Review: Posner's Economic Analysis of Law

Reviewed Work(s): Economic Analysis of Law. by Richard A. Posner

Review by: Peter A. Diamond
Source: The Bell Journal of Economics and Management Science , Spring, 1974, Vol. 5,
No. 1 (Spring, 1974), pp. 294-300
Published by: RAND Corporation

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 Posner's Economic
Analysis of Law

Reviewed by

Peter A. Diamond

Professor of Economics
Massachusetts Institute of Technology

* Richard Posner has written an exceptionally interesting book.'

It is a wide ranging discussion of the impact of the legal system
on the allocation of resources by the market and of economic
aspects of the behavior of participants in the legal system, written
as a text for law students knowing little or no economics by a
nonmathematical Chicagoan. (Of course, it is only the absence
of mathematics that I hold against the author.) I shall briefly lay
out the range of analysis and variety of audiences who will find
this book interesting, some limitations of the absence of mathe-
matics, and some examples of the tone of the book. Then, in a
more leisurely fashion, I shall discuss contract law to show an
example of the type of analysis in the book.
This is a textbook for law students, intending to teach
economic principles while conducting a survey of the rules and
institutions of the legal system, summarizing, and extending the
applications of economics to law. I expect that it does its job well
and would be an interesting book to teach or study from in this
sort of course, for it is very well written and interesting in content.
As an economist, I naturally believe that the book would be better
for law students if it taught a little more economics, particularly
noting which assumptions play major roles in the analysis. (I also
suspect that some discussion of the different nature of marginal
and lumpy decisions would be valuable, i.e. the complications
arising from nonconvexities.) The text would also serve very well
for a law and economics course for economics students (either
advanced undergraduates or graduate students), although the
more conventional economics subjects, such as taxation and
regulation, would need considerable expansion, or better, omis-
sion since they are already a standard part of economics curricula.
While this is basically a text, it is also a monograph in a field of
growing interest to economists, and I will review it primarily on
that basis.
The scope of this book is exceptionally wide. It encompasses
the traditionally analyzed areas of government intervention in the
market (antitrust, regulation, taxation), the areas of great recent
interest of the impact of the legal system on private use of the
market (property rights, contracts, torts, crime control, anti-

1 Richard A. Posner, Economic Analysis of Law (New York: Little,

294 / PETER A. DIAMOND Brown and Co., 1973).

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discrimination regulations) and of the economics of the functioning
of the legal system (due process, civil and criminal procedure, law
enforcement). With the hypothesis that the common law is seeking
economic efficiency, it also seeks to explain judicial decision-
making.2 The style is lucid but unfortunately, to my taste, non-
mathematical except for numerical examples and a few diagrams.
Mathematics is both a method of exposition that makes some
assumptions (or their importance) more apparent and a method
of thought that makes some types of errors more difficult. For
example, in the discussion of expenditures on litigation,3 under the
assumption that each party takes the litigation expenditures of the
other as given, it is stated that increased optimism results in higher
expenditures. But the perceived probability of success is a function
of expenditures. For an upward shift in the function to increase
expenditures, the derivatives must change appropriately since the
first-order condition involves the derivative, not the level of
probability.4
Another example where mathematics might clarify comes in
the discussion of free entry and profitability. With free entry and
identical cost functions for all actual and potential firms, all firms
have zero profits (i.e. just earn the normal return) in competitive
equilibrium. When different firms have different cost functions, the
marginal firm (with a continuum of firms) will have zero profits,
but other firms may be earning positive profits (or rents) without
encouraging further entry, since potential firms (which have not
yet entered) have higher costs and cannot duplicate the profitable
position of some of the existing firms. A priori I do not see any
reason to assume that all potential entrepreneurs would start firms
with identical cost functions. Particularly in a book where trans-
action costs play a major role, we would expect existing firms to
have at least an informational advantage, vis-'a-vis customers, rela-
tive to potential firms. Empirically, in particular industries, the
supply of potential entrepreneurs may be such that the identical
firm assumption is a good one. I do not believe it is a good assump-
tion in all industries. This distinction is not drawn despite repeated
use of a zero profit assumption (and the implied eventual bank-
ruptcy of any firm that is not successfully profit maximizing). At

2 Of course, this hypothesis is not universally accepted. See, e.g.,

George Fletcher, "Fairness and Utility in Tort Theory," Harvar-d Law
Review (January 1972).
3 A dose of game theory might be helpful here, particularly in the
discussion of the existence of equilibrium when each party is aware that
litigation expenditures may induce a response.
4 It seems to me that clearly distinguishing average from marginal
ranks as an important economic lesson. Thus sloppiness on this point is
a weakness in the book. See, e.g. "he will stop spending [on an appli-
cation for a broadcast license] at the point where, if he prevails, the
difference between his expenditures and the value of the license will be
large enough to compensate him for the risk," (p. 14). For the example
in the text, expected profit of the plaintiff is fl(E)D-E, where E is expendi-
tures, D damage award if the case is won, fl(E) the probability of winning
if E is spent. The first-order condition is fl' D = 1. E will increase with
a shift in fl that increases LI' at the previous optimum (given suitable THE BELL JOURNAL
regularity conditions). rl could shift up and Hl' shift down in the relevant OF ECONOMICS AND
range.
MANAGEMENT SCIENCE / 295

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 least in organized crime one would expect an existing firm to have
an advantage over potential firms, particularly if they are going to
shoot it out for a (temporary?) monopoly position. (Do potential
firms use potential bullets?)
Now let us turn to a few quotations which will give the tone
of the book more easily than description:

There is abundant evidence that legislative regulation of the economy

frequently, perhaps typically, brings about less efficient results than the
market-common law system of resource allocation. [Footnote containing
references omitted.]5

A newer view, which draws on economic analysis, argues that the

structure of the administrative process is designed to increase political
control over the process of legal regulation rather than to, increase effi-
ciency but that within the constraints imposed by the fundamentally po-
litical purpose of regulation the evidence is consistent with the hypothesis
that the agencies, like most other organizations, are rational utility maxi-
mizers.6

The analysis in the preceding section assumes that judges make their
decisions in accordance with the criterion of efficiency. But what is the
linkage between the judges' self-interest and the promotion of efficient
resource use?7

Delay is not due to the fact that the demand for litigation is high and
the amount of judge time limited. . . . An appropriately graduated system
of surcharges for people desiring to have their cases heard promptly would
[clear the market.]8

Without statutory protection against disinheritance, women could

negotiate with their husbands for contractual protection. The statutory
provision minimizes transaction costs.9

As this last quotation suggests, Posner does not examine the

question of the effect of institutions on preferences and inter-
personal relations. Rather, he uses the standard concept of Pareto
optimality in terms of given preferences.10 This mode of analysis
is very well employed and pushed into new regions of uncertainty
and transaction costs. One curious aspect of the structure of the
book is the treatment of the transaction costs of the legal system.
In much of the book, they are taken to be zero (particularly in
the discussions of the correct measurement of damages to induce
efficient behavior). Then, when the procedural system is directly
discussed, the measure of damages which would be optimal for a
frictionless legal system is assumed to hold. (This can, of course,
be viewed as a version of how the legal system is currently trying
to measure damages. Posner does discuss separately damages
where the probability of apprehension is less than one.) Treating

5p. 329.
6P. 386.
TP. 325.
8p. 355.
9 P. 250.
10 While the effect of legal rules on the incentive to settle dispute
examined, I was sorry to see no discussion of the very interesting analy
by Arthur Leff ("Injury, Ignorance and Spite-The Dynamics of Coercive
Collection," Yale Law Journzal, October 1970) of the dynamics of sett
ment and impact of legal rules on different types of litigants (wage earners
corporations, high volume litigants-infrequent litigants).
296 / PETER A. DIAMOND

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simultaneously the measurement of damages and the structure of
procedures would be interesting.
To see more of the flavor of this book and of this burgeoning
field of research, let us consider one topic in more detail. I have
selected the area of contracts.11 Discussion of the role of contract
law is greatly complicated by the presence of the contracting
parties. By hypothesis they are (were, will be, or could easily be)
negotiating. This prevents the simple analysis of tort law where
the assumed high transactions costs prevent parties affected by
externalities from negotiating to consider all of the social costs
conventionally viewed by a general equilibrium model with exter-
nalities. Rather we must move into the fine structure of transac-
tions to find any role for the law at all, other than dissuading
outright cheating (and the costs induced by feai of cheating).
There are three types of effects of the law which seem worth
considering separately-adjusting allocation where the parties can-
not or have not worked everything out, saving on their transaction
costs in the process of working things out, and affecting information
flows, and so, what they are trying to work out. Put differently,
the three types are where the parties are indeed strangers, where
they are filling in details of an agreed bargain, and where they are
determining the nature of the bargain.
In the first category Posner considers a contract where the
delivery date stipulated omits the month. A, new to the industry,
means next month; B, an old hand, knows and is following the
custom of the industry that an omitted reference to the month
means the current month. The court will interpret the contract
as incorporating the customs of the industry. Posner points out
that this encourages newcomers to master the language of the trade
promptly, which presumably increases efficiency in the industry.
One should also point out that it also affects the costs of entering
a new field, and so, both long-run efficiency and income distribution.
Imperfect communication can also take the form of faulty tele-
grams and garbled messages. In addition, where communication
takes time, there are risks of changing conditions that must be
borne in some division between the parties. By deciding who bears
the risk (of increased costs, say, between transmission and receipt
of an offer) the court can affect the efficiency of the bearing of
this risk and the decisions affecting its magnitude. Since in these
situations the parties are in imperfect communication, court im-
posed rules will generally determine where risks are borne (and
so who adjusts to bear them).
An example in the second category considered by Posner is
a quantity of wool with a latent defect that has not been examined
by either the seller or tne buyer. The buyer then uses the wool in
manufacturing and so ruins the suits made from it. Efficiency calls
for inspection by the party with lower inspection costs,'12 or no

11 The selection reflects my own interests, of course, as well as the

fact that Posner's analysis here is, to my knowledge, new and very inter-
esting.
12 These costs are not simply physical inspection costs but also reflect
THE BELL JOURNAL
other transactions, for example whether self-protection against cheaters
OF ECONOMICS AND
already called for some inspection by one of the parties. What is needed
MANAGEMENT SCIENCE / 297

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 inspection if expected damages are lower than inspection costs.
By trying to place liability on the cheaper inspector, the court can
attempt to minimize the sum of expected inspection and damage
costs. In the world of "transactors knowledgeable of the law,"
misplaced liability merely leads to a corrective transaction, shifting
the liability. But corrective terms in the contract have transactions
costs, so by getting liability right, the court permits a cheaper
reliance on the common law to substitute for a more expensive
explicit contract.13 Partially restating the categorization of topics,
Posner describes three economic functions, "maintenance of ap-
propriate incentives" (i.e., putting risk where it is most cheaply
borne), reduction of "the complexity and hence cost of transac-
tions by supplying a set of normal terms"'14 and, not mentioned
above, furnishing "prospective transacting parties with information
concerning the many contingencies that may defeat an exchange,
and hence to assist them in planning their exchange sensibly.
The parties, through their lawyers, are guided around the pitfalls
in the process of exchange revealed by the opinions in decided
contract cases."'15
Here we move into the third category, of making transactors
more knowledgeable. The more difficult version of this is con-
sidering how people might have acted had they been more knowl-
edgeable and considering how, if at all, legal rules applying both
to carefully and carelessly worked out bargains should adjust for
the careless. Let us look more closely at the role of information
exchanges. Posner considers a contract induced by "an outright
and calculated lie." In this case, he argues "the presumption that
a contract, if carried out, will produce a value-increasing exchange
fails . . . [and] nonenforcement may discourage such conduct in
the future." Considering the case of withholding of information
he argues, "It would be inefficient to require the seller of a house
to obtain and disclose every fact that might be material to a
purchaser; it would be particularly inefficient to require the seller
to obtain and disclose information that the buyer could obtain at
lower cost [footnote omitted]."16 He does not consider the tougher
case of nondisclosure of already obtained information of value to
the purchaser. Efficiency at that point would call for disclosure.
This would be a disincentive to the seller to obtain information
which he might make use of but which might later negatively
affect the selling price. It would also be a disincentive for the
buyer to obtain information which he might presume the seller
has checked for him, although this problem is easily handled by
asking. This question is also considered separately (in ?3.6), where
Posner considers information flows between seller and consumer,
arguing that information about simple, frequently purchased,

here is consideration of the total set of costs, not just those of the single
transaction.
13 Obviously legal placement of liability independent of the contract
does not permit this shifting.
14 Posner also considers the reverse case of compelling market rather
than legal exchanges where the former are cheaper, as in determination
of price, when the parties have been vague.
15 P. 44.
16Pp. 48-49.
298 / PETER A. DIAMOND

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products subject to patent defects is most cheaply gathered by the
consumer; while information about complex infrequently pur-
chased products subject to latent defects will be cheaper for the
seller to obtain. Posner also considers other types of information
flows in the market, problems of suits for damages where damages
are small and Federal Trade Commission's regulation of advertising.
The implicit background for this discussion is a conventional
resource allocation model where markets are functioning more or
less properly, so one can focus on the single transaction against
a background of efficient resource allocation. But it is natural to
ask whether the same information and transaction costs which
create the questions at hand do not simultaneously imply some
systematic biases in the entire market setting which are relevant
for the treatment of the single transaction and efficiency. As an
example, let us consider Posner's discussion of standard form con-
tracts (?3.7). Many offers are made on a take-it-or-leave-it basis
by individual firms. This pattern may well reflect significant cost
savings for a firm engaged in many small transactions. But, he ar-
gues, competition will adjust for this. "If one seller offers unattrac-
tive terms to a purchaser, a competing seller, desiring to obtain the
sale for himself, will offer more attractive terms. The process should
continue until the terms are optimal from the purchaser's stand-
point. Thus the purchaser who is offered a printed contract on a
take-it-or-leave-it basis does have a real choice: he can refuse to
sign, knowing that if better terms are possible another seller will
offer them to him. All of the firms in the industry may find it eco-
nomical to use standard contracts and to refuse to negotiate with
purchasers. But what is important is not whether there is haggling
in every transaction but whether competition forces sellers to in-
corporate in their standard contracts terms that maximize the
purchaser's benefits from transacting."17
But what has happened to all those information limitations
and transaction costs that were the heart of the argument? For
terms of limited importance is it worth the cost of seeking a better
contract? (Can you be sure one even exists?) Is it even worth
the cost of finding out what would be a better term?' 8 If the
answers to these questions are no, where is the incentive for better
terms? Might not all firms find it to their interest to offer bad
terms19 (just as models have been constructed where prices exceed
the competitive price because information limitations remove the
advantages of price decreases)? If in some cases the market system-
atically diverges from efficiency, is not the role of a legal system's
seeking efficiency basically different from that analyzed?20 Perhaps
no rules to cure this problem can be found which are better than

17p. 54.
18 Examples would be risks better borne by the seller, so the consumer
benefits from better terms and a higher price.
19 Free entry cannot come to the rescue here, for even with identical
firms we merely get zero profits, not efficient terms.
20 These problems are further complicated by the presence of plain
THE BELL JOURNAL
old-fashioned careless consumers in addition to new-fangled transaction-
OF ECONOMICS AND
cost-avoiding careless consumers.
MANAGEMENT SCIENCE / 299

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 those which ignore it. Perhaps the legal system can only help effi-
ciency for the (excessively?) well informed. Apart from the obvious
distributional questions, this appears to be an extremely important
efficiency question, the outcome of which is not at all clear.
As I hope I have indicated by this discussion, Posner is examin-
ing an area of great intrinsic interest and analytical difficulty and
making considerable progress. The book is broad as well as deep.
I found it fascinating to read and I look forward to using it as a
text.

300 / PETER A. DIAMOND

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