The legal system and its rules and norms facilitate the formation of formal and informal markets on which voluntary, value-creating exchanges and resource movements can take place. As Coase (1991) notes, ‘without the appropriate institutions no market economy of any significance is possible’. Just as understanding markets, the process of trade and the gains from trade are all central to understanding economics, understanding the role that legal rules and institutions play in facilitating economic exchange is a vital part of understanding of the very same phenomena.
What role do legal rules and courts play in a market economy? What role should they play? Why do courts make the decisions that they do, and what are the some of the problems that arise with collective legal decision making?
When do legal rules matter for efficiency? This chapter presents and discusses the Coase Theorem (1960), which is one of the most important and remarkable findings in economics. The theorem states that under certain conditions legal rules will have no bearing on the economic efficiency of resource allocation. As long as there is some legal rule in place, then an efficient outcome will ensue.
Chapter 3 examined situations where transactions costs were sufficiently low to render legal rules irrelevant from an efficiency point of view. If these conditions always prevailed and transactions costs were sufficiently low — and if economists cared only about economic efficiency — then the study of law and economics would not be very interesting (and this would be a very short book!). In such a world, parties would always be able to bargain around the law, and as a result of the reasoning embodied in the Coase Theorem, legal rules would simply not matter for efficiency — although they would of course matter for distribution and for the parties involved.
Up to this point we have analysed tort laws under the assumption that the victim cannot take any care. Let us now drop this assumption. That is, suppose now that the victim can also take action (in the form of care or precaution) that reduces expected harm. This situation is referred to as the bilateral care model. The approach outlined in this chapter not only allows us to study a much wider set of situations; the possibility that a second party can affect the probability and extent of harm introduces new complications and also means that legal rules will potentially become more complex.
In the previous chapter we examined situations where the parties undertaking care and incurring harm were ‘economic strangers’ in the following important sense: there was no existing economic relationship between the parties when they chose their levels of care, or when accidents occurred.
This chapter examines one of the most important institutions in market economies: private property rights. Private ownership of property rights over an asset typically consists of a ‘bundle’ of rights, which usually include:1.The right to use the asset;2.The right to exclude others from using the asset; and3.The right to dispose of the asset.
In Chapter 3 we examined situations in which transactions costs were low. We focused on the ability of parties to bargain around legal rules, which rendered those rules irrelevant for efficiency and, in certain cases, also irrelevant for production decisions (although not irrelevant for the distribution of wealth). In these situations, we assumed that a body of contract law or rules was in place, so that any agreements between the parties were enforceable and were in fact enforced. Under these assumptions, the efficiency properties of economic outcomes are not so much reliant on the nature of legal rules as they are on the existence of some legal framework and some set of rules, as well as a set of rules regarding contracts.
In previous chapters we examined legal rules that govern private harms and breaches of private agreements. This chapter analyses markets for illegal activities, which are thought to generate a more widely dispersed kind of social harm and which, in general, cannot be perfectly detected or enforced.
One of the key insights of the Coase Theorem is that the inefficiencies and difficulties that are associated with uncompensated positive and negative external effects can be mitigated if parties are permitted to bargain. For firms, one extreme form of bargaining is to permanently internalise externalities by merging. This can happen through formal merger negotiations or via takeover bids. This chapter examines some of the economic issues that arise within firms in response to different legal rules, and when firms seek to internalise externalities by merging. The Chapter also studies a wide variety of economic issues that arise in corporate law and governance, and competition law.
Chapter 3 examined situations in which parties to a dispute could potentially (if transaction costs were sufficiently low) negotiate over an economic outcome and, by doing so, exhaust all gains from trade. Moreover, under certain assumptions (for example, quasi-linearity of utility functions), the final outcome and the size of the aggregate gains from trade were independent of the initial allocation of property rights or legal rule than was in place. This is the essence of the Coase Theorem.
