approach, I have applied the framework to some familiar areas of paternalist regulation, reaching the conclusion that some (for example, cooling-off periods for doorstep-trading and consumer-credit transactions) may be justified, while others (for example, the prohibition of sales of foodstuffs subject to uncertain and remote risks and the ex ante scrutiny for public offers listings) may not be.

252

(J) Ogus Ch9

20/2/06

16:35

Page 253

9 Lawyers and their Influence on the Law

Minks, Accident Compensation and Conveyancing In 1961 a new disease affecting mink emerged in England. All the infected animals had been fed a specific cereal supplied originally under a contract between Christopher Hill Ltd (sellers) and Ashington Piggeries (buyers) according to a formula agreed between them. Unknown to the buyers, the sellers had substituted a different substance for one of the prescribed ingredients. When the sellers claimed the purchase price of the food, the buyers counter-claimed for damages resulting from breach of contract. The hearing at first instance lasted 50 days; that before the Court of Appeal 32 days; and the final appeal before the House of Lords lasted 13 days.1 No doubt, at the time, minks were very valuable and large sums must have been at stake; but the costs of resolving this relatively straightforward legal dispute must have been enormous. No doubt, too, exploration of the facts required some careful investigation at the stage of trial. But, notwithstanding the complexities of sales of goods law, was it really necessary to have such protracted arguments at the appellate levels? Determined litigants expect that the lawyers representing them in court will do their best to win the case, but litigants are rarely able themselves to make sound judgements on the extent to which (say) an additional day’s argument by their barrister 1

Ashingon Piggeries v Hill [1972] AC 441.

253

(J) Ogus Ch9

20/2/06

16:35

Page 254

Lawyers and their Influence on the Law

will improve their chances of success. Barristers can and should be able to make such judgements, but, if their fee is calculated on an hourly or daily basis, can we be sure that their willingness impartially to communicate the information to their client will not be influenced by their own private interest in the matter? In the 1970s criticism of tort law as the principal instrument for providing compensation for accident was ubiquitous,2 not least after the publication of the Pearson Royal Commission’s Report, recommending major reforms.3 At the time when these issues were vigorously debated, an Oxford colleague revealed to me that during a dinner conversation, a leading judge had said that he would fight “tooth and nail” any proposal to introduce a no-fault compensation scheme because such a reform would “destroy the Bar.” Most of the recommendations in the Pearson Report were never implemented. Whether the reform proposals would have generated major social welfare gains is difficult to determine; evidence on the matter is inconclusive.4 But given the fact that, at the time, personal injury litigation generated an important percentage of the income of barristers,5 it would not be surprising if opposition from that quarter helped to withstand the pressure for reform. Take, then, the question of conveyancing. There has been a widespread perception that the English system of land transfers is seriously flawed, creating unnecessary delays, risks of opportunistic behaviour particularly by sellers, and much uncertainty and anxiety.6 Indeed a government-commissioned empirical study concluded that the transaction process was not “designed 2 See D Harris et al, Compensation and Support for Illness and Injury (Oxford, Clarendon Press, 1984), esp ch 1. 3 Report of the Royal Commission on Civil Liability and Compensation for Personal Injury (London, HMSO, Cmnd 7054). 4 D Dewees, D Duff, M Trebilcock, Exploring the Domain of Accident Law: Taking the Facts Seriously (Oxford, Oxford University Press, 1996). 5 M Zander, Legal Services for the Community (London, Temple Smith, 1978), 37. 6 For an economic analysis of the problems, see R Inderst and M Ottaviani, “Microeconomic Assessment of the Home Buying Offer and Contract Process” (2003), available at http://faculty.london.edu/mottaviani/hbr.pdf.

254

(J) Ogus Ch9

20/2/06

16:35

Page 255

Lawyers and their Influence on the Law

with the interest of the consumer in mind”; and that there was a need to spread the risk more evenly between seller and buyer and reduce the period of uncertainty which accompanies most transactions.7 As a consequence of the study, and to deal with the problem, the government in 1998 proposed the introduction of compulsory “sellers’ packs” which would include information on, inter alia, the title and condition of the property.8 The proposal was incorporated into the Homes Bill 2000, but the latter was withdrawn in the face of strong opposition, particularly from the Law Society of England and Wales, representing the solicitors’ profession.9 Eventually a revised proposal became law in 2004, and “home information packs” will become compulsory in 2007.10 No doubt there were serious technical defects in the original proposals, but it is surely not beyond the bounds of possibility that the opposition of the profession, and the delay in introducing the system, were at least partly the consequence of awareness that the reform proposals might reduce the time spent by solicitors on land transactions, and therefore their income.11 The common feature of the three phenomena described is that practising lawyers may have attempted to exert their influence to reach outcomes which furthered their own interest but which may not have advanced social welfare generally. An economic perspective can help us explore legal rules and development in a way which sheds important light on this possibility. As we have seen in chapter one,12 one branch of the law-andeconomics literature is concerned to explain how and why law is made. Restated briefly, scholars within this tradition disregard the perhaps orthodox assumption that law is generally designed 7 DETR Consultation Paper, The Key to Easier Home Buying and Selling (1998). 8 Ibid, paras 25–8. 9 See M King, “The Law Society’s Views of the Seller’s Pack” (2001), available at http://www.lurotbrand.co.uk/splinta/Lawsoc.htm. 10 Housing Act 2004, pt 5. 11 Losses to the solicitors’ profession from pt 5 of the Housing Act 2004 are predicted in P Kenny, “Conveyancer’s Notebook” [2005] Conveyancer and Property Lawyer 103, 104–6. 12 Above, 16–21.

255

(J) Ogus Ch9

20/2/06

16:35

Page 256

Lawyers and their Influence on the Law

to further the public interest, however that might be defined; instead they hypothesise that it is a product “supplied” by legislators to private-interest groups who benefit from it, the price being some form of political support. As one such interest group, practising lawyers have particular advantages in relation to government policy-making. In the first place, governments need the cooperation of lawyers because much of the process of government is carried out through legal institutions and therefore by lawyers.13 Secondly, lawyers possess considerable power in relation to the legislative process itself. All reform proposals must be scrutinised carefully by lawyers to ensure that the outcomes are legally feasible and, of course, at the ultimate stage, must be subjected to the process of legislative drafting. All of this suggests, then, that lawyers can exert a considerable influence on the content of legislation. In this chapter, with the aid of these economic ideas, I wish to explore the hypothesis that lawyers, concerned to maximise their own income, are able to exploit their influence over law-making to divert legal rules and institutions away from public interest goals. I shall also examine the related question of lawyers’ relationships with clients and how some characteristics of legal rules and procedures can generate opportunities for profit-making.

Legal Formalities Legal formalities are required for a number of a transactions14: some, for example the disposition of property after death, the formation of a company, and the transfer of real property require particular documentation; some, for example, entering a marriage, require adherence to specific procedures; some, for example, the eviction of a tenant, necessitate a court order. In a classic paper, Fuller articulated three justifications for legal 13 A Ogus, “The Economic Basis of Legal Culture: Networks and Monopolisation” (2002) 22 Oxford Journal of Legal Studies 419, 426. 14 JS Johnston, “legal formalities” in P Newman (ed), The New Palgrave Dictionary of Economics and the Law, (London, Macmillan, 1998) vol 2, 524–30.

256

(J) Ogus Ch9

20/2/06

16:35

Page 257

Lawyers and their Influence on the Law

formalities.15 Two of these are connected: engaging in a formal process both may indicate an awareness that legal consequences attach to the transaction and, for that reason, should induce some degree of caution into the transacting parties. However, taken by themselves, these justifications are not easy to defend because if a party makes an oral declaration acknowledging the legal character of the transaction that will not normally16 suffice as an alternative to the formal requirement.17 True, the oral declaration will be more difficult to prove for legal enforcement purposes, but that relates to Fuller’s third justification of formalities, that they have an evidentiary function, thus reducing the uncertainty and costs of enforcement. The historical evolution of formalities provides much support for Fuller’s third justification. The 17th-century Statute of Frauds which imposed formal requirements on a large area of transactions was designed, as its title indicates, to reduce fraudulent reliance on oral agreements: judicial enforcement of informal contracts had been facilitated by the writ of assumpsit gaining ascendancy over the antiquated action in debt, which required contracts to be made under seal.18 The transfer of land was, to achieve public notoriety and thereby reliable evidence, originally by physical delivery and symbolic ceremony; and the essence of the deed of conveyance which later became the formal requirement, was the witnessing of the signature of the transferor.19 In time, and with the technological advances necessary to constrain costs, title registration was to fulfil these 15 LL Fuller, “Consideration and Form” (1941) 41 Columbia Law Review 799, 800–4. 16 There may, of course, be alternative formal requirements. An example in Anglo-Saxon contract law is the furnishing of (nominal) consideration to sustain a gratuitous promise (Chappell v Nestlé [1960] AC 87) as an alternative to the transactions being executed in a deed: Fuller, above n 15, 820. 17 EA Posner, “Norms, Formalities, and the Statute of Frauds: a Comment” (1996) 144 University of Pennsylvania Law Review 1971, 1984–85. 18 AWB Simpson, A History of the Common Law of Contract (Oxford, Clarendon Press, 1975), 599–600. 19 T Plucknett, A Concise History of the Common Law (London, Butterworths, 5th edn 1956), 611–13.

257

(J) Ogus Ch9

20/2/06

16:35

Page 258

Lawyers and their Influence on the Law

functions in many contexts.20 Registration systems are in some jurisdictions used for proof of security interests in personal property; here the value of providing reliable information on the existence and priority of such interests is particularly high.21 Formalities may help to solve some of the problems of proof, and thereby generate important benefits, but they also impose non-trivial costs, notably on the parties obliged to comply with them. We need therefore to explore both the benefits and the costs22; such analysis can lead us, though not in any precise way, to the notion of an optimal level of formalism. Clearly a formality, such as a will or document authenticated by witnesses or notarial act, reduces the costs to subsequent adjudicators or enforcers of obtaining information on the content of the transaction and the obligations involved.23 As such it also reduces the variations of possible outcomes and, in particular, outcomes not intended by the parties. So, as with other procedural devices designed to reduce error costs, for example, higher standards of proof and restrictive rules of evidence,24 we need to appraise the level of such costs likely to arise, and the probability of error occurring in the absence of the formality. The wide variety of situations subject to this problem makes evaluation and generalisation difficult,25 but—other things being equal—the larger the value of the transaction to the relevant parties, the greater the potential error costs. 20 On the economic merits of the different approaches see T Miceli, Economics of the Law (New York, Oxford University Press, 1997), 127–31. 21 D Baird and T Jackson, “Information, Uncertainty and the Transfer of Property” (1984) 13 Journal of Legal Studies 299. 22 A Katz, “The Economics of Form and Substance in Contract Interpretation” (2004) 104 Columbia Law Review 496. 23 Ibid, 525–6. 24 ML Davis, “The Value of Truth and the Optimal Standard of Proof in Legal Disputes” (1994) 10 Journal of Law, Economics and Organization 343. On economic justifications for the different standards of proof required in civil and criminal cases, see A Ogus, “Enforcing Regulation: Do We Need the Criminal Law?” in H Sjögren and G Skögh (eds), New Perspectives on Economic Crime (Cheltenham, Edward Elgar, 2004), 50–1. 25 Cf L Kaplow, “The Value of Accuracy in Adjudication: An Economic Analysis” (1994) 23 Journal of Legal Studies 307.

258

(J) Ogus Ch9

20/2/06

16:35

Page 259

Lawyers and their Influence on the Law

If the effect of the formal requirement is to render inadmissible evidence extrinsic to the document or procedure, then it can confer the additional benefit of channelling the parties’ cautionary efforts as to what they do—and do not—want to be legally binding: it avoids the risk that legal consequences will attach to statements made during negotiation, or otherwise prior to the formality.26 Of course, for these and other advantages to accrue from the formalities, they should not be exploited opportunistically by one of the parties. For example, one contracting party with superior knowledge concerning the formal requirements can ensure that the terms more beneficial to the other party are not contained in the required instrument. To combat this possibility, legislatures but more usually judges have created large areas of exceptions to any rules limiting the evidence admissible to the court,27 thereby reducing the value of the rules to parties not requiring protection and adding significantly to the complexity of the law. Where the consequences of any error are largely confined to the parties to the transaction, one might question why the law should impose formal requirements, because the parties themselves are in the best position to appraise the costs and therefore to judge whether the formalities are justified.28 The possibility of opportunism considered in the last paragraph provides one answer; otherwise we should look for the existence of important externalities, third parties benefiting from the formalities. An obvious example is taxation, the cost to the fiscal authorities of determining and enforcing liabilities being thereby significantly reduced. Private third parties may also need evidence of the transaction where, for example, interests in property serve as security or successors in title will need proof of earlier acquisitions.29 26

JS Johnson, “Statute of Frauds” in Newman, above n 14, vol 3, 532. Particularly under the influence of equitable doctrine, so that for example it is said that the Statute of Frauds should not be used as “an engine of fraud”: Steadman v Steadman [1976] AC 536, 558, per Lord Simon. 28 Posner, above n 17, 1985. 29 Baird and Jackson, above n 21. For this purpose, the formality must be verifiable ex post by the third parties: Johnson, above n 14, 527. 27

259

(J) Ogus Ch9

20/2/06

16:35

Page 260

Lawyers and their Influence on the Law

We turn now to the costs of the formalities. These are incurred primarily by the parties to the transaction if, in the absence of compulsion, they would not have engaged in the required behaviour. And of course, the more that is required by way of formality, for example, appearing before a court or tribunal, the greater the costs, particularly the opportunity costs of time. Significantly also, not the least because of the theme of this chapter, the existence of formal requirements is, in many contexts, likely to induce the parties to purchase the services of a legal professional. In the case of a notarial act, familiar particularly in the civil law tradition, they will have no option.30 In common law jurisdictions, there has not been the same degree of insistence on professional involvement in the processing of most formal documents. But, in the marketing of their services, legal practitioners stress the importance of professional guidance and astute references to legal jargon or technicalities (for example, settlements or trusts in a will; deeds or seals, in relation to contracts) can enhance the message.31 I shall return to the question of legal jargon later in the chapter. How are the differences in approaches between the common law and civil law traditions to be explained? If the framework of analysing formalities developed above is, in broad terms, appropriate, would we not expect there to be some approximation in the way the relevant variables are assessed in countries of equivalent economic and social development? And if that is right, would we not find a relatively similar pattern to the degree of formalism required in, for example, contracts for the sale of land, wills and the formation of corporations? The perpetuation of substantially different levels of formalities in different jurisdictions has been confirmed by a recent,

30 K Zweigert and H Kötz, An Introduction to Comparative Law, 3rd edn (Oxford, Oxford University Press, 1998), 366–8 and, for the economics of notarial acts, see B Arruñada, “The Economics of Notaries” (1996) 3 European Journal of Law and Economics 5. 31 A search of websites using as keywords “wills”, “trusts” and “settlements” should convince the reader on this point.

260

(J) Ogus Ch9

20/2/06

16:35

Page 261

Lawyers and their Influence on the Law

World Bank-financed, comparative study.32 Some of its findings, for example, that the level of formalism is higher in poorer countries, than in richer countries, and that higher levels of formalism are associated with lower quality in the legal system meeting the goal of resolving disputes, suggest, indeed, that legal formalities serve purposes other than that of advancing the welfare of the users of the legal system. One possibility is that governments use formal requirements simply to exert control over businesses and citizens. This may be an end in itself; but in some circumstances it may also enhance the ability of court officials to raise corrupt payments.33 A less sinister possibility is that legal practitioners are, as a group, more powerful in some jurisdictions than in others and in consequence are able to maintain legal formalism at a level which will enhance their earnings, given as we have seen, that the higher the level of formalism, the greater will be the demand for legal services.

Legal Complexity Law can be more or less complex and this applies not only to legislation but also to the private law-making involved in the drafting of, for example, contracts, patents, articles of association and wills. It may also extend to the arguments and materials deployed in a legal dispute. Legal complexity may refer to the interaction between different rules or set of rules all of which have some application to a particular set of facts.34 Here, along with others,35 I wish first to focus on the level of detail in the 32 S Djankov, R La Porta, F Lopez-de-Silanes and A Shleifer, “Courts” (2003) 118 Quarterly Journal of Economics 453. 33 Cf A Ogus, “Corruption and Regulatory Structures” (2004) 26 Law and Policy 329. 34 See further, W Twining and D Miers, How To Do Things With Rules, 4th edn (London, Butterworths, 1999), 413–19. 35 The classic paper is I Ehrlich and R Posner, “An Economic Analysis of Legal Rulemaking” (1974) 3 Journal of Legal Studies 257. See also: A Ogus, “Quantitative Rules and Judicial Decision Making” in P Burrows and C Veljanovski (eds), The Economic Approach to Law (London, Butterworths, 1981), 210–25; R Epstein, Simple Rules for a Complex World (Cambridge, Mass,

261

(J) Ogus Ch9

20/2/06

16:35

Page 262

Lawyers and their Influence on the Law

rules or, as it is sometimes called, rule-specificity. The issue resembles that of legal formalities in that the greater the level of detail in a rule or other provision, in general, the lower the number of errors of interpretation to which it will give rise. But, like legal formalities, complexity comes at a cost, so that the two principal questions ensue: what is the optimal complexity in legal rules and other legal provisions? To what extent are lawyers motivated to provide that optimum? Legal provisions, whether in legislation, case law or private documents, operate as signals to others on what should, or should not be, done. Let us begin with a simple example. In the preparation of (say) a trust in my will, I will be concerned that my intentions concerning the disposition of my property after my death should be adhered to as closely as possible. I could give general powers of distribution to the trustee, but the more detailed the instructions I leave, the greater the probability of the particular parts of my property reaching the intended beneficiaries. Of course, greater detail comes at some cost to me: more time has to be spent. And, since legal technicalities and tax implications may arise, it may well be to my advantage to employ a professional lawyer to draft the will for me. In theory, I should aim at the optimal level of investment of expenditure, where the marginal benefits to me (closer adherence to my intentions) are roughly equivalent to the marginal costs (the extra time which I—or more likely my lawyer—will need to secure that degree of legal certainty of outcome). To assess the efficiency implications of the level of complexity adopted, account should also be taken of the costs incurred ex post by the trustee or executor. The more detailed the will, the greater the costs to that person of acquiring information as to what to do. On the other hand, the less the ambiguity in my ex ante instructions, the lower the likelihood of a dispute emerging between actual and potential beneficiaries with the costs, Harvard University Press, 1995); L Kaplow, “A Model of the Optimal Complexity of Legal Rules” (1995) 11 Journal of Law, Economics and Organization 150.

262

(J) Ogus Ch9

20/2/06

16:35

Page 263

Lawyers and their Influence on the Law

including perhaps those from litigation, arising from that possibility. The same idea becomes more important when we turn from the small number of (specialist) individuals to which a private will is addressed to the larger community expected to respond to legislative rules. So, greater precision in rules governing conduct should make it easier for individuals to know what is required, thereby reducing uncertainty. This, in turn should lead, in a private law context, to more out-of-court settlements and less litigation and, in a public law context, to an increase in the productivity of law enforcers.36 As regards costs, precision obviously requires more resources for drafting and more information being available to law-makers; the promulgation process may also become more expensive, as the greater detail in the rules renders them more controversial. Moreover, as rule-specificity generates complexity, the information costs of those to whom the rules are addressed increase, perhaps to the point where expert assistance has to be employed.37 Account must also be taken of error costs arising from imperfect fit38: the more general and therefore flexible the rule, the more easily it can be adapted ex post to admit borderline cases that fall within the objectives of the rule and to exclude those that do not. When more specific rules are over-inclusive they can inhibit socially valuable behaviour; when they are under-inclusive they can fail to deter socially undesirable conduct—with welfare losses in either case. An example can be drawn from a rule with which most of us must be all too familiar.39 The highly specific speed limit of 30 mph in urban areas deters faster driving during the early hours of the morning, when few pedestrians are present, and when the optimal speed might be 40 mph. It insufficiently deters slower driving in icy conditions, when the optimal speed might be 15 mph. 36

Ehrlich and Posner, above n 35, 261–7. A Ogus, “Information, Error Costs and Regulation” (1992) 12 International Review of Law and Economics 411. 38 Ehrlich and Posner, above n 35, 268–9. 39 A Ogus, Regulation: Legal Form and Economic Theory (Oxford, Hart Publishing, 2004), 169. 37

263

(J) Ogus Ch9

20/2/06

16:35

Page 264

Lawyers and their Influence on the Law

These are then the most important variables which are relevant in determining the optimal specificity or complexity of the law. Scientific analysis of this issue is, of course, very difficult because of the unavailability of much of the data, but there may be a perception, derived impressionistically, that many legal systems are overly rule-specific and complex. A forthright exponent of this view is Richard Epstein who argues in particular that “we should celebrate tests that give us a 95 percent fit to their chosen end, and not bemoan the 5 percent of cases that stand between us and some unattainable perfection.”40 And it may also be the case that private legal documents, such as wills, contracts and articles of association, are subject to the same criticism. To explain why this might occur, we should explore the question of who might (privately) benefit from excessive complexity. We may begin by noting that groups of individuals and firms attempting to extract favourable treatment in legislative and administrative rules will find it easier to achieve such outcomes in a regime of specific rules.41 The reason is that those responsible for formulating specific rules will typically require some information from the groups to whom the rules are addressed, if the rules are to be well tailored to the policy goals; and the groups providing the information can skew it to serve their own interests. As a special instance of this, and as we have already seen, lawyers, because of their key role in legislative drafting, exert a huge influence on how legislative rules are formulated. They may have little difficulty in convincing the policy-makers responsible for the legislation that additional precision in the rules is necessary if the policy goals are to be effectively pursued. Such extra precision will create a greater demand for expert lawyers in the drafting process; it will also generate additional demand for legal professional services from those to whom the 40 Above n 25, 42. See also R Epstein, “The Optimal Complexity of Legal Rules” University of Chicago John M. Olin Law & Economics Working Paper No 210 (2004)). 41 PG Mahoney and CW Sanchirico, “General and Specific Legal Rules” (2005) 161 Journal of Institutional and Theoretical Economics 329.

264

(J) Ogus Ch9

20/2/06

16:35

Page 265

Lawyers and their Influence on the Law

rules are addressed. So lawyers, as a group, are motivated to push the law towards greater complexity than is justified on public interest grounds.42 The phenomenon described in the last paragraph is an example of what we referred to in chapter two as the principal-agent problem.43 Individuals (the principals) without sufficient information or expertise to implement their preferences employ agents who have such information or expertise; unless constrained, agents may be able to exploit their discretion to advance their own interests, rather than those of their principals. In the context of legislative drafting, the principals are the policy-makers and the agents legislative draftsmen.44 The problem also arises, of course, in a private context, where individuals or firms (the principals) employ lawyers (the agents) to draft wills, contracts, articles of association and other documents.45 And here the problem may be exacerbated where there are different parties with different interests in the outcome of the transaction. Take a relatively long-term contract between, say, a manufacturer and a distributor. The contract is expected to generate a surplus, profits for both parties, but how the surplus will be divided between the two parties, will depend, among other things, on how the contract is drafted. The manufacturer’s aim may be, with the aid of the legal professional input, to secure as great a share as possible of that surplus. But the distributor will be similarly motivated and thus has the incentive to engage a lawyer to negotiate terms no less favourable to herself. The result may be a prisoner’s dilemma46: the more the manufacturer’s 42 MJ White, “Legal Complexity and Lawyers’ Benefit from Litigation” (1992) 12 International Review of Law and Economics 381. 43 Above, 60–1. 44 The same reasoning can be applied to the formulation of legal rules and decisions by judges: G Hadfield, “The Price of Law: How the Market for Lawyers Distorts the Justice System” (2000) 98 Michigan Law Review 953, 965–6. 45 A Ogus, “Lawyers as Designers or Disputants? Some Observations on the Economics of Civil Justice” in J Godard and D Guild (eds), Justice and Money, Hume Papers on Public Policy vol 7, no 1 (Edinburgh, Edinburgh University Press, 1999), 29–34. 46 Cf above, 23–4.

265

(J) Ogus Ch9

20/2/06

16:35

Page 266

Lawyers and their Influence on the Law

lawyer inserts by way of precise terms into the contract, to capture the greater part of the surplus, the more that investment will provoke the distributor’s lawyer to do likewise. The complexity of the contract will increase, adding to current and future legal costs, and the value of the surplus will be reduced. Now it may be that, in the context described, of an ordinary business deal, the problem should not be exaggerated. Even profit-maximising enterprises will appreciate that normally it is in their interests to cooperate, at least to some extent; and they will perceive that excessive haggling on how the surplus is to be divided will jeopardise the contract and the profits to be gained from it.47 Such co-operation is much less likely if the parties are engaged in a legal dispute. In this context, each disputant must decide how much they should invest in terms of arguments and materials to be deployed in litigation, and hence also the degree of complexity which they and their legal representatives should engage in.48 Here, in the light of our earlier analysis, we can see that rationally a disputant will invest in the procuring of favourable evidence and arguments up to the point where the marginal returns, in terms of winning the dispute and deriving thereby financial and non-financial gains, are equal to the marginal costs of the additional expenditure. But the reaching of a decision on this is clearly affected by the principal-agent problem. Knowledge of the strength of the case (ie the probability of winning) and then of the marginal benefits of additional investments is likely to be held by the lawyer, but not the client. It follows, too, that if the lawyer is paid on the basis of an hourly rate of remuneration, she will have an incentive to add to the complexity and length of the proceedings.49 These difficulties are compounded by the fact that the outcome of a case is dependent not so much on the quality and 47 It may be different if the parties are already locked into a long-term relationship and one of them is seeking to alter the terms of the arrangement. See the discussion of Williams v Roffey Bros, above 152. 48 Ogus, above n 45, 31–3. 49 Hadfield, above n 44, 965.

266

(J) Ogus Ch9

20/2/06

16:35

Page 267

Lawyers and their Influence on the Law

quantity of input into the case by one party but on that quality and quantity relative to that provided by the other party. Suppose that a given claimant calculates that investing a further £1000 on the case by means of an additional witness, or some additional arguments by his lawyer, will raise the probability of winning the case from 60 per cent to 70 per cent; a decision by the defendant to match the investment by an equivalent strategy and amount may lead to the probability reverting to 60 per cent. Both parties, perhaps under the influence of their lawyers, may incur greater costs, but without any benefits. It is clearly a classic instance of a prisoner’s dilemma, and one rendered worse by the incentive on lawyers to generate increased demand for their services.50

Legal Jargon In 1881 Parliament enacted a statute, the long title of which indicated that it was intended “for simplifying and improving the practice of conveyancing”.51 One of the schedules to the statute contains precedents which were to serve as models for certain legal documents. That intended for marriage settlements is as follows: This Indenture made the day of 1882 between John M. of [&c.] of the 1st part Jane S. of [&c] the 2nd part and X. of [&c] the 3rd part Witnesseth that in consideration of the intended marriage between John M. and Jane S. John M. as settlor hereby conveys to X and T. All that [&.] To hold to X. and Y. in fee simple to the use of John M. in fee simple until the marriage and after the marriage to the use of John M. during his life without impeachment of waste with 50 For further analysis and commentary on the problem, see: RA Posner, “An Economic Approach to Legal Procedure and Judicial Administration” (1973) 2 Journal of Legal Studies 429–31; G Tullock, Trials on Trial: the Pure Theory of Legal Procedure (New York, Columbia University Press, 1980), ch 7; BGM Main, “An Economic Perspective on the Cost of Justice” in The Reform of Civil Justice, Hume Papers on Public Policy, vol 5 (Edinburgh, Edinburgh University Press, 1997), 1–28. 51 Conveyancing Act 1881.

267

(J) Ogus Ch9

20/2/06

16:35

Page 268

Lawyers and their Influence on the Law remainder after his death to the use that Jane S. if she survives him may receive during the rest of her life a yearly jointure rentcharge of £ . . . to commence from his death and to be paid by equal halfyearly payments the first thereof to be made at the end of six calendar months from his death if she is then living or if not a proportional part to be paid at her death and subject to the before-mentioned rentcharge to the use of X. and Y. for a term of five hundred years without impeachment of waste on the trusts herein-after declared and subject thereto to the use of the first and other sons of John M. and Jane S. successively according to seniority in tail male with remainder to the use of all the daughters of John M. and Jane S. in equal shares as tenants in common in tail with cross remainders between them in tail with remainder to the use of John M. in fee simple.52

It is very striking that Parliament should have encouraged the use of a sentence of 14 lines and without any punctuation. It certainly does not facilitate understanding; nor does it render more precise the meaning of the legal formulation—rather the opposite. It does not reflect standards of written English at the time, as any reference to the masters of Victorian prose will reveal. In that respect it is not different from the use of Latin in legal documents in the early mediaeval period and the use of Law-French in courts’ pleadings until the early 18th century.53 Clearly use of language without punctuation, or in an antiquated tongue, distances the transaction or procedure from lay people and everyday forms of communication. So, also, the use in the marriage-settlement precedent of legal concepts such as “impeachment of waste” “fee simple” and “tail male” might be assumed to have been largely incomprehensible to most lay individuals involved in transactions of this kind. Nevertheless, and somewhat paradoxically, the concepts may have helped to reduce the legal costs of the transaction. They had, in law, very specific meanings and to lawyers would have signalled a set of characteristics with important consequences. The use of the 52

Conveyancing Act 1881, sch 4, para IV. A Harding, A Social History of English Law (Harmondsworth, Penguin, 1966), 205. 53

268

(J) Ogus Ch9

20/2/06

16:35

Page 269

Lawyers and their Influence on the Law

concepts in the document avoids the necessity of describing those characteristics and consequences at the much greater length which would have been required if ordinary language, with its inherent ambiguity, were to have been used instead. Of course, use of special language or “lawyer-speak” comes at a cost. The more specialist the language of the law, the greater the burden for lay people in being informed about it and understanding it; and, as with complexity, this will normally lead to an increase in the demand for legal professional services. In theory, then, we can envisage an optimal level of “lawyer-speak,” where the marginal benefits—principally the reduced costs of interprofessional communication—equal the marginal costs to lay people. It does not follow that all forms of legal discourse can be justified on this basis. It is unclear what benefits are to be derived from, for example, the absence of punctuation in the model marriage settlement, nor from the use of antiquated if also specific legal concepts, such as “plaintiff”, when a modern word, “claimant”, has exactly the same meaning and has much greater currency.54 To attempt to explain the use of excessive “lawyerspeak” by reference to tradition is inadequate: we need to explore why non-optimal practices were allowed to survive. One possibility emerges from the general theme of this chapter. Lawyers are motivated to engage excessively in specialist language and concepts because that will increase demand for their services. It is a form of artificial product-differentiation55: if individuals are induced to believe that transactions in which they are involved are more likely to reach a satisfactory outcome if supported by a document without punctuation, then they will consider that to be a product which is different from a normally-written document 54 This change of terminology was formally undertaken by the Civil Procedure Rules 1998, following the Woolf Report, Access to Justice, Final Report (London, Stationery Office, 1996). See, particularly in the latter, ch 20, para 13: “terminology should be changed where it is useful to do so. I have sought to remove expressions which are meaningless or confusing to non-lawyers.” 55 On which see, JS Bain, Barriers to New Competition (Cambridge, Mass, Harvard University Press, 1956).

269

(J) Ogus Ch9

20/2/06

16:35

Page 270

Lawyers and their Influence on the Law

and they will need to secure the services of suppliers of the special product. These insights are far from novel. About two centuries ago Jeremy Bentham wrote stringent criticisms of the then state of English law.56 In particular he condemned its obscurity and complexity. He found court procedures to be artificial and irrational. He made a detailed study of the formalities and technical language used by lawyers and observed how different the latter was from the language used in ordinary social and commercial intercourse. He saw all this as “mystification” by lawyers, designed to create for themselves an atmosphere of awe, to set themselves apart from other professionals and, most importantly, to enable them to engage in depredation, by the creation of business and the securing of substantial fees.

Remuneration and Competition Between Lawyers So far in this chapter we have been considering features of the legal system—formalities, complexity, language—which may facilitate the achievement of legal goals but which, if taken to excess, will be counter-productive and add significantly to legal costs. We have also seen why lawyers may be motivated to advocate, or engage in, such excess, because that leads to a greater demand for their services. Whether or not they will be able to succeed in turning these phenomena to their advantage depends to some extent on how lawyers are paid and the competitiveness of the market for legal services.57 Take the situation where lawyers are engaged by their clients to draft a legal document or to pursue a litigious claim. If they are paid by the hour, they will have the incentive to render the document or case more com56 See, especially, J Bowring (ed), The Works of Jeremy Bentham (London, Tait, 1843), vol III, 239–47. The reference and the following para is derived from HLA Hart, “Bentham and the Demystification of the Law” (1973) 36 Modern Law Review 2. 57 On which, see G Bevan, P Fenn and N Rickman, Contracting for Legal Services with Different Cost Rules, (London, Lord Chancellor’s Department, 1998); Hadfield, above n 44.

270

(J) Ogus Ch9

20/2/06

16:35

Page 271

Lawyers and their Influence on the Law

plex than is necessary and thus increase the fee payable; and it is difficult for the client to judge what input would be optimal.58 Paying a lump sum for the lawyer to complete the task will avoid this problem and some price competition is likely to emerge in the market, thus constraining costs. But lawyers may then be motivated to reduce their input to the minimum and that too will be difficult to monitor. Suggestions were made in a paper presented to the Woolf Inquiry on Access to Justice, that (in relation to litigation) costs might be controllable ex ante by some form of compulsory budget-setting.59 Unsurprisingly, these suggestions, in the words of Lord Woolf, “occasioned a general outcry from the legal profession. Prospective budget-setting was seen as unworkable, unfair and likely to be abused . . .”60 Admittedly, some lawyers and clients will be potentially “repeat players” and the lawyer’s need to maintain a reputation may constrain any tendency to exploit the situation. However, this is much more likely to apply to drafting-work than to litigation,61 and the most effective way of solving the principal-agent problem in relation to the latter might be to align the interests of the client and lawyer in some way, notably by the US-style contingency fee (winning client pays lawyer a percentage of compensation received) or the UK-style conditional fee (client pays fixed fee only if wins).62 58 AM Polinsky and D Rubinfeld, “Aligning the Interests of Lawyers and Clients” (2003) 5 American Law and Economics Review 165. 59 AAS Zuckerman, “Devices for Controlling the Cost of Litigation through Costs Taxation”, referred to in the Woolf Report, above n 54, 81. The paper is substantially reproduced in AAS Zuckerman, “Reform in the Shadow of Lawyers’ Interests” in AAS Zuckerman and R Cranston (eds), Reform of Civil Procedure: Essays on “Access to Justice” (Oxford, Oxford University Press, 1995), ch 3. 60 Above n 54, 81–2. 61 See JS Johnson and J Waldfogel, “Does Repeat Play Elicit Cooperation? Evidence from Federal Civil Litigation” (2002) 31 Journal of Legal Studies 39. 62 There is a considerable literature on these issues. For a valuable survey, see D Rubinfeld and S Scotchmer, “contingent fees” in Newman, above n 14, vol 1, 415–19. See also Polinsky and Rubinfeld, above n 58 and, for a recent comparison on conditional and contingent fees, W Emons and N Garoupa, “The Economics of US-Style Contingent Fees and UK-Style Conditional Fees”, Centre for Economic Policy Research Working Paper No 4473 (2004).

271

(J) Ogus Ch9

20/2/06

16:35

Page 272

Lawyers and their Influence on the Law

We should be aware, too, that lawyers may be concerned to further their interests in relation not only to clients but also to others providing equivalent services in the market. Professional lawyers will not want to lose profitable business to, for example, mediators, conciliators providing alternative dispute resolution (ADR) services; lay persons offering guidance on the drafting of legal documents; or lawyers from a foreign jurisdiction. To some extent, these aims may be furthered by legislation giving them exclusive rights to engage in activities, such as pleading before a court or executing a property conveyance. Historically, they have been very successful at securing such monopoly powers,63 but in recent years, in Britain at least, under pressure from governments, many of these powers have been lost64; and EU legislation has attempted to facilitate competition between lawyers from different Member States.65 One alternative strategy, as we have already seen, is to create barriers to competition by product differentiation. If purchasers are led to believe, through the use of jargon or otherwise, that only individuals with relevant technical expertise can supply what is needed, then demand for the services of others will be contained. This important point may help us not only to explain the excessive technicality and complexity of legal rules and transactions; it may also generate insights for our understanding of legal cultures and the relationship between legal principles in different jurisdictions.

63 A Ogus, “Regulation of the Legal Professions in England and Wales” in M Faure, J Finsinger, J Siegers, R Van den Bergh (eds), Regulation of the Professions: a Law and Economics Approach to the Regulation of Attorneys and Physicians in the US, Belgium, the Netherlands, Germany and the UK, (Antwerp, Maklu, 1993), 307–29. 64 See Director-General of Fair Trading, Report on Competition in Professions (London, Office of Fair Trading, 2001). 65 H Schneider, “The Free Movement of Lawyers in Europe and its Consequences for the Legal Profession and the Legal Education in the Member States” in M Faure, J Smits and H Schneider (eds), Towards a European Ius Commune in Legal Education and Research (Antwerp, Intersentia, 2002), 15–38.

272

(J) Ogus Ch9

20/2/06

16:35

Page 273

Lawyers and their Influence on the Law

Legal Culture and Competition Between Legal Systems The internationalisation of markets, most obviously within regions such as the European Union, has created pressure for there to be a harmonisation of, or at least convergence between, national legal principles, for the obvious reason that legal differences can inhibit transboundary trade.66 In the area of technical regulatory law, for example, that dealing with the safety of products, harmonisation has proved to be difficult and slow. One reason is that specific legal formulations in national legislation can generate competitive advantages for particular industrial interests and these will be lost if the formulation is overridden by more general principles.67 One might assume that this problem would not arise in relation to the harmonisation of general private law, such as the law of contract. But here too there have been difficulties68 which an influential branch of comparative law scholarship attributes to inherent differences of legal culture, especially between that of the common law and civil law jurisdictions.69 These scholars tend to under-estimate the importance of practising lawyers who may gain by resisting international harmonisation. For example, in 1981 the Law Society of England and Wales opposed the Vienna Convention on Contracts for the International Sale of Goods on the ground, inter alia, that it would result in a diminished role for English law within the international trade arena.70 The profit motivation for 66

Zweigert and Kötz, above n 30, 28–31. J Pelkmans, “The New Approach to Technical Harmonization and Standardization” (1987) 25 Journal of Common Market Studies 249. 68 J Smits, “The Future of European Contract Law; On Diversity and the Temptation of Elegance” in Faure et al, above n 65, 239–56. 69 P Legrand, “European Legal Systems Are Not Converging” (1996) 45 International and Comparative Law Quarterly 52; G Teubner, “Legal Irritants: Good Faith in British Law or How Unifying Law Ends Up in New Divergences” (1998) 61 Modern Law Review 11. 70 RG Lee, “UN Convention on Sale of Goods: OK for the UK?” [1993] Journal of Business Law, 131, 132. 67

273

(J) Ogus Ch9

20/2/06

16:35

Page 274

Lawyers and their Influence on the Law

such opposition to cost-reducing reform proposals is often disguised by atavistic or parochial references to local legal culture.71 What is “legal culture”? According to Merryman and Clark, it is “those historically conditioned, deeply rooted attitudes about the nature of law and about the proper structure and operation of a legal system that are at large in the society.”72 By relating it to the context of the present chapter, we can see it as a system which functions to facilitate communication between practitioners, but also to differentiate the product from other systems and thereby to generate or maintain demand for those practitioners’ services.73 Whether the latter negative effects may be constrained may again depend on the existence and degree of competition—here between different legal cultures. If the users of legal services can effectively choose between different systems to achieve their goals, then the competition between the suppliers of those systems should curb monopolistic exploitation. History provides some excellent examples of this phenomenon. In the medieval period, both canon law and the law merchant had their own legal culture different from that of the English legal system.74 The outreach of both systems had a marked impact on the evolution of English law, in particular by rendering contract law more flexible and responsive to individual needs.75 And the same conclusion can be drawn from the competition provided by the chancery courts, in competition with the excessive rigidity of the law expounded in the common law courts.76 71 U Mattei, “Efficiency in Legal Transplants: an Essay in Comparative Law and Economics” (1994) 14 International Review of Law and Economics 3, 16. 72 JH Merryman and DS Clark, Comparative Law: Western European and Latin American Legal Systems (Indianapolis, Bobbs & Merrill, 1978), 29. 73 In Ogus, above n 13, I characterise legal culture as an economic network which, like Miscrosoft, may become dominant and generate monopolistic profits but which, if there are appropriate forces of competition, may interact and adapt to, or converge with, other systems. 74 Plucknett, above n 19, 301–6, 657–64. 75 Simpson, above n 18, 279–80. 76 Plucknett, above n 19, 159–63, 595–5, 644–5.

274

(J) Ogus Ch9

20/2/06

16:35

Page 275

Lawyers and their Influence on the Law

Competition also exists between national legal systems.77 Take a contract for the international sale of goods. This will normally contain a choice-of-law clause in which the parties indicate the jurisdiction whose set of legal principles and procedures are to be applied for the interpretation and enforcement of the contract. Clearly in stipulating their choice, the parties will seek to adopt legal systems which reduce their ex post dispute costs. Lawyers in jurisdictions with a reputation for excessive formalities or excessive complexities will lose business in consequence. Indeed, under the pressure of competition, the principles of law may themselves evolve towards a better meeting of the parties’ needs. In the 1970s, English courts became aware that other jurisdictions had taken the lead in restricting the doctrine of state immunity, which prevented state organs from being sued even when acting in a commercial capacity. As a consequence of international competition, the judges felt compelled to adapt English law accordingly.78 The extent to which there is effective competition between national legal systems will differ according to the area of law and the impact of two variables: the proportion of transactions having a transboundary dimension and the degree of freedom of choice of law allowed to the parties. Both variables are positive in relation to contract law79 which may, therefore, be most responsive to the forces of competition and least vulnerable to “capture” by legal practitioners from within a particular culture. At the other extreme, almost all land transactions are connected with a single jurisdiction and there is no freedom of choice of law. Our analysis suggests that, in the absence of competition, land law will be strongly influenced by local legal culture and 77 A Ogus, “Competition between National Legal Systems: a Contribution of Economic Analysis to Comparative Law” (1999) 48 International and Comparative Law Quarterly 405. 78 Trendtex Trading Corporation v Central Bank of Nigeria [1977] 1 QB 529: See RM Goode, Commercial Law in the Next Millenium (London, Sweet & Maxwell, 1998), 92. 79 P Nygh, Autonomy in International Contracts (Oxford, Clarendon Press, 1999).

275

(J) Ogus Ch9

20/2/06

16:35

Page 276

Lawyers and their Influence on the Law

vulnerable to exploitation by legal practitioners. The history of English land law and conveyancing practice would seem to support the hypothesis.80 In between, we might take the example of company law in Europe. The predominant rule there is that the law governing a company’s existence and internal affairs should be that of its “real seat”, thus contrasting with the freedom of choice of legal regime offered to those creating corporations in the USA.81 On the other hand, there are large numbers of corporations with a transboundary dimension and the legal regime pertaining in a particular jurisdiction may influence to some extent where the “real seat” is established.82 Competition here may, therefore, have a mild impact on the effectiveness local legal culture to generate profits for legal practitioners.

Conclusions In much of this book I have been concerned to explore the capacity of law to advance economic welfare. But there are many legal principles which do not have this characteristic, notably where law-makers are pursuing other goals, such as distributional justice. Another possibility is that influences have been brought to bear on the law-making process, with the consequence that the law has served private, rather than public, interests. 80 Cf FW Maitland, “The Law of Real Property” in HAL Fisher (ed), The Collected Papers of Frederic William Maitland (Cambridge, Cambridge University Press, 1911), vol I, 162. 81 On the differences between Europe and USA, see W Carney, “The Political Economy of Competition for Corporate Charters” (1997) 26 Journal of Legal Studies 303. There is a considerable literature on competition between US jurisdictions for corporate charters (the so-called “Delaware-effect”). For a survey, see eg LA Bebchuk and A Hamdani, “Vigorous Race or Leisurely Walk? Reconsidering the Competition over Corporate Charters” (2002) 112 Yale Law Journal 553. 82 S Deakin, “Regulatory Competition versus Harmonization in European Company Law” in DC Esty and D Géradin (eds), Regulatory Competition and Economic Integration—Comparative Perspectives (Oxford, Oxford University Press, 2001), ch 9.

276

(J) Ogus Ch9

20/2/06

16:35

Page 277

Lawyers and their Influence on the Law

This is a familiar story in relation to the efforts of industry to derive benefits from regulation which has been ostensibly designed for more general welfare purposes.83 Its application to mainstream law, and the benefits which can be secured by the legal profession, has been less well noticed. The importance of the topic is, nevertheless, considerable given that it concerns significant features of the legal system and legal culture. In this chapter I examine legal complexity, and the use of legal formalities and legal jargon. Each of these phenomena can be rationalised in terms of the benefits they generate: they may provide better focused signals on the content of legal obligation and thus reduce errors; and they may serve to facilitate communication between-lawyers. But they also generate costs, in particular because they force lay people to rely more on the expertise of professional lawyers. Public interest analysis requires an exploration of the optimal level of formalities, complexity and jargon; but if, relative to that level, there is an excess of these phenomena, lawyers will profit from the increased demand for their services. There is then a reasonable hypothesis that lawyers will attempt to influence the content of the law towards that end. No less plausible is the possibility that the information asymmetry between practising lawyers and their clients can be exploited when they are engaged in drafting legal documents or conducting litigation. Depending on how they are paid for their services, here they may be able to profit by inducing clients to invest more resources into the transaction or process than is objectively justified. The profit-making endeavours of the kind described can be constrained by the forces of competition, a topic I discuss in the last section of the chapter. Most obviously, greater competition in the market for the supply of legal services, resulting perhaps from adjustments to, or greater transparency of, the method of calculating professional fees, can address the problem in relation 83 A Ogus, “W(h)ither the Economic Theory of Regulation? What Economic Theory of Regulation?” in J Jordana and D Levi-Faur (eds), The Politics of Regulation: Institutions and Regulatory Reforms for the Age of Governance (Cheltenham, Edward Elgar, 2004), 31–44.

277

(J) Ogus Ch9

20/2/06

16:35

Page 278

Lawyers and their Influence on the Law

to legal work. Less obviously, competition between legal systems and cultures, fostered by the growth in trans-jurisdictional trade and activities and the need to attract legal business from foreign sources, can render the law more responsive to the interests of those engaged in such trade and activities.

278

(K) Ogus Ch10

24/3/06

08:21

Page 279

10 Conclusions: Is There an Economist in the House?

Introduction In June 2004 a small group of economists working in the Department of Constitutional Affairs (DCA) convened in Whitehall a meeting of individuals, mainly economists and lawyer-economists, known to them to be interested in the economic analysis of law. The intention was to explore how that approach might enhance policy-making within the DCA. The conveners apparently considered this a novel idea and were taken aback when I referred to an evaluative survey of British work in law-and-economics which, some years previously, I and a colleague had been commissioned by the Lord Chancellor’s Department, the DCA’s predecessor, to undertake. This had been published,1 and was (and at the time of writing still is) obtainable by reference to the DCA’s website.2 The convenors were relatively new to the DCA; they had not known about the survey; and no one had referred them to it. This incident may tell us more about the workings of government, and the lack of continuity within it, than about the receptiveness of DCA and policy-makers more generally to the economic analysis of law. Indeed, elsewhere within the policymaking and law-reform process, such analysis is being increasingly used. Government departments making regulatory proposals have 1 A Ogus and R Amass, Research Review on Law-and-Economics: State of the Art and Questions for the Future (Lord Chancellor’s Department, Research Series No 4/97, 1997). 2 http://www.dca.gov.uk/research/1997/497esfr.htm.

279

(K) Ogus Ch10

24/3/06

08:21

Page 280

Conclusions: Is There an Economist in the House?

normally to prepare a regulatory impact assessment and this includes some form of cost-benefit appraisal.3 The Law Commission in its reports on company directors devoted a whole chapter to “economic considerations”4 and its proposals are now also subjected to impact assessment.5 The extent to which economic analysis does, and should, influence judicial decision-making adds a new dimension to the debate. Even the most ardent advocate of economic analysis in the context of government, and therefore legislative, policymaking, may hesitate before arguing that it should play an important role in the judicial process. The hesitation might, in part, reflect the fact that economists, qua economists, are not appointable to the judicial bench and economics is not (yet) a mandatory part of legal training. In part, it might also reflect jurisprudential arguments that judicial decisions should apply “principles” and not “policy”, and therefore that the recognition of rights should overreach the pursuit of economic efficiency.6 Nevertheless while, outside the areas of competition law and intellectual property, there are only a few signs of English judges being interested in economic analysis,7 things have been very different in the American courts. Writing in 1995, Judge Posner asserted that law-and-economics is a factor in the courts’ increasing hospitality to claims of constitutional protection for commercial speech . . . has influenced . . . the proof of commercial damages . . . has underwritten the movement towards awarding “hedonic” damages in personal injury cases . . . has armed divorcing women to argue that a husband’s professional 3

See http://www.cabinetoffice.gov.uk/regulation/ria-guidance/intro.asp. Company Directors: Regulating Conflicts of Interests and Formulating a Statement of Duties, Consultation Paper No 153 (1998), pt 3; Report No 261 (1999), pt 2; and see below, 296–8. 5 The Law Commission and Government (2004), 25–8, available at: http://www.lawcom.gov.uk/files/Report.pdf. 6 Eg R Dworkin, “Rights as Trumps” in J Waldron, Theories of Rights (Oxford, Oxford University Press, 1984), 153–67. 7 Notably Lord Hoffmann. See, particularly, Stovin v Wise [1996] AC 923, 944; Wildtree Hotels v Harrow London Borough Council [2001] 2 AC 1, 8; and below, 305–6. 4

280

(K) Ogus Ch10

24/3/06

08:21

Page 281

Conclusions: Is There an Economist in the House? degree is a (human) capital asset to which the wife contributed . . . has greatly influenced the proof of injury and damages in securities cases . . . has changed the way in which lost earnings are computed in tort cases . . .8

In the earlier chapters of this book, I have sought to show how economic analysis can generate important insights for lawyers and the law. In this final chapter, I wish to draw together some of the threads to reach some conclusions on what that analysis can contribute to law-making and legal decision-making in their different institutional settings. Potentially this covers a very broad area. Of course, economic analysis is widely used in a variety of public policy- and decision-making environments. To give this chapter a sharper focus, I shall concentrate on three particular areas: where the analysis is required as a formal input into the lawmaking, specifically regulatory process; where it contributes to policy-making in non-regulatory areas of law, what is sometimes (and misleadingly) referred to as “lawyers’ law”; and where it is submitted to, or adopted by, judges within the judicial process. I shall not be considering here the contributions of economists and economic analysis to special areas of law, notably competition law, public finance law and intellectual property, which are overtly, to some extent at least, “economic” in character. The principles of law, in these areas, explicity incorporate economic concepts, two examples being “abuse of dominant position”9 and “a market for the export of any patented product . . . is not being supplied”.10 Some involvement of economists in the explanation and interpretation of the concepts is inevitable, has therefore existed for some time11 and is uncontroversial. Indeed, 8 RA Posner, Overcoming Law (Cambridge, Mass, Harvard University Press, 1995), 96–7. See also WM Landes and RA Posner, “The Influence of Economics on Law: a Quantitative Study” (1993) 36 Journal of Law and Economics 385, 386–7. 9 Competition Act 1998, ch II. 10 Patents Act 1977, s 48(3)(d). 11 Hence their contributions in these areas have sometimes been referred to as “old law-and-economics”. See, eg: RA Posner, “The Economic Approach to Law” (1975) 53 Texas Law Review 757, 758.

281

(K) Ogus Ch10

24/3/06

08:21

Page 282

Conclusions: Is There an Economist in the House?

it is clear from scrutinising databases of judicial decisions that economists12 frequently appear as expert witnesses in cases in these areas, particularly in European and British courts hearing competition law cases.13

Formal Requirements of Economic Analysis: Regulatory Impact Assessment The idea of introducing economic analysis as a formal part of the law-making process is relatively new.14 Its main use has been as part of what has been variously known as “regulatory impact analysis,” “regulatory impact assessment” and “regulatory impact appraisal.” These systems developed15 as perceptions became widespread in the last decade of the 20th century that much regulation was disproportionate or ill-targeted; and even where the intervention was appropriate, the same outcome could be achieved by cheaper means. The developments were, in part, imspired by the American model which requires a fully-fledged cost-benefit analysis to be undertaken for major regulatory proposals.16 The current UK regime requires a “regulatory impact assessment” (RIA) to be undertaken by government departments making any proposal for regulation which has “an impact on business, charities or the voluntary sector”.17 The document 12 Two of the prominent earlier exponents of law-and-economics in Britain, Bill Bishop and Cento Veljanovski, abandoned academic careers to concentrate on this work. 13 A search in March 2005 of the Westlaw database on “economist” in UK court decisions reported since 1995 revealed 232 cases, the great majority of them involving competition law and/or European law. 14 J Froud, R Boden, A Ogus and P Stubbs, Controlling the Regulators (Basingstoke, Macmillan, 1998), 163–9. 15 For a recent survey, see C Radaelli, “The Diffusion of Regulatory Impact Analysis—Best Practice or Lesson-Drawing” (2004) 43 European Journal of Political Research 723. 16 Froud et al, above n 14, ch 11. 17 Cabinet Office, Better Policymaking: a Guide to Regulatory Impact Assessment (2003).

282

(K) Ogus Ch10

24/3/06

08:21

Page 283

Conclusions: Is There an Economist in the House?

must include an identification of, inter alia: the risks that the proposal is addressing and an attempt to quantify them; the different regulatory options for meeting them; the benefits and costs of these options and the sectors which will bear them; “equity and fairness issues”; and any distributional impacts of the proposals. It should conclude with a recommendation regarding the preferred option, giving reasons based on the elements of the assessment “in particular the analysis of the benefit and costs.”18 What are the problems in undertaking an exercise of this kind? With what degree of success can they be met? And, therefore, how important is this type of economic analysis of law to legal policy-making? Cost-benefit Analysis: Problems of Quantification Cost-benefit analysis was first used as an instrument of policymaking to evaluate the appropriateness of particular projects, such as the siting of the Third London Airport.19 Law-making is not a “project” in this sense since it does not necessarily lead to the desired outcome; rather it principally involves changing incentives of actors in the hope that they will induce the desired outcome. This difference forces the parameters of project analysis to be extended.20 First, some prediction must be made on the level of likely compliance with the new legal obligation, a function of, notably, the resources made available for enforcement. Secondly, there may be a need to explore the counterfactual, what will happen if the proposal is not implemented, in particular, to what extent the desired outcome might be reached by existing legal instruments or market behaviour. 18

Ibid, 35–6. ADJ Flowerdew, “Choosing a Site for the Third London Airport: the Roskill Commission’s Approach” in R Layard (ed), Cost-Benefit Analysis (Harmondsworth, Penguin, 1972), ch 17. 20 A Ogus, “Regulatory Appraisal: a Neglected Opportunity for Law and Economics” (1998) 6 European Journal of Law and Economics 53; S Deakin and A Hughes, “Economics and Company Law: a Fruitful Partnership” (1999) 20 Company Lawyer 212. 19

283

(K) Ogus Ch10

24/3/06

08:21

Page 284

Conclusions: Is There an Economist in the House?

Other limits arise from what is feasible in terms of data and the resources made available for the analysis. The RIA guidelines expect “unintended consequences and indirect costs” to be identified.21 This is clearly important. Take, for example, a proposal to raise regulatory safety standards for a particular product. Because of the higher price which is likely to result from the reform, some demand may shift to a near-equivalent, but less-regulated, product with perhaps no reduction in accidents and therefore damage costs. Alternatively, suppliers may seek to recoup compliance costs by reducing quality, in other, perhaps less observable, aspects of the production process. But even if some attention is given to these possibilities,22 quantifying the effects may be beyond the capacity of the assessment process. Another area of difficulty is that of quantifying nonmarketable assets. A recurrent theme of this book has been the ambiguous character of economic conceptions of “welfare.” If, in theory, the economic goal is to maximise aggregate social utility, in practice in many contexts, because of the impossibility of measuring utility, the goal becomes that of wealth maximisation. The extent to which this problem undermines the validity of the analysis depends on the context. Where the costs and benefits relate to resources which are regularly the subject of market transactions, then the market value will generally provide a reasonable proxy for the subjective utility to be attributed to the resource. But much depends on the character of the market in question and the degree of substitutability within it. The market value of a DVD player will provide a more reliable measure of the loss to a consumer when it is damaged, than the value which buyers are willing to pay for, say, a house or a picture where exact equivalents might not be available. The difficulties become more pronounced when the resources in question are not normally the subject of trade, such as life, 21

Above n 17, 35 and 56. An impressionistic scrutiny of RIAs published on the Cabinet Office’s website—http://www.cabinetoffice.gov.uk/regulation/docs/ria/ reveals that “unintended consequences” and “indirect costs” are rarely mentioned. 22

284

(K) Ogus Ch10

24/3/06

08:21

Page 285

Conclusions: Is There an Economist in the House?

health and the safety of human beings or the environment. Given that the goals of large areas of legal intervention are to protect against injuries, death and harm to the environment, the quantification of such benefits is of some significance for costbenefit analysis and economists have developed techniques for this task, based on estimates of individuals’ willingness to pay for them. Such techniques involve two different types of evidence.23 The first is based on hypothetical willingness-to-pay, in that, by questionnaire or survey, individuals are asked what they would be willing to pay to experience the benefits of greater safety, or a cleaner environment. The second is based on data of actual decisions, statistical analysis being undertaken of, for example, differentials in earnings between riskier and safer jobs and differentials in property prices between environmentally more and less attractive areas, trying to control for all other variables which might explain the differences. It is relatively easy to criticise these methods of quantification.24 A hypothetical question such as “what additional price would you would be prepared to pay for your air tickets to reduce the risk of a fatal accident from one in one hundred thousand to one in a million?” may not be very meaningful to many to whom it is addressed and answers may not, in any event, be reliable because respondents are not actually having to pay anything. Then, as regards statistical analysis of actual decisions, adequate data for all relevant variables are difficult to obtain. These criticisms are important because they constitute a challenge not only to the use of cost-benefit analysis in relation to legislative proposals, but also to the economic analysis of law generally. As we have seen throughout this book, economic reasoning frequently employs variables relating to costs and benefits, the quantification of which is very difficult. Even where 23 WK Viscusi, “The Value of Risks to Life and Health” (1993) 31 Journal of Economic Literature 1912; WM Hanemann, “Valuing the Environment Through Contingent Valuation” (1994) 8 Journal of Economic Perspectives 19. 24 See, eg: T McGarity, Reinventing Rationality: the Role of Regulatory Analysis in the Federal Bureaucracy (Cambridge, Cambridge University Press, 1991).

285

(K) Ogus Ch10

24/3/06

08:21

Page 286

Conclusions: Is There an Economist in the House?

it is less difficult, in practice it may not be undertaken, the comparison between the costs and benefits being made only intuitively. However, that does not undermine the validity of the exercise. In adopting an economic framework for reasoning, if only implicitly, the decision-maker is required to identify and address the key issues in a systematic way. Taking an example used in chapter five,25 suppose that the judges in Bolton v Stone 26 wished to know what standard of care required of the defendant cricket club would presumptively maximise wealth. Getting them to identify the cheapest way of preventing a ball being hit out of the ground and then comparing the cost of that measure with the benefit to the claimant of not being subjected to the risk of being struck by the ball (involving an estimate of the risk of being hit and the costs of her injury), can provide meaningful information for that purpose, even if the appraisal is intuitive, and not quantified. The same applies to regulatory impact analysis. In 2003, regulations were introduced limiting the use of mobile telephones in road vehicles.27 For the purposes of the RIA which preceded this measure,28 it proved impossible to obtain most of the data which a sound cost-benefit analysis would require. So, as regards costs, it could not be predicted how many would purchase hands-free equipment which could be lawfully used in vehicles, nor the “loss of efficiency if hand-held phones cannot be used while driving.” On the benefits side, the likely reduction in damage costs could not be estimated, because data were not available on the number of accidents involving the use of mobile phones. However, applying the values attributed by the Department for Transport in 200129 for preventing one fatality 25

Above, 144–5. [1951] AC 850. 27 The Road Vehicles (Construction and Use) (Amendment) (No 4) Regulations, SI 2003/2695. 28 Available at: http://www.dft.gov.uk/stellent/groups/dft_rdsafety/documents/ pdf/dft_rdsafety_pdf_025495.pdf. 29 See: http://www.dft.gov.uk/stellent/groups/dft_rdsafety/documents/pdf/dft_ rdsafety_pdf_507642.pdf. 26

286

(K) Ogus Ch10

24/3/06

08:21

Page 287

Conclusions: Is There an Economist in the House?

(£1.19 million), one serious injury (£134,000) and one slight injury (£10,000), the conclusion was reached that if there was a reduction of 1 per cent in the number of accidents, the benefit would be about £118 million. At the foot of the document the relevant Minister felt able to declare that he was “satisfied that the benefits justify the costs.” Given the absence of data, that was an intuitive response but the fact that the process had forced officials to identify and categorise the costs and benefits (I have not mentioned all identified categories here) and to provide some estimates should have made the eventual judgment more reliable than if no such process had taken place. Cost-benefit Analysis: the Normative Dimension Cost-benefit analysis, as typically used, simply compares the aggregate gains to be secured by the legal intervention against aggregate losses. As such, it reflects the Kaldor-Hicks criterion of efficient improvements (aggregate gains exceeding aggregate losses). In chapters one and seven, I explored some of the problems that arise when this criterion is used to guide legal policy-making, most importantly, that the approach allows losses to be imposed on some individuals or groups, for the purpose of generating benefits for the community as a whole.30 Outcomes justified by the criterion might also offend commonly-held notions of distributional justice, for example, if the benefits from a particular law accrue particularly to richer people at the expense of poorer people. Cost-benefit analysis can throw up several other delicate normative issues, the evaluation of human lives saved by regulatory programmes providing some good examples. If, as has been suggested, willingness-to-pay is the basis of the evaluation, then the value of a life will reflect the wealth of the relevant individual, since richer people will be prepared to pay more than poorer people for their own health and safety. This has the apparently awkward implication that larger resources ought to be deployed to save the life of a rich man compared with that of a poor man 30

28–9 and 193–7, respectively.

287

(K) Ogus Ch10

24/3/06

08:21

Page 288

Conclusions: Is There an Economist in the House?

and therefore justifying, for example, legislative standards of safety that are higher for taxis than for buses.31 It follows, too, from this approach that the value to be attributed to the life of an elderly person will generally be higher than that for a child, because the elderly person will typically have more resources available to pay for higher levels of safety. Such a policy conflicts with an ethical stance according to which account should be taken of the duration of the life saved32 as well as basic ideas of distributional justice: “every old person was once young, and (with a little luck) young people will eventually become old.”33 These dilemmas are not, of course, peculiar to regulatory intervention. They potentially arise wherever the law is used to uphold the market as a system for allocating resources. That includes not only contract law but also tort and other areas of private law, where the aim is to meet the preferences which it is assumed the relevant parties would have had if transactions costs had not inhibited them making agreements.34 Now the importance of taking account of non-economic values, such as distributional justice, is not to be denied. Normatively, economic analysis cannot be determinative of legal policy-making. It is, in any event, inevitable that the law, particularly legislation, will reflect distributional and other goals because of the political dimension to law-making and the way in which interest groups influence policy-making.35 The concession that the law often involves a trade-off between efficiency and non-economic values has prompted some critics of the economic analysis of law to repudiate the validity, or use-

31 CR Sunstein, “Lives, Life-Years and Willingness to Pay” (2004) 104 Columbia Law Review 205, 229. 32 J Harris, “QALYfying The Value of Life” (1987) 13 Journal of Medical Ethics 117. 33 Sunstein, above n 31, 217. 34 Ch 3, above. 35 A Ogus, “Legislation, the Courts and the Demand for Compensation” in RCO Matthews (ed), Economy and Democracy (London, Macmillan, 1985), 151–67.

288

(K) Ogus Ch10

24/3/06

08:21

Page 289

Conclusions: Is There an Economist in the House?

fulness, of the approach.36 They are wrong. In the first place, the question of what legal principles and institutions can best increase society’s wealth must be important information for policy-makers even though the selection of the principles and institutions must often accommodate other aims.37 Secondly, economic analysis can provide some indication of what it might cost, in terms of reduced social wealth, to pursue specific noneconomic goals. More than this, as I sought to demonstrate in chapter eight, because of its ability to predict behavioural responses to legal norms, such analysis can also furnish guidance on whether a given set of arrangements will, or will not, generate the desired outcome. If it be acknowledged that, in most cases, consideration should be given within the policy-making process to both economic and non-economic goals, how should this affect the institutional arrangements? The question is not easy to answer. Take regulatory proposals which might lead to outcomes which are likely to generate problems of distributional justice. Those undertaking the cost-benefit analysis are best placed to identify how the proposals might have a differential impact on certain groups within society. For the purposes of the concluding comparison of costs and benefits, the analysts can introduce into the estimates weightings to reflect distributional concerns, for example, to increase the perceived benefit of saving the life of a poorer person relative to a richer person,38 or that of a child, relative to an elderly person.39 Both the American40 and British41 systems of RIA are supposed to provide some information on the “equity” or “distributive outcomes” of the proposals. 36 Eg JM Steiner, “Economics, Morality and the Law of Tort” (1976) 26 University of Toronto Law Journal 227. 37 MD Adler and EA Posner, “Rethinking Cost-Benefit Analysis” (1999) 109 Yale Law Journal 165. 38 RH Frank and CR Sunstein, “Cost-Benefit Analysis and Relative Position” (2001) 68 University of Chicago Law Review 323, 374. 39 Sunstein, above n 31, 240–1. 40 Executive Order 12,866 (1993) para (1)(b)(5). 41 See text accompanying n 18 above.

289

(K) Ogus Ch10

24/3/06

08:21

Page 290

Conclusions: Is There an Economist in the House?

Nevertheless, there is not much evidence of detailed responses on distributional aspects in assessments made publicly available42; perhaps differential impacts are identified only where these are considered to be particularly problematic.43 Whatever occurs in practice, it may be doubted whether it is appropriate to mix economic and non-economic analysis in this way.44 There can be no consensus on what is, and what is not, “equitable” in this context, and analysts can only take a lead from, or attempt to second-guess, the opinion of their political masters. In either case, allowing political considerations to infiltrate the process undermines its objectivity and thus diminishes its status. It seems preferable to separate the economic from the noneconomic inputs and deal with the latter as part of the political decision-making which must follow the cost-benefit analysis. Cost-effectiveness Analysis Formal systems of impact assessment sometimes suggest or require cost-effectiveness analysis rather than cost-benefit analysis. Compared to the latter, cost-effectiveness analysis is a less ambitious mode of economic appraisal.45 It has two principal functions: to determine the type of intervention which will maximise benefits for a given level of costs, specified by policymakers; and to determine what intervention will generate specified benefits at lowest cost. The fact that benefits are, generally, more difficult to quantify than costs means that the second function is more frequently encountered. 42 In the USA, identification of such issues tends to be masked under the oft reiterated finding that the proposals were “consistent with the regulatory philosophy and principles identified in the Executive Order”: see, eg: the RIA on Antiperspirant Drug Products, (2004) 69 Federal Register 61148. In the UK, there is typically a paragraph in RIAs headed “issues of equity and fairness,” but casual sampling of RIAs suggests that it only rarely raises matters of substance. 43 See, eg: the UK RIA on The Prohibition of Fishing with Multiple Trawls Amendment Order 2003 where the regulation had a differential impact geographically: http://www.defra.gov.uk/corporate/regulat/ria/2003/nephrops-fishing.pdf. 44 Adler and Posner, above n 37, 241. 45 See, generally, HM Levin, Cost-Effectiveness: a Primer (London, Sage, 1983).

290

(K) Ogus Ch10

24/3/06

08:21

Page 291

Conclusions: Is There an Economist in the House?

The American requirements for RIA show how costeffectiveness analysis can complement cost-benefit analysis: [W]hen an agency determines that a regulation is the best available method of achieving the regulatory objective, it shall design its regulations in the most cost-effective manner to achieve the regulatory objective.46

If, on scrutinising the proposal, it is concluded that the benefits of a regulatory intervention will exceed its costs, or—as we shall see—if it is assumed that benefits, which include some unquantifiables, are likely to exceed the costs, then the specific regulatory option to be adopted is that which can achieve the regulatory objective at least cost. We should note, in passing, that this form of inquiry has been a major feature in the economic analysis of law literature. And this is true not only of regulation where much attention has been given to the “choice of instrument” question47 but also of other types of law. In Chapter Four, for example, I explored a variety of different legal instruments (private and public) which could be used to achieve a desired behavioural outcome, and examined the cost implications of each, focusing on such variables as enforcement and information costs. In New South Wales, the governmental guidelines for economic appraisal recommend that cost-effectiveness analysis be available for decisions where most of the benefits . . . are not readily measurable in (actual or proxy) dollar terms. This may occur in areas such as health, education, law and order, and social welfare.48

46

Executive Order 12,866 (1993), para (1)(b)(5). My own book, Regulation: Legal Form and Economic Theory (Oxford, Hart Publishing, 2004) is largely devoted to this question. See also S Rose-Ackerman, “Progressive Law and Economics—and the New Administrative Law” (1988) 98 Yale Law Journal 341. 48 NSW Treasury Office of Financial Management, Guidelines for Economic Appraisal (1997) annex 5, available at: http://www.treasury.nsw.gov.au/pubs/ tpp97_2/annex5.htm. 47

291

(K) Ogus Ch10

24/3/06

08:21

Page 292

Conclusions: Is There an Economist in the House?

This guidance contains, in fact, two ideas which are different, though related. On the one hand, there are cases where the benefits of the intervention are difficult or impossible to quantify but by guesswork, intuition or otherwise, the proposal is treated as satisfying the cost-benefit test, and thus, in normative economic terms, is Kaldor-Hicks efficient. On the other hand, there are interventionist measures which do not, or cannot, pass the cost-benefit test but which nevertheless governments are determined to introduce for other reasons, perhaps on grounds of distributional justice. Some transfer payments, such as grants or allowances, come into this category since what is transferred might have the same value to the recipient as to the transferor, and thus generate no benefits, while the transfer itself is costly.49 More generally, cost-effectiveness analysis has an important role to play in relation to legal interventions which are regarded as desirable politically and which do not aim at allocative efficiency. Too often, those engaging in economic analysis of law have regarded the scrutiny of such measures as outside their ambit, because they have been too obsessed with advocating efficient outcomes.50 As such, they have missed a major opportunity for exploiting their talents. Eric Posner puts the matter succinctly: [E]ven if politically motivated transfers are regrettable, they are a fact of life, and it is an important task to analyze how to implement them in a way that minimizes their disruptive impact on the economy.51 49 EA Posner, “Transfer Regulations and Cost-Effectiveness Analysis” (2004) 53 Duke Law Journal 1067. Note that it may be mistaken to place social security benefits in this category because, given the diminishing utility of wealth, they will generally have a greater value for the poorer people who receive them than the richer people who pay taxes to fund them: A Culyer, The Political Economy of Social Policy (New York, St. Martins Press, 1980), ch 4. 50 There is, nevertheless, a small but important literature on the relative merits of redistributing resources either by taxation and payments systems or through the operation of legal rules, for example tort law. It is summarised in C Curran, “Optimal Techniques of Redistribution” in B Bouckaert and G de Geest (eds), Encyclopedia of Law and Economics (Cheltenham, Edward Elgar, 2000), vol IV, 301–10. 51 Above, n 49, 1076.

292

(K) Ogus Ch10

24/3/06

08:21

Page 293

Conclusions: Is There an Economist in the House?

“Lawyers’ Law” and Law Reform52 More frequently in the past than today, one came across references to “lawyers’ law.”53 The meaning of this expression was never quite clear but it was generally used in relation to areas of law which historically tended to be developed by judges rather than the legislature, as well as to rules and procedures which, because of their technicality, required a significant degree of legal expertise. There was an unspoken assumption that, given the technical content, lawyers alone were competent to evaluate it critically and to formulate proposals for its reform. In chapter nine, I attempted to show how the monopoly power of legal practitioners in this respect can be exploited by them to generate excessive profits.54 The focus of the discussion here is different. An important conclusion to which I have been leading in this book is that economic analysis is as relevant to the evaluation of “lawyers’ law” as it is to regulation and other areas of law associated with individual government departments. We need to see how economics has influenced, and might influence, the processes of law reform undertaken by the Law Commission and similar agencies. The story is one of development from (largely) indifference and misunderstanding to (partial) acceptance, with the joining-up of law reform to regulatory impact assessment. Before 1965,55 review and reform of “lawyers’ law” in Britain were capricious, much depending on the initiative of legal practitioners, especially judges.56 The creation of the Law 52 This section draws on, but departs significantly from, A Ogus, “Economics of Law Reform: Thirty Years of Law Commission Endeavour” (1995) 111 Law Quarterly Review 117. 53 Cf A Ogus, “Economics, Liberty and the Common Law” (1980) 15 Journal of Society of Public Teachers of Law 42, 46; and, on the concept, see G Sawer, Law in Society (Oxford, Clarendon Press, 1965), ch 8. 54 Above, 254–6. 55 Law Commissions Act 1965. 56 J Farrar, Law Reform and the Law Commission (London, Sweet & Maxwell, 1974), 13.

293

(K) Ogus Ch10

24/3/06

08:21

Page 294

Conclusions: Is There an Economist in the House?

Commission in that year was intended to render the processes of reform coherent and systematic,57 but little guidance was given to the new institution on the objectives of, and the values implicit, in “good” law reform. Intuitive concepts of corrective justice and fairness58 undoubtedly played a major role, although the content of these sets of values was rarely rendered explicit. The Commission, like most law reform agencies in other jurisdictions,59 is independent of government. That very distance from politics, and its concomitant accountability, suggests that distributional justice and other political or ideological goals should not be adopted by such agencies. There is some evidence that the Law Commission in its early years perceived that one of its missions was to strengthen the position of poorer people in relation to the law,60 but political and distributional neutrality clearly soon became the orthodoxy.61 What then of economics? We can envisage how a law reform agency, without in-house economists and without the resources to engage in data collection or analysis, might use economics to contribute to the exposition of the relevant issues and the formulation of the reform proposals in ways which would enhance the policy-making process. It is possible to hypothesise on what might be the efficiency implications of any given set of proposals. With or without reference to the academic literature, the analysis could identify the principal types of cost to which implementation of the proposals would give rise, with an indi57 Lord Gardiner, the Lord Chancellor responsiible for the development, had adumbrated his ideas earlier in G Gardiner and A Martin, Law Reform NOW (London, Gollancz, 1963). 58 Cf above, 164–5. 59 G Murphy, “Law Reform Agencies” (2005) available at: http://canada. justice.gc.ca/en/ps/inter/law_reform/. 60 A lawyer working for the Commission during this period has suggested that there was then “a tendency to see law as a set of rules whose main purpose was to give protection to the weak from the strong and a wish to make the rules more apt to serve that purpose”: RT Oerton, A Lament for the Law Commission (Chichester, Countrywise, 1987), 5. 61 See, eg: Report No 208, Landlord and Tenant Business Tenancies (1992), para 1.9.

294

(K) Ogus Ch10

24/3/06

08:21

Page 295

Conclusions: Is There an Economist in the House?

cation of the likely benefits which might justify those costs. It would not be necessary, or perhaps even advisable, to reach a tentative conclusion on the cost-benefit trade-off, since the proposal has, in any event, to enter the political domain. There have been examples of the Law Commission engaging in this kind of exercise. Its report recommending that the courts should have the power to grant a landowner access to neighbouring land for the purpose of carrying out work there, contains a passage which is striking, not the least because it addresses the counterfactual issue which is sometimes neglected in cost-benefit analysis.62 The public interest would be served by enabling necessary repairs to be done. . . . If the introduction of the scheme would cause private and public costs to be incurred only in those cases in which, without the scheme, refusal of access would be maintained, then, in our view, the balance of social gain would be clearly in favour of implementing the scheme. If, however, introduction of the discretionary scheme would cause costs to be incurred, including the costs of disputed applications to courts, in a significant number of cases in which, as things now are without any right to ask for a court order, consent would be given, then the balance of social gain would be doubtful, if not adverse.63

But there have also been occasions when economic objectives and distributional justice objectives have been confused.64 In its report on liability for defective products, the Commission argued that the risk of losses from such products should lie principally with the risk creator particularly when a product is mass produced, this solution makes sense as a matter of economics. If 10,000 products are manufactured in the same run and one of them, being defective, causes an accident, 62

Above, 283. Report No 151, Rights of Access to Neighbouring Land (1985), para 3.46. The recommendations were eventually implemented as the Access to Neighbouring Land Act 1992. 64 For a similar example drawn from the experience of the Australian Law Reform Commission, see C Veljanovski, “Cost Benefit and Analysis and Law Reform in Australia” (1982) 132 New Law Journal 893, 894. 63

295

(K) Ogus Ch10

24/3/06

08:21

Page 296

Conclusions: Is There an Economist in the House? the easiest way of spreading the loss fairly is to place it on the manufacturer, who can recover the cost of insuring against the risk in the price he charges for his product.65

Most people would agree that, as a matter of distributional justice, loss-spreading in this way is a fair solution, but that should be distinguished from the economic question of how to allocate the risk in a way which will maximise welfare (or wealth). For the latter purpose, loss-spreading might not be the appropriate solution in situations where consumers would prefer to take the risk in return for paying less for the product, or where consumers could avoid the risk at lower cost but their incentive to do so would be dulled by manufacturer liability.66 The most ambitious, and perhaps also the most significant, attempt to use economic analysis in relation to the Commission’s work was undertaken in relation to projects on company law, more specifically on the duties of company directors. It was contributed by the ESRC Centre for Business Research, where an empirical study was also undertaken for the project.67 As the two principal authors of this study observed in another publication, although other jurisdictions have recently engaged on highly ambitious programmes of company law reform, none has given the economic analysis of law such a central place.68

In the chapter, both of the Consultation Paper and the Report,69 devoted to “Economic Considerations,” an overview was given of the “contractarian” perspective on company law, familiar from the law-and-economics literature,70 and how that approach could facilitate identification of efficient rules relating to, for 65

Report No 82, Liability for Defective Products (1977), para 38(a), my italics. S Shavell, Economics of Accident Law (Cambridge, Mass, Harvard University Press, 1987), 60–2. 67 “Directors’ Duties: Empirical Findings”, app B to Report No 261, above n 4. 68 Deakin and Hughes, above n 20, 212. 69 Above n 4. 70 See B Cheffins, Company Law: Theory, Structure and Operation (Oxford, Clarendon Press, 1997) and ch 1, above, 4–6. 66

296

(K) Ogus Ch10

24/3/06

08:21

Page 297

Conclusions: Is There an Economist in the House?

example, the duties of company directors. The approach taken was, nevertheless, cautious, the authors stressing that the reasoning gave rise to hypotheses which, ideally, should be the subject of empirical verification; and that efficiency was not the only goal of law reform.71 Perhaps that caution was advisable because when one examines the extent to which the “economic considerations” actually influenced the reasoning and recommendations in the report, the results appear to be rather disappointing.72 Certainly the contractarian approach was seen to clarify the relationship between default rules and mandatory regulation within company law generally,73 but in terms of guidance for the identification of appropriate rules, economic analysis seems to have been taken into account only in relation to rules of disclosure74 and the period of service of directors.75 One has the impression that the Commissioners were somewhat unsure as to what could and should be drawn from efficiency analysis for policy-making purposes. In their summary of the “guiding principles” for the report, they list “the principle of efficiency and cost-effectiveness” which is declared to be that “the law must achieve its purpose without unnecessary waste of costs and management resources.”76 A footnote to this acknowledges that [t]here is some overlap here with the economic considerations, but efficiency in this context is primarily directed to the working of the legal rule rather than the wider meaning of efficiency

provided in the economic chapter. “Efficiency” as used in this guiding principle can be identified with “productive efficiency,” 71

Report No 261, above n 4, para 2.9. See also S Worthington, “Reforming Directors’ Duties” (2001) 64 Modern Law Review 439, 443–5. 73 Report No 261, above n 4, para 8.2. 74 Ibid, paras. 7.3, 9.3, 13.1. 75 Ibid, para. 9.29. 76 See the guarded language used in the section “the different functions of the guiding principles and the economic considerations”: ibid, paras 3.10–3.13. 72

297

(K) Ogus Ch10

24/3/06

08:21

Page 298

Conclusions: Is There an Economist in the House?

the concept applied in chapter two of this book77 and, of course, cost-effectiveness corresponds to the approach described earlier in this chapter. Indeed, cost-effectiveness analysis lies more comfortably within the capacities of law reform agencies, such as the Law Commission. So, although a recent consultation paper included a chapter entitled “The Economic Implications of Regulating Trustee Exemption Clauses”, this was limited to a survey of the costs which questionnaire respondents perceived to be likely to flow if the proposals for regulation were implemented; potential benefits were not even described.78 The approach mirrors earlier investigations which, though they may not have been identified as “economic,”79 nevertheless involved costeffectiveness appraisals. Most obviously, this occurred in relation to proposals for reducing the transactions or administrative costs associated with particular legal rules or institutions. Thus, for example, measures taken to render the title to land more certain reduce the costs of conveyancing.80 Then there are instances where there is an intuitive perception that the benefits of a major reform, such as the introduction of a general rights in third parties to enforce contractual obligations, will exceed its costs, and the task is to identify and select the specific rules which will implement this idea at lowest cost.81 In this connection, we should remember the importance of the distinction between mandatory and default rules, the subject of discussion in chapter three.82 Investigation may suggest that the preferences of the majority of those likely to engage in a contractual or property transaction would be met by an obligation 77

Above, 35–64. Consultation Paper No 171, Trustee Exemption Clauses (2002), 29–46. 79 After reading my published paper on economic analysis and the Law Commission, above n 52, a former Commissioner, Stephen Cretney, sent me a note saying that it made him feel like Monsieur Jourdain who had not realised that, for 40 years, he had been speaking prose. 80 Eg Report No 62, Transfer of Land: Report on Local Land Charges (1972). 81 Report No 242, Privity of Contract: Contracts for the Benefit of Third Parties (1996). 82 Above, 77, 85. 78

298

(K) Ogus Ch10

24/3/06

08:21

Page 299

Conclusions: Is There an Economist in the House?

which, if it were to be incorporated as a standard term in that transaction, would obviate the need for the parties to make explicit provision for it. However, casting the obligation in the form of a default rule would enable those whose preferences were not met in this way to substitute their own choice, thus increasing potential welfare gains.83 Whatever has been the frequency of cost-effectiveness exercises of this nature, the UK government has in recent years come to see as artificial the distinction between the Law Commission’s law reform proposals and those emanating from its own departments, which have been the subject of RIAs. Impact assessments must now be undertaken for Law Commission projects: consultation papers must include a short description of identified costs and benefits, although a full impact assessment is only prepared when the government department responsible for implementing any proposals prepares them for a policy decision by the relevant minister.84

Judicial Reasoning and Decision-making The last two sections of this chapter have shown that, while there may be some debate about the type of economic analysis appropriate for legal policy-making, and the institutional arrangements for its input, the relevance and importance of the economic contribution have now been widely accepted. What then of judges? In the USA, for over 20 years, there has been a serious debate as to the role of economic analysis in the courts.85 83 Examples of this approach being taken by the Law Commission include: Report No 191, Transfer of Land: Risk of Damage After Contract (1990) and Report No 219, Contributory Negligence as a Defence in Contract (1993). 84 The Law Commission and Government (2004), paras 2.6.1–2.6.10, available at: http://www.lawcom.gov.uk/files/Report.pdf. See also J Halliday, Quinquennial Review of the Law Commission (London, DCA, 2003), paras 5.6–5.9. For a good example of a departmental RIA of Law Commission proposals, see DTI, Reform of Partnership Law: the Economic Impact (2004), available at: http://www.dti.gov.uk/ access/ria/pdf/ria-partnershiplaw.pdf. 85 S Breyer, “Economics for Lawyers and Judges” (1983) 33 Journal of Legal Education 294; and see, esp, the Symposium, “Economists on the Bench” (1987) 50(4) Law and Contemporary Problems.

299

(K) Ogus Ch10

24/3/06

08:21

Page 300

Conclusions: Is There an Economist in the House?

That is not surprising, given the strength of the American lawand-economics movement, the fact that some major figures from that movement, for example, Richard Posner and Frank Easterbrook, have been appointed to the bench, as well the large numbers of judges who attended programmes in economic analysis of law, organised by Henry Manne.86 Although a handful of judges from other common law jurisdictions have expressed an interest, and some enthusiasm, for economics as an input to the judicial process,87 the topic has largely been ignored by the legal establishment. Interestingly, and somewhat ironically, lawyers in civil law jurisdictions attribute the greater success of law-and-economics in the common law world to the fact that judges there have, because of the strength of precedent in case law, a more active role in law-making.88 An important part of the earlier law-and-economics literature was addressed to the so-called “efficiency of common law” thesis which argued that that the principles of the common law, derived from judicial decisions, tended to lead to allocatively efficient outcomes. One branch of that literature, associated particularly with Judge Posner, was concerned mainly to test the hypothesis by reference to large and diverse areas of law, purporting to identify what were efficient solutions to the relevant problems and then correlating those solutions against the 86 By 1983, over one-third of federal judges had attended the programme: N Duxbury, Patterns of American Jurisprudence (Oxford, Oxford University Press, 1995), 360. 87 Notably, Michael Kirby, Justice of the High Court of Australia, “Law and Economics—Is There Hope?” and Sir Ivor Richardson, President of the New Zealand Court of Appeal, “Law, Economics and Judicial Decision-Making”, both in M Richardson and G Hadfield (eds), The Second Wave of Law and Economics (Sydney, Federation Press, 1999), 114–28 and 129–41 respectively. 88 T Kirat, “Legal Systems and Economic Analysis: How Relevant Is American Law and Economics for the Understanding of French Jurisprudence?” in B Deffains and T Kirat (eds), Law and Economics in Civil Law Countries (Amsterdam, Elsevier, 2001), 61–78. Interestingly, a programme of lectures on the economic analysis of law has, in 2004 and 2005, been given to judges of the French Cour de Cassation. See: http://www.courdecassation.fr/manifestations/ Cycles-seminaires/2005/programme(3).htm.

300

(K) Ogus Ch10

24/3/06

08:21

Page 301

Conclusions: Is There an Economist in the House?

leading principles which emerge from judicial decisions.89 The process by which judges arrive at efficient outcomes was not fully explored, although it was sometimes attributed to the innate utilitarian sense with which most judges are assumed to be endowed.90 According to another branch of the literature, efficient outcomes were achieved not so much through the conscious choices of judges, but rather through the evolutionary features of litigation.91 The basic idea was that inefficient rules were more likely to be litigated than efficient rules and therefore, over time, the process of appealing against decisions would mean that inefficient rules would gradually be superseded.92 Both versions of the thesis, while not unimportant, are peripheral to my concerns in this section which are to explore the extent to which economic analysis can, and should, be incorporated explicitly into judicial reasoning and decision-making. I begin with a discussion of efficiency as a judicial goal. Efficiency as a Goal of Judicial Decisions There is a wide spectrum of views on the extent to which judicial reasoning and decision-making should encompass economic analysis.93 Few now claim that judges should invariably, and in relation to all types of claims, attempt to pursue economic goals of allocative efficiency. Most obviously it would be inappropriate to do so where legislation prescribes an outcome which is inconsistent with efficiency. 89 Judge Posner’s monograph, Economic Analysis of Law, 1st edn (Boston, Little Brown, 1973; 6th edn, 2003) predominantly takes the approach. For a more explicit statement, see especially, WM Landes and RA Posner, “The Positive Economic Theory of Tort Law” (1981) 15 Georgia Law Review 851. 90 Economic Analysis of Law (6th edn), above n 89, 252. For elaboration, see RA Posner, “What do Judges Maximize? (The Same Thing Everybody Else Does)” (1993) 3 Supreme Court Economic Review 1. 91 The literature is summarised in P Rubin, “Judge-Made Law” in Bouckaert and de Geest, above n 50, vol V, 543–58. 92 G Priest, “The Common Law Process and the Selection of Efficient Rules” (1977) 6 Journal of Legal Studies 65. 93 “Foreword: Economists on the Bench” (1987) 50(4) Law and Contemporary Problems 1.

301

(K) Ogus Ch10

24/3/06

08:21

Page 302

Conclusions: Is There an Economist in the House?

The debate intensifies when one is considering principles of common law in relation to which legislation has had little or no impact, as well as legislative rules the goals of which are uncertain or ambiguous. But even here the extreme view of universal adherence to efficiency goals seems to be untenable. Some common law doctrines, for example, those which refuse to allow the marketability of certain interests such as those associated with liberty and bodily integrity,94 clearly adopt non-economic values. Once this is recognised, it would seem that we ought to attempt to classify common law principles into those which are, and are not, efficiency-orientated. But that task is far from easy. Take, for example, the tort of negligence. It may be that the standard of care imposed in cases like Bolton v Stone 95 is equivalent to optimal care which economic analysis would require to maximise wealth, but it might also be characterised as that dictated by corrective justice, and its moral content. Alternatively, to justify an efficiency approach to judicial reasoning, it might be regarded as sufficient for the common law principles to be efficiency-compatible, as illustrated by Bolton v Stone, rather than efficiency-orientated. This would appear to have been the approach often adopted by Richard Posner when he became a judge. Studies of his judicial opinions and rulings reveal that he has been very selective in incorporating efficiency goals into his reasoning, focusing on those areas of law, for example tort and antitrust, which in his view are most compatible with economic goals.96 94 CR Sunstein, Free Markets and Social Justice (New York, Oxford University Press, 1997), ch 3. 95 Above n 26 and accompanying text. 96 W Samuels and N Mercuro, “Posnerian Law and Economics on the Bench” (1984) 4 International Review of Law and Economics 107; LL Chubb, “Economic Analysis in the Courts: Limits and Constraints” (1989) 64 Indiana Law Journal 769. An analogous study of the judicial opinions of Judge Breyer, another prominent lawyer-economist, reveals a greater diffidence to the adoption of efficiency reasoning: H Latin, “Legal and Economic Considerations in the Decisions of Judge Breyer” (1988) 50(4) Law and Contemporary Problems 57.

302

(K) Ogus Ch10

24/3/06

08:21

Page 303

Conclusions: Is There an Economist in the House?

Were judges, generally, to engage in this approach, they would of course encounter the problems of competence, data97 and resources which we have identified in relation to nongovernmental law reform agencies.98 More than this, they would have to confront the difficulties, absent from other law-making contexts, of resolving the tension between providing a satisfactory outcome ex post to the parties in the individual dispute before them and issuing a statement of principle to influence ex ante the behaviour of other individuals and groups.99 The Relevance of Efficiency Reasoning in the Courts The fact that efficiency may not be, in relation to particular instances or areas of law, the goal of judicial decision-making does not imply that economic reasoning is necessarily inappropriate or irrelevant. The main purpose of this book has been to show how it can generate insights for the law. Drawing on the content of earlier chapters, I need now to elaborate on how this might apply to judicial decision-making. First, there is the relevance of efficiency reasoning. Whatever be the goal of legal decision-making, whether generally or in relation to particular principles or rules, an understanding of the efficiency characteristics of different decisions, in the sense of what outcomes are likely to generate wealth gains, may be valuable information for the decision-maker to possess. The significance of the information will, of course, vary according to the context. No doubt the value will be at its greatest where the acknowledged objective of the principle or rule to be applied is to maximise wealth. In chapter two, I reviewed some legal forms which are presumptively wealth-creating: where actors are, expressly or impliedly, using these legal forms to co-ordinate their wealth-creating endeavours, then the judge’s task in interpreting 97 This constraint is particularly important in jurisdictions which do not have the tradition or practice of the “Brandeis brief”: Kirby, above n 87, 124. 98 Above, 294; and see A Ogus, “Social Costs in a Private Law Setting” (1983) 3 International Review of Law and Economics 27. 99 PM Wald, “Limits on the Use of Economic Analysis in Judicial Decisionmaking” (1988) 50(4) Law and Contemporary Problems 225, 232.

303

(K) Ogus Ch10

24/3/06

08:21

Page 304

Conclusions: Is There an Economist in the House?

and applying the relevant principles is facilitated by an understanding of how the forms serve the intended purpose. So also, as we saw in chapter three,100 where arguments are advanced that consensual arrangements should not prevail because of an information or externality problem, then efficiency reasoning provides some guidance on when intervention is appropriate and, with a view to minimising costs, what form it should take. If, to continue with the themes developed in chapter eight, there is a perception, derived perhaps from legislation, that other values, for example, distributional justice or paternalism, are to take precedence over wealth-maximisation, or must compete with it, then economic reasoning can help in determining how those values should be applied. The juxtaposition of economic and non-economic reasoning can give some indication of the likely sacrifice, in terms of reductions in wealth, entailed in pursuit of the non-economic goal. And that can, of course, lead to some form of cost-effectiveness analysis, in which different legal means of implementing the non-economic goal are compared, with a view to identifying the approach which might achieve the goal at lowest cost. More than that, as I sought to demonstrate in chapter eight, economic reasoning can shed important light on the noneconomic goal itself. Take paternalism: the insights derived from behavioural economics can help decision-makers in identifying when perceptions of, and reasoning about, choices may be flawed, and therefore when it might be appropriate for legal rules to override individuals’ preferences.101 Then notions of distributional justice or equity may inspire legal rules which seek to transfer costs from one group (say accident victims) to another (say risk-creators). Some understanding of how the rule will impact on the economic behaviour of the relevant actors is essential, if the rule is to fulfil its given redistributional objective.102

100 101 102

304

Above, 76–8. Above, 230–40. Above, 222–30.

(K) Ogus Ch10

24/3/06

08:21

Page 305

Conclusions: Is There an Economist in the House?

Throughout this book I have stressed the explanatory function of economics in relation to law. For this purpose, allocative efficiency is used as a tool for explaining and rationalising legal rules and structures, and their development.103 The reasoning here takes the form of efficiency as an unproven hypothesis. Thus, if the goal of the law in a given area were wealth maximisation, then, for example, liability would be imposed in situations L, M and N, and not in situations X, Y and Z. If case law has imposed liability in situations L, M and N, but not in situations X, Y and Z, the efficiency explanation may provide a helpful rationalisation, particularly if it is difficult to distinguish the situations by reference to other sets of values. A study of Judge Posner’s judicial opinions reveals that, on the bench, he often engages in reasoning of this kind.104 In chapter six, I examined some areas of law, notably liability for negligent omissions and the defence of “coming to a nuisance,” where reference to corrective justice, the goal from which most tort lawyers draw inspiration, proves to be an uncertain criterion for deciding hard cases, because the moral arguments for and against liability seem, in many cases, to be evenly balanced.105 With the aid of Coasean reasoning, I was able to show how an efficiency hypothesis provides a useful instrument for rationalising the case law. Liability for negligent omissions is, indeed, one of the very few areas of private law in which a judge, in an English court, has made explicit reference to efficiency reasoning, for explanatory purposes.106 Ironically, as I demonstrated in my discussion of the case,107 his failure to 103 JT Coleman, “Efficiency, Exchange and Auction: Philosophic Aspects of the Economic Approach to Law” (1980) 68 California Law Review 221. 104 Chubb, above n 96. He distinguishes between cases where Posner used “economic analysis” to reach his decision and cases where the reasoning involved an “economic explanation” of a decision reached on another basis, eg the following of precedent. Between 1981 and 1984 19% of Posner’s opinions involved “economic explanation” and only 5% “economic analysis”: ibid, 790. 105 Above, 168–78. 106 Lord Hoffmann in Stovin v Wise, above n 7. 107 Above, 170.

305

(K) Ogus Ch10

24/3/06

08:21

Page 306

Conclusions: Is There an Economist in the House?

appreciate the Coasean perspective meant that the explanation was less than convincing. Other Economic Inputs Some legal rules and principles can benefit from an economic input, whatever their perceived objective. This is most obviously the case where the law explicitly addresses economic issues, as with competition law and (to some extent) intellectual property. But the technical input can also facilitate good decision-making in other, mainstream areas of law. The evaluation of assets in cases involving notably personal injuries, death, divorce, employment has, within the USA, created a demand for expertise leading to the growth of so-called “forensic economics.”108 In the UK, economists have made significant critical contributions to the literature in relation to compensation for lost earnings,109 award of interest on pre-judgment losses,110 and damages in foreign currencies,111 although the extent to which they have influenced practice in the courts is less clear. We have already seen how the task of reaching an appropriate decision on the merits of individual cases may inhibit judges pursuing efficient outcomes. Nevertheless the courts, particularly appellate courts, must take into account the impact of their rulings on behaviour in general. As I demonstrated in chapter five, economic reasoning can facilitate the gaining of this broader perspective, since economists focus on the impact of legal rules and principles ex ante, and are less concerned with the ex post outcome. Such a perspective can, for example, show 108 See the list of forensic economic consultants at: http://www.willyancey.com/ for_cons.htm. 109 See R Lewis, R McNab, H Robinson and V Wass, “Loss of Earnings Following Personal Injury: Do the Courts Adequately Compensate Injured Parties?” (2003) 113 Economic Journal F568, showing that, in comparison with the US approach based on an economic input, English courts tend to undercompensate accident victims. 110 RA Bowles and CJ Whelan, “Compound Interest: Could Multipliers Be the Way Forward?” (1986) 136 New Law Journal 876. 111 RA Bowles and CJ Whelan, “Judgments in Foreign Currencies: Extension of the Miliangos Rule” (1979) 42 Modern Law Review 452.

306

(K) Ogus Ch10

24/3/06

08:21

Page 307

Conclusions: Is There an Economist in the House?

how the rule in Hadley v Baxendale should induce contractual promisees to communicate important information to promisors before the contract is concluded.112 So, also, asking what contracting parties would have agreed in ex ante efficient contracts on the type and extent of compensation to be paid in the case of default by one of them can help an ex post judicial determination of the same issue.113 Statutory Interpretation and Public Choice Analysis Statutory interpretation plays a very large role in the judicial process. The conventional approach is to ascertain and then to implement the actual or presumed intent of the legislature. How can and should economic analysis contribute to this task?114 If reference is had to mainstream welfare economics, the question involves the same issues, and receives the same answers as those which we have explored in relation to judicial reasoning generally. Indeed, the task of statutory interpretation can be regarded as analogous to that of identifying implied terms to add to incomplete contracts, which we explored in chapters two and three.115 If the legislation is perceived to have wealth maximisation as its goal, then an economic input can facilitate the interpretation of a statutory provision and a working through of its implications for individual cases. If the provision has other goals, or its objectives are unclear, then an understanding of the efficiency characteristics of alternative interpretations can assist the judge in making a choice. 112

Above, 145–6. Above, 211–2. 114 There is a very large (predominantly American) literature on this, including two symposia which focus on the topic: “Symposium on Public Choice” (1988) 74 Virginia Law Review (March issue) and “Constitutional Law and Economics” (1992) 12 International Review of Law and Economics ( June issue). For an overview, see WN Eskridge and J Ferejohn, “statutory interpretation and rational choice theories” in P Newman (ed), The New Palgrave Dictionary of Economics and the Law (London, Macmillan, 1998), vol 3, 535–40. 115 Above, 57–60 and 72–74, respectively; and see FH Easterbrook, “The Court and the Economic System” (1984) 98 Harvard Law Review 4, 15. 113

307

(K) Ogus Ch10

24/3/06

08:21

Page 308

Conclusions: Is There an Economist in the House?

However, the public choice school of economic thought has very different insights to offer. As was explained in chapter one, the main idea of this branch of law-and-economics reasoning is to challenge the assumption that the behaviour of public decision-makers, notably legislators, is to be understood by reference to public interest. Rather, these individuals are assumed to have the same utility or wealth-maximising motivations as other individuals. That proposition has major implications for statutory interpretation. In the first place, if it is inappropriate to assume a collective legislative adoption of some general, over-arching goal, such as wealth maximisation, then it becomes necessary to ascertain the specific intent of all individuals involved in the relevant legislative decision. This is, of course, a practical impossibility. But, even if it were possible, there is no logical method of deriving from the multitude of individual preferences what can meet the group’s majority preferences.116 Shepsle concludes, in consequence, that legislative intent is an oxymoron . . . along with military intelligence, jumbo shrimp, and student athlete . . . [it] is an internally inconsistent, self-contradictory expression.117

The argument has particular force in an American context where congressmen have considerable freedom in their voting behaviour, but may be considered less significant in relation to Britain, where most legislation has its origin in government proposals, and where there is strong party discipline.118 This is not to imply the irrelevance to the British context of the public choice model of legislation as a product supplied by politicians to interest groups in accordance with competing demands for it and for the price of some form of political 116 This is the result of the “Arrow Theorem”: KJ Arrow, Social Choice and Individual Values, 2nd edn (New Haven, Yale University Press, 1963), on which see Ogus, above n 47, 60–1. 117 KA Shepsle, “Congress Is a ‘They’, Not an ‘It’: Legislative Intent as an Oxymoron” (1992) 12 International Review of Law and Economics 239, 239. 118 Ogus, above n 35, 160–1.

308

(K) Ogus Ch10

24/3/06

08:21

Page 309

Conclusions: Is There an Economist in the House?

support. Some legislative measures can be explained wholly or mainly by reference to such a model,119 but more typically specific provisions within a statute may be so understood where they are necessary to placate particular groups, especially where the provisions are the result of amendments made during the course of parliamentary proceedings.120 Now, of course, the public choice model can assist statutory interpretation in the narrow sense of facilitating an understanding of the political background of a particular measure. But should it do more than this and prompt the judiciary to endorse deals struck between politicians and pressure groups even when such an outcome would appear to be manifestly against the public interest? That is not an easy question to answer and American authors are divided on the issue. Some would have courts simply implement the bargain struck between legislators and interest groups as if it were an ordinary contract, at least where the relevant provisions are perceived to result from such a transaction.121 Others argue that this approach is inconsistent with the constitutional role of judges, which, in the light of public-interest considerations, is to control private-interest exploitation of the legislative process.122 The latter argument has less force in the UK, where—subject to human rights considerations—parliamentary sovereignty is sacrosanct. With or without reference to a constitutional perspective, expectations that judges can and should treat “private-interest” legislation as different from “public-interest” legislation would be plagued with difficulty, because the distinction is so problematic. Let us examine two examples. During the passage of the Human Tissue Bill 2004, as a result of successful lobbying, the bioscience industry was able to secure an amendment relaxing some of the intended prohibitions on commercial dealings 119

Eg Pneumoconiosis (Workers Compensation) Act 1979: see below, 310. Eg Human Tissue Act 2004, s 32: see below, 310. 121 Eg Easterbrook, above n 115, 16–18. 122 Eg JR Macey, “Promoting Public Regarding Legislation through Statutory Interpretation: an Interest Group Model” (1986) 86 Columbia Law Review 223. 120

309

(K) Ogus Ch10

24/3/06

08:21

Page 310

Conclusions: Is There an Economist in the House?

with human tissue.123 This may be considered as a fairly obvious illustration of a “private-interest” provision, but it was, of course, presented as being in the “public interest”. And how are we to know whether the effect of the lobbying was to convince MPs that the amendment was in the public interest, or rather that it simply provided a private benefit which was, effectively, “purchased” from some MPs? My second example, the Pneumoconiosis (Workers Compensation) Act 1979, which granted rights of compensation to a group of predominantly Welsh quarrymen, even more obviously resulted from a “deal”. The measure was introduced by the Callaghan government in a desperate attempt to secure the support of Welsh Nationalist MPs, thus maintaining a tiny majority in the House of Commons.124 Now, even though the case for a special scheme had not won the support of a Royal Commission on Compensation, reporting a year previously,125 cannot it be argued that this is an example of the legislature pursuing a goal of distributional justice? And can it easily be distinguished from a multitude of other measures which provide financial and other support for disadvantaged groups? In summary, public choice models of legislation serve a valuable purpose in alerting or reminding lawyers that laws may not always be made in the public interest. More specifically, they can assist judges in understanding the background to particular statutory provisions, and thus in interpreting them. In my judgment, the fact that, in accordance with the models, a given measure is perceived to have been passed for private-interest purposes should not be used as a justification for overreaching the intent of the legislature and attempting to impose an interpretation more consistent with what is deemed to be in the public interest. 123 In what is now Human Tissue Act 2004, s 32. Evidence of the industry’s involvement is available not only from the parliamentary debates (Hansard Debates on the second Reading of the Bill, 28 June 2004), but also from the website of the Bioindustry Association: www.bioindustry.org. 124 Ogus, above n 35, 157–8. 125 Report of the Royal Commission on Civil Liability and Compensation for Personal Injury (Cmnd 7054, 1978), vol 1, paras. 888–92.

310

(K) Ogus Ch10

24/3/06

08:21

Page 311

Conclusions: Is There an Economist in the House?

Envoi Ten years ago I published a paper reviewing the contribution law-and-economics had by that time made to social-legal research in Britain, and commenting on its prospects.126 Although the output of the handful of scholars then working in the area was not trivial and certainly had begin to influence mainstream academic legal literature, it seemed to have made little impact on legal policy-making more generally and, in this respect, could not compare with what had occurred in North America. As this chapter has revealed, some important developments in relation to policy-making have occurred in the last decade, but the picture is a mixed one. Perhaps most significant has been the growth in the use of cost-benefit analysis by governmental policy-makers and, in the context of regulatory impact assessment, that has necessarily involved some economic analysis of the law. There have also been striking examples of interest shown by the Law Commission in economic analysis in some areas of its work. However, there also seems to have been some uncertainty as to what inferences should be drawn from the analysis. There has been the reference by one House of Lords judge in a tort case to “efficient allocation of resources” and “externalities,”127 but that seems to have been an isolated occurrence and there have otherwise been few signs of economic reasoning intruding on the judicial process outside of areas of law dealing explicitly with economic concepts. I have argued that economic reasoning can play a valuable role in each of the three identified arenas. Most obviously this is the case in the formalised cost-benefit context of regulatory impact assessment. But even here, because of data limitations and the normative difficulties associated with efficiency analysis, it should function primarily as an informational aid to good 126 A Ogus, “Law and Economics in the United Kingdom: Past, Present and Future” (1995) 22 Journal of Law and Society 26. 127 Above 170; see also 305–6.

311

(K) Ogus Ch10

24/3/06

08:21

Page 312

Conclusions: Is There an Economist in the House?

policy-making. If the desired outcomes are determined by political or other non-economic considerations, then costeffectiveness analysis is available to explore how the goal can be implemented at lowest cost. These conclusions apply with even greater force to lawreform agencies and judicial decision-making. Throughout this book I have been at pains to resist ambitious claims that efficiency analysis can always provide a reliable guide to appropriate legal outcomes. I have, instead, attempted to show how economic reasoning can enrich our understanding of the law and its impact on behaviour, and that should lead to better policy-making. I have also demonstrated that the economic insights can be acquired without engaging in exposition which is unduly technical, abstract or mathematical. Some of the insights generated are particularly interesting because they conflict with the intuitions of many lawyers. Maybe there is a risk of unjustified belief in these insights, particularly when they are based on predictions of the impact of law which are not verified empirically. But it is the very experience of thinking about these predictions which can prove to be so valuable: An important metaphor in economics has the quality admired in a successful scientific theory, a capacity to astonish us with important implications yet unseen.128

128 D McCloskey, “The Rhetoric of Economics” (1983) 21 Journal of Economic Literature, 481, 503.

312

(L) Ogus Index

22/2/06

14:02

Page 313

Index

Ackerman, Bruce causation, on 9 pollution, on 181 Becker, Gary 14–16 compliance with criminal law, on 15 economics of crime 14–16 Behavioural incentives 101–138 Behavioural law and economics development of 25 Bentham, Jeremy legal jargon, on 270 Breach of contract foreseeability 145–146 Holmes on 9–11 paternalism, and 243–244 Business organisational forms 47–56 consumer ownership 56 employees, property rights of 55–56 integration 50–51 joint property-holding organisation 50–51 legal forms 47–56 market contracting 48–49 owner-manager firm 52 partnership 52–53 productive efficiency, and 54–55 public company with limited liability 53–54 relational contracting 49–50 shareholders, and 56 Calabresi, G classification of legal entitlements, on 197 Causation Ackerman, on 9 Coase on 8–9 Chicago lawyer-economists 2–3

Classification contract 65–71 importance of 65–71 law of obligations 68–69 law of persons 68 modern civilian legal systems 68 nuisance 67 policy issues 66–67 regulation 69–70 tort 65–71 Coase, Ronald causation, on 8–9 corrective justice, and 166–168 reciprocity, and 7–9 reciprocity principle 33 social cost, on 4–5 Common law Posner on 11–14 Compensation 125–126 deterrence, and 125–126 Competition between legal systems 273–276 internationalisation of markets 273–274 national legal systems 275–276 Confiscation 123–125 advantages 123 deterrence, and 123 Consumer credit 246–248 information, supply of 247 paternalism, and 246–248 Consumer ownership arguments for 56 Consumer Protection Act 1987 exclusion of agricultural products 19, 20–21 Contract classification 65–71 default rules 57–60 liability in tort, and 65–67

(L) Ogus Index

22/2/06

14:02

Page 314

Index See also. Contractual invalidity and contractual risk allocation Contractual invalidity 127–129 illegal transactions 128 Contract and tort, relationship between 86–92 limitation of actions 89–92 market failure justifications 86–87 prescription 88–92 public policy 87 remoteness 88–89 Contractual risk allocation 147–152 contract surplus 148 explicit 149 implied terms 149–151 Pareto test 148 risk dimension 148–149 Conveyancing 254–255 lawyers, influence of 254–255 Corrective justice 163–187 causation 165 Coasean reasoning, and 166–168 damage 178–186 economic approach 165 infliction of harm 166 morality, and 163–164 negligent omissions 168–173 reciprocity principle, and 33 Corporate actors 131–133 deterrence, and 133 profits 132 sanctions, and 131–133 shareholders 132–133 Cost-benefit analysis 183–290 allocation of resources 288 evaluation of human lives 287–288 “equitable” 290 institutional arrangements, and 289 Kaldor-Hicks criterion 287 non-marketable assets 284 normative dimension 287–290 qualification, problems of 283–287 variables 285–286 Cost-effectiveness analysis 290–292 American requirements 291 functions 290 New South Wales 291–292 Crime, economics of Becker on 14–16

314

Criminal law function 83–84 Damage 178–1 86 Coasean reasoning, and 178–182 environment, and 180 hierarchy of protected interests 183–184 meaning 179 neighbourhood test 181 non-physical 183 personal evaluation 184, 185 physical 183, 184 polluter-pay-principle 180–183 types 182–186 Defamation 189 Default rules 57–63 asymmetry of information between contracting parties 59 contra proferentem rule 59 contracts 57–60 economic function 57 fiduciary duties 60–63 principal-agent 60–61 profits made by trustees 61–62 remuneration of trustees 62–63 function of 59–60 implied terms 59 judicial interpretation 58 trusts 60–63 variation in costs, and 58–59 Department of Constitutional Affairs policy-making 279–280 Discretionary sanctions cost 117–1 19 Distance selling 244–245 Distributive justice 219–252 allocative efficiency criteria 224 contract law, and 221 cost of administrative structures 225 costs 226–227 economic goals 251 economics, relevance of 222–224 impact of legal rules on costs and prices 228 influence of 220 Kalder-Hicks test 223 market transactions, and 227

(L) Ogus Index

22/2/06

14:02

Page 315

Index Pareto test 223, 224 paternalism 230–250. see also Paternalism physical capacities 229–230 redistributional goal 223 shareholder, and 228–229 social psychology, and 251–252 socialisation of tort law, and 222 targeting 226 taxation 230 welfare costs 225–229 welfare rights 221 Doorstep selling 244–245 Duxbury, N American legal scholarship, on 3 Economic analysis competition law 281–282 formal requirements 282–292 influence on judicial decisionmaking 280 Kaldor-Hicks efficiency 27, 28, 29 Kaldor-Hicks improvements 27 mathematics, and 22–24 normative dimensions 24–25, 25–31 controversies 28–29 efficiency, and 25 gains and losses, measurement of 29 judgmental nature 28 limitations 28–29 tools 26–27 Pareto efficiency 27, 28 Pareto improvements 27 positive dimensions 24–25 criticisms of 24–25 non-economic goals, and 31 trade-off between economic and non-economic goals 30–31 Economic welfare 76–77 competition, and 76 externalities, and 76 Efficient breaches of contract 205–212 airline policy, and 207–208 bargaining process, and 209–210 economic approach 206 increased profit, and 210

market context 210–211 policies encouraging 207–209 specific performance 209 Employees property rights of 55–56 Enforcement costs 108–112 civil procedure 110–111 criminal procedure 110–111 monitoring 108–109 sanction impositions 111–112 sanction processes 109–110 Environmental law regulation, and 70 Epstein, Richard legal complexity, on 264 ESRC Centre for Business Research duties of company directors, on 296–297 External inducements 102–108 additional cost 103–104 cost-benefit appraisal 104–105 effectiveness 104–105 law interacting with other price variables 103–105 taxonomy 106–108 wealth of individual, and 105 Fiduciary duties default rules 60–63 Fixed sanctions cost 117–119 Foreseeability 142–147 breach of contract 145–146 economic reasoning, and 147 negligence 144–145 reliance on 143–144 tort law 144–145 use of contract 142–143 Friedman, D Posner, on 13–14 wrongdoing, on 192–193 Fuller, LL legal formalities, on 256–257 Game theory mathematics, and 21–24 usefulness 23–24 Goff, Lord classification, on 67

315

(L) Ogus Index

22/2/06

14:02

Page 316

Index Hatfield railway disaster 160 Hoffman, Lord negligent omissions, on 170 Holmes, Oliver Wendell breach of contract, on 192 efficient breach, and 9–11 Implicit pricing 101–138 Implied terms contractual risk allocation, and 149–151 Informal costs 129–131 formal finding of liability, and 130 operation of 129–130 reputational costs 130–131 social or moral norms, and 131 Information costs 134–135 administrative charges 134, 138 breaches of social norms 134 Injunctions 126–127, 201–205 damages in lieu 202–203 interference with property rights in land, and 201–205 Kalder-Hicks test, and 203 negotiation, and 202 Pareto test, and 201 private nuisance, and 203–204 Insolvency law risk allocation, and 151 Judicial decision-making 299–310 classification of common-law principles 302 corrective justice 305 economic analysis 299–300 efficiency as goal 301–303 “efficiency of common law” 300–301 efficiency reasoning 303–306 explanatory function of economics, and 305 forensic economics 306 mainstream welfare economics 307 paternalism, and 304 private interest legislation, and, 309–310 public interest legislation, and 309–310

316

statutory interpretation 307–310 wealth maximisation, and 308 Judicial reasoning 299–310 Law and wealth creation 35–64 property rights. See Property rights “tragedy of the commons” 63 Law Commission 294–299 cost-effectiveness analysis 298 economic analysis, and 295–299 Law reform lawyers’ law, and 293–299 Lawyers designers, as 35–37 drafting of documents 36 economic function 37 functions in relation to disputes 36–37 public perception 35–36 Lawyers, influence of 253–278 competition 270–272 compulsory budget-setting, proposal for 271 conditional fees 271 contingency fees 271 conveyancing 254–255 equivalent market services 272 fees, and 253–254 government policy-making, and 256 legal formalities 256–261. see also Legal formalities legislative drafting 264 Pearson Report 254 public interest analysis 277 remuneration 270–272 Lawyers’ law 293–299 economics, and 294–295 law reform, and 293–299 mandatory default rules distinguished 298–299 meaning 293 Legal complexity 261–267 benefits 264 costs 263 efficiency implications 262–263 principal-agent problem 265–266 rule-specificity 262

(L) Ogus Index

22/2/06

14:02

Page 317

Index Legal culture 273–276 effects 274 meaning 274 Legal entitlements, classification of 197–201 efficient wrongdoing, and 198 liability rules 198–199 moral judgments 197–198 negotiations between infringers and right-holders 200 property rules 199–200 Legal formalities 256–261 advantages 259 comparative 260–261 costs, and 258, 260 justifications for 256–257 land, transfer of 257–258 reasons for 259 Legal jargon 267–270 costs 269 marriage settlements 267–268 punctuation 267–268 Legislation, economics of 16–21 American context 20 Consumer Protection Act 1987 19 Stigler on 16–21 Licence revocation 127 suspension 127 Limitation of actions 89–92 contract and tort, relationship between 89–92 economic justification 90–91 personal injury 90–91 transaction-cost analysis 91–92 Limited liability partnership 53 Listing of securities 248–250 merit regulation 248 Mapping the legal system 71–86 contract or tort 86–92 economic welfare implications 76–77 private governance 71–76 private law and regulatory standards 94–99 property rights and tort actions 92–94 public governance 79–86

Market contracting 48–49 contract specification 48–49 costs 48–49 information 48–49 monitoring 48–49 Mathematics 21–25 economic analysis, and 22–24 game theory, and 21–24 modelling 21–25 McNeill, William Plagues and People 2 Melamed, D classification of legal entitlements, on 197 Millett, Lord fraud, on 127 Morality corrective justice, and 163–164 Negligence foreseeability 144–145 Negligent omissions 168–173 casual bystander 171–173 Coasean reasoning 170 contractual relationship, and 170–1 71 corrective justice, and 168–173 English law 169–170 market transactions, and 170–171 rescuer 171–173 Nuisance 173–178 character of neighbourhood, and 177 classification 67 Coasean reasoning 175–176 coming to 173–178 consensual modification 93–94 “hypersensitivity” 174 injunctions, and 203–204 polluters 174–1 75 transaction costs, and 176–177 Obeying the law external inducements 102–108 internal explanations 102 reasons for 101–102 Owner-manager firm 52

317

(L) Ogus Index

22/2/06

14:02

Page 318

Index Partnership 52–53 cost of monitoring 52–53 limited liability 53 Paternalism 230–250 accident treatment costs, and 231 administrative costs 239–240 availability heuristic 236 benefits of interventions 238–250 BSE, and 243–244 consumer credit 246–248 costs of interventions 238–250 distance selling 244–245 distributional justice, and 230–250 doorstep selling 244–245 excessive discounting 237 externality justifications 232 goal 234 health and safety measures 241–244 individual decision-making 235–238 inertia 235–236 institutional costs 239–240 listing of securities 248–250 overriding individual preferences, and 232–234 pedestrian crossing 240–241 provision of information 233–234 rational delegation 234 seat-belts 241–243 selective optimism and control 237–238 social pressure 238 status quo bias 235–236 Pearson Report 254 Pedestrian crossings 219–220 paternalism, and 240–241 Polluter-pay-principle 180–183 Posner, Eric cost-effectiveness analysis, on 292 Posner, Richard 11–14 Economic Analysis of Law 11–14 efficiency of common law 11–14 “efficiency”, on 12–13 Pound, Roscoe classification, on 67–68 Precautionary principle risk management, and 158–161 Private governance 71–76

318

economic welfare, and 76–77 general obligations, and 74 law for 77–79 property rights 71–72 public governance, and 79–86 sources 85–86 standardised rights 72–73 state, limited role 77–79 tort law, and 74–75 Private law and regulatory standards, relation between 94–99 abrogation of private rights 95–96 actionability of regulatory standards 96–99 American approaches 97–98 distributional goals 98 errors of judgment, and 99 “evidence of negligence” principle 97 fault-based tort liability 97 policy considerations 95–96 road traffic legislation 96 Property rights 38–47 community land use 39–40 concurrent interests 38–39, 42 co-ownership 42 costs 39 development to reflect changes in cost and benefit variables 39–40 disputed entitlements 43–47 finder versus occupier 43–45 economic considerations 44 moral considerations 44 superior title in finder 45 superior title in occupier 44–45 limited interests in land 40–43 owner versus bona-fide purchaser 45–47 moral considerations 45–46 wealth-maximising perspective 46–47 residual entitlement 38–40 right of tenant to purchase residual freehold estate 41–42 “tragedy of the commons” 41 trusts 42–43 waste, common law doctrine 41

(L) Ogus Index

22/2/06

14:02

Page 319

Index Public company limited liability 53–54 publicly traded shares 54 Public governance 79–86 bounded rationality 81 cost of enforcing private rights, and 79–80 costs, and 81 criminal law 83–84 economic justifications 79 financial incentives 84–85 forms of 83–85 informative discrimination 81 private law, and 85–86 regulatory objectives 83 remedies, and 80 state, increased role of 79–80 Public law 82–85 classification 84 command-and-control systems 84 co-regulation 82–83 enforcement 82 modification by private citizens 82–83 Public policy contract and tort, and 87 Punishment 119–123 administrative action 122 community service 121 “culpability” 120 fines 121 imprisonment 121 inducement function, and 119–120 punitive damages 122 “seriousness of offence” 120 Reciprocity Coase, and 7–9 Regulation classification, and 69–70 environmental law, and 70 Regulatory contraventions 212–216 consensual bargaining, and 214 crimes 212–213 efficient facilitation 213–214 emissions trading 214–215 mala in se 213 mala prohibita 213 private contracting, and 215

statutory interpretation 215–216 targeting 213 Regulatory impact assessment 282–292 cost-benefit analysis 283–290 cost-effectiveness analysis 290–292 requirement for 282 variables 286–287 Relational contracting 49–50 characteristics 49–50 costs 50 examples 49 Remoteness of damage 88–89 contract and tort, relationship between 88–89 Restitution 123–125 Risk allocation 139–162 contract law 152 contractual remedies 152–153 ex ante analysis 151–154 ex post adjudication 151–154 insolvency law 151 market conditions, and 153–154 Risk management 139–1 62 burden of proof, and 158–159 expert opinion, and 155–156 Hatfield railway disaster 160 “hindsight bias” 141 language of 141 maximization of utility, and 156 moral hazard, concept of 157 opportunity cost, and 159–160 perceived risk of very serious harm 159 policy, and 156–157 popular attitudes 155 precautionary principle 158–161 public opinion, and 156–157 regulatory interventions 154–155 subjectivity, and 154–157 Russia restructuring of companies 140, 141 Sanctions, costs of targeting 112–114 normative alternative 114–129 reference to harmfulness of activity 114–129 cost disadvantage 116–117

319

(L) Ogus Index

22/2/06

14:02

Page 320

Index Sanctions, costs of targeting (cont.): reference to harmfulness of activity (cont.): mainstream crime 115–116 social costs 115 simple deterrence 112–114 Sanction impositions costs 111–112 Sanction processes costs 109–110

private nuisance 93–94 Tort law foreseeability 144–145 private governance, and 74–75 Transaction costs 4–6 Trustees profits made by 61–62 remuneration 62–63 Trusts default rules 60–63

Seat-belts paternalism, and 241–243 Specific performance 209 Standardised rights 72–73 contractual dealings, and 73 numerus clausus principle 72 variation 73–74 Stigler, George 16–21 economics of legislation 16–21 theory of regulation 17–18 Structures of the law 65–100

Unjust enrichment 124

Thames Trains Automatic Train Protection 139–140 Tort classification 65–71 contractual liability, and 65–67 Tort and property rights, relation between 92–94 private and public governance, and, 92–93

320

Wealth-maximisation importance of 29–30 Welfare rights 221 Wrongdoing 189–217 compensation, and 190 compromise between Pareto and Kaldor-Hicks criteria 196 defamation 189 flexibility of law enforcement, and 192 generation of welfare gains, and 193–1 97 Kaldor-Hicks test 193–196 lawful and unlawful conduct distinguished 216 legal obligations, and 191 morality, and 190 perfect compensation, and 195–196 welfare maximisation, and 189–217