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Law and economics

J Brauer | © Stone Garden Economics

Trawl the internet and you will find that economics features as a top-undergraduate degree to have in hand when applying for a spot in law school. And so it should be as many areas of law revolve around economic concerns or otherwise deal with economic aspects of a case. Property law and contract law are obvious examples. Questions of risk and insurance often are dealt with in law, as they are in economics. Restitution for wrong-doing frequently comes down to dollars and cents. Thus, nowadays one cannot attend law school without being exposed to a good dose of economics, hence the value of that undergraduate degree.

But there also exists a separate field within economics, called the economics of law. One of its main propositions is that the very function of law is to enhance efficiency. A. Mitchell Polinsky, in his excellent, concise book, An Introduction to Law and Economics (4th ed., 2011), provides the following illustration. A factory settles nearby your home. The implicit threat is that it will emit air pollutants that will adversely affect you or the value of your property. First, an entitlement must be determined: Does the factory have the right to pollute, or do you have the right to clean air? When a case comes before a court, a judge will adjudicate and stipulate who, according to the law, has the right to use the air in which way.

Regardless of who wins the case, the next question is how to protect the entitlement either party may have. There are two options: An injunction or damages. If you won the case, an injunction means that you can prevent the factory from doing harm but also that you sell your rights to the air to the factory. It is a before-the-fact remedy. Conversely, if the factory won, you can pay the factory not to emit pollutants, i.e., compensate it for installing air-cleaning technology for example. Damages refer to after-the-fact remedies. If yon won the case, you can sue for damages to compensate you for losses incurred (for example, loss of health or loss of home value, etc.). Conversely, if the factory won, you can compensate it for forgone profits if it installs clean-air technologies.

The big questions now are (1) which entitlement to choose (yours or the factory’s) and (2) which remedy to seek (injunction or damages).

Suppose that as production levels increase from 0 to 1, 2, and 3, the factory makes additional profits of $10, $4, and $2, with total profits of $10, $14, and $16. Also suppose that additional damages caused to you are $1, $15, and $20, for total damages of $1, $16, and $36. Net out the numbers, and total profits minus total damages amount to $9, -$2, and -$20 at the three production levels of 1, 2, and 3. From society’s point of view, the “efficient” solution is an output level of 1 because that maximizes the difference between benefits to the factory and costs to the resident, you. If we shut down the factory altogether, you gain $1 from harm not suffered but the factory loses $10 from not producing anything and not employing anyone. If, in contrast, we permitted 2 units of production, the additional benefit to the factory of $4 does not compensate for the additional damage done to you of $15. Thus, production levels of either 0 or 2 are inefficient.

Under an injunction remedy, if you had the entitlement, you would permit the factory to pollute so long as it compensated you for your loss of $1, and the factory would happily pay you since obtaining a net profit of $9 is better than a net profit of $0. Conversely, if the factory had the entitlement, it would be unconstrained and produce output at level 3, with the highest level of pollution. Net cost to society would be -$20. Therefore, to achieve an efficient outcome, the entitlement should be given to the resident!

Under a damage remedy, if the entitlement again is given to the resident, the factory again would produce at level 1, for its gains $10 and pays $1 in damages, for a net gain of $9. If the factory produced at a higher output level, the damages it would then have to pay would more than eat up all its profits. Therefore, it will not consider producing more than at level 1. If, in contrast, the damage entitlement lies with the factory, then it would produce at level 3 to realize profits of $16, on the presumption that the resident does not have the wherewithal to pay off the factory to reduce production to level 1. Thus, the damage entitlement should be given to the resident.

On the efficiency criterion, then, the resident should get both the injunction and the damage remedy. Which is better? The answer is that the damage remedy is better. And the reason for that is that under the injunction remedy, the resident (i.e., you) knows that at output level 1, the factory makes $10 in profit and you have losses of $1. So, instead of asking the factory to compensate you for your $1 loss, you can hold out for up to $9, exactly equivalent to the factory’s net profit. If you succeed in your strategic behavior of holding the factory hostage to your entitlement, the factory’s profit will revert to $0, so it might as well produce at level 0, which is an inefficient outcome. In contrast, under the damage remedy you are compensated for your $1 loss, and that’s it.

Alternatively, instead of the law granting you an absolute entitlement, it can grant you an intermediate entitlement, which says that the factory can produce at level 1 (and compensate you) but no more. Thus, you cannot hold the factory hostage.

There are a number of implicit assumptions in the above example, but in his book, Prof. Polinsky doggedly chips away at these assumptions to make his examples ever more real-life like. In the process, one learns a great deal about law and economics and efficiency.

J Brauer is Professor of Economics, James M. Hull College of Business, Georgia Regents University, Augusta, Georgia, USA. He is also a Visiting Professor of Economics at the EBA Program, Department of Economics, Chulalongkorn University, Bangkok, Thailand.

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