The Chimera of Efficiency (Part 1)

The judicial decision-making takes place in three phases. First, every judge must acquaint himself with the facts of a particular dispute and decide which of them are relevant for rendering the decision. He then must determine which legal norms are to be applied and interpreted. The interpretation of legal norms may however lead to different or even contradictory outcomes. Where does the economic analysis of law stand in all that? The law and economics approach dictates that the judge should decide the case on the basis of cost-benefit analysis so as to maximize societal wealth.  

      1.       Preliminary issues

In the heart of the economic analysis of law lie price theory and welfare economics. Economists see legal rules as price signals which should incentivise the correct behaviour of (almost fully) rational actors. Welfare economics is supposed to offer some criteria for determining which transactions or states of affairs are economically efficient. It is thus concerned with the so-called economic problem of determining an efficient allocation of recourses among individuals with different goals.

To begin, Austrians have been very sceptical about the entire notion of welfare economics. Not only because economists have tried for several decades to circumvent the strictures on economics that are embodied in the principles methodological individualism and subjectivism and necessary corollaries that follow thereof, but also because the notion of efficiency is a highly disputable concept. For efficiency makes sense only when talking about individuals’ ends and utilities. All theories which uses such terms the utility of society or social welfare must therefore be jettisoned.

Moreover, an economic theory cannot itself establish the basis for making an ethical judgment. The economic analysis of law however recommends that a judge should decide a case on the basis of weighing costs and benefits incurred by the parties to a dispute. Since it is extremely difficult to derive an “ought” from an “is”, the argument that the case should decided so as to impose liability on the party who was a cheaper cost avoider is plainly unscientific and must be abandoned. Further, as costs are purely subjective, it is by no means guaranteed that the judge will reach a decision that will maximize the wealth of society.

Hayek famously questioned the notion of welfare economics when he stated that “the fact that most of us believe that they can judge which of the several needs of two or more known persons are more important, does not prove either that there is any objective basis for this, nor that we can form such a conceptions about people whom we do not know individually. The idea of basing coercive actions by government on such fantasies is clearly an absurdity.” (Law, Legislation and Liberty, Vol. 2, The Political Order of a Free People, p. 201 – 202)

2.  From Pareto to Kaldor-Hicks

The first criterion for judging whether a transaction is economically efficient is that of Pareto superiority. Pursuant to this principle, a transaction or, alternatively, a change in the legal system is efficient if and only if at least one person is made better off while no other person is made worse off. The advantage is that it does not entail interpersonal comparisons of utility. If two persons enter into a contract, they both expect to benefit which means that their utility ex ante increases.

The limitation of this criterion is however obvious. In a world where transactions have third-party effects it is impossible to find out if any party has been made worse off. Let us remind that it was Hayek who pointed out the impossibility of gathering information that is widely scattered among individuals.  

In order to avoid this particular problem, Rothbard introduced the ingenious concept of demonstrated preferences. As Rothbard puts it: “The concept of demonstrated preference is simply this: that actual choice reveals, or demonstrates, a man’s preferences; that is, that his preferences are deducible from what he has chosen in action. Thus, if a man chooses to spend an hour at a concert rather than a movie, we deduce that the former was preferred, or ranked higher on his value scale. Similarly, if a man spends five dollars on a shirt we deduce that he preferred purchasing the shirt to any other uses he could have found for the money.  This concept of preference, rooted in real choices, forms the keystone of the logical structure of economic analysis, and particularly of utility and welfare analysis.” (Toward a Reconstruction of Utility and Welfare Economics)

Thus, praxeology can only say that two parties to contract ex ante increase their utilities. Government taxation on the other hand necessarily entails an element of coercion which reduces the utility of at least one person. It is therefore impossible for an economist to say that a government intervention increases utility for he cannot know what is exactly happening on a individual’s scale of preferences.

It wasn’t enough for mainstream economists and they developed another criterion, namely Kaldor-Hicks efficiency. According to this criterion, a transaction is deemed efficient as long as the gainers are able to compensate the losers. The compensation does not have to necessarily take place which is the crux of the problem. Since the losers might not be compensated at all, how could they consent to such a transaction or a change? As soon as we understand this, it becomes crystal clear that the notion of Kaldor-Hicks is at variance with welfare economics.

But the entire bunch of efficiency-based economics of law literature is based on this very concept of Kaldor-Hicks efficiency. The reason for this may be that the law and economics scholars see the real world from the perspective of the general competitive equilibrium, the conditions of which are unattainable. Since they all believe that people act as if they were rational maximizers, it is easy for them to conclude that the market fails in some areas. This opens them the door to their legal creativity. In such a situation they can insert in legal codes whatever legal restriction they could possibly think of.