Why a Law Student Studies Economics

• Monopoly. A single seller charges more and produces less than a competitive industry would. The Competition Act 2002 answers it. Section 4(1) says no enterprise or group shall abuse its dominant position, and section 4(2) lists what abuse means: unfair or discriminatory prices including predatory prices, limiting production or technical development, denial of market access, tying, and using dominance in one market to enter another. [Monopoly] works through the economics that provision is built on.
• Externalities. An externality is a cost or a benefit that falls on somebody who is not a party to the transaction. A factory's effluent is a cost borne by villagers downstream who never bought the product. The whole of environmental law, and much of the law of nuisance, exists to put that cost back on the person who caused it.
• Public goods. A public good is one that nobody can be excluded from and that one person's use does not diminish, such as street lighting or national defence. No private seller can profitably supply it, because everybody can enjoy it without paying. So the State supplies it and taxes to pay for it, which is the subject of [The Sources of Public Revenue] and [Public Expenditure and Its Classification].
• Information asymmetry. One side of a bargain knows more than the other. Consumer protection law, the duty of disclosure in insurance, and the disclosure requirements in a prospectus all answer it.

4. Courts and tribunals must value things. Damages for a lost crop, compensation for land acquired, maintenance under a matrimonial statute, the multiplier in a motor accident claim, the compensation for a lost limb: every one of these is a valuation, and valuation is an economic operation. [What Economics Is] introduced opportunity cost for exactly this reason. A court that compensates only out of pocket expenses has ignored the value of the alternative the claimant gave up.

5. Legislation is drafted to economic objectives, and its success is measured in economic terms. The Insolvency and Bankruptcy Code was passed to move assets out of unproductive hands faster. The goods and services tax was designed to remove the tax on tax that a chain of separate State levies produced. A lawyer who cannot state the economic object of a statute cannot argue about its interpretation when the words run out.

The distinction that matters most: efficiency and equity

Two words do most of the work when law and economics meet, and they are not the same word.

Efficiency asks whether the total quantity of value produced is as large as it can be, whatever its distribution. An arrangement is efficient in the ordinary economic sense if no change can make somebody better off without making somebody else worse off.

Equity asks who gets what, and whether the division is fair.

A rule can be efficient and unfair, or fair and wasteful. A land ceiling law that redistributes holdings may reduce total output and still be defended on equity. A rule that lets a factory pollute freely may maximise output and be indefensible.

Law almost never chooses efficiency alone. Article 39 puts distribution in the Constitution, and a student who answers a question about a welfare statute purely on efficiency has answered half of it.

A worked example: a rent control law in Mumbai

Mr Kulkarni owns four flats in a building in Dadar. Mrs Fernandes is a tenant in one of them. A statute is passed freezing rents at their 1999 level and giving tenants an indefinite right to remain.

What the lawyer sees. A protective statute that secures a home for a tenant of modest means against a landlord who has other flats. The purpose is unmistakable and, on its own terms, achieved: Mrs Fernandes cannot be evicted and her rent cannot rise.

What the economist adds, in four steps.

1. The price is now below the market price, so the quantity demanded exceeds the quantity supplied. This is the excess demand of [How Demand and Supply Together Set a Price].
2. The landlord's incentive to supply changes. Mr Kulkarni will not offer his three vacant flats on rent at all. He will keep them empty, sell them, or let them only to somebody who pays a large lump sum in advance that the statute does not reach.
3. The shortage is rationed by something other than price, and usually by whatever the law does not regulate: a premium, a personal connection, or a willingness to sign a licence rather than a lease.
4. The stock decays. A rent that cannot rise will in time not cover repairs, so buildings under long rent control are conspicuously worse maintained than buildings outside it.

The point of the example. None of this shows that the statute is wrong. Mrs Fernandes has a home she would otherwise have lost, and that is an equity gain the economics does not measure. What the economics shows is that the statute has a second set of effects, falling on people who are not before the court, and that a lawyer who argues only the first set will be surprised by the second. A well drafted statute anticipates them: this is why modern rent legislation usually permits periodic revision and distinguishes new tenancies from old ones.

Where the two subjects genuinely disagree

Three honest disagreements, which are worth a paragraph in an answer because they show the relationship is not one of servant and master.

Economics tends to treat people as consistent maximisers. Law knows they are not, which is why it has doctrines of undue influence, unconscionability and consumer protection.

Economics values outcomes. Law also values process. A trial that reaches the right result by the wrong procedure is a failure in law and a success in economic terms.

Economics has no place for rights that cannot be traded. Law has many: the right to personal liberty, the right against forced labour. An analysis that prices everything has misunderstood what a right is.

What this chapter does NOT claim

It does not claim that economics decides legal questions. It supplies a prediction and a valuation. The choice of objective is made by the Constitution, the legislature and the court.

It does not claim that the efficient answer is the right answer. See the distinction above.

It does not claim that a lawyer needs mathematics. Everything in this book can be done in words and simple arithmetic.

Quick revision

1. Five connections: law creates the framework markets need; every rule changes costs and so changes behaviour; much of the law answers a market failure; courts must value things; and statutes are drafted to economic objectives.
2. Four market failures: monopoly, externalities, public goods, information asymmetry. Each has a body of law answering it.
3. Constitution, article 39(b) and 39(c): distribution of material resources to subserve the common good, and prevention of concentration of wealth and the means of production to the common detriment. These put economics into the Constitution.
4. Competition Act 2002, section 4(1): no enterprise or group shall abuse its dominant position. Section 4(2) lists the forms of abuse.
5. Efficiency against equity: efficiency asks how large the pie is, equity asks how it is cut. Law weighs both; an answer that uses only one is half an answer.
6. The rent control example is the standard illustration: an intended effect on the tenant before the court, and unintended effects on people who are not.

Test yourself

1. State four reasons why a law student is required to study economics. Because the law supplies the framework, contract, property, currency and corporate personality, without which markets cannot function; because every legal rule alters the costs facing those it binds and so alters their behaviour, often in ways the drafter did not intend; because a large part of the law exists to correct market failures such as monopoly, externalities, public goods and information asymmetry; and because courts must value losses and fix compensation, which is an economic exercise. A fifth reason is that statutes are drafted to economic objectives and their interpretation turns on those objectives.

2. Which articles of the Constitution place an economic objective on the State, and what do they say? Article 39(b) directs the State to secure that the ownership and control of the material resources of the community are so distributed as best to subserve the common good. Article 39(c) directs it to secure that the operation of the economic system does not result in the concentration of wealth and means of production to the common detriment. Both are directive principles in Part IV, so they guide legislation and are not directly enforceable by a court.

3. What is a market failure? Name four kinds and the law that answers each. A market failure is a situation in which a market left to itself does not produce the outcome society wants. Monopoly, answered by the Competition Act 2002 and in particular section 4 on abuse of dominant position; externalities, answered by environmental law and the law of nuisance; public goods, answered by public provision financed from taxation; and information asymmetry, answered by consumer protection law and by disclosure duties in insurance and in company prospectuses.

4. Distinguish efficiency from equity, and give an example of a rule that is one and not the other. Efficiency concerns the size of the total product and asks whether resources are being used so that nobody can be made better off without somebody being made worse off. Equity concerns the distribution of that product. A law permitting a factory to discharge effluent without treatment may raise total output and is inequitable to those downstream; a land ceiling law may reduce total output and be defended as equitable. Legal systems choose a mixture, and in India article 39 makes distribution a constitutional objective.

5. A statute freezes rents. Describe the economic effects a lawyer should anticipate. The controlled rent lies below the market rent, so the quantity of housing demanded exceeds the quantity supplied and a shortage appears. Landlords withdraw units from the rental market or let them only on terms the statute does not reach, so new tenants find it harder to rent at all. Rationing shifts to non price devices such as premiums and personal connections. And maintenance falls, because a frozen rent eventually fails to cover repairs. The tenant already in occupation gains; prospective tenants and the housing stock lose.

6. Give one respect in which economic reasoning does not fit the law, and explain it. Economics values outcomes and is largely indifferent to procedure, while law treats fair procedure as a value in itself: a decision that happens to be correct but was reached without hearing the affected party is a failure in law. A second respect is that some legal rights are deliberately not tradeable, such as the right against forced labour, so an analysis that treats every entitlement as having a price has misdescribed them.