Economic Theory in the 1L Curriculum (First Draft)

-- By DanielMargolskee - 27 Feb 2009

Writing about the study of law, Justice Holmes predicted that while “the blackletter man may be the man of the present, the man of the future is the man of statistics and the master of economics.” In many 1L classrooms, Holmes’s prediction has come half true--but only half.

In standard Contracts or Torts classes, students are expected to be able to analyze what consequences a proposed rule of law would have in society, under the stylized assumptions of economic theory--that people and firms are utility maximizers, that some amount of money damages is enough to make a person indifferent to suffering a given injury, and that markets are perfectly efficient. The results of these economic thought experiments, however, are incomplete substitutes for the study, using statistics and other disciplines, of what the actual empirical effect a given rule of law would be on society in practice. Still less can economic models substitute for frankly confronting whether the changes produced by a given rule will, in their actual empirical operation, help to bring about a society we actually prefer to live in.

In studying whether a particular rule of law is a desirable one (or, indeed, whether a particular rule of law is ever actually applied as conceived), the empirical dimension is often missing from the 1L classroom: predictions about the social consequences of a rule are extrapolated from standard economic axioms, instead of examining what the consequences of changed rules actually are in society through empirical study. Then, as a normative matter, the proposed rule is judged according to the efficiency of the outcomes that are predicted in theory, rather than the actual social interactions that are produced by the rule in fact.

The result is that while moral language is largely displaced from the study of Contract and Tort law for 1Ls (as Holmes indeed did advocate), the notion that ideal rules of law can “be worked out like mathematics from some general axioms of conduct” has not been completely expelled.

The Efficient Breach Hypothesis and the Assumption of “Full” Compensation

Contrast, for example, the efficient breach hypothesis as taught in a 1L Contracts class with the account of contract breach Holmes sets out in The Path of the Law.

Our Contracts textbook suggests that, in understanding how the law operates, we might fruitfully think of a promisor as having the equivalent of an “‘option’ to breach and pay expectation damages instead of performing, when it is in her economic interest to do so.” Farnsworth et al., Contracts, 20 (7th ed. 2008). This is quite in line with Holmes’ observation that, from the perspective of the bad man, the “duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it--and nothing else.” So long as (and only so long as) the resulting consequences are the same, it does not matter to the bad man whether the law gives different names to a “cancellation option” and to a “breach.”

In contrast to Holmes, however, the Contracts text suggests that, as long as the promisee is in some ill-defined sense fully compensated for his expected benefit under the contract, a breach by the promisor will “leave the promisee just as well off as he would have been had the promisor performed. In principle, then, breaches of this sort make promisors better off without making promisees worse off.” Id.

Moral considerations are eliminated not only from the analysis of how the party in breach is likely to perceive the consequences of breach, but also from the question of what the consequences of breach should actually be in our society. Instead, it is hypothesized that there exists a sufficient level of compensation which will be enough to make the aggrieved party indifferent to the breach, and that when damages are fixed at that point, society as a whole is made “better off” through the breaches that result, because the inefficient performance of contracts is discouraged.

Contract Breach in the Absence of “Full” Compensation

In principle, it is trivially true that if an aggrieved party’s expectations are “fully” compensated, then he would be as well off as if the promise had been performed––if the aggrieved promisee isn’t indifferent in some sense, then hasn’t been “fully” compensated for that expectation. In practice, though, when courts award “expectation damages,” they typically don’t fully compensate the aggrieved party’s expectations. The damages for breach compensate only the consequences which are “reasonably foreseeable”; attorneys fees are typically not compensable; and no accommodation is made for the non-economic value the aggrieved party places on the performance of the contract.

The efficient breach hypothesis, then, describes the situations under which a breach would make all parties better off, only because of the implicit assumption that every injury is in compensable with some amount of money, and because of the definitional relationship between “full” compensation and the aggrieved party’s indifference. But a definition and an assumption, under Holmes’ framework, is not the equivalent of an argument which would “justify” the “social advantage” of a given rule of law. It is rather more the equivalent of the “blind guess” that punishment actually deters crime--or, to put it a different way, that a sufficient level of punishment for crime would produce only the “efficient” level of criminal activity.

• Two different arguments are made here, and they are somewhat in conflict despite their compatibility's being taken for granted and going undiscussed. In the first place, you argue (correctly) that "law and economics" has become a form of transcendental nonsense done by theory, rather than in relation to facts discovered about the way things actually work. (The first critic to observe this, as it happens, was Art Leff, who reviewed Posner's Economic Analysis of Law in 1974 and presciently there discovered the onset of what he called "American Legal Nominalism.") In the second place, you argue that the doctrine of efficient breach is based on a biased definition of full compensation, because it ignores both specific idiosyncratic value in performance and the general moral value of promise-keeping. This argument is made solely on the basis of theoretical constructs, without any showing of the extent of actual insufficient compensation in the world of real-life transactions.

• Both of these arguments can be made. Maybe even in the same essay. But their conflicting methodologies would have to be acknowledged and dealt with somehow. And one must say that the first seems stronger without the second. It sounds as though there might be an alternative before you throw in the towel and start steering by speculation, just like everyone else.

New Revision:

Economic Theory and the Rational Study of Law (Revised Draft)