Incentives are the essence of economics.1
Edward Lazaar, 1998
The purpose of studying economics is . . . to learn how to avoid being deceived by economists.
Joan Robinson, 1955
Economics, declared John Maynard Keynes over half a century ago, does not offer a body of furnished conclusions, but an approach; a way of thinking about a problem. Its approach centres on choice, trade-offs, consequences, incentive effects, costs and benefits. As such, economics offers a different and external perspective on legal problems which can shed new insights, reveal new relationships and perhaps explain more clearly the law and its effects. The basic economics useful for legal analysis is set out in this chapter.
c h o i c e a n d s c a r c i t y
The economic approach to law can be defined as the application of eco- nomic theory – mostly price theory and statistical methods – to examine the formation, structure, processes and impact of the law and legal institu- tions.2
It employs the same economics used to study the market for beans and steel to analyse law and institutions. This is known as price theory, the study of the interaction and behaviour of individual units in the economy – the firm, the consumer and the worker.
At the heart of price theory are the concepts of scarcity and choice. With- out scarcity there would be no need to make choices since in a world of
1
E. P. Lazaar, ‘Incentive Contracts’, in J. Eatwell, et al. (eds.), The New Palgrave – A Dictionary of
Economics, vol. 2, London: Macmillan, 1998, 744–748.
2
C. G. Veljanovski, The New Law-and-Economics – A Research Review, Oxford: Oxford Centre for Socio-Legal Studies, 1982; C. G. Veljanovski, The Economics of Law, 2nd edn., London: Institute of Economic Affairs, 2006.
inexhaustible abundance we would simply take what we wanted. Scarcity, whether in rationing the law or allocating resources, involves choice. Eco- nomics is the study of the choices of individuals in their roles as judges, people at risk, litigants and lawyers make in response to harms, to the law and other factors such as costs, income and so on.
Economic rationality
When faced with a choice, individuals and companies must have a basis for selecting between alternatives and how much of each alternative to consume or produce. Economists assume that individuals and organisations do this in a rational way. This is not only a workable assumption but also a necessary one if law is to guide behaviour and actions in a predictable way.3
The concept of economic rationality has a specific but simple meaning in economics. It means little more than that people prefer more to less and maximise net benefits, whether utility, wealth, or profits, as perceived by them.4
This theory of rational choice is based on several assumptions – substitutability, marginality and fixed tastes and preferences:
r Substitutability Goods are assumed substitutable for one another (or
for money) at the margin. That is, there is a rate of exchange (price) between any pair of goods that will make an individual indifferent between them. This notion of a trade-off is central to economic rea- soning.
r Marginality or equi-marginal principle Maximising implies equal-
ising marginal values and diminishing marginal returns – i.e. the equi-
marginal principle. In any activity, to obtain the maximum utility or profit
from the available resources they must be allocated so that the marginal benefit from the last unit of a resource devoted to each use is equal to its marginal costs. The maximisation principle thus not only requires that benefits exceed costs for each activity but that the level of each activity be at a point where the marginal costs of expanding the activity are equal to the marginal benefits. To illustrate the importance of marginal anal- ysis consider the debate over whether more migrant workers benefit an economy and what is the optimal number. The debate typically proceeds
3
Recent research suggests that homo sapiens displaced Neanderthal man because of their superior economic approach. This suggests that economic rationality may not only be in our genetic makeup but the very reason for our existence. R. D. Horan, E. Bulte and J. F. Shogren, ‘How Trade Saved Humanity from Biological Exclusion: An Economic Theory of Neanderthal Extinction’, 58 Journal
of Economic Behavior & Organization, 1–29 (2005).
4
The choices must also be consistent or transitive – i.e. if x is preferred to y , and y to z, then x will be preferred to z.
by claiming that on average migrant workers contribute more than they cost in terms of public services and pressure on a country’s infrastruc- ture. However, the correct (marginal) analysis is not to compare average contribution with average costs, as this gives the wrong answer. Suppose the first 100 migrants are bankers and entrepreneurs who each contribute £1 million annually while the last 5,000 migrants are unskilled manual workers contributing only £1,000 annually. If the average cost of sup- porting migrants is £20,000 annually, then using average figures (which in this case gives £21,000) indicates that migrants are net contributors. However, the truth of the matter is that that they are not because the high earners have distorted the figures and the last 5,000 migrants in fact are causing net losses. The optimal level of migration is not 5,100 migrants annually but only the first 100 migrants. As this shows, the
optimal level of an activity which yields maximum net benefits is deter-
mined by comparing marginal costs and benefits, and not average costs and benefits.
r Fixed tastes and preferences The tastes and preferences of individ-
uals are assumed to be given and stable. This assumption is related to, and implied by, rational behaviour. If tastes change over time or with past choices, preferences may not be consistent. For positive eco- nomics (what is), the assumption of given tastes prevents the economist from rationalising inconsistencies between theory and evidence by ad hoc claims that tastes have changed. For normative economics (what should be), changing tastes would render measures of economic welfare unreliable indicators of changes in individual wellbeing. For example, if tastes are constant one can say that a fall in the price of a good improves the economic welfare of consumers of that good. However, if at the same time consumers’ tastes alter so that they come to regard the good as less desirable, it would not be possible to make such a statement.
The assumption of economic rationality is not without its critics. Indeed a whole field of behavioural economics, and behavioural law and eco- nomics, has dispensed with the assumption and investigated the implica- tions of the cognitive limits to, and biases of, individual decision-making. This approach is not adopted here for the simple reason that if economic rationality is abandoned then economics loses much of its predictive and explanatory power and can easily collapse into a descriptive approach less likely to produce genuine insights.
The view adopted here is that the economists’ assumption of rational- ity is best regarded not as a description of individual decision-making but as a way of identifying the predictable response of a group of individuals
(markets) to changes in the factors which affect choice. As Cooter and Ulen put it, rationality should be viewed ‘as an account of behaviour, not as an account of subjective reasoning processes’.5
In this regard, economic man is ‘marginal man’ representing the change in a group’s response. It thus allows for marked differences in individual responses – and, indeed, may accurately predict behaviour when individuals act irrationally or randomly.6
Incentive analysis
Economists believe that groups react in a predictable way to changes in the costs and benefits of the options they face. This incentive analysis is a direct implication of the rationality assumption. As a result prices and laws are primarily viewed as creating incentives which alter behaviour and outcomes.7
Incentive analysis is formalised by the economists’ ‘laws’ of demand and supply. These are ‘laws’ in the sense that they describe observed regularities in behaviour and outcomes. The ‘law’ of demand states that when the price of a good or service, increases, all other things equal, less is purchased. The proposition that when a good or service becomes more expensive, less of it will be consumed is not a radical one. The ‘law’ of supply states that as the price increases the quantity supplied increases, holding other factors constant. The interaction of demand and supply creates a market and a mechanism by which the plans and actions of those wanting goods and services, and those supplying them are brought into balance at any one time and adjust in a mutually consistent way over time.
The economic approach applies incentive analysis to all economic and non-economic activities. There is no reason not to suppose, and every rea- son to believe, that incentive analysis has wide application – in drug dealing, prostitution, crime, adoption, sale of body parts, marriage, divorce, illegal immigrants, armies and so on. Economics simply formalises the demand and supply conditions operating in these activities – and, most impor- tantly, works through the implications of how changes in economic and
5
R. Cooter and T. S. Ulen, Law & Economics, 4th edn., New York: Pearson Addison Wesley, 2004, 462.
6
G. S. Becker, ‘Irrational Behavior and Economic Theory’, 70 Journal of Political Economy, (1962) 169–217, reprinted in G. S. Becker, The Economic Approach to Human Behavior, Chicago: University of Chicago Press, chapter 8.
7
For a more detailed discussion of the differecne between legal and economic analysis, see Veljanovski,
non-economic factors affect the willingness of people to demand and supply the activity under consideration.
The economists’ incentive analysis can be illustrated by the law restricting the speed limit. Most people, even those who would regard themselves as law abiding, break the speed limit from time to time. If there is no penalty, people will speed if the benefits they derive at the time exceed the likely costs in terms of the potential likelihood of an accident and its consequences to others and themselves. If a penalty is imposed, the costs of breaking the speed limit rises and, all things equal, we expect that fewer people will speed. Drivers will take into account not only the inherent risks, benefits and costs, but also the potential penalties – the fine, the loss of their licence, potential incarceration and the impact of a conviction on their insurance payments. As the penalties get greater, most people, even non-economists, would agree that less and less speeding will occur. More people will speed if the penalty is £10 than if it is £20,000! This is informal economic modelling.
In looking at the world in this way one is conscious of the fact that the ‘price up/quantity demanded down’ prediction may not apply to all, or even a large number, of people. If the penalty for speeding (or the price of bread) goes up 5 per cent or 10 per cent many people will simply take it in their stride and not modify their behaviour. If the courts mete out more severe punishment some, maybe many, criminals will simply go on as before. Does this undermine the economists’ incentive analysis? Certainly not!
Incentive analysis does not assume that every individual reacts to a curb on his or her actions. Some will react by reducing their participation or cease altogether; others will not. But all that is required for, say, fines, to deter is that a subset of those who previously speed now decide not to, or to do so less frequently. To put it more graphically, criminals at the margin will be deterred by higher penalties; not the psychopath or deranged serial killer.8
It is the reaction of some that generates the response predicted by the economists’ rationality model: clearly, the greater the number sensitive to increases in fines or costs the greater the reaction.
It is often useful to know not only whether an increase in penalties or costs deters or reduces a particular activity, but by how much. A quantitative
measure of the incentive effects of a change in price, cost or legal sanction
is known as its elasticity. This measures the proportionate response to a 1per cent increase/decrease in the price/cost/sanction. An elasticity of minus 1(–1) would mean that a 1 per cent increase in, say, the penalty imposed
8
For a clear statement of this, see M. Friedman, ‘The Methodology of Positive Economics’, in Fried- man’s Essays in Positive Economics, Chicago: University of Chicago Press, 1953; see also M. Blaug, The
on criminals leads to a fall (hence the minus) of 1 per cent in the number of crimes. A higher elasticity indicates greater responsiveness. For example, governments have been very skilled at taxing goods which have an inelastic demand (that are unresponsive to price increases) such as cigarettes, alcohol and petrol. This is because they appreciate that the reduction in demand as a result of the price increase will be small – people are either addicted to them (alcohol) or they are an essential input that is very difficult for people to substitute for (petrol).
b e n e f i t s a n d c o s t s
Economics uses the measuring rod of money to evaluate economic and legal outcomes. It thus places heavy reliance on assessing the costs and ben- efits of the law, considerations that will always be relevant when resources are limited. However, the relationship between monetary value, economic efficiency and economic and legal activity is a subtle one, frequently mis- understood. The underpinnings of the efficiency criterion or cost-benefit
criterion are now set out.
Benefits: willingness to pay (WTP)
The economist is said to know the price of everything but the value of nothing (actually, it’s a cynic). This could not be further from the truth – the economist is concerned equally with price and value.
Economic value or benefits are measured by the ‘willingness-to-pay’ (WTP) of those individuals who are affected. That is, the economist’s notion of benefit is similar to the utilitarian notion of happiness (util- ity) but it is happiness backed by WTP. Mere desire or ‘need’ is not rele- vant. WTP provides a quantitative indication of the intensity of individual preferences.
In many markets identical goods frequently sell for the same price to all customers. It follows that individuals with an intense preference for the good – those who would be prepared to pay more – receive a surplus benefit from their purchase which is not measured in the marketplace. This benefit is called the consumers’ surplus – it is the difference between the maximum WTP and the sum actually paid for a good or service. It is the consumers’ equivalent of ‘economic profit’ to the firm (the difference between revenues and costs plus a competitive return to capital). The con- cept of consumers’ surplus provides a quantitative measure of the economic value of changes in prices and quantities of goods and services. The goal
of an efficient economic system is to maximise the joint or total surplus of consumers and manufacturers, not the market price and not money profits (see figure 2.1). Supply E Qc Price (P) Demand 0 Output (Q) Pc Consumers’ surplus Producers’ surplus
Figure 2.1 Demand, supply and consumers’ surplus
The law of supply and demand is depicted in a simple diagram uni- versally used by economists. The demand for a commodity, service or activity is shown as a negatively sloped line (labelled Demand) which shows that a greater quantity is purchased the lower the price. The supply line (labelled Supply) shows the marginal opportunity cost of pro- ducing an additional unit of the good. Usually the supply schedule is drawn with a positive slope, indicating increasing marginal opportunity costs arising from the growing scarcity of resources. Prices adjust until they ‘clear’ the market. In a competitive market the market clearing price equals the marginal opportunity costs of production determined by the intersection of supply and demand schedules (E ), giving quan- tity produced and purchased of Qc sold at price Pc. The market value of the goods sold is the price multiplied by the quantity (given by the rectangle 0 QCEP). The consumers’ surplus – which is the maximum
willingness to pay of all consumers’ above the price – is the shaded triangle under the demand schedule. The producers’ surplus is the dif- ference between the costs of production including a reasonable profit and the price. It is shown by the unshaded triangle below the consumers’ surplus.
Valuing intangibles
It is frequently argued that many aspects of life cannot be reduced to a monetary value – the so-called ‘intangibles’ of freedom, life, love and the environment. It would be fruitless to deny that these are non-economic in character, and often not traded in a market. But it would be equally foolish to suppose that that point undermines economic analysis. Many intangibles can be valued in monetary terms, and are implicitly done so by individuals and society daily, and are frequently ‘traded’ in markets.
Take, for example, the choice of a job. It may be claimed that economists assume that people select jobs based on only the wage rate. This is not the case: an individual does not accept a job solely on the basis of its wage or salary but the whole package of benefits – fringe benefits, working conditions, prospects of advancement, security of employment, travel, the reputation of the firm or institution, its location and so on. As a result, people are willing to trade money for more of these attractive factors. Academic lawyers are thus paid substantially less than practising solicitors and presumably remain academics because the total non-monetary benefits exceed the higher salary that they could earn in practice. That is, there is a ‘monetary equivalent’ of the non-pecuniary employment benefits which, when added to the financial salary, gives us the money value of the total package of benefits received from employment in a particular job. Looked at another way, people are paying for the privilege of consuming these benefits in terms of the forgone salary. This is the way that economists value intangibles.
Take another more extreme example, but highly relevant to tort law – life and death. How can a monetary value be placed on a life? It certainly cannot be done (rationally) by asking the question: ‘How much would you pay to stay alive?’ Yet the law does this daily in the form of ex post damage claims for wrongful injury and death. These payments, viewed prospectively, can be seen as a ‘price’ for engaging in a hazardous activity – if you negligently injure a pedestrian you must ‘pay’ compensation that will make the victim whole. While the law may believe that this is possible, the economist does not.
The economist asks the more subtle question: ‘How much are those at risk willing to pay to reduce the death rate to save one statistical life?’ – i.e. a future life of an unknown member of the relevant group. To illustrate, suppose there are 1 million people at risk, each prepared to pay £1 to reduce the risk of death by 1 in 1 million. This means that collectively they would be prepared to pay £1 million to save a statistical life. This valuation of ‘life’ is derived from the willingness to pay for risk reduction and directly links