Economic Foundations of Law and Organization / Edition 1

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This book serves as a compact introduction to the economic analysis of law and organization. At the same time, it covers a broad spectrum of issues. It is aimed at undergraduate economic majors who are interested in law and organization, law students who want to know the economic basis for the law, and students in business and public policy schools who want to understand the economic approach to law and organization. The book covers such diverse topics as bankruptcy rules, corporate law, sports rules, the organization of Congress, federalism, intellectual property, crime, accident law, and insurance. Unlike other texts on the economic analysis of law, this text is not organized by legal categories such as property, torts, contracts, and so on, but by economic theory. The purpose of the book is to develop economic intuition and theory to a sufficient degree so that one can apply the ideas to a variety of areas in law and organization.

About the Author:
Donald Wittman is Professor of Economics at the University of California, Santa Cruz. He previously taught at the University of Chicago

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Editorial Reviews

From the Publisher
"A huge amount of law, as it relates both to individual rights and social organization, can be simply and effectively explained by the consistent application of a few basic economic concepts. In this volume, Don Wittman deftly uses two key tools - an accurate definition of social welfare and the critical role of transaction costs - —to show the common threads that unite such disparate legal fields as bankruptcy, contracts, land use planning, and torts. His useful, rigorous and readable introduction to the principles of economics lays the groundwork for further study at the intersection of law and social organizations." - Richard A. Epstein, University of Chicago

"Wittman has written an economists' law and economics text. It is organized around economic, not legal, principles. It provides an economic analysis of legal and organizational issues. More importantly, it showcases the power and flexibility of economic analysis in unusual and interesting settings." - Paul H. Rubin, Emory University

"Readers will welcome the sophistication of this book on the new and growing subject of economics and law for its two distinctive qualities. First, it is organized around themes of economic theory. This allows the reader to gain a kind of insight that would not be possible were the book organized in the more usual way, according to legal subject matter. Second, the book covers more than purely legal subject matter -— it discusses important aspects of organizations and their governance. I enthusiastically recommend the book to students and scholars alike." - Steven Shavell, Harvard Law School

"Wittman takes a fresh approach to law and economics, rethinking the traditional subject areas and covering many new ones." - Michelle J. White, University of California, San Diego

"Wittman has succeeded in writing a textbook that distinguishes itself from the competition in its topical orientation and its organizational structure.... I would recommend this book to instructors who teach law-and-economics to general economics majors (or as a prelude to a more advanced law-and-economics course), or, as Wittman suggests in his introduction, a supplement to intermediate microeconomics courses focusing on the Coase Theorem and transaction costs." - Eastern Economic Journal

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Product Details

  • ISBN-13: 9780521685245
  • Publisher: Cambridge University Press
  • Publication date: 6/30/2006
  • Edition description: New Edition
  • Edition number: 1
  • Pages: 400
  • Product dimensions: 6.97 (w) x 9.96 (h) x 0.79 (d)

Meet the Author

Donald Wittman is Professor of Economics at the University of California, Santa Cruz. He previously taught at the University of Chicago. Professor Wittman's book The Myth of Democratic Failure (1995) won the American Political Science Association award for the best title in political economy in the years 1994–6. He is coeditor of the forthcoming Oxford Handbook of Political Economy. Professor Wittman's research has appeared in journals such as the American Economic Review, Journal of Political Economy, American Political Science Review, Journal of Economic Theory, Journal of Legal Studies, Journal of Law and Economics, and Journal of Public Economics. His research has been supported by various National Science Foundation programs.

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Read an Excerpt

Cambridge University Press
0521859174 - Economic foundations of law and organization - by Donald Wittman

1   Introduction
    A. Economics Provides the Analytic Framework 2
    B. Organization of This Book 2

Should a surrogate mother be allowed to keep the fetus? Should the hospital, the donor, the Red Cross, or the patient be liable for the harm if a patient contracts hepatitis from a blood transfusion? Should there be regulations against smoking in airplanes? Should plea-bargaining be allowed? Should hostile corporate takeovers be encouraged? Should a bystander be found liable for not rescuing a drowning person if the rescue could have been accomplished with little risk to the potentialrescuer? Should homeowners be allowed to force a cattle feedlot to move without compensation by the homeowners if the cattle feedlot was there before the homes were built? Why are nuclear power plants subject to strict liability? Why are there few consumer cooperatives? When should a firm vertically integrate? How should congressional committees be structured? What should be the creditor priority in bankruptcy?


The answers to these questions are found in economic theory. In this book, we use economic analysis to explain various areas of the law, including criminal, corporate, contract, accident, bankruptcy, and environmental law. Along the way, we explain why relationships are organized in a certain way. For example, why McDonald’s is a franchise, while Ace Hardware Stores are independently owned and Safeway stores are a single corporation. As another example, we explain why stockholders have limited liability. Hence, the title of this book – Economic Foundations of Law and Organization.

   The connection between law, organization, and economics is very close. Economics is the study of what, how, and for whom. Standard textbooks in economics define the field as the study of resource allocation in the presence of scarcity. Laws affect resource allocation and help to determine what, how, and for whom. For example, a law that finds trucking companies liable for accidental harm will create incentives for more careful driving by truckers. A well-ordered society will tend to choose laws that promote economic efficiency. Laws create a public ordering; that is, they organize society in a certain way. Private entities are also organized in a certain way. For example, in corporations, stockholders supply capital and managers of the firm make day-to-day decisions. Economics provides the key to understanding why firms and society are organized in particular ways.

   Economics also provides insight into many ethical issues. Why is theft wrong? If there are three starving men are in a lifeboat, is it ethical to kill one of them for food, and if so, how should this be decided? And returning to some of the questions posed at the beginning of this chapter (because legal and ethical issues are often entwined), when does being first deserve extra consideration and what duties are owed to strangers? Thus the title of the book could also have been Economic Foundations of Law, Organization, and Ethics.


This book is organized into sections. The sections need not be read in order, the major exception being Part II on the Coase theorem, which should be read first if the reader is not well acquainted with Coasean analysis.

   Part I explains the concepts of rationality and efficiency and provides the underlying rationale for cost-benefit analysis. Part II introduces the concept of transaction costs and argues that this concept is critical to understanding law and organization. Part III develops the underlying intuition needed to grasp the economic implications of the law. Part IV discusses when and why property rights, liability rules, communal rights, restitution, or regulation is chosen instead of the other methods of protecting entitlements. Along the way, blackmail, patents, and the takings clause are considered. Part V derives optimal liability rules (including the optimal level of punishment for criminals). Among other things, why liability rules differ for falling trees, automobile accidents, and dangerous pets is explained. Part VI considers how sequential inputs changes the analysis provided in Part V. Topics such as coming to the nuisance, the Good Samaritan rule, and mitigation of damages are covered. Part VII considers the role of the courts in contract law, including marriage contracts. Part VIII focuses on explicit and implied warranties for exploding soda bottles, lawnmower accidents, and air conditioner failures. Part IX is concerned with the allocation of risk and the role of insurance in the law. This topic goes far beyond the narrow confines of what people ordinarily think of as insurance. For example, royalties for artists can be viewed as insurance for investors. Problems arising from over-regulating the insurance industry and under-regulating insured savings deposits are discussed. Part X, the longest section, is devoted to governance and organization and answers such questions as, why are investor-owned firms common, but worker-owned firms rare? Why do we have franchises? And how is Congress organized? Part XI is devoted to bargaining in the shadow of the law.


Three useful reference texts are the New Palgrave Dictionary of Economics and the Law, the Encyclopedia of Law and Economics, and the Handbook of Law and Economics.


1. What does economics have to do with the law? Is it about howmuch we pay for lawyers and prisons? (3)Note that points in parentheses refer to the number of points the answer is worth and suggest approximately how many sentences should be used in answering the question.


Bouckaert, Boudewijn, and Gerrit De Geest. (2000). Encyclopedia of Law & Economics. Cheltenham: Edward Elgar Publishing Limited.
Newman,Peter (ed.). (1998). The New Palgrave Dictionary of Economics and the Law. London: Macmillan Reference Limited.
Polinsky, A. Mitchell, and Steven Shavell (eds.). (2006). Handbook of Law and Economics. Amsterdam: North Holland.


In Part 1, we consider two fundamental building blocks of economics – rationality and efficiency.1

   Almost all of economics assumes rational behavior by individuals in their roles as consumers, workers, or business owners. Rationality typically focuses on how individuals respond to prices. Rational consumers have downward-sloping demand curves and rational business owners have upward-sloping supply curves. Much of the legal system also assumes that individuals respond rationally to prices. If individuals are rational, then, other things being equal, larger fines for speeding will reduce the number of speeders. Suppose that individuals were irrational in this regard. Then the legal system would reduce fines for speeding to reduce the number of speeders, unless the legal system, itself, was irrational, in which case it would do the opposite. As this last thought experiment suggests, assuming irrationality leads to some unrealistic predictions about human behavior and legal rules.

   Chapter 2 is devoted to a deeper discussion of rationality. We first show that the economist notion of rationality is nowhere near the cartoon caricature of rationality presented by the critics of rational behavior. Next, we show that when people are rational, the price reflects the benefit of the last item purchased. That is, if a person is rational, then paying $10 for an item means that the person valued the item for at least $10. This rather trivial insight allows us to undertake cost-benefit analysis, the subject of Chapter 4.

   The theme of this book is that laws can be evaluated according to whether they are economically efficient and that many laws (particularly, judge-made laws) do, indeed, promote economic efficiency. But what does it mean to be economically efficient and why is that criterion chosen instead of another? This is the subject of Chapter 3. Economic efficiency (Pareto optimality) is a noncontroversial method of assessing welfare. It does not mean that individuals work without taking lunch or that pollution is ignored. Instead it just means that no one individual’s welfare can be increased without reducing another individual’s welfare. In Chapter 3, the concept of economic efficiency will be discussed in-depth because it is hard to understand from a mere definition. We also discuss why other approaches such as the utilitarian approach and various distributive approaches are not very helpful in evaluating legal rules.

   In Chapter 4, we consider cost-benefit analysis. Cost-benefit analysis uses prices to measure welfare. As previously indicated, this is justified by the argument presented in Chapter 2 that rational individuals are willing to pay $X for an item only if the item is worth $X to them. We show how cost-benefit analysis is related to economic efficiency and why as a practical matter it is used rather than the Pareto criterion. Thus the theme of the book can be restated as follows: legal rules and organizational structure are often chosen on the basis of their costs and benefits.

   Part I can be seen as the underlying argument for the use of cost-benefit analysis (to the exclusion of other criteria) in evaluating the law. For those who are already comfortable with the concept and don't desire a deeper understanding of cost-benefit analysis and don't need to be convinced that rationality is a plausible starting place for analyzing human behavior, Part I (and in particular chapters 2 and 4) can be skipped. For the rest, Part I provides the justification for the economic approach to law and organization.

2   Rational Behavior, Preferences, and Prices
    A. Rational Behavior 8
    B. Advertising# 9
    C. Preferences and Utility Functions 10
    D. Prices 11
    E. Concluding Remarks 12

The basic premise of this book is that individuals generally act rationally. Because there is often confusion regarding what is meant by rationality and a great deal flows from assuming rationality, it is useful to start with a definition.


The following is how economists define rationality. If a person can rank order her preferences (e.g., Tom prefers (A) to travel around the world and eat caviar every night over (B) working forty hours a week and eating burritos every night over (C) playing video games all day, living with his parents, and eating steak and potatoes) and the person chooses his most preferred feasible alternative, then the person is rational.1 Rationality is a plausible assumption regarding human behavior. Isn’t it a better theory of human behavior that people do what they prefer to do rather than that people behave randomly (they are arational) or that they consistently act against their own preferences (they are irrational)?2

   For the most part, this book is devoted to explaining aggregate or market behavior rather than a particular individual’s behavior. While one might argue that a particular person is either irrational or uninformed, it is much harder to claim this to be the case for the market.3 Thus, for example, one might argue that a manager of a particular firm is paid more money than she is worth, but it is much harder to argue that managers in general tend to be paid more than they are worth. Because we are interested in aggregates, our predictions are not undermined if some people do not act rationally.

   Note that there is no need to assume that individuals are perfectly informed. Rational people can be misinformed and make mistakes. For example, they may carry a raincoat on a day when it does not rain. However, people will not persist in their mistakes if the evidence is to the contrary. They will not carry a raincoat in Santa Cruz in July once they learn that it does not rain there in the summer. Of course, carrying a raincoat when it is does not rain is not very costly. If mistakes were very costly, rational individuals would gain more information ahead of time. For example, first-time strawberry farmers in Santa Cruz County will install irrigation systems to grow their crops in the summer rather than rely on rainfall.

   Although people make mistakes, it is unlikely that people are consistently prone to misjudgments in a particular direction. I am skeptical of arguments that assume that people tend to underestimate or overestimate the dangers of some activity (for example, underestimating the dangers of taking prescription drugs) when such information is public. Here, the basic premise is that some people may overestimate and others may underestimate the probability of a bad outcome, but over all issues, the average person’s beliefs do not systematically differ from the experts’ beliefs in a certain direction.

   Note that being rational does not mean that the person is selfish. Rational people may be altruistic; but being rational, they will try to achieve their ends in the best way possible. A surgeon trying to save someone’s life will use sterilized equipment when possible and will not purchase more expensive equipment if it is not better.

   When it comes to producers, there is very strong pressure for rational profit maximizing behavior because large deviations from profit maximization are likely to result in the firm going out of business. Consider a farmer in North Dakota where the winters are cold and there is not much rain. If the farmer prays for rain but does not install an irrigation system or plants bananas instead of wheat, he will not survive for very long. Of course, if the farm is otherwise very profitable, there is room for some behavior that modestly deviates from profit maximization (for further discussion, see Chapter 33 on agency costs in corporations).

   In this book, we sometimes use mathematics, including calculus, to explain people’s behavior and at other times the arguments are counterintuitive. A common criticism is to assert that people do not have the cognitive skills to make such judgments. But we are not assuming that individuals actually use calculus in their decisions. Rather that calculus is a useful way to characterize their behavior. Perhaps, the easiest way to understand the logic behind my argument is to consider maple trees. The leaves on maple trees are not stacked in a row one right behind the other; instead they are arranged in a way to maximize the amount of light falling on all of the leaves. Advanced mathematics is needed to solve this maximization problem, but, as far as I know, no maple tree has ever gone to college. If trees can act rationally, it should not be unreasonable to assume that people act rationally as well.

   So for the remainder of the book, we will assume that, on average, producers and consumers are rational and do not have biased expectations.


Now it is conceivable that people are manipulated by advertising and therefore they do not make rational choices. One could argue that without television advertising, fewer brand names would be sold. However, it would be much harder to argue that without television advertising, people would drink milk instead of smoke cigarettes, eat raw vegetables instead of fast food, buy bicycles instead of muscle cars, live in teepees instead of houses, and wear clothes until they fell apart instead of until they became unfashionable.

   Of course, firms that advertise are not doing it for our pleasure. They are doing it to gain sales. Sales are gained in the following ways: (1) Some advertising is directly informative. When Nissan advertises the Titan truck, not surprisingly, it is advertising that it now provides large trucks. (2) Some advertising is just a reminder that the brand exists and serves as an implicit statement that the firm stands behind its product. A brand name is likely to be of higher quality than its unadvertised counterpart. Advertising content is irrelevant in such cases.5

   Now it is possible that advertising tricks people. For example, the beautiful female in the passenger seat of a Corvette advertisement might convince someone to buy the Corvette in hopes of attracting similarly beautiful women. But if manipulation were that easy, then Prius would engage in a similar tactic and possibly sellers of hamburgers, milk, and bicycles would do the same; in which case, this manipulation would no longer determine what the susceptible person would buy.

   Part of our enjoyment of life is aesthetic. Minimum daily food requirements can be met by spending less than $3.00 a day, but who wants to eat like that if they can afford to spend more? No one argues that it is advertising that drives us to eat more than the minimal cost diet. Yet when a person chooses a muscle car (such as a Corvette), others argue that the person is irrational (it does not maximize fuel economy) or that the person is susceptible to advertising. But advertising is geared to the person’s aesthetic sensibilities and brand choice allows others to infer preferences of the purchaser. All of us employ different mental images of the typical Corvette owner in comparison to the typical Prius owner. Advertisers know that our minds are not a empty tablet; Prius does not engage in direct-mail campaigns to Corvette owners.

   Of course, at the margin, advertising does have an effect. Advertising tries to capture the otherwise indifferent consumer of a competing brand. But the effect of advertising is limited. Burger King can advertise day and night that the Whopper is better than the Big Mac, but the demand will decrease dramatically if the price of the Whopper is doubled.


   The fundamental building block of rationality is that each individual can rank order their preferences and then choose the highest-feasible alternative. But writing down preference rankings is a time-consuming matter. As a result, economists tend to formulate their discussion of preferences in terms of utility functions, which are a more concise method of characterizing preference relationships.

   To illustrate, we will consider a very simple preference ranking. Suppose that a person prefers more apples to fewer apples and more bananas to fewer bananas, but the person is indifferent between having two more bananas or one more apple. The person’s preference rankings from most desired to least desired are then

   {2 apples} or {4 bananas}
   {1 apple and 1 banana} or {3 bananas}
   {1 apple} or {2 bananas}
   {1 banana}
   {no fruit at all}

This ranking does not include the possibility of half an apple or ten apples. So such lists can be very long.

© Cambridge University Press
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Table of Contents

1 Introduction 1
2 Rational behavior, preferences, and prices 7
3 Pareto optimality versus utilitarianism 13
4 Cost-benefit analysis 21
5 Transaction costs 33
6 Fencing in and fencing out 41
7 Coase versus Pigou 49
8 How to think like an economist : drunk drivers, hawks, and baseballs 59
9 Smoking regulations : market solutions to high-transaction-cost situations 69
10 Rules of thumb : sports and driving rules 75
11 The protection of entitlements : why one method is chosen over another 91
12 Property rights or communal rights in knowledge? 103
13 Liability for harm or restitution for benefit? 113
14 The takings clause : should there be compensation for regulation? 121
15 Cost minimization and liability rules 131
16 Negligence rules 141
17 Crime and criminal law 153
18 Mitigation of damages and last clear chance 167
19 The good samaritan rule 175
20 The role of being first in allocating rights : coming to the nuisance 181
21 Default rules and breach of contract 193
22 When is a handshake a contract and when is a "contract" not a contract? 207
23 Marriage as contract : family law 217
24 Exploding coca-cola bottles 231
25 The role of asymmetric information 239
26 Consumers and producers cause damage : lawnmowers 247
27 The market for insurance 257
28 Royalties for artists and insurance for investors 269
29 Automobile insurance 277
30 Bankruptcy 283
31 Deposit insurance and banking crises 295
32 The governance of organization 305
33 Corporate law and agency problems 313
34 Insider trading 323
35 Organizational response to opportunism : McDonald's, the Mafia, and mutual of Omaha 331
36 The organization of legislatures 341
37 Federalism 349
38 The internal organization of the family 357
39 Settlement or trial? 367
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