By Henry E. Smith (Harvard Law School)
As an important set of social institutions, law and the legal system have played an important part in the development of the Institutional and Organizational Economics (IOE). And while a good number of legal scholars use institutional and organizational economics in their work, there is room for growth in the application of IOE to law.
The most obvious point of contact between law and IOE is through transaction cost analysis. Coase’s 1960 article is the most cited ever by the legal academy. Indeed the entire field of law and economics takes that article as its most important starting point. There is no small irony in this, because Coase himself did not intend to analyze the legal system. His purpose was to show, through a thought experiment based on a hypothetical world without transaction costs, that transaction costs are important to the working of the economy. His target was the style of theorizing based on perfect completion models – in what he termed “blackboard economics” – which unrealistically assume all sorts of transaction costs away. Years later Coase (1988:174) lamented that far from being “Coasean,” the zero transaction world is precisely what he was trying to persuade economists to leave.
The larger message of Coase (1960) is that no institutional arrangement can be spoken of as “efficient” without knowing what the alternatives are – in the real world. This is where law comes in. Law is not the only social institution governing people’s behavior – and work by Robert Ellickson (1991) and others has shown how important extralegal or even illegal social norms are – but law is a framework and set of constructed incentives that shape behavior. And, crucially, law is not costless: different legal solutions will carry with them different sets of benefits and costs, in terms of administrability, understandability, the effect on actors’ behavior, the impact on the feasibility of exchange, and so on.
Where does law fit into the total set of economically significant institutions? Williamson (2000:597) has set out four levels of economic institutions, ranging from L1 resource allocation and employment (which requires continuous adjustment of marginal conditions), L2 governance (which calls for (re)designing the governance structure of interactions, on the order of 1–10 years), L3 institutional environment (requiring changes to the rules of the game on the order of decades to a century), and L4 embeddedness (exhibiting often spontaneous evolution of customs, transitions, norms and religion, taking 100 to 1,000 years). Most of what falls under “law” occupies L2 (governance) and L3 (institutional environment), although its embeddedness in L4 informational institutions and traditions is easy to forget. (North 1990) Indeed, not only are social norms important, but the interchange between them – custom becoming law and law becoming custom – can occur as well.
Within law and economics, contracts and contracting are central topics. What IOE brings to this area is an emphasis on the imperfections in any institutional arrangement, even one designed by contractual parties themselves. Very prominently, much analysis of relational contracting and organizations has gone under the banner of Transaction Cost Economics, a branch of the New Institutional Economics (Williamson 1985). Studies of custom and extralegal enforcement also put the role of institutions – law and its close substitutes – front and center. (Bernstein 1992)
More recently, organizational economics is growing in the law. Problems of corporate governance and the nature of the firm are live questions in law and economics. The overlap in the table of contents of the recent landmark Handbook of Organizational Economics (Gibbons and Roberts 2013) with law and economics attests to this convergence. IOE has always been somewhat open-ended in its subject matter and eclectic in its methods, and therefore its receptiveness to newer behavioral end econometric approaches has paralleled developments in law and economics.
Another strand of IOE deals with “property rights,” which can span Williamson’s L3 and L4. The analysis of property rights has been very fruitful as applied to the law. Coase was concerned with “property rights,” and for his purposes he adopted an atomized picture of property as a bundle of rights. On this view, property is not a relation between a person and a thing but a collection of malleable relations between people that affords some persons’ decisions about uses of things protection against interference by others. Coase did not aim at explaining property itself, and it was Demsetz (1967) who started the economic analysis of property rights themselves. On the famous Demsetz Thesis, when externalities become more serious, property rights will emerge to internalize them. Although Demsetz abstracted away from the process or supply side of property rights, others, starting with Ostrom (e.g. 1990) and Libecap (e.g. 1989), have explored the factors leading to the emergence of various kinds of property rights, common and private.
One theme in the IOE of property rights that harks back to the Coasean beginnings is the tight relationship between property and contract. Breaking down resources into valued attributes that are costly to measure allows a deep analysis of many problems of institutional change. (Barzel 1982, 1997) It allows one to analyze how people will contract to reallocate property rights. For example, actors will contract to give residual claimancy over collections of attributes over farmland (landlord, tenant) or a taxicab (co-owners). In sales of goods, a variety of mechanisms like warranties and reputation plus information suppression will help maximize the value of property rights in a transaction between the sellers and buyers of apples. This helps explain why diamonds are sometimes sold by the lot or apples are sold in opaque bags. (Barzel 1982)
One feature of property that tends to be left out of most IOE analysis of property is what differentiates property from contract. The New Institutional Economics definition of “property” as the right to decide on the use of a thing (Alchian 1965:818; Cheung 1970:67; Eggertsson 1990:33) does not tell us much about the nature (or importance) of the thing, the persistence of rights, or the set of duty bearers against whom they avail. In law and economics and legal theory there has of late been a resurgence of interest in aspects of property that make it distinctive. These include the idea that property is a right to a thing, that the rights it affords its holder persist in the hands of transferees, that a property right often binds the world at large rather than a designated person, and that property rights are more standardized than are contract rights. (For a quick introduction, see Merrill and Smith 2010.) These hallmarks of property were all emphasized in traditional legal doctrine but have until recently received short shrift from IOE, law and economics, and legal scholarship in the United States. (Legal commentary in civilian countries and the Commonwealth, by contrast, tends to emphasize these aspects of property.) Nevertheless, IOE is uniquely well positioned to take this next step. A legal “thing” as the object of property economizes on delineation costs, and the different hybrid structures of exclusion and governance over various resources are a natural extension of IOE. (Smith 2000, 2012) Indeed it is because of positive transaction costs in the sense of the costs of institutions (Allen 1991) that property law takes the shape it does. (Lee and Smith 2012; Merrill & Smith 2000, 2001, 2011) Institutions like land records are also a prime subject for IOE. (Arruñada 2102)
One welcome development from the IOE in the area of property is the wider set of tools this methodologically open-ended field is willing to bring to bear. In contrast to contract, property has been hard to model and to study with econometric techniques, because property is characterized by emergent properties. If property law is a platform for further interaction among actors and rights avail against others generally, it is harder to capture property using the two-party actor models that are in vogue in the areas of contracts and torts. This is changing. The transaction costs of property have now been modeled. (Segal and Whinston 2013) Likewise, something as fundamental as the effect of surveying on land transactions and land value can be teased out by natural experiments. (Libecap and Lueck 2011)
Ultimately, law and economics is an applied field. Through the application of economic techniques, we are now getting a better understanding of law as a system rather than as just a collection of rules. With its emphasis on the importance of institutions and its methodological experimentalism, IOE is well suited for making further progress in analyzing legal institutions.
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