Thursday, July 10, 2003
The Use of Economics in Law: An Application
posted by James
In the fall semester of my last year at Amherst, I took a class on law and economics. The class seemed full of ideas for debate, but I had trouble turning them into workable cases. One case that I ran a few times, producing absolutely awful rounds, was essentially Laidlaw v. Organ. I recently revisited the case while doing some reading, and I was stunned at how badly I had missed the actual crux of the analysis. The analysis, while it seems obvious in retrospect, is quite elegant, and it illustrates some of the shortcomings of traditional legal thought. None of it is original; I rely primarily on Law & Economics, by Robert Cooter and Thomas Ulen, pp. 272-274, and on Economic Analysis of Law, by Richard Posner, pp. 109, 111, 128 for the rest.
The Facts
At the end of the War of 1812, New Orleans was under a British blockade, and the price of tobacco was significantly depressed. A man named Organ heard of the Treaty of Ghent, which would of course result in the lifting of the blockade. Organ signed a contract to buy a lot of tobacco from the Laidlaw firm, which hadn't yet heard of the treaty (the information was not public). The next day, the news became public, causing an upward spike in tobacco prices. Laidlaw sued, arguing that the contract should not be enforced.
Intuition Gets Us Nowhere
The challenge is to come up with a legal doctrine that will yield correct judgments in similar circumstances in the future. Specifically, the question is whether courts should enforce contracts in which one party has relevant knowledge but doesn't share it with the other party. This is difficult because our intuition gives different answers depending on the circumstances. In the case of insider trading, we would like to invalidate the transactions (and punish the culprits). On the other hand, if I develop a model to predict the weather, and I find that it's going to be a good year for a certain crop, our intuition (or at least my intuition) is that it's okay for me to buy and sell futures without disclosing the results of my computations.
This means that we can't issue a very simple rule, such as “never enforce contracts in which one party withheld relevant information from the other.” It also seems inadvisable to leave the decision up to the intuition of the judge in any given case, since such intuitions are likely to vary widely. Often, a rule's clarity and consistency are more important than its holding in any one case (a clear rule can prevent litigation in the first place).
Simplistic Economic Analysis Is Unsatisfactory
In trying to devise a good rule, I originally concentrated on a rather simplistic economic concept, one that had little intuitive appeal and made debate rounds miserable. The idea was that allowing one party to benefit from asymmetric information in a contract provided incentives to acquire the information and bring it to market. In my example of the weather forecasting model, society benefits when it has good forecasting models, because it can allocate resources more efficiently (say, eating more now in anticipation of plenty in the future). One objection would be that sharing the model is precisely not what I'm doing; I'm hiding it from my contractual partner. This objection misses the impact of the contract; the information gets to market, because my activity drives prices in the correct direction.
The same argument applies to insider trading, except that only the second effect is produced. The price is driven in the correct direction, but only because of fortuitous information, not a model that is the result of effort. Of course, there's no need to reward good fortune, but it still makes sense to reward the bringing of information to the market. Note, though, that we've come to the conclusion that such contracts should always be enforced, even in the case of insider trading. This is very unappealing, but can we explain why this doesn't sit right?
Thorough Economic Analysis Illuminates
The key to finding the optimal (i.e., wealth-maximizing) rule is to consider the ways in which people gain wealth. One way is to produce it. This could be as obvious as building your own house, or raising crops, but it could also consist of buying low in one place and selling high in another (moving resources to increase their value counts as wealth production). The other way to get wealth is to take someone else's. This could be stealing, or government-sponsored redistribution, or winning at cards.
To maximize overall wealth, we would like people to put their effort into production of wealth, not redistribution. Redistributive effort by definition produces no wealth, and what is worse, it usually spurs the other party or parties to expend resources defending their wealth, which is also wasteful from society's perspective. This is not to condemn all redistribution, but in general we want to use as few resources to redistribute wealth as possible.
Now, we can analyze the incentives to find and use information in contractual settings. Some information is productive. For instance, a good weather forecasting model could produce considerable wealth, and allowing the information to be profitable creates incentives to develop and use such a system. On the other hand, some information is primarily redistributive. If the cost of acquiring such information (including the defensive expenses that its potential use will motivate) is higher than the gain in wealth when the information is brought to market, overall efficiency will be improved by invalidating contracts in which one party withheld such information.
A good legal rule is now easy to derive, if somewhat difficult for judges to apply. Enforce contracts whose net effect is to bring productive information to market, invalidate contracts when this effect is overwhelmed by costly investment in redistributive information. We can see why insider trading might be illegal (although it is also possible to see circumstances in which it could be efficient). Can we justify the ruling in Laidlaw?
Non-Economic Reasoning, Inefficient Rule
In fact, the court found for Organ, upholding the contract and setting the precedent that such contracts should be upheld in the future (so long as one party didn't “impose on” another; the whole opinion is available on Lexis-Nexis). Clearly, this rule is inefficient. It coincides roughly with the simplistic economic analysis that I presented above, although the judges steered well clear of economic argumentation. It has the benefit of being fairly clear (assuming “imposition” is somewhat comprehensible). It is easy to apply. For all I know, it's the best that could have been done at the time.
Still, with the benefit of a little economic analysis, we can see why the finding is socially inefficient. In the case of Laidlaw, the information came to market only one day earlier than it would have otherwise. This can't have led to much productive activity; the only possibilities I can think of is that the higher price would have convinced people to take good care of their tobacco (people might dump wares during a blockade), or that it would have alerted planters to go ahead and plant. On such a short time scale, these activities can't have been significant.
Moreover, the rule generally leads to over- investment in information that is largely distributive rather than productive. The opinion (or possibly the argument of counsel; apparently published opinions were much different back then) makes frequent reference to classical authority (Cicero, Florentinus, St. Thomas). This shows a familiarity with philosophy that can clearly benefit legal analysis greatly (if not in this case). I hope that advances in economic thought and shifts in attitudes toward rigor will make it respectable to cite economic theory in law cases beyond anti-trust, where it has always been welcome. A judiciary that is economically literate will shape the law to serve society in a way that the judges of Laidlaw could not, however much Cicero they had read.
The Facts
At the end of the War of 1812, New Orleans was under a British blockade, and the price of tobacco was significantly depressed. A man named Organ heard of the Treaty of Ghent, which would of course result in the lifting of the blockade. Organ signed a contract to buy a lot of tobacco from the Laidlaw firm, which hadn't yet heard of the treaty (the information was not public). The next day, the news became public, causing an upward spike in tobacco prices. Laidlaw sued, arguing that the contract should not be enforced.
Intuition Gets Us Nowhere
The challenge is to come up with a legal doctrine that will yield correct judgments in similar circumstances in the future. Specifically, the question is whether courts should enforce contracts in which one party has relevant knowledge but doesn't share it with the other party. This is difficult because our intuition gives different answers depending on the circumstances. In the case of insider trading, we would like to invalidate the transactions (and punish the culprits). On the other hand, if I develop a model to predict the weather, and I find that it's going to be a good year for a certain crop, our intuition (or at least my intuition) is that it's okay for me to buy and sell futures without disclosing the results of my computations.
This means that we can't issue a very simple rule, such as “never enforce contracts in which one party withheld relevant information from the other.” It also seems inadvisable to leave the decision up to the intuition of the judge in any given case, since such intuitions are likely to vary widely. Often, a rule's clarity and consistency are more important than its holding in any one case (a clear rule can prevent litigation in the first place).
Simplistic Economic Analysis Is Unsatisfactory
In trying to devise a good rule, I originally concentrated on a rather simplistic economic concept, one that had little intuitive appeal and made debate rounds miserable. The idea was that allowing one party to benefit from asymmetric information in a contract provided incentives to acquire the information and bring it to market. In my example of the weather forecasting model, society benefits when it has good forecasting models, because it can allocate resources more efficiently (say, eating more now in anticipation of plenty in the future). One objection would be that sharing the model is precisely not what I'm doing; I'm hiding it from my contractual partner. This objection misses the impact of the contract; the information gets to market, because my activity drives prices in the correct direction.
The same argument applies to insider trading, except that only the second effect is produced. The price is driven in the correct direction, but only because of fortuitous information, not a model that is the result of effort. Of course, there's no need to reward good fortune, but it still makes sense to reward the bringing of information to the market. Note, though, that we've come to the conclusion that such contracts should always be enforced, even in the case of insider trading. This is very unappealing, but can we explain why this doesn't sit right?
Thorough Economic Analysis Illuminates
The key to finding the optimal (i.e., wealth-maximizing) rule is to consider the ways in which people gain wealth. One way is to produce it. This could be as obvious as building your own house, or raising crops, but it could also consist of buying low in one place and selling high in another (moving resources to increase their value counts as wealth production). The other way to get wealth is to take someone else's. This could be stealing, or government-sponsored redistribution, or winning at cards.
To maximize overall wealth, we would like people to put their effort into production of wealth, not redistribution. Redistributive effort by definition produces no wealth, and what is worse, it usually spurs the other party or parties to expend resources defending their wealth, which is also wasteful from society's perspective. This is not to condemn all redistribution, but in general we want to use as few resources to redistribute wealth as possible.
Now, we can analyze the incentives to find and use information in contractual settings. Some information is productive. For instance, a good weather forecasting model could produce considerable wealth, and allowing the information to be profitable creates incentives to develop and use such a system. On the other hand, some information is primarily redistributive. If the cost of acquiring such information (including the defensive expenses that its potential use will motivate) is higher than the gain in wealth when the information is brought to market, overall efficiency will be improved by invalidating contracts in which one party withheld such information.
A good legal rule is now easy to derive, if somewhat difficult for judges to apply. Enforce contracts whose net effect is to bring productive information to market, invalidate contracts when this effect is overwhelmed by costly investment in redistributive information. We can see why insider trading might be illegal (although it is also possible to see circumstances in which it could be efficient). Can we justify the ruling in Laidlaw?
Non-Economic Reasoning, Inefficient Rule
In fact, the court found for Organ, upholding the contract and setting the precedent that such contracts should be upheld in the future (so long as one party didn't “impose on” another; the whole opinion is available on Lexis-Nexis). Clearly, this rule is inefficient. It coincides roughly with the simplistic economic analysis that I presented above, although the judges steered well clear of economic argumentation. It has the benefit of being fairly clear (assuming “imposition” is somewhat comprehensible). It is easy to apply. For all I know, it's the best that could have been done at the time.
Still, with the benefit of a little economic analysis, we can see why the finding is socially inefficient. In the case of Laidlaw, the information came to market only one day earlier than it would have otherwise. This can't have led to much productive activity; the only possibilities I can think of is that the higher price would have convinced people to take good care of their tobacco (people might dump wares during a blockade), or that it would have alerted planters to go ahead and plant. On such a short time scale, these activities can't have been significant.
Moreover, the rule generally leads to over- investment in information that is largely distributive rather than productive. The opinion (or possibly the argument of counsel; apparently published opinions were much different back then) makes frequent reference to classical authority (Cicero, Florentinus, St. Thomas). This shows a familiarity with philosophy that can clearly benefit legal analysis greatly (if not in this case). I hope that advances in economic thought and shifts in attitudes toward rigor will make it respectable to cite economic theory in law cases beyond anti-trust, where it has always been welcome. A judiciary that is economically literate will shape the law to serve society in a way that the judges of Laidlaw could not, however much Cicero they had read.
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