Economic Efficiency in Law and Economics Richard O. Zerbe Jr., Professor of Public Affairs, Daniel J. Evans School of Public Affairs and Adjunct Professor, Law School, University of Washington, USA NEW HORIZONS IN LAW AND ECONOMICS Edward Elgar Cheltenham, UK • Northampton, MA, USA © Richard O. Zerbe 2001 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UA UK Edward Elgar Publishing, Inc. 136 West Street Suite 202 Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data Zerbe, Richard O. Economic efficiency in law and economics / Richard O. Zerbe, Jr. — (New horizons in law and economics) Includes bibliographical references and index. 1. Law and economics. 2. Economics—Philosophy. I. Title. II. New horizons in law and economics series. K487.E3 Z47 2001 330—dc21 00–047645 ISBN 1 84064 301 3 (cased) Typeset by Manton Typesetters, Louth, Lincolnshire, UK. Printed and bound in Great Britain by Bookcraft (Bath) Ltd. Contents 1 History of the concept of economic efficiency 1 2 The foundation: A new measure for economic efficiency 14 3 The nature of economic efficiency 34 4 The nature of inefficiency 65 5 Rights and the relationship of law to efficiency 84 6 The problem of missing values in normative law and economic analysis 134 7 The failure of market failure 164 8 Of distributive justice and economic efficiency: An integrated theory of the common law 188 9 The efficiency of the common law: An economic analysis of dueling, cannibalism, the gold rush, racism, and antitrust law 236 10 A recapitulation 291 References 298 Name index 321 Subject index 325 v This book is dedicated to my wife, Diane, for her support and encouragement and to Ronald H. Coase in great appreciation. I would like to thank Steve Vinyard and Robin Boadway. 1. History of the concept of economic efficiency 1.1 INTRODUCTION James Buchanan won the Nobel Prize by proving that the process by which elected officials enact policy in a decentralized polity, such as the United States, leads to spending patterns that are inevitably inefficient. Ronald Coase won the prize for showing that traditional concepts of efficiency fail to account for costs that affect every trade and government action: the costs of transactions. Both Coase and Buchanan showed how institutional arrange- ments affect efficiency, and how changes in these arrangements can be either efficient or inefficient.1 If the concept of efficiency is to serve a useful role, it needs to rest on a firm foundation. To create such a foundation is the aim of this book. Practical people need practical measures of economic efficiency. Theorists want meas- ures that are theoretically sound. Still others want measures that are ethically satisfying. No current measure of efficiency satisfies all of these require- ments. The weight of moral and technical criticism promises to undermine the authority of the current efficiency criteria (Zerbe ‘Three Rules’ 1998b). Indeed, criticisms of legal and economic thinking about efficiency has reached the popular press (see, for example, Purdy 1988). The purpose of this book is to meet the critics’ challenges. Its purpose is not to argue, or to determine, whether or not their charges are true, but rather to provide a version of normative analysis, the foundation and use of which are robust with respect to these sort of charges. In this book, I will produce a definition of efficiency that is workable in practice, theoretically sound, and ethical. To accomplish this task, I will suggest criteria for defining efficiency, and demonstrate how they can be used to judge one of the most concrete expres- sions of collective will: the creation of law. I will strip the current concept of efficiency to expose its moral and ethical basis. Then, I will build up a similar concept, which differs in small – but crucial – ways from the traditional concept. To accomplish this task, I suggest seven axioms to use in forming a definition or criterion of efficiency, and I demonstrate the power of the criterion through several applications, particularly in that most practical arena, 1 2 Economic efficiency in law and economics the law.2 The aim of this book, then, is to suggest measures of efficiency that are practical, that are reasonably well motivated theoretically, and that are logical extensions and modifications of the existing measures, namely the Kaldor–Hicks (henceforth KH) measures of economic efficiency.3 I refer to my definition of efficiency as KHZ. In the course of doing these things, I will demonstrate that the Scitovsky paradox does not occur for our welfare measure and, indeed, is irrelevant for benefit–cost analysis in its usual and customary applications. I will further explain why the sum of compensating variations is both a necessary and sufficient condition for KHZ efficiency. I will show that the incorporation of distributional considerations – and the facts about whether or not compensa- tion actually occurs – are a logical part of any welfare measure built on traditional grounds, so that the present exclusion of such considerations is unnecessary and damaging. I will show that current ethical criticisms of normative economics gener- ally do not apply when the theory is correctly understood, and clearly do not apply when the modest modifications to the definition of efficiency I suggest are adopted. I will show that the alleged ‘status quo bias’ that occurs when considering welfare changes is not a bias, but is well founded. Further, I will demonstrate that the problem of indeterminacy in assigning an previous unassigned right that Posner (and others) say arises does not in fact exist when the problem is approached correctly. Incidental to this, I will show that the Coase theorem – even the efficiency part of the Coase theorem – is wrong, even if we accept the assumption that transactions costs are zero, in that there is a loss of efficiency if the right is assigned to the wrong person. I will show that Baker’s (1980) objections to the application of efficiency analysis to legal issues are incorrect and that Hovenkamp’s (1991) suggestion for measuring the value of changes is not well grounded. Then, I will show the general form of the efficiency equation to apply to the assignments of rights in dispute. In the last two chapters, I present a theory of common law efficiency and indeed inefficiency. Finally, and most importantly, I provide numerous examples from the law of the application of the criteria developed here. But what are the current measures of economic efficiency, and how did they arise? To understand the foundation for KHZ, it is useful to understand the foundation for the traditional KH measures. The history given here is hardly definitive, as the material on KH is voluminous. Rather, the history here is meant primarily to provide a context for the practical measure sug- gested. History of the concept of economic efficiency 3 1.2 CURRENT MEASURES OF ECONOMIC EFFICIENCY Pareto Efficiency The most prominent notion of welfare criteria, a Pareto optimum, was intro- duced by Vilfredo Pareto (1896). A Pareto optimum is a state of affairs such that no one can be made better off without making someone else worse off.4 A change in the economy is said to represent a Pareto improvement if at least one person is made better off as a result of the change and no person is made worse off. The obvious limitation of this criterion is that it is not applicable to most changes; few policies indeed have no losers.5 This limitation was recog- nized early on, resulting in a search for a more applicable measure of welfare that continues to this day. The attraction of the Pareto notion of efficiency is that it seems to elimi- nate interpersonal comparisons of welfare. Many economists feel that the inescapable conclusion is that if one precludes interpersonal comparisons of welfare the only logically consistent foundation analysis is the Pareto princi- ple (Slesnick 1998; Arrow 1951). Yet even the Pareto principle makes interpersonal comparisons in an important sense. A choice rule that is identi- cal with the Pareto principle is that any loss of welfare to even one person is sufficient to offset or to veto any possible gains to others, regardless of how large the gains are. This gives infinite weight to losses as a basis of making interpersonal comparisons.6 In this sense, then, the Pareto principle not only makes interpersonal comparisons, it does so in a manner that is unlikely to be widely acceptable. An early approach, lasting until the 1930s, rested, according to Hammond (1985, p.406), on the notion that interpersonal comparisons of utility could be made on a more or less objective basis. The basic assumption was that every individual had an ‘equal capacity for enjoyment’ and that therefore gains or losses among different individuals could be directly compared (Mishan 1981, pp.120–121). As Hicks (1939, p.640) noted, ‘[D]uring the nineteenth century, it was generally considered to be the business of an economist … to lay down principles of economic policy, to say what policies are likely to be conducive to social welfare, and what policies are likely to lead to waste and impoverishment.’ During the nineteenth century, economists believed that the marginal utility of income (the satisfaction associated with an additional dollar of income) decreased with total income, and, largely on this basis, they supposed that an optimal distribution of income was an equal distribution.7 Although Robbins (1932) objected that this assumption about the marginal utility of income was unscientific, the issue remained unsettled. For example, even in the late 1930s, Harrod (1938) continued to argue that the net benefit from a policy could be established, if the aggregate changes in 4 Economic efficiency in law and economics income were positive, on the assumption that the individuals affected were equal in their capacity to enjoy income.8 Harrod (1938) used this reasoning to justify the 1846 repeal of the English Corn Laws, a classic test case for British economists. In response, Robbins (1938, p.640) pointed out that interpersonal comparisons of utility cannot rest on a scientific foundation since utility cannot be measured, and that the justification for such compari- sons is more ethical than scientific.9 Harrod (1938, pp.396–397) then complained that, in the absence of comparability of utility of different indi- viduals, ‘the economist as an advisor is completely stultified’.10 Thus, by the late 1930s, leading British economists, including the future Nobel prize win- ner Hicks (1939), were raising questions about such policy prescriptions because they were seen to rest on interpersonal comparisons of utility. Harrod’s complaint about stultification was echoed elsewhere, creating a sort of tem- porary professional depression among economists, who feared the loss of their ability to pronounce judgments with respect to normative policy. Nor- mative economic analysis remained in this state until the Kaldor–Hicks criteria were introduced. Kaldor–Hicks The origin of the Kaldor-Hicks criteria The Kaldor–Hicks (KH) efficiency criteria have now existed for over sixty years. Both the legal and the economic literatures consider the validity of the KH criteria to be an important issue. For example, a computerized search of law reviews and legal journals finds a total of 1933 citations to Kaldor–Hicks or its synonyms.11 The criteria arose out of discussions among prominent British economists during the late 1930s.12 The goal was to develop a welfare measure that was more broadly applicable than Pareto efficiency and that avoided interpersonal comparisons. Kaldor (1939, pp.549–550) acknowl- edged Robbins’ point about the inability to make interpersonal utility comparisons, but suggested its irrelevance. He suggested that where a policy led to an increase in aggregate real income: the economist’s case for the policy is quite unaffected by the question of the comparability of individual satisfaction, since in all such cases it is possible to make everybody better off than before, or at any rate to make some people better off without making anybody worse off. Kaldor goes on to note (1939, p.550) that whether such compensation should take place ‘is a political question on which the economist, qua economist, could hardly pronounce an opinion’. Kaldor’s (1939) suggestion was later formalized by other economists, such as Boadway and Bruce (1984, p.96) as the proposition that: History of the concept of economic efficiency 5 state a is preferable to another state if, in state a, it is hypothetically possible to undertake costless (lump-sum) redistribution and achieve an allocation that is superior to the other state according to the Pareto criterion. Hicks (1939) agreed with Kaldor’s potential compensation approach and suggested a test similar to Kaldor’s, which is formally stated as state a is preferable to another state if, in the other state, it is not possible, hypothetically, to carry out lump-sum redistribution so that everyone could be made as well off as in state a. (see Boadway and Bruce 1984, p.97) In less formal language, the Kaldor test is passed if in the new state, redistributions are possible that would create a state Pareto superior to the original state. The Hicks test is that there exist no redistributions in the original state that would produce a situation Pareto superior to the new state. These two tests are generally known as the Kaldor–Hicks compensation tests13 or, alternatively, as the potential compensation – or potential Pareto – tests.14 They represent what economists and lawyers generally mean, or think they mean, when they speak of economic efficiency.15 Posner (1985a, pp.86– 89; 1986, pp.12–13; 1987a, p.16) has indicated that a term of his creation, ‘wealth maximization,’ is identical with KH. Although this identity has not been borne out in his actual uses of the term, this identity will be assumed here, except as otherwise indicated.16 1.3 THE SEPARATION OF EFFICIENCY AND DISTRIBUTION The Origin of the Separation The approach adopted by Kaldor, and then by Hicks, attempted to separate economic efficiency from issues of the distribution of income. It was gener- ally thought that by separating distributional considerations from aggregate gains a value-free measure would be obtained (Kaldor 1939; Hicks 1939; Chipman and Moore 1978, p.578).17 The change in aggregate gains was to be the measure of efficiency, so that there was a separation of effects into those of efficiency and distribution. The eagerness of economists to separate considerations of efficiency from those of distribution arose from a desire to put economics on a firm base as a policy instrument. Kaldor (1939, p.551) argued that the economist cannot be concerned with distributional questions, and then endorsed the procedure adopted by Pigou (1932), which Kaldor describes as ‘dividing welfare effects into two parts: the first relating to production, and the second to distribution.’ With respect to the second part, 6 Economic efficiency in law and economics Kaldor (1939, p.551) suggests, ‘the economists should not be concerned with prescriptions at all … For, it is quite impossible to decide on economic grounds what particular pattern of income-distribution maximizes social wel- fare.’ Hicks (1939, p.712) agreed with this separation and noted that ‘if meas- ures making for efficiency are to have a fair chance, it is extremely desirable that they should be freed from distributive complication as much as possible.’ To Hicks (p.696) it would be ‘rather a dreadful thing’ to have to accept the view that welfare analysis was unscientific. If it were, its conclusions would depend on the scale of social values held by a particular investigator. Such conclu- sions can possess no validity … one’s welfare economics will inevitably be different according as one is a liberal, or a socialist, a nationalist or an internationalist, a christian [sic] or a pagan. This separation of efficiency and equity has remained the standard analysis of economists to this day. From this period in the late 1930s, then, this dichotomy between efficiency and distribution has been, in the main, accepted by the economics profession as necessary to avoid interpersonal comparisons of utility.18 Notwithstanding this rationale the major criticism of the KH com- pensation tests, by critics of benefit–cost analysis, is that the tests ignore income distribution effects (see, for example, Anderson 1993, p.191). Earlier, before the advent of the KH tests, Pigou (1932) had suggested a dual test, and proposed that greater equality in income was a good thing. Under Pigou’s test, a new position was better than an old one if, for an unchanged KH efficiency, it showed an increase in the equality of distribu- tion. Later, Little (1957) correctly pointed out that any criteria, whether KH or not, rested on value judgments. Value judgments are inescapable in norma- tive economics. The important thing is to make the judgments clear so that the decision maker knows what he is getting into. Little proposed that there also be a distributional test in addition to the hypothetical compensation test. Thus, a change in policy that causes a movement from position A to position B is desirable if (1) it passes a compensation test and (2) position B is distributionally superior to position A. Little did not, however, suggest what the distribution test might be. And this failure probably explains Little’s lack of influence, aside from bringing attention to the issue of distribution of income. Although Little, unlike Pigou, did not suggest a distribution test, his work ushered in an outpouring of literature about distribution tests for judg- ing economic policy.