Abstract
To describe the role of law in the new institutional economics (NIE), we compare this approach with the economic analysis of law (EAL) of the 1970s when the NIE evolved. At that time the EAL was dominated by the “Chicago” or “market-based” approach that builds on the theory of perfect competition. Contracts are complete and Pareto efficient (allocative efficient). Ten years on, informational economic models that are briefly touched upon here extended this approach. After a few methodological considerations, this chapter concentrates on the Williamsonian branch of the NIE, i.e., the transaction cost approach (TCA). This theory argues that, in the real world of positive transaction costs and limited foresight, adaptation to the unforeseen becomes a central issue. Incomplete contracts can at most be “adaptive efficient” (North 1990, p. 80). The governance structure of contracts matters and becomes a bargaining point. Court ordering has to be complemented or substituted by private ordering. Attentive actors come to terms on a governance structure that protects them against ex post opportunistic manoeuvres of their opponents. Generic governance structures are (according to Williamson) markets, hybrids, and hierarchies. Court ordering works best for market governance. In the case of hybrid modes (franchising, leasing, etc.), courts would mainly be supplanted by private ordering between the parties. As for hierarchies, courts would stay out of conflict resolution (fraud and conflict of interest excepted). While the objects of research in NIE and EAL remained different, the latter’s methodology appears to move closer to that of NIE.
In slightly changed form reprinted from Washington University Journal of Law & Policy, Vol. 26: 13; 2008, pp. 13–36 (Wahington University, St. Louis, MO, USA). The manuscript was finalized during my stay at the Hoover Institution, Stanford University, Fall 2006. I wish to thank Ken Arrow, Eirik Furubotn, Scott Kieff, Mitchell Polinsky and Oliver Williamson for their critical comments - and especially Ken Scott who advised me patiently on my legal presentations. Any remaining mistakes are the sole responsibility of the author.
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- 1.
The term “New Institutional Economics” is used as a generic term by different authors for different combinations of the above mentioned and other fields; see Richter (2005) and these Essays Chap. 1.
- 2.
Veljanovski (1979, p. 1).
- 3.
Legal Philosophy (2006).
- 4.
What Posner (2006, p. 406) calls the “second generation of economic analysts of law.”
- 5.
- 6.
Williamson and Ouchi (1981, p. 352).
- 7.
As understood by this author, see Richter (2005).
- 8.
That is the transaction cost approach (TCA), which considers issues of private law (contract law in particular) given an institutional framework; while the Northian branch of NIE, the new institutional economics of history (North 1986, 1990), deals more with issues of law making and public law (changes of the institutional framework). For a more detailed description of the two branches see Richter (2005) and Chap. 1 of these Essays.
- 9.
- 10.
The latter term seems to have been introduced by Veljanovski (1979).
- 11.
- 12.
Kaplow and Shavell (2002, p. 1666).
- 13.
The central claim is that the fundamental economic concepts, such as maximization, equilibrium, and efficiency are [understood to be] also fundamental to understanding and explaining the law.” (Cooter and Ulen 1988, p. 9).
- 14.
Information, bargaining, contracting, monitoring, enforcement etc. costs.
- 15.
Arrow (1974, p. 255). Note, however, that the concept of Pareto efficiency does not require general equilibrium, it is also applied to partial equilibria.
- 16.
Cf. Eidenmüller (1995, p. 486 etc.).
- 17.
Breaches of contracts or tortious acts are not an issue of general equilibrium theory (rational utility maximizers are in the zero transaction cost world by definition strictly law abiding people). Still, with some good will, one may use it to explain in neoclassical style the regulation of individual liability for contractual obligations and torts.
- 18.
The classical rules demand that the state abstains from altering the personal wealth of its citizens and goes “not a step further than necessary to secure its citizens against themselves and foreign enemies; for no other final purpose should the State restrict their freedom” (Humboldt [1792] 1967, p. 52).
- 19.
That is, they have (1) the right to use up their resources physically (ius utendi), (2) the right to the income from them (ius fruendi), and (3) the power of management, including that of alienation (ius abutendi) (see Lawson and Rudden 1982, p. 6).
- 20.
Caution is in place in accepting the proposition that unrestricted bargaining leads to Pareto efficiency. (Arrow 1969, 52 ff.).
- 21.
- 22.
As excellently described by Debreu himself in his Theory of Value (1959).
- 23.
For instance: I purchase x bushels of wheat to be delivered here, 1 year from now, payable today, on the condition that my next year’s crop has been destroyed by hail (i.e., the purchase of hail insurance). Individuals have full knowledge of all possible events (hail, drought, normal weather) and their probability distributions at each particular location etc.
- 24.
Cooter and Ulen (1988, p. 235).
- 25.
The complete commodity space of the economy.
- 26.
Under this condition, since all firms are assumed to be privately owned, their managers have to maximize the firms’ profit subject to the firms’ production functions. Managers are fully informed about their technically feasible production plans.
- 27.
No large (or infinite) number of buyers and sellers is needed but only “the utter dispersion of power” (Stigler 1968b, p. 181).
- 28.
They are in particular mentioned as justification for the use of money, see, e.g., Hicks, J. R. (1935), “A Suggestion for Simplifying the Theory of Money,” Economica, N.S., 1, 1–19.
- 29.
Complete contracts (or perfect contracts) are contracts whose terms are completely stated and verifiable for all possible contingencies. They are strictly enforceable (Cooter and Ulen 1988, p. 230).
- 30.
The question of the social welfare function—as a target function of society—would be both, logically (cf. Arrow’s impossibility theorem) and institutionally (cf. the theory of public choice and constitutional economics) a rather difficult topic to deal with.
- 31.
- 32.
Or compensation criterion, see Varian 1992, p. 405).
- 33.
Eidenmüller (1995, p. 95): “The EAL commits the state to ensure the establishment of efficient methods of public control where the transaction costs of private negotiations would be prohibitively high.” (Own translation).
- 34.
As an example of informational economics (Stiglitz 1985).
- 35.
A case of “adverse selection.”
- 36.
A “moral hazard” case.
- 37.
Under certain further conditions.
- 38.
Cf., for instance, the description by Furubotn and Richter (2005, p. 218).
- 39.
Friedman refers to the theories of monopolistic and imperfect competition which were explicitly motivated by the argument that the assumptions of “perfect competition” or “perfect monopoly” are a false image of reality. (ibid.)
- 40.
This author tried to ask Milton Friedman himself while he was at the Hoover Institution during Fall 2007. But Friedman had just died.
- 41.
Williamson (1981, pp. 40, 42).
- 42.
Williamson uses instead the term “discrete transaction paradigm.”
- 43.
That is, as it was widely understood during the period of time when Williamson developed his TCA.
- 44.
As Crocker and Masten (1991, 69f.) explain: “As a number of legal and economic scholars have emphasized, contracts are not the precise, mechanically enforced documents often encountered in economic theory. Indeed, contracts are extremely imperfect tools for controlling opportunism.”
- 45.
But also public regulation as in the case of private purchases of a natural monopoly (e.g., Williamson 1976); see below.
- 46.
- 47.
- 48.
Williamson avoids the term “incomplete contracts” in this context. Instead, he speaks of “a richer conception of contract” than the “market-based paradigm.” (Williamson 1981, p. 57).
- 49.
To offer a predictive theory of contract the “critical transaction cost dimensions for describing transactions need to be identified, and the resulting mix of transactions needs to be matched with governance structures in a discriminating (economizing) way.” (Williamson 1981, p. 57).
- 50.
North (1978, p. 974) even writes: “To abandon neoclassical theory is to abandon economics as a science.” It may be questioned whether he is still of this opinion.
- 51.
At least in their earlier writings.
- 52.
Actors don’t know all possible contingencies. Valid probabilities cannot be calculated in such a context. On this problem see, e.g., Wiseman (1991, 151f).
- 53.
See, e.g., Williamson (1981, p. 45).
- 54.
- 55.
Williamson (1993, p. 104) writes: “The Fundamental Transformation explains why the problem of bilateral dependence—previously treated as a very special condition of pre-existing bilateral monopoly—is actually a very widespread and troublesome condition. … The discovery and explication of the Fundamental Transformation is very much a transaction cost economics exercise.” (Italics in the original).
- 56.
That details all possible future contingencies.
- 57.
More detailed examples of opportunistic tactics of contractors “..to effect a redistribution of the gains from trade include capitalizing on ambiguous terms, suing for trivial deviations, making false claims of dissatisfaction, withholding relevant information, interfering with or failing to cooperate in the other party’s performance, and failing to mitigate damages where a breach has occurred.” (Crocker and Masten (1991, p. 72) with a long footnote on sources for more extensive lists and further discussions.
- 58.
“The courts (at least in the United States) will not enforce a “no renegotiation” clause in a contract…” (Roberts 2004, p. 86).
- 59.
Williamson (1991b).
- 60.
Which one is chosen depends among others on its involved degree of asset specificity and level of transaction costs (its governance costs) (loc. cit., 105 ff.).
- 61.
- 62.
Optimality could at most be determined in very simple decision problems, where everything relevant can be known and computation and deliberation are virtually costless (Gigerenzer 2001, 40 f.).
- 63.
An alternative may be to use Williamson’s (1996, p. 379) term “remediable.” He understands, however, the term in an objectively profitable sense and writes: “A condition is held to be remediable if a superior feasible alternative can be described and implemented with net gains.” At another place he remarks, the NIE “…eschews hypothetical ideals and insists that the relevant comparisons are with feasible alternatives, all of which are flawed.” (Williamson 1996, 7 quoting Coase 1964). See also Furubotn and Richter (2005, p. 109).
- 64.
- 65.
Friedman (1953, p. 38).
- 66.
- 67.
See below footnote 50.
- 68.
In the sense of Coombs, et al. (1954, p. 24).
- 69.
Williamson (1981, p. 49).
- 70.
Williamson (1996, p. 107): “…the hybrid mode is located between market and hierarchy with respect to incentives, adaptability, and bureaucratic costs,…” Examples are complex contracts or partial ownership arrangements.
- 71.
As Williamson (1991a, p. 79) puts it: TCA is an effort to “align transactions, which differ in their attributes, with governance structures, which differ in their costs and competencies, in a discriminating (mainly, transaction cost minimizing) way.”
- 72.
They point out: “The empirical work in transaction cost economics uses a variety of econometric and historical methods. …qualitative case studies, quantitative case studies, and cross-sectional econometric analyses. …. The bulk of the empirical literature…consists of case analyses of various kinds…because the main variables of interest—asset specificity, uncertainty and frequency—are difficult to measure consistently across firms and industries.” (loc. cit. 338 f. See also Boerner and Macher (2002).
- 73.
Though not necessarily in the sociological literature (see Richter 2001).
- 74.
Macneil (1974, 1978).
- 75.
Williamson (1981, p. 42).
- 76.
- 77.
- 78.
- 79.
Shavell (2004, p. 301).
- 80.
Mackaay (2000, p. 90).
- 81.
Williamson (1985, p. 29).
- 82.
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Richter, R. (2015). The Role of Law in the New Institutional Economics in Comparison With the Economic Analysis of Law. In: Essays on New Institutional Economics. Springer, Cham. https://doi.org/10.1007/978-3-319-14154-1_4
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