False Efficiency and Missed Opportunities in Law and Economics

This Article points out a simple flaw common to many law-and-economics analyses, ranging from fundamental models like the Hand Formula to narrower arguments like those that oppose the doctrine of unconscionability.

The flaw is straightforward: economic analyses of law often assume, either implicitly or explicitly, that when it is more efficient for an activity to occur than for it not to occur, it is efficient for legal rules to encourage the activity. Even on grounds of efficiency alone, however, knowing in isolation whether an activity produces more wealth than its absence is insufficient to conclude that the activity is efficient. The determination of efficient legal rules requires an answer to a further question too often neglected by legal economists: what are the activity's alternatives? Even if an activity is more efficient than its absence, it may produce less wealth (perhaps significantly less wealth) than its alternatives, once its harms are taken into account. Encouraging all activities that appear to produce wealth on their own runs the risk of encouraging opportunistic behavior whose effect is more to transfer wealth than to create it.

As a simple example, a legal regime that followed the Hand Formula would encourage businesses to earn $100,000 by causing $95,000 worth of unavoidable harms to others; that incentive alone, while probably objectionable for other reasons, is not inefficient because, instrumentally speaking, the $100,000 social gains justify the $95,000 social losses. But a rule based on the Hand Formula would also encourage economic actors to engage in that $100,000-earning activity rather than one that paid $90,000 but caused no harms; that incentive is inefficient.

Some economic analyses acknowledge related points, but the law-and-economics movement insufficiently understands the flaw that this Article describes. Similarly, critics of the law-and-economics movement—while aware of other fundamental flaws in legal-economic analysis, such as the inapplicability of the rational-actor model in many circumstances—do not readily enough engage economic models on their own terms. This Article attempts to remedy those oversights, and in doing so, it suggests greater caution in applying economic reasoning to law.