Methodology in LAW & ECONOMICS Maria Alessandra Rossi University of Siena and EconomiX CARGESE, May 19th 2006

"Today law and economics is a subject over which controversy and confusion reigns. Defining the subject is like trying to eat spaghetti with a spoon. Law and economics can be positive, normative, neoclassical, institutional, Austrian – quite simply the subject is weighed down by a multitude of competing methodologies and perspectives which are not always easily distinguishable." (Duxbury, 1995)

Overview of the talk The methodology of “mainstream” law and economics A glimpse at the evolution of L&E scholarship Focus on selected methodological questions General thrust of the argument: –L&E raises interesting methodological issues with a distinctive character with respect to those raised by economics proper –Current L&E is best described as an assortment of a plurality of methodologies

What is L&E? The distinguishing feature of L&E is the method Economic analysis of law is the application of economic theory to examine the formation, structure, processes and economic impact of law and legal institutions (Mercuro and Medema) Economic analysis of law is the application of the rational choice approach to the study of law (Becker) The economic analysis of law is the application of an efficiency perspective to legal rules (Shäfer and Oh)

Law and economics relies on the standard economic assumption that individuals are rational maximizers, and studies the role of law as a means for changing the relative prices attached to alternative individual actions. Under this approach, a change in the rule of law will affect human behavior by altering the relative price structure—and thus the constraint—of the optimization problem. Wealth maximization, serving as a paradigm for the analysis of law, can thus be promoted or constrained by legal rules. (Parisi, 2004)

Main methodological tenets Methodological individualism –The fundamental unit of analysis is the individual Rational Choice –Individuals are rational maximizers of their wealth or utility –The rational choice hypothesis ensures predictability of behavior in response to changes in incentives Stable Preferences –Preferences remain constant at least in the short run –Stability of preferences contributes to ensure predictability of behavior Equilibrium –Both market and non-market human interactions tend toward equilibrium Consequentialism –Laws are evaluated for their outcomes –Laws are evaluated ex-ante

The evolution of “mainstream” L&E ( MacKaay, 1999) present “Old” Chicago L&E: focus on antitrust law, tax law and regulation Emphasis on the generation of testable predictions and on empirical testing “New” Chicago L&E: focus on property, contract and torts Extension of the rational choice approach to non-market behavior Diffusion of L&E in US Law Schools Predominance of neoclassical analysis and of the “efficiency of the common law” hypothesis Paradigm questioned Debates mainly on the “efficiency of the common law” hypothesis Diffusion of a multiplicity of methodologies within L&E

Principal trends in the evolution of L&E Change in the object of study Change in the identity of L&E scholars Enhanced interdisciplinarity: L&E&… –L&E & sociology of law –L&E & organization –L&E & psychology –L&E & history –L&E & neurology –L&E & development –L&E & …

Main L&E approaches Chicago Law and Economics New Haven School Old/New Institutional Economics Public Choice Theorists Virginia School Critical Legal Studies Behavioral L&E

The object of study of current L&E Positive description of the nature and origin of existing legal systems and distributions of rights Analysis of the effect of legal relationships and the legal structure on economic outcomes Identification of the necessary conditions for the development and emergence of efficient legal structures Identification of the conditions/processes of implementation of an efficient legal structure Analysis of the relationships among different legal rules, social norms and institutions Study of the effects of law on the economy and of the effects of the economy on legal change ….

Selected methodological issues Definition of the appropriate interface between legal and economic analysis Realism of assumptions in model-building Role of the empirical testing of theories

Law vs. Economics? Induction vs. deduction Positive vs. normative analysis Efficiency vs. justice

Deduction vs. Induction Law inherently inductive (from the particular to the general), economics inherently deductive (from the general to the particular) (Kronman, 1993) But… –Is economics always deductive (v. Coase’s lighthouse)? –The scientific method is entirely consistent with attention towards the particular –Is this really a constraint or rather a source of value added for L&E? The ability to combine theoretical insights with a nuanced characterization of practical details is a valuable feature of economic methodology AssumptionsHypothesesTest Observation Generalization vs.

Positive vs. normative analysis/1 Legal research necessarily addresses normative questions Economic analysis is surely positive, but may it also be normative? Can L&E research be normative?

Positive vs. normative analysis/2 Only positive EAL is possible: to evaluate the efficiency of a legal rule is an objective endeavor; to argue that such rule is desirable is a value judgement (De Geest, 1994) Economics is strictly positive, law is strictly normative: no marriage is possible (Couwenberg et al., 1980) Both positive and normative L&E are possible (Friedman, 1987)

Positive vs. normative analysis/3 The answer to this question depends on other questions: –What should be the relevance of L&E research for policy? –What metrics should be used to evaluate L&E research? Is policy relevance one of such criteria? At a minimum, economics may explore the relationships between the various value judgements underlying legal discourse and indicate where and when they may conflict More generally, I do think that relevance for policy is an important criterion for the evaluation of L&E research

Efficiency vs. justice/1 What is the role of efficiency as a normative criterion? Efficiency as a “first-order” rule: efficiency is the goal or one of the goals of economic policy –ex. Determination of the efficient level of pollution through max of the net value of pollution abatement Efficiency as a “second-order” rule: efficiency is a criterion to choose among the means through which other non-economic goals can be achieved –ex. Determination of the least-cost way of achieving a given level of pollution

Efficiency vs. justice/2 Debate on efficiency as a “first-order” rule prominent in the early years of L&E –Posner: efficiency is moral and comports with the dictates of justice –Calabresi: justice is a goal per se, efficiency is just an ingredient of justice Some issues at stake: –Circularity of the efficiency analysis –Separability of allocation and distribution –Predictive power of efficiency analysis

Efficiency vs. justice/3 Efficiency analysis is nonetheless important to identify the trade-offs involved in choices among competing ends Is a ranking among different objectives of the legal system possible/useful? Often efficiency analysis is not in contrast with justice considerations but rather supports laws based on justice considerations (v. Parisi’s lecture)

Realism of assumptions in model-building

“We should be pragmatic about theory. It is a tool, rather than a glimpse of ultimate truth, and the criterion of a tool is utility” (Posner)

The higher the realism of assumptions, the more a theory becomes similar to a description (Posner) As long as irrealistic assumptions predict well, we are fine (Friedman)

Even if predictions on the basis of unrealistic assumptions are correct, a theory based upon them may fail in providing insight in the working of the economic (or legal) system (Coase)

What is the goal of economic theorizing? If it is prediction, then it may well be the case that models based on irrealistic assumptions do not predict well If it is explanation, models based on irrealistic assumptions almost certainly do not explain well (Coase)

Some challenges to the rational actor model Bounded rationality vs. perfect rationality –Cognitive limitations in the understanding of law –Social norms Social preferences vs. self-regarding preferences –Reciprocity –Inequality aversion –Envy –Altruism Process-regarding preferences Situation-dependent preferences –Loss aversion –Endowment effect –Intertemporal choice (ex. Hyperbolic discounting) –Endogeneity of preferences

The role of empirical testing/why To leverage the gains from the combination of inductive and deductive approaches Payoffs for both legal research per se and economic research per se Evidence-based policy-making Increased credibility and success of the L&E movement

The role of empirical testing/what Historical empirical analysis –What forces have motivated change in legal rules? –What has been the effect of changes in legal rules on the economic environment? Contemporary empirical analysis –How do individuals actually respond to changes in legal rules? –What is the impact on economic outcomes of alternative legal rules? Lack of data, especially for EU Need for attention in capturing relevant legal variables (v. Doing Business report)

Questions for the beach…

Is there really an evolution towards different methodologies and/or methodological pluralism or the different approaches can be reconciled within the mainstream? Is the evolution towards a plurality of methodologies a positive development? What is the best criterion to choose among competing approaches? To what extent does the rational choice model need amendment? What is the appropriate combination of induction and deduction? Should the economic analysis of civil law differ methodologically from the economic analysis of common law?