Review of Law and Economics

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The New Palgrave Dictionary of Economics and the Law: Surveying Two Waves of Economic Analysis of Law1

January 11, 2000


The American Review of Law and Economics
Professor Aaron S. Edlin

Department of Economics and

The School of Law

University of California, Berkeley

I. Introduction

In 1897, Oliver Wendell Holmes wrote that “For the rational study of the law, the black-letter man may be the man of the present, but the man of the future is the man of statistics and the master of economics.”2 Reading through the New Palgrave Dictionary of Economics and the Law, I could not help but wonder whether this bold prophecy might have come true. The three volume tome contains a truly vast body of economic analysis of law.

The First Wave of economic analysis of law swept over the shores of Lake Michigan and flooded through Hyde Park in Chicago. The Chicago-school insights from this wave are extremely straightforward; and yet, their consequences are so often missed by those not steeped in economics, that we must admit them to be extremely important insights. Some insights come wholesale from economics such as the insight of trade-offs: almost all pursuits, whether public or private, involve trade-offs, and to ignore or minimize trade-offs is to miss the point. Another insight in this category is that free-trade leads to gains: if A and B seek to enter an exchange, then they generally do so to mutual advantage; even when this advantage may be hard for an outsider to discern or when ex ante advantage turns into ex post disadvantage and leads one party to complain. Unless this trade works to the disadvantage of third parties, it should be facilitated and not hindered by the law. A third major insight, more particular to law and economics, is that when it is difficult or impossible for parties to contract before one takes an action, then the law should endeavor to implement the solution that would prevail in a transaction cost-free world; liability should attach when parties deviate from what they would agree to in such a world, and liability should be in an amount that they would agree to in such a world. (See, e.g., DeMeza’s entry on the Coase Theorem.)
These insights commonly lead the First Wave of Chicago-style law and economics to champion the virtues of a free market, and argue that the law is best when it facilitates and allows all voluntary transactions, with the minimum of regulation. Gaps in contracts should be filled with deference to the third insight, so that, for example, when no damage measure is specified in a contract, and when renegotiation is difficult, then the expectation damages rule may be imposed in order to facilitate efficient breach. When practicalities prevent any contract from being negotiated in advance, then law and economics scholars argue for the fundamental principle that the law (e.g. tort law) should strive to force parties to internalize costs that would otherwise be external.
The New Palgrave also contains insights from a Second Wave of law and economics. This wave moves beyond simple price-theoretic arguments to make sophisticated observations about market failures that justify interfering with freedom of contract. Examples from this movement reviewed here include John Donohue’s entry on “discrimination in employment” which explains how racial prejudices can justify civil rights laws under a wealth maximization standard, Richard Arnott’s entry on “rent control” which demonstrates that rent controls can increase the efficiency of housing markets, and Richard Gilbert and Oliver Williamson’s entry on “antitrust policy,” which points out the special concerns of antitrust enforcement in markets exhibiting network externalities or other demand-side returns to scale.
It would be a mistake to overemphasize the distinctions between these two waves. Writers in the Second Wave generally agree with all three insights that I attribute to the First Wave. And, it would be a mistake to think that writers in the First Wave are entirely laissez-faire: the Chicago School has long advocated interfering with freedom of contract when a contract injures a third party (hence the antitrust ban on cartel arrangements and other contracts in restraint of trade).3
Below, I briefly discuss some of the major themes in the New Palgrave. Then, I review selected entries from both waves. Robert Cooter’s entry on “liability rights as contingent claims” shows that the First Wave continues to roll, providing valuable insights. Entries on antitrust reveal the impact of the First Wave on legal decisions, and the emerging Second Wave of analysis. As a teacher of antitrust, I found these entries as a group to be quite useful. Finally, I consider entries from the Second Wave on “discrimination in employment” and “rent control”.
I chose articles that caught my eye, articles that seemed worth drawing your attention to, and worth quarreling with or considering. Many other articles meet these qualifications, but I have neither the capacity nor the space to present an exhaustive review. My apologies to the many who are left out.

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