Economics Of Non-State Legal Systems Essay, Research Paper
The Economics of Non-State Legal Systems”Perhaps the most distinctive characteristic of the Western legal tradition is the coexistence and competition within the same community of diverse jurisdictions and diverse legal systems. The pluralism of Western law, which has both reflected and reinforced the pluralism of Western political and economic life, has been, or once was, a source of development, or growth – legal growth as well as political and economic growth. It also has been, or once was, a source of freedom. A serf might run to the town court for protection against his master. A vassal might run to the king’s court for protection against his lord. A cleric might run to the ecclesiastical court for protection against the king.” –Harold Berman, Law and RevolutionTABLE OF CONTENTS1. Introduction2. Adjudication of Disputes 2.1. Inefficiency in the public courts: overview 2.2. Inefficiency in the courts: under-pricing, nuisance suits, input waste, and more 2.3. Inefficiency in the courts: fostering wasteful legal conflicts 2.4. Private dispute resolution: an efficient alternative 2.5. The potential and limits of private dispute resolution3. Formation of Rules 3.1. Preview 3.2. The economic theory of rule-making with no externalities 3.3. Rule-making in the real-world: the problem of externalities 3.4. Non-patentable innovations and externalities problems 3.5. The evolution of custom as a substitute for intellectual property rights 3.6. Ways to internalize the benefits of rule-production 3.7. The variety and flexibility of private rule production 3.8. Public vs. private rule-creation: an exercise in comparative institutions4. Private Enforcement of Law 4.1. Ostracism and boycott 4.2. The Becker-Stigler model 4.3. Posting rewards and the Posner criticism 4.4. Torts and crimes: incentives for enforcement 4.5. Security guards and private police 4.6. Monopoly on coercion: the source of the limits of arbitration 4.7. Purely private enforcement: a model 4.8. Criticisms of purely private enforcement5. Conclusion————————————————-1. IntroductionLaw, even more than national defense, appears to be the perfect example of a public good which simply must be supplied by the government if society is to exist at all. It is non- excludable because everyone enjoys the fruits of law merely by living in society. And it is entirely non-rivalrous — once the state creates a body of sound legal principles, an unlimited number of people can benefit from them at no additional cost.But these seemingly iron-clad truisms can be undermined by even a cursory glance at history. In primitive societies, law develops gradually from custom in the absence of any sort of government. As Richard Posner explains, “The remaining source of law [in the absence of the state], and the one that dominates primitive law, is custom. Custom (including customary law) resembles language in being a complex, slowly changing, highly decentralized system of exact rules.”1 On occasion, this primitive law gradually spreads outside the narrow confines of a single tribe to encompass a broader community. Thus, early tribal Germanic law evolved into a more universal legal code in the absence of a central government. What makes this progress gradually unfold? As legal historian Harold Berman explains, “Violation of the peace of the household by an outsider would lead to retaliation in the form of blood feud, or else to interhousehold or interclan negotiations designed to forestall or compose blood feud.”2 (emphasis added) By this process primitive law became more civilized, broadening its vision to include anonymous as well as face-to-face societies. In order to exist and evolve, such systems must have given rule-creating incentives to someone; in other words, at least some of the benefits were not public but exclusive.There is another sense of “non-exclusion” that legal systems must allegedly have: they must govern everyone in order to function at all. If law-breakers could simply drop out of the system, law could hardly protect us from their misdeeds. And yet, history contains many instances of pluralistic legal systems, in which there were multiple sources of law in one and the same geographic region. In the medieval society that Prof. Berman investigates, canon law, royal law, feudal law, manorial law, mercantile law, and urban law co-existed; none was automatically supreme over the others. Naturally, there were jurisdictional conflicts. But this system of concurrent jurisdiction overlapped with a period of economic and political growth (c.1050-1250), not a period of chaos and impoverishment. Apparently these diverse systems did what Thomas Hobbes (along with most modern political thinkers) declared impossible: They created social order and peace in the absence of a distinct, supreme sovereign. These examples might seem to be historical anomalies, fascinating but irrelevant to current economies and legal systems. Yet in modern times parallels have sprung up, albeit in a less dramatic form. Commercial disputes, for example, are handled virtually in toto by means of private arbitration. Accurate figures are very difficult to get; but one expert in alternative dispute resolution, Jerome Auerbach, estimates that businesspeople arbitrate 75% of their commercial disputes.3 In earlier times, one of the central functions of government was business dispute resolution; but now it has largely escaped the state’s sphere of influence. A more extreme example is that of the VISA corporation.4 Member banks agree to keep their quarrels within the VISA family when they join the central organization. Anticipating many costly legal disputes between the system’s members, the VISA corporation saw the opportunity to invent a cheaper way to resolve disagreements. It created the VISA Arbitration Committee to judge the disputes of the member banks according to VISA’s very own legal code. The methods are quick, lawyerless, and unbureaucratic. Compared to the slow and costly justice that the banks receive when they have to settle a conflict with a firm outside the VISA camp (and within the reach of the public courts), the VISA banks get a bargain.It is the economic characteristics of these sorts of legal systems that this thesis investigates. How do they work? To what extent might private legal systems of this kind partition and swallow up the near-monopoly of law that most governments possess? How does customary law give incentives to create and develop a legal framework? It should be noted that I am not merely studying the economics of federalism. While there are some parallels between pluralistic legal systems and federalism, there is a crucial difference. Under federalism, a central government delegates the authority to make laws to two or more sub-polities. In this sense, there is legal choice and legal competition. But federalism gets rid of a national legal monopoly by creating a host of smaller geographic monopolists, each of which has sovereignty in its own territory. Truly plural legal systems such as arbitration compete within the same geographic region.There is more than an analogy between pluralistic legal systems and the economist’s conception of competition. With a large number of potential source of law in a given geographical region, plus some method of excluding non-contributors from benefits, economic theory implies the familiar results that hold of competitive markets generally: productive efficiency (a given level of output gets produced at the minimum cost), allocative efficiency, (resources get assigned to their most socially productive uses), and dynamic efficiency (declining cost curves over time). We might also expect to find the greater flexibility and attentiveness to individual differences that typify private supply.This thesis investigates the non-state supply of the three essential aspects of law: dispute resolution, rule formation, and enforcement. The first and least controversial is the non-state resolution of individual disputes. The state could still choose the rules and merely privatize their application. Economists usually see the rule-application aspect as the best candidate for privatization, because the parties to the dispute get all of the benefits. This is one factor that explains the emergence of primitive law: the need to avoid inter-family bloodshed over every wrong gave both sides to a dispute an incentive to voluntarily submit to a peaceful settlement procedure and abide by whatever result emerged. Even the loser benefits, since he trades submission on a single quarrel for long-run peace. In terms of game theory, what looks like a zero-sum game (a tort, say) is actually a cooperative game because refusal to adjudicate leads to feuds between individuals, families, or clans that leave both sides worse off.But there is a second element to law; as Landes and Posner explain, “A court system (public or private) produces two types of service. One is dispute resolution – determining whether a rule has been violated. The other is rule-formation – creating rules of law as a by-product of the dispute-resolution process.”5 To many people, the latter is a less likely candidate for private supply, because the production of rules of law is a public good. The economic value of precedents (like other intellectual innovations) is hard to internalize. Section three will examine this issue at length. But there are prima facie reasons to be skeptical of this criticism of private rule creation. The VISA corporation has its own legal code; so do other professional associations, clubs, and cooperatives. More startlingly, most primitive law and a great deal of commercial law were developed by bodies other than the state. Thus, the law merchant (later adopted, not created, by most governments) evolved during the Middle Ages (c.1000-1200), while national governments ignored the demand for well-defined rules of international trade. Merchant courts gradually developed contract and tort law, defining rules of incorporation, credit instruments, and damages.6 Legal growth on this level would seem to be possible only if private incentives existed somewhere; section three will seek out the incentives’ sources.Last, there is the most controversial function of law that might be executed privately: enforcement. The right to use force seems to be a necessary monopoly of the state; otherwise wouldn’t chaos and random violence be inevitable? Still there are many types of non-violent private enforcement. Commercial boycott and ostracism enforce most forms of arbitration. Within the business community these sanctions are quite effective. Becker and Stigler note that termination of employment (rather than legal action) can and often does deter malfeasance. “The fundamental answer is to raise the salaries of enforcers above what they could get elsewhere. A difference in salaries imposes a cost of dismissal equal to the present value of the difference between the future earnings stream in enforcement and in other occupations.”7 Section four explores the enforcement tools of private legal systems and how they work. It also raises questions about what might happen if we relaxed the state’s monopoly on force and let more drastic forms of enforcement fall into private hands.In sum, this thesis examines how non-state legal systems work in their three distinct aspects: dispute resolution, rule-creation, and enforcement. It will draw on many conclusions from economic theory; most frequently, the prima facie superiority of private competitive supply to public monopoly. There are many conceivable market failures that might exist; but the strategy of this paper is to at least explore overlooked legal alternatives. Before the body of the paper can begin, however, it is necessary to point out a a major misconception that might prevent one from seriously considering the private supply of law.The most deeply rooted obstacle to the appreciation of non-state legal systems is the theory, eloquently stated by Thomas Hobbes, that the law-making function indivisibly and necessarily belongs to the sovereign. As Hobbes famously wrote, “The only way. to defend them [mankind] from the invasion of foreigners, and the injuries of one another. is, to confer all their power and strength upon one man, or upon one assembly of men, that may reduce all their wills, by plurality of voices, unto one will.”8 On this view, the presence of more than one law-giver in a region has to degenerate into violent battle until only one remains. Imagine, the argument might go, that two councils issue law in one city. Their laws will inevitably conflict on occasion. And since by assumption there is no higher body to resolve their dispute, they will have to resolve it violently.Two things can be said here. First, history gives examples of concurrent jurisdictions that operated peacefully. Harold Berman, for example, describes multiple competing sources of law in the Middle Ages, with only a handful of serious conflicts between them. So Hobbes must be wrong at least sometimes. Second, Hobbes’ game theoretic deductions are inconsistent. Supposedly, driven by the desire for food, money, and power, rational egoists turn to violence to get what they want when there is no stronger entity to preserve peace. And yet, as Hobbes says, the fear of death is even stronger than the drive for food, money, and power. Given this, isn’t the rational strategy the defensive one of live-and-let-live? Given the choice between two evils – a small chance of death vs. slightly less consumption – a Hobbesian man would surely prefer the latter .9 This preliminary observation gives a plausible explanation for why peaceful cooperation was frequently the dominant strategy. Throughout this paper I imagine that profit-making firms, rather than non-profit organizations, would be the major alternative suppliers of law. This assumption overlooks the fact that much, perhaps most, arbitration is not run for profit. I do this for two reasons. First, I find it difficult to believe that non-profit firms could compete with for-profit firms if they were on equal legal footing. The second reason is simply that the economic theory of profit-making organizations is better-developed than the theory of non-profit groups. I trust that this assumption will not seriously affect the analysis.A final caveat. This paper considers only the non-state supply of private, as opposed to public law. That is, it considers systems of alternative resolution of conflict between individuals whose rights are defined by the common law categories of property, contract, tort, and crime. Public law must be left for another time.2. Adjudication of Disputes2.1 Inefficiency in the public courts: overviewOne of our most ridiculed institutions is the public court system. Interestingly, economic analysis gives us clues about many of its central weaknesses. Some of these problems could be solved with fairly minor reforms. For example, court services are under-priced (usually, free). These leads to serious excess demand, permanent shortages, and strategic delays. Presumably, if the public courts were so inclined they could charge court fees for civil cases to ration demand. A second problem is nuisance suits. Frequently, there are lawsuits where one party is clearly in the wrong, but drags the battle into court anyway in the hope that the other side will simply give up. The public courts could solve this problem by changing the indemnification rule – for example, by making the loser in a nuisance suit pay the other side’s court costs.Other inefficiencies in the public courts would be hard to eliminate with minor reforms. The public courts are supported by taxes; they therefore have little incentive to control costs. Trials take too long, appeals are too frequent, and labor discipline is lax. Since juries are conscripted, courts treat their labor as a free good; consequently, they use juries even when the value of their contribution to justice is small. And perhaps most seriously, the courts foster wasteful legal battles. Instead of encouraging litigants to limit their joint legal expenditures, they give them incentives them to race to out-spend each other. But since the expenditures usually cancel each other out, this legal competition is rather futile. It is hard to see how the public court system could solve the second group of problems even if it wanted to. Indeed, it probably won’t remedy the first set of difficulties either. In order to understand the benefits of turning disputes over to private alternatives, we must first understand why and how the public courts fail. This done, we can investigate the ways that private bodies overcome the inefficiencies that the public courts cannot.2.2. Inefficiency in the courts: under-pricing, nuisance suits, input waste, and moreAn excellent work detailing the public courts’ failures is Judge Richard Neely’s Why Courts Don’t Work. As judge with training in economics, he is particularly qualified to point out the failures of our court system. Neely has a long list of complaints.First, the courts grossly underprice their services, leading to excess demand and non-price rationing (usually, waiting in line). It is illegal to sell one’s place in line. The most urgent cases must wait as long as trivial ones, leading to protracted legal conflict and higher legal costs. If courts charged user fees, people with insignificant disputes would be more likely to drop them. Or they might try a cheaper resolution method. Yet the courts provide subsidized (free) services, often complete with juries. The whole process is expensive, but litigants only need to consider their lawyers’ fees. They ignore the cost to taxpayers of extra trials. They also ignore the cost of justice denied and delayed to everyone waiting behind them for their day in court.Underpricing also helps the legally well-endowed wear out their opponents. As Neely puts it, “Often the attractive products that the court delivers free are delay itself or a forum that provides the stronger litigant with an opportunity to wear out or outgun the opposition.”10 (With perfectly functioning capital markets this could not happen: banks would happily loan money to litigants with good cases. But strategic delay does seem to be a real problem.) Since a longer delay gives both sides a greater opportunity to out-spend each other, delay usually favors the richer litigant. Delay also deadens the deterrent effect of damages: future damages, like other future income streams, will be discounted by the interest rate. There is a simple economic explanation for all of these problems: since court services are free, there is no way to ration them other than waiting in line. And this probably is uniquely severe for dispute resolution, because the litigants can ferociously struggle with one another while they wait to go before the judge.Neely points to a second problem that plagues the justice system: the courts give incentives to litigate non-disputes. For instance, in landlord-tenant cases or creditor-debtor cases, there is rarely any “legal issue.” Instead, as Neely explains, one side normally just refuses to fulfill its half of the bargain. “In the universe of all the routine cases that go to court, most of the time one party will be flat wrong, and he or she will know that from the beginning.”11 If legal costs exceed the expected value of the judgment, then aggrieved parties may well drop legitimate cases. When nuisance cases do get a full trial, they crowd out more substantive disputes. One solution for insincere cases (though Neely rejects it on distributive grounds) would be to make the loser pay both sides’ costs — but this is a reform that courts are loath to try. At the very least, in areas of the law filled with nuisance suits, this idea has potential.Profs. Landes and Posner argue that the public courts waste and misallocate their resources; after all, it is taxpayers, not judges or litigants, who pick up the tab. Landes and Posner then reasoned that the arbitrators are likely to make more efficient use of inputs than the public courts. Since arbitrators do survive on user fees, disputants and arbitration firms alike will want to contain costs. From these assumptions, these two legal economists proposed the following test of the efficiency of the public courts’ civil trials: the public courts are efficient if they match the practices of arbitration. Since arbitration does not use juries or lawyers, and the public courts do, Landes and Posner conclude that these may be inefficient, as least in civil cases.12 (Since criminal cases are not arbitrated, we can’t know what criminal arbitration would be like.) This is input waste on a huge scale – a majority of the inputs in civil cases may well be unwarranted. The misallocation of jury time is especially egregious, since they are conscript labor – virtually a free good. While juries cost a great deal to society (including the jury members themselves, who lose work time), courts and litigants have the incentive to use them even when the benefit is negligible.Landes and Posner use the same efficiency test for other public court practices. For example, controversy exists over the merits of the loser-pays rule for legal expenses. Arguments cut both ways: If trials occur because of over-optimism, then the loser-pays rule leads to more suits; if many suits are “nuisance” suits in which the party in the wrong strategically delays, then the loser-pays rule would lead to fewer suits.13 It is hard to do an empirical test to everyone’s satisfaction. However, we could reasonably predict that profit-maximizing private courts would use the more efficient rule, especially if the parties pre-contract to arbitrate with a specific firm with a set indemnification rule. How does the test turn out? The American Arbitration Association requires the defendent to pay all legal costs if the plaintiff wins, but splits the difference if the defendant wins.14 Posner suggests that this vindicates the American rule over the English; but actually this rule implies that defendants are often clearly guilty, whereas malicious suits by plaintiffs are infrequent. Or in other words, nuisance suits by defendents are more common than nuisance suits by plaintiffs (in disputes currently open to arbitration). The parties can also voluntarily change the indemnification rule: some contracts change the standard AAA rules, stipulating that the plaintiff pays the legal costs if he loses. Landes and Posner bring up another interesting issue: appeals. They argue that private arbitration (excluding trade associations) lack appellate courts because the sole function of such courts is to formulate rules of law, not resolve disputes; and the former, unlike the latter, is a public good. Landes and Posner view the production of rules as a pure public good: society at large benefits when someone refines a legal principle, but (as is often the case with intellectual creations), it is hard to claim a property right in a precedent.This claim may well be true; it will be examined in section three. But perhaps there is another explanation: Private courts do not permit appeals simply because the extra costs (in time, legal fees, court services, and so on) are not worth the social benefits. Both parties gain if they agree ex ante to limit each other to a single hearing. But in public courts there is no way to credibly commit to limit appeals. On this theory, the lack of appeals is a benefit to both parties because it keeps dispute resolution costs low. Posner and Landes point out that trade associations do permit appeals; and these appeals sometimes produce precedents. They argue that this happens because a trade association can internalize the benefit of a precedent. True, but they also concede that appellate tribunals are not universal. In all likelihood, trade associations rarely permit appeals, strictly limit their expense, or both. Furthermore, the VISA corporation does not permit appeals, even though the corporation’s unique structure and secrecy enable it to fully internalize the benefit of precedents. Quite possibly the permission of appellate review in criminal cases makes economic sense; for as Posner suggests, the high error costs of convicting the innocent may justify the reasonable doubt rule for evidence in criminal proceedings.15 On the other hand, the behavior of many arbitration firms and trade tribunals suggests that the appeals process in civil cases has excessive costs. 2.3 Inefficiency in the courts: fostering wasteful legal conflicts Even the most harmonious society has disputes. In the interest of peace, these disputes must somehow get resolved. The upshot is that every dispute comes with resolution costs tied to it. There is some additional burden on top of the costs of the dispute that the disputants must eventually split. This is often a substantial sum. From this is follows that to a limited extent the plaintiff and defendent have a common interest: minimizing their respective dispute resolution costs. We may infer that the parties share an incentive to cheaply resolve their conflict.In the government’s court system we see this principle at work when defendants settle, or alleged criminals plea bargain. Yet public courts have clear inefficiencies that both increase the costs of dispute resolution and make settlement more difficult. Judge Neely’s strongest criticism of the public court system is that it promotes futile but expensive strategic behavior. The outcome of a case depends not merely on the facts of the dispute; it is also a function of the respective legal expenses of the two sides. Since the disputants cannot reach a cooperative solution to the dispute itself, it is likewise difficult to agree to limit joint legal expenditures. The result is that both plaintiff and defendant rush to outspend each other, but ultimately the probability of success remains unaltered because the competitive expenditures cancel one another out.Neely’s proposed solution would likely arouse skepticism from economists: “What is needed is a court version of the Strategic Arms Limitation Treaty – a method for determining in advance what a reasonable investment in a particular lawsuit is, and a court order forbidding both sides from spending money for a competitive advantage that in the nature of things will be illusory.”16 Like statutory caps set on excessive punitive damages, this is probably a band-aid measure destined to create bureaucratic inefficiencies of its own. Hard questions present themselves. First, judicial determination of maximum legal expenditures would itself use up valuable court time. Maximum permissible expenditures might itself be an issue of legal contention. Second, there would surely be active interest groups who would struggle to adjust the ceiling in their preferred direction. Frequent defendents might very well want the cap pushed down as far as possible to remove the incentives for plaintiff’s lawyers to bring suits against them. Habitual plaintiffs and their attorneys would in turn lobby in the opposite direction. (Or perhaps they would favor a cap that applied solely to defendents!) Third, it seems difficult to see how lawyers working on contingency could be dealt with under Neely’s rule. Would their awards be capped? Would the courts set a ceiling for the permissible total lawyer-hours per case? These problems seem serious — for public courts. Politics would probably prevail over economics.Private courts, on the other hand, already limit legal expenses with marked success. The AAA does not permit lawyers — a quite drastic limitation. VISA does not even allow the parties to attend their own hearing. But these are efficient results. On the average, these practices are unlikely to harm the legal prospects of either side. Yet these practices limit the joint legal costs per case — a big plus. Since both sides typically agree to arbitrate disputes in advance, before cooperation has broken down, it is easy to pre-commit to mutually limit legal costs in future disputes.Why has private dispute resolution worked so well in this area? The public courts would find it hard to administer such a rule. Is there a critical difference between the limitations that private and public courts place on legal expenditures? I think there is. To understand it, we should turn to Ronald Coase’s classic article, “The Nature of the Firm.”17 Managers of a firm, Coase explained, usually run it by the “command-and-control” methods that economists deplore on the economy-wide level. Once a worker gets hired, he is expected to do what he is told; similarly, office supplies are likely to be centrally allocated to each department rather than sold to them. What this shows, said Coase, is that command-and-control methods (since they survive and thrive within competitive firms) must be useful to some extent; most notably, command-and-control reduces transactions costs. The problem with centrally-planned economies is that they extend command-and-control techniques far beyond their efficient point — and then eliminate the competitive pressure that checks this inefficiency. In competitive markets, a firm that grows so large that it cannot effectively manage itself starts to lose market share and profits. This gives an incentive to scale back to a less cumbersome size. Central planning by a government does not face this disincentive. For private courts, limiting the use of lawyers, expert witnesses, and so on would be akin to any other business decision. All firms use command-and-control to some extent; what prevents inefficient command-and-control is the pressure of competition. When private courts experiment with restrictions on legal expenditures, they need merely judge the needs of their own clientele, not those of the whole society. And when they judge incorrectly, competition can straighten them out. If a firm decides to limit legal expenditures, market share and profits can indicate whether or not the practice is efficient in that particular case. No one ever needs to make the much more difficult judgment about what is efficient for all firms.In contrast, the public court system is a centrally-planned industry — when it uses command-and-control there is little or no feedback to show whether its actions are sensible. And if it chooses wrongly, consumers often have no close substitute. More critically, the public courts choose not merely for a single firm; they choose for the whole society. Judgments of this kind are likely to be wrong because, first, there is no market feedback, and second, because individual preferences and circumstances differ too much for one