The Economics of Crime and Litigation (Encyclopedia of Law and Economics , Vol 5)

4000 CONTRACT LAW: GENERAL THEORIES Richard Craswell Professor of Law, Stanford Law School © Copyright 1999 Richard Craswell

Abstract When contracts are incomplete, the law must rely on default rules to resolve any issues that have not been explicitly addressed by the parties. Some default rules (called ‘majoritarian’ or ‘market-mimicking’) are designed to be left in place by most parties, and thus are chosen to reflect an efficient allocation of rights and duties. Others (called ‘information-forcing’ or ‘penalty’ default rules) are designed not to be left in place, but rather to encourage the parties themselves to explicitly provide some other resolution; these rules thus aim to encourage an efficient contracting process. This chapter describes the issues raised by such rules, including their application to heterogeneous markets and to separating and pooling equilibria; it also briefly discusses some noneconomic theories of default rules. Finally, this chapter also discusses economic and non-economic theories about the general question of why contracts should be enforced at all. JEL classification: K12 Keywords: Contracts, Incomplete Contracts, Default Rules

1. Introduction This chapter describes research bearing on the general aspects of contract law. Most research in law and economics does not explicitly address these general aspects, but instead proceeds directly to analyze particular rules of contract law, such as the remedies for breach. That body of research is described below in Chapters 4100 through 4800. There is, however, some scholarship on the general nature of contract law’s ‘default rules’, or the rules that define the parties’ obligations in the absence of any explicit agreement to the contrary. The phrase, ‘complete contingent contract’ is sometimes used to describe an (imaginary) contract that would spell out in complete detail the exact legal rights and duties of each party under every possible state of affairs. While no real contract ever achieves this level of completeness, the concept is still useful to define one endpoint of a spectrum of completeness. If any contract ever succeeded in reaching this endpoint, the law’s default rules would then be irrelevant, as no issue would ever arise that could not be settled by the terms of the contract itself. Indeed, the same is true 1

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of the interpretation of most other legal documents, such as wills (see Chapter 5830) or legislative enactments (see Chapter 9200). As long as legal documents fall short of this level of completeness, the law must have some set of presumptions or default rules, in order to resolve disputes that are not settled by the terms of the document itself. The law could, of course, simply refuse to enforce any contract (or any will, or any statute) that fell short of absolute completeness. But such a rule would itself be a ‘default rule’: it would be a legal rule defining the obligations (or lack of obligations) that result when a contract does not itself specify what rules should govern. As long as actual contracts fall short of full completeness, then, the existence of default rules is not so much a choice as a logical necessity. The only question is what the content of those default rules ought to be. In choosing the content of default rules for contractual relationships, it is often useful to distinguish default rules chosen to increase efficiency if they are allowed to remain in force (as discussed in Sections 2-4) from those chosen to increase efficiency if many parties contract around the default rule (discussed in Sections 5-9). In some cases, the steps required to contract around a default rule could themselves increase efficiency, by inducing one party to reveal private information (as discussed in Sections 6-8). In other cases, it may be too hard for the law to identify a single rule that would increase efficiency if allowed to remain in force, so the default rule may instead be selected purely for its simplicity or ease of administration (as discussed in Section 9). The choice between these approaches depends in part on the ability of courts or lawmakers to identify efficient default rules; this issue is addressed in Section 10. The possible effect of default rules on the parties’ own preferences is discussed in Section 11, while Section 12 discusses some non-economic theories of default rules. Finally, there is also a good deal of scholarship on the general question of when contracts ought to be enforceable, either through informal social sanctions or more by formal legal mechanisms. Section 16 introduces these issues, and discusses the choice of enforcement mechanisms. Sections 18-20 focus on the question of whether promises should be enforceable at all (whatever the mechanism), with Section 18 discussing noneconomic theories of enforcement and Sections 19-20 discussing the economic theories.

A. ‘Majoritarian’ or ‘Market-Mimicking’ Default Rules 2. Introduction to Majoritarian Default Rules One way to select a default rule is to identify the rule that would be most efficient if that rule were allowed to remain in place (for example, if the parties

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did not specify some other rule in their contract). For example, if the expectation measure of damages were determined to be the most efficient remedy for breach of contract, this approach to selecting a default rule would argue for making expectation damages the default remedy. Much of the economically-oriented research on specific topics of contract law falls into this category. For example, many analyses of the remedies for breach aim to identify the remedy that would produce the most efficient result if that remedy were allowed to govern the parties’ relationship (for example, if the parties’ contract did not stipulate that some other remedy would govern). The same is true of many analyses of implied excuses such as impracticability and mistake, or of other terms such as implied warranties. This work is described at more length in Chapters 4500 (unforeseen contingencies), 4600 (remedies), and 4700 (warranties). This section addresses only those issues common to all default rules of this sort.

3. Majoritarian Rules and Hypothetical Consent Default rules selected on this basis - that is, on the grounds of their efficiency if allowed to remain in force - are sometimes described as the rules that the parties themselves would have chosen, if they had taken the time to agree explicitly on a rule to govern their relationship. In most cases, parties to a contract have an interest in maximizing the efficiency of their relationship, so the rule the parties themselves would have chosen will be the same as the rule that would be most efficient if allowed to remain in place. Thus, default rules chosen on this basis have also been labeled ‘market mimicking default rules’, or default rules based on the principle of ‘hypothetical consent’. To be sure, if there are third-party effects, or if the parties to the contract are imperfectly informed or are subject to any other market failures, the rule that would be chosen by the actual parties might no longer coincide with the rule that would in fact be most efficient. For general discussions of the relationship between efficient default rules and hypothetical consent, see Posner and Rosenfield (1977, p. 89), Ayres and Gertner (1989, pp. 89-93), Coleman, Heckathorn and Maser (1989), and Craswell (1992). Section 4 discusses some additional complexities that arise in heterogeneous markets, in which the same rule would not be chosen by every pair of contracting parties. This basis for selecting default rules has been supported by two economic arguments, both of which involve transaction costs. (Some noneconomic arguments will be discussed in Section 12 below.) The first economic argument applies when it would be prohibitively expensive for the parties to make their contract more complete by specifying the rule they want to govern a particular contingency. This is especially likely for extremely low-probability

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contingencies, where the expected benefits of specifying a rule in advance are likely to be low. In such a case, any rule the law selects as a default rule will inevitably be left in place by the parties, so the only way to get the benefits of whatever rule is most efficient is to make that rule the default rule. The second economic argument applies if it would be costly, but not prohibitively expensive, for the parties to make their contract more complete by specifying their own rule. In such a case, selecting a default rule that matches whatever rule the parties prefer may save some parties from having to incur those transaction costs, thus producing all the benefits of the most efficient rule with lower total transaction costs. These arguments become more complicated, however, if a ‘marketmimicking’ default rule is being applied to a market that is imperfect in some respect. For example, if a remedy of expectation damages would in fact be most efficient, but if imperfect information has led the parties to believe that some other remedy would be more efficient, should the law adopt as its default remedy the one that is in fact most efficient, or should it adopt the less efficient remedy that the (imperfectly informed) parties would choose if left to their own devices? The transaction-cost argument discussed in the preceding paragraph could suggest that, if the cost of contracting around the default rule is sufficiently low that the parties are likely to do so, then the law might as well adopt the less efficient remedy as the default rule, because that is the remedy the parties will contract for anyway. Alternatively, if the costs of transacting around the default rule are so high that the parties are likely to leave the default rule in place, perhaps the law should adopt the remedy that in fact is most efficient, as that will give the parties the benefit of the more efficient rule. But this latter approach is complicated by the fact that the identity of the rule that is most efficient (if allowed to remain in force) may itself change if the parties are imperfectly informed, or if there are other market imperfections. Moreover, in some cases the presence of information asymmetries or other market imperfections may call for an entirely different approach to the selection of default rules, in which the default rules are intentionally chosen not to be left in force by many parties. This approach is discussed below in Sections 5-9.

4. Majoritarian Rules in Heterogeneous Markets Market-mimicking or ‘majoritarian’ default rules raise additional issues in markets characterized by heterogeneity, where different rules would be efficient for different contracting pairs. If a single default rule must be chosen to govern all contracts in such a market, the rule selected will determine which contracting pairs can do best by leaving the default rule in place and which pairs could potentially do better by incurring the transaction costs needed to

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specify some other rule. It is sometimes assumed that the most efficient single default rule would be that which was most efficient for most of the contracting pairs (hence the label ‘majoritarian’ default rule, coined by Ayres and Gertner, 1989). But if transaction costs differ across heterogeneous parties, this conclusion actually depends on the exact levels of transaction costs that each member of each contracting pair would have to incur to contract around whatever default rule the law adopts (see Ayres and Gertner, 1989, pp. 112115). If different rules would be efficient for different contracting pairs, the law must also to decide the extent to which its default rules should be ‘tailored’, or customized to match the rule that would be most efficient for each individual contracting pair (see Ayres, 1993; Goetz and Scott, 1985; Baird and Weisberg, 1982). If the law adopts a single, untailored default rule, that will be most efficient for only some of the contracting pairs: all other pairs will have to incur either (1) the transaction costs of contracting around the default rule, or (2) the efficiency loss from leaving in place a default rule that is less than efficient for their contract. A set of default rules tailored to each individual contracting pair can in theory eliminate or reduce these costs, but such ‘tailoring’ will usually introduce other costs. For instance, individually tailored rules will usually be more complex, thus increasing the drafting costs that must be incurred by the legislature or other lawmaking body. Moreover, it is often impossible to spell out a complete set of individually tailored rules in advance, so the law will instead have to rely on vague standards to be applied by courts on a case-bycase basis (for example, an implied excuse in cases where performance is no longer commercially ‘reasonable’). Vague standards such as these usually entail higher litigation costs; they also introduce the possibility of case-by-case error in the application of the standard, and may make it hard for the parties to predict what rule will be applied to their relationship. In short, the question of how finely to tailor a default rule - and, indeed, whether to tailor it at all raises most of the same issues that are raised whenever the law faces a choice between specific rules and vague standards (see Chapter 9000).

B. ‘Information-Forcing’ or ‘Penalty’ Default Rules 5. Introduction to Information-Forcing Default Rules In many transactions, the two parties begin with differing amounts of information. In some cases, they may be differently informed about the relevant legal rules, or about the risks involved in the transaction. They may also be differently informed about the characteristics of the other party - for example, the seller may not know how much the buyer will lose if the seller’s product turns out to be defective. Differences such as these are often referred to as

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‘information asymmetries’. While information asymmetries are often addressed directly through disclosure regulations and the like (see Chapter 5110), they can also have implications for the law’s choice of default rules. Section 6 below discusses cases where the two parties are differentially informed about the governing legal rule. Sections 7-8 then discuss cases where the two parties are differentially informed about some other aspect of the transaction.

6. Forcing Information about the Legal Rule In some cases, the choice of default rule may help correct one party’s information about the legal rule itself. For example, suppose that the default remedy for breach provides for only a small monetary payment. Suppose also that the seller (the potential breacher) knows this, but the buyer (the potential nonbreacher) does not. Suppose that the buyer instead thinks, incorrectly, that the law’s default rule provides for a very large payment in the event of breach. If left uncorrected, this information asymmetry could lead to either of two problems. First, if a larger remedy would be more efficient for this contracting pair, they may not alter their contract to provide for the larger and more efficient remedy, because the buyer will think that he or she already has the benefit of a larger remedy. Second, even if the smaller remedy provided by the default rule is in fact most efficient for this contracting pair, the buyer’s ignorance about the actual rule may keep him or her from optimally adapting his or her behavior to that rule. For example, the buyer may purchase insufficient insurance, or take insufficient precautions to reduce the losses that would be caused by breach. (The effect of legal remedies on the incentives governing decisions such as these is discussed at more length in Chapter 4600.) By contrast, suppose now that the default rule were changed to provide for a very large payment in the event of breach. If this remedy is left in place, that is, if the parties do not contract around it), then both parties will optimally adapt their behavior: the buyer will adapt because this rule matches what he or she thinks the rule is; while the seller will adapt because, by hypothesis, he or she is correctly informed about whatever the default rule is. And if this default remedy is not left in place (that is, if the parties contract around it by stipulating a smaller remedy), the act of stipulating some other remedy should serve to inform the buyer about what remedy will apply in the event of breach. Indeed, if the default rule is one that the parties will be certain to contract around - for example, if it is chosen to be highly unfavorable to whichever party is better informed about the law - that will virtually ensure that the other party will also become correctly informed about the resulting rule, by the very process of stipulating to some other rule in their contract. Hence, these default rules are sometimes described as ‘information forcing’ rules (Scott, 1990, p. 609), or as

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‘penalty defaults’ slanted against the better-informed party to induce him or her to contract around the default rule (Ayres and Gertner, 1989, p. 97). A number of analyses of particular topics in contract law have recommended default rules chosen on this basis, or have suggested that actual legal rules could be understood as serving this function. See, for example, Ayres and Gertner (1989, pp. 98-99, 104-106), Goldberg (1984, pp. 295-296), Muris (1983, p. 390), Verkerke (1995, pp. 885-890), Isaacharoff (1996, pp. 1793-1795). One difficulty raised by default rules slanted against the better-informed party is that it may not be clear which party is better informed. This raises another ‘tailoring’ question of the sort discussed above in Section 4: should the party against whom the default rule is slanted be determined in advance for a broad category of cases, or individually on a case-by-case basis? Another difficult issue, even in cases where it is clear which party is least well-informed, concerns the comparison between the benefits and the costs of correcting the information asymmetry. The benefit of correcting the asymmetry will vary from case to case, depending on the information involved, so it is difficult to generalize. The costs of correcting the asymmetry clearly include the direct costs of contracting around the original default rule (which will depend in turn on the procedures that are required to contract around a default rule, as discussed in Section 14 below). The costs of correcting the asymmetry also depend on the risk that the parties will simply forget to contract around, thereby unintentionally leaving in force a default rule that was chosen not to be efficient for these contracting parties.

7. Forcing Information about the Other Contracting Party In many markets there is heterogeneity among the potential parties on a single side of a proposed transaction. For example, sellers may differ in the reliability of their products, or buyers may differ in the losses that they would suffer if the product they purchase fails to perform. At the outset of the transaction, this information is often known to one party but not to the other - for example, each buyer may already know how much loss he or she would suffer, but sellers may have no way of knowing how much any individual buyer has at stake. This is another example of information asymmetry. When this asymmetry is present, contract law’s default rules can again create incentives for one party to take actions that will reveal information to the other party. For example, if the default remedy for breach of contract provides for only a small monetary payment, buyers who would lose a larger amount in the event of breach may have an incentive to try to contract around that rule, by negotiating for a clause stipulating a larger payment in the event of breach. By contrast, if the default remedy is already set at a larger payment, buyers who

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would lose less may be the ones with an incentive to contract around that rule, by negotiating for a smaller stipulated damage to get a more favorable price). In other words, the choice of default rule will determine which set of buyers buyers with little at stake, or buyers with lots at stake - have an incentive to try to contract around the default rule. As a result, sellers may be able to infer something about the amount that any given buyer has at stake by observing whether that buyer does or does not try to contract around the default rule. And if buyers also differ in the gains they would get from transacting around the default rule, or in the costs they would face in doing so, the resulting equilibrium may depend critically on which default rule the law adopts. (The welfare consequences of these differences are discussed below in Section 8.) These differences are often analyzed using signaling models from game theory (see generally Chapter 0550). If sellers have no information about how much any given buyer would lose in the event of breach, the result may be a pooling equilibrium in which all buyers are charged an identical price. But if this asymmetry can somehow be overcome, the result may be a separating equilibrium in which buyers who face large losses in the event of breach will have a right to collect those losses, but will pay a higher price (to compensate the seller for its greater potential liability), while buyers who face lower losses will pay a lower price. One way to achieve this separating equilibrium is to select a default rule that induces one of these classes of buyers to signal the amount they have at stake, by their actions in trying to contract around the default rule. For formal models of this effect see, for example, Ayres and Gertner (1989, 1992), Johnston (1990), Allen and Gale (1992), Hviid (1996).

8. Information-Forcing and Economic Welfare Unfortunately, it is often difficult to assess the welfare implications of default rules that produce separating equilibria. Part of the difficulty is that, while there will usually be efficiency gains from eliminating this information asymmetry, that will not always be the case. Gains could arise if information about each individual buyer’s potential losses may let some sellers make customized adjustments to the reliability of their products. Gains could also arise if this information let sellers calculate a price that better reflected the true risk of selling to that particular buyer, thus sending buyers the correct signals about whether to purchase that product (see Ayres and Gertner, 1989; Quillen, 1988). In some cases, though, information about the buyer’s potential losses may be of no relevance to sellers - as, for instance, when sellers operate mass businesses that cannot practicably adjust their actions or prices for individual buyers (Danzig, 1975; Eisenberg, 1992, pp. 591-596). In such markets, there will be no efficiency gains at all from curing the information asymmetry. In

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still other markets, there may be positive gains from curing the asymmetry but those gains may not outweigh the costs of communicating the necessary information (Bebchuk and Shavell, 1991). Moreover, even when net efficiency gains are possible, the parties’ private incentives may lead them to act in a way that fails to achieve those gains. For example, if buyers face a price-discriminating monopolist who can charge higher prices to buyers who have more at stake in a particular transaction, buyers may be reluctant to do anything to reveal the amount they have at stake for fear of having to pay a higher price (Wolcher, 1989; Johnston, 1990; Ayres and Gertner, 1992). In other cases, some buyers may get private benefits (such as a more favorable price) by distinguishing themselves from other buyers, thus leading to socially excessive signaling (Rea, 1984; Aghion and Hermalin, 1990). At present, it is difficult to generalize about when the signaling or separating effects of a default rule will improve overall efficiency (see Hviid, 1996).

9. ‘Formalities’ as Default Rules Still another approach to selecting default rules aims entirely at ease of administration. That is, rather than trying to identify the default rule that would (1) be most efficient if left in place, or would (2) induce an efficient disclosure of information, this approach aims for default rules that are easily administered by courts, and easily learned and understood by contracting parties. In an influential early article, Fuller (1941) coined the term ‘formality’ to refer to rules designed to induce parties to specify their intentions in a way that could easily be recognized by courts. In this respect, Fuller’s rules were designed to force the parties to disclose information to the court, rather than (or in addition to) forcing one party to disclose information to the other contracting party. For example, if the parties to a contract fail to specify the quantity of goods they intend to convey, many jurisdictions refuse to enforce any obligation whatsoever, thus implicitly filling the gap with a quantity of ‘zero’ (see Ayres and Gertner, 1989, pp. 95-96). This default rule clearly is not designed to match what any contracting pair would have intended anyway. Instead, its purpose is to induce each pair to contract around the default rule by specifying the quantity they prefer, thus sparing the court from having to guess about the parties’ preferred quantity. Thus, unlike majoritarian or market-mimicking default rules, formalities are not necessarily intended to be left in place by the parties. Unlike other ‘penalty’ or ‘information-forcing’ rules, however (see Sections 5-8), formalities need not be slanted against any particular party. For example, the default rule for contracts that fail to specify any quantity of goods could just as easily be set at any specific number, not necessarily zero. True, a default rule of ‘zero’ has certain administrative advantages over any other number: there

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is no way to breach an obligation to deliver a quantity of zero, and hence no need to ever measure damages. Still, the essential feature of a formality is merely that some number be fixed in advance and be easily learnable by the parties, so that they can determine whether they will have to specify some other number in their contract. The formality could even be set at the number that most parties would prefer (if that number were known), thus giving it one feature in common with a market mimicking or majoritarian default rule. The only key is that, since formalities are chosen for their simplicity and ease of administration, they will necessarily be ‘untailored’ in the sense defined earlier in Section 4. As a result, no matter what specific rule is adopted as the default formality, many (perhaps most) contracting pairs will find it in their interest to specify some other rule in their contract. Because formalities are designed to be easily administered, they will at least have the virtue of reducing litigation costs in all cases when the parties fail to specify some other rule in their contract, so the default rule remains in effect. This same ease of administration may also minimize another component of transaction costs: the cost to the parties of becoming informed about the legal rule, and of predicting how that rule might be applied. Also, if the formality is not chosen to be deliberately unfavorable to either party, it may reduce the costs imposed when parties forget to specify some other rule in their contract: in this way, formalities may reduce the cost of remaining uninformed about the law. (These two effects have offsetting influences on parties’ incentives to become informed about the law.)

C. Other Issues in Designing Default Rules 10. Default Rules and Institutional Capabilities The preceding sections have discussed three bases on which default rules might be selected: market-mimicking or majoritarian defaults (Sections 2-4), information-forcing or penalty defaults (Sections 5-8), and pure formalities (Section 9). The choice among these various approaches depends in part on the competence and capabilities of legal institutions. For example, the first two approaches - market mimicking or majoritarian defaults, and informationforcing or penalty defaults - place obvious demands on those institutions, either to identify the rule that would in fact be most efficient (if left in place) for most contracting pairs, or to identify the default rule that would induce the most efficient disclosure of information. These demands are only increased if either of these approaches is to be adopted on a relatively ‘tailored’ basis, requiring the legal decision makers to assess the effect on individual markets or even individual contracting pairs. Thus, it is obviously an oversimplification to

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analyze how either of these approaches would work if it were to be administered by an omniscient legal decision maker. The real question is how well either of these approaches will work when administered by actual courts and legislatures. Two views of this question have developed in the contracts literature. The first begins by positing that certain rules - often, the rules that would have been efficient in a first-best world with perfect legal institutions - are simply beyond the capability of real legal institutions. This assumption is often made when the rule in question depends on information that, although observable by one or even both of the parties, cannot be demonstrated or verified publicly in court. For example, if the default remedy for breach were based on the net profits the breacher made, this would require a court to be able to measure the breacher’s revenues and costs, which might in some cases require more accounting expertise than real courts possess. Scholars often posit that such a rule would be unworkable in order to focus their analysis on alternative rules: rules that, while they might be less efficient in a first-best world, place fewer demands on the court or other legal decisionmaker (for example, Hermalin and Katz, 1993). For a general discussion and defense of this approach, see Schwartz (1992, pp. 279-280, 1993, pp. 403-406). By simply positing that certain rules are ‘unworkable’, though, these scholars implicitly assume an unfavorable balance between (1) the sum of all costs that would be imposed if courts tried to apply the unworkable rule, with the large number of errors that would entail; and (2) the sum of all costs associated with whatever rule is second-best. Other scholars have attempted a more finely-grained analysis by explicitly modeling the costs associated with judicial implementation of an unworkable rule. However, those costs depend in part on the nature and the probability of various errors courts might make in applying such a rule, and there is no consensus (and, regrettably, no empirical data) on how best to model such an error function. For two applications of this approach to contract issues, see Hadfield (1994), Hermalin and Katz (1991) and Allen and Gale (1992). The general discussion of legal errors and uncertain rules in other bodies of law (see Chapter 0790) is also relevant here.

11. Default Rules and Preference Formation In some situations, the law’s choice of default rules could alter contracting parties’ beliefs or preferences, thereby changing the value of the costs and benefits associated with different rules. For example, if the law adopts an implied warranty making sellers liable for all defects in their products (unless explicitly disclaimed), this could conceivably lead buyers to increase the value they place on such a warranty. At the same time, the adoption of the opposite default rule (no implied warranty) might lead buyers to the opposite view, if it

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caused them to reduce the value they place on such a warranty. In that event, it would be possible for either default rule (an implied warranty, or the absence of an implied warranty) to be left in place by the parties, if the law’s adoption of each default rule changed the parties’ preferences sufficiently. It would also be possible for both default rules to be perfectly efficient, at least when judged by the preferences the parties would have once the law adopted either default rule. The possibility that default rules might influence parties’ preferences is only just beginning to be explored. Experimental tests of this possibility can be found in Schwab (1988) and Korobkin (1998); the latter also discusses many of the potential policy implications. (Other experimental work regarding the effect on preferences of legal rules generally is discussed in Chapter 0570). Brief discussions of the implications for default rules in particular can also be found in Charny (1991, pp. 1835-1840); and in Schwartz (1993, pp. 413-415), who refers to default rules with this effect as ‘transformative default rules’.

12. Non-Economic Theories of Default Rules While default rules have received less attention in scholarship outside of law and economics, there are several non-economic theories that deserve mention. For general discussions in the legal literature, see Charny (1991), Barnett (1992), and Burton (1993). The first, and least well-developed (at least as a general theory), depends on the identification of certain rules as morally superior, as a sort of ‘merit good’. That is, just as it is sometimes argued that all citizens ought to have certain goods (education, health care, and so on), it is sometimes said that all citizens ought to have certain contract rights, such as the right to complete compensation in the event of a breach; or that the law should especially promote certain kinds of relationships, such as those based on long-term cooperation. Arguments of this sort could be particularly compelling if the law’s choice of default rule influenced citizens’ own beliefs about the value of certain relationships, as discussed above in Section 11. A second non-economic theory rests on the idea of hypothetical consent. There is an entire family of non-economic theories that traces the binding force of contracts to individual autonomy, and to the fact that the contractual obligation was freely chosen by the contracting party (see Section 17 below). To be sure, these theories might seem to have little to say about the content of default rules, which (by definition) fill in the content of obligations that were not explicitly chosen by the parties (see Craswell 1989a). However, some have argued that, even in the absence of explicit consent, a party should still be bound to the rule that he or she would have consented to if he or she had explicitly negotiated an agreement on that point. Interestingly, this argument

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converges with the market-mimicking or majoritarian approach discussed earlier in Sections 2-4. As a result, some economically-oriented scholars have sought to rest their recommendations on this philosophic position, as well as on more conventional economic grounds (for example, Schwartz, 1988, pp. 357-360). In the philosophical literature, however, it is disputed whether this invocation of hypothetical consent carries any of the moral force of ‘real’ consent, or whether it adds anything to standard efficiency arguments. For discussions in the legal literature of this issue, see Barnett (1992), Charny (1991), Coleman, Heckathorn and Maser (1989), Craswell (1992), and the exchanges between Coleman (1980a, 1980b) and Posner (1980, 1981). In the philosophical literature, useful discussions include Scanlon (1982), Gauthier (1986), and Brudney (1991). A third non-economic approach suggests that default rules should be designed to mimic the norms or customs that are already observed, either in the community at large or in the parties’ prior relationship. This approach is often employed in the ‘relational contract’ theory usually identified with Ian Macneil (1978, 1980, 1981); see also Brown and Feinman (1991), Feinman (1993), and Craswell (1993b). In addition, some scholars working from philosophical theories of individual autonomy and consent have seen the prevailing norms and customs as acceptable sources of default rules, at least in the absence of any explicit agreement to the contrary (Barnett, 1992; Burton, 1993). In particular cases, this approach could of course converge with any of the economic theories discussed here, depending on whether the norms or customs happened to be efficient (see the general discussion in Chapter 0800). Among the issues raised by this approach are questions about the manner in which the norms or customs are to be identified (see Bernstein, 1996, pp. 1787-1795; Craswell, 1998), and about the ability of courts or other legal decisionmakers to properly carry out this identification (see Section 10 above).

D. Contracting Around Default Rules 13. Displacing Default Rules by Agreement A default rule, by definition, leaves parties free to specify some other rule to govern their relationship if they so choose. There is, however, very little scholarly analysis of the steps the parties must take if they wish to specify some other rule. Most scholars implicitly assume that specifying some other rule would require a valid provision to that effect in a valid contract. This could suggest that the rules governing those steps can be left to the law of contract formation and contract interpretation, two bodies of law that are addressed at more length in Chapters 4300 and 4400.

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Unfortunately, those bodies of law are themselves among the least analyzed portions of contract law. Moreover, the choices made by a legal system in selecting the rules of contract formation and interpretation can both be influenced by, and exert an influence upon, the choice of the original default rule. Sections 14 and 15 briefly discuss some of the interactions between these sets of rules.

14. Procedural Requirements for a Valid Agreement Any attempt to displace a default rule will normally have to satisfy (at a minimum) all the requirements of an enforceable contract. For example, depending on the legal regime, the agreement may (or may not) have to be in writing, and it may (or may not) have to be supported by consideration. These requirements, and the other rules governing contract formation, are discussed at more length in Chapter 4300. Should there be extra procedural requirements for parties who wish to contract around a default rule? If the default rule is presumptively valid, and especially if it is presumptively valid for moral or other non-economic reasons, it might be argued that parties who wish to choose a presumptively less valid rule should have to take extra steps, if only to ensure (and to demonstrate to a court) that this is what the parties really intend. For example, it might be argued that one party should not be able to displace a default rules by means of a single clause buried in a 30-page document that the other party will not normally bother to read. Arguments of this sort are often made in connection with standard form contracts and the legal doctrine of unconscionability (see Chapter 4100). Some of the links with standard default rule analysis are noted briefly in Craswell (1993a, pp. 12-14). Indeed, arguments of this sort may fit best in connection with informationforcing or penalty default rules. As discussed earlier (see Section 6), such rules may be deliberately designed to induce the better-informed party to contract around the default rule, in the hope that the process of contracting around the rule will itself give the other party more information about the rights that he or she now has. The efficacy of this approach, however, depends on whether the process of contracting around the rule really does inform the other party - and this, in turn, depends on the procedures that are required to contract around the rule. Again: if a default rule can be altered merely by inserting a clause in a 30page contract that nobody ever reads, the process of contracting around the default will not inform the other party at all. On the other hand, extra procedural requirements will usually increase the transaction costs required to contract around the default rule. For example, if altering a default rule requires the clause in question to be pointed out and

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explained to the other party, the process of contracting around the default might indeed increase the other party’s information. However, this requirement may also be costly to satisfy, especially if a single contract alters a large number of default rules, and if the other party has no desire to sit through a lengthy set of explanations. In that event, the cost of altering the default rules via this procedure might turn out to be effectively prohibitive, so many parties would end up leaving the original default rules still in force. If so, this would require reevaluation of the original decision to select a default rule that was designed not to be left in force (that is, a default rule that was chosen to be inefficient precisely in order to induce the parties to contract around it). In this way, the rules governing the process of contracting around a default rule can themselves affect the principles on which the original default rule should be chosen.

15. Interpreting Contractual Terms that Alter a Default Rule Contracting parties often use language which appears to address an issue that would otherwise be governed by a default rule, but which is vague or ambiguous, and thus requires interpretation. For example, imagine a contract providing that the remedy to be paid in the event of a breach should be an amount that would ‘reasonably compensate’ the nonbreacher. Should the courts treat this vague language as leaving a gap in the contract, to be filled by the normal default remedy? Or should they instead apply some other set of principles? In conventional legal terminology, default rules are said to apply only when there is an actual gap in the contract, while questions of vague contractual language are usually described as questions of interpretation. There is, however, no consensus (and very little theory) on what should count as a ‘gap’ (see Ayres and Gertner, 1989, pp. 119-120). Fortunately, this distinction often will not matter, because the approaches used to interpret contracts (see Chapter 4400) have much in common with the approaches used to select default rules. In many cases, for example, vague or ambiguous language is interpreted so as to fit whatever the parties probably would have agreed to if they had discussed the matter, thus producing the same result as the majoritarian or marketmimicking default rules discussed in Sections 2-4 (see also Goetz and Scott, 1985). In other cases, vague or ambiguous language is interpreted against the party who drafted it, just as in the case of a penalty or information-forcing default rule designed to induce more careful and explicit communication (see Sections 5-9). Notice, though, that some decision must still be made to determine when the parties have taken enough steps to make their language sufficiently clear to avoid the rule construing ambiguities against the drafter, or when their language is sufficiently clear to avoid being interpreted in accordance with the

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court’s idea of what most parties would have wanted. This is the question of precisely how far the parties must go to contract around an otherwise applicable default rule (or, in this case, around an otherwise applicable rule of interpretation). As discussed in Section 14, whatever requirements the law adopts here will have to be considered in deciding what default rule (or what interpretive presumption) to adopt in the first place.

E. The Enforceability of Contracts Generally 16. Introduction to Theories of Enforceability The analysis of default rules takes it as given that contracts are enforceable, and concerns itself with determining the content of the enforceable obligation. This Section addresses the opposite issue: given a contract of (let us assume) definite content, when should that contract be legally enforceable? One branch of this question asks whether contracts should be enforced by a legal system, or whether non-legal enforcement mechanisms might be superior (see, for example, Bernstein, 1992, 1996; Charny, 1991). Non-legal enforcement mechanisms could include arbitration panels or trade association boards that function much like a court, except for not being backed by official state sanctions. They could also involve much less formal mechanisms, such as the threat of withholding business from anyone who had broken a promise in the past. In both of these respects, they are similar to the non-legal mechanisms that might be used to enforce any other obligation (see Chapters 0780 and 0800), with which this literature has much in common. By contrast, most of the literature on whether contracts ought to be enforced typically abstracts from the choice of the enforcement mechanism, and focuses instead on the question of whether (and why) contracts ought to be enforced by any mechanism whatsoever. Non-economic theories are discussed briefly in Section 17 below, followed by a discussion of the law and economics literature in Sections 18-19.

17. Non-Economic Theories of Enforceability Moral philosophers have written extensively about the question of whether (or why) a promise should be morally binding. Some of their theories rest on utilitarian accounts that have much in common with the economic theories; these will be discussed in Sections 18-19. This section focuses instead on the non-utilitarian or non-instrumental accounts. In the legal literature, general

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surveys of these accounts can be found in Atiyah (1981), Barnett (1986), Craswell (1989a, pp. 491-503), and Gordley (1991). One family of theories derives the obligation to keep one’s promise from considerations of individual freedom and moral autonomy. For example, Fried (1981) argues that if the law did not allow individuals to bind themselves with respect to their future conduct, it would thereby fail to respect the individuals’ status as autonomous moral agents. (For a variant account of when individual autonomy requires that promises be enforced, see Barnett, 1986.) These accounts do not imply that promises ought to be kept in every circumstance: this theory, like all of the others discussed in this section, allows for the possibility of a set of implied conditions or implied excuses. Instead, the goal of these theories is to explain why promises are prima facie binding, and this family of theories rests that binding force on the promise’s status as the voluntary commitment of a autonomous moral agent. Another, different set of theories rests the obligation to keep a promise on the substance of what has been promised. Perhaps the best-known theories in this set focus on harm to others: if one’s promise has led others to change their behavior in reliance on the promise, so that they would now be injured if the promisor failed to perform, that promise is binding because it is wrong to harm other agents. Making a promise and then failing to keep it might also be seen as a form of lying, for such a promisor has misled others about the future. Other theories in this set focus on reciprocity or restitution: if one has received a benefit and promised to pay for it, that promise is binding because it is only right to pay for the benefits one has received (Atiyah, 1981, pp. 34-36). Under some theories, the fairness of the terms of the promise is also relevant to whether the promise is binding (for example, Gordley, 1995). Under any of these substance-based theories, the promise’s status as the voluntary commitment of a free moral agent is less significant, for the agent is (in some sense) promising to do what he or she ought to be doing anyway. Indeed, under many of these theories, if there is no independent reason for the agent to perform the action - for example, if the agent has received no benefits, and if no one has yet relied on the promise - the obligation to keep the promise is seen as weaker or non-existent. These theories thus have difficulty explaining why the obligation should be stronger in the case of an individual who has made a promise than it is in the case of an individual who has acted identically but has explicitly disclaimed any promise (for example, ‘I think I’m going to do x, but I warn you that I’m not promising to do it, so you should rely only at your own risk’, or ‘you can confer those benefits on me if you want, but I warn you now that I have no intention of paying you anything for them’). Atiyah (1981, pp. 184-202) has argued that an explicit promise could serve as evidence, perhaps even conclusive evidence, that the underlying obligation really is a just one that ought to be enforced. If one asks why an individual’s

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promise ought to be given such evidentiary weight, however, it is difficult to avoid falling back either on autonomy-based explanations of the sort discussed earlier in this section, or on utilitarian theories of the sort to be discussed in Sections 18 and 19.

18. Economic Theories of Free Exchange Economic theories of why promises should be enforced can be divided into two categories. One set of theories, to be discussed in this section, focuses on the utility created by the eventual performance of the promise. The other set, to be discussed in Section 19, focuses on the utility created by the ex ante incentives that the promise sets up. The first economic argument for enforcing promises rests on the utility that will be produced when the promise is eventually performed. Since voluntary transactions generally increase the welfare of all parties to the transaction, whenever a promise is voluntary it could be argued that welfare will usually be increased if the promise is carried out. Viewed in these terms, the economic argument for enforcing promises is very similar to the economic argument for free exchange and free markets generally (see Chapter 5000). This argument, however, could imply that a promise should not be binding if conditions have changed sufficiently that the promised transaction would not increase both parties’ welfare. For example, if a promisor’s costs have increased to the point where it is no longer efficient for him or her to perform the promise, this theory could suggest that the promisor ought to be released with no obligation to pay any damages at all, because this particular efficiency rationale for enforcing promises no longer applies. Under this theory, the only way to save the prima facie obligation to keep one’s promises (even after conditions have changed) is to argue for the virtues of a general rule over a case-by-case inquiry into the efficiency of any given transaction - in philosophical terms, by shifting from act-utilitarianism to rule-utilitarianism. That argument, in turn, must rest on empirical claims about the ability of courts to determine whether and when performance of the promise was still efficient. More generally, there is an important difference between permitting free exchange and permitting (or enforcing) binding promises. An exchange can take place instantaneously, but a promise necessarily involves a commitment to act in a certain way at some time in the future. Once this temporal element is recognized, it can be seen that enforcing promises does not simply transfer existing goods from one owner to another. Instead, the enforcement of promises creates a new good: it allows people to exchange ‘wheat to arrive on September 1' (for example), where without a binding promise they could only exchange actual bushels of wheat. Viewed in these terms, the economic case for enforcement rests on the proposition that this new good (that is, the good

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represented by a future commitment) is a socially useful good which people frequently will want to exchange. To explain why such a commitment is useful and valuable, economists have focused more on the ex ante effects created by such a commitment, as discussed in Section 19 below.

19. Economic Theories of Advance Commitments Most economic justifications for enforcing promises have focused on the ex ante effects that would be created by a general rule of enforceability. In essence, these economic theories analyze promises as effectuating a present transfer not of goods and services, but of rights and duties. (For a similar view expressed in non-economic terms, see Barnett, 1986, pp. 291-300.) Such a transfer of rights and duties may itself produce efficiency gains, independently of whether it is efficient to actually carry out the promise. The efficiency gain that is analyzed most often stems from the effect on the promisee’s incentive to rely on the promised behavior (see Goetz and Scott, 1980). If the law denied promisees any compensation whenever a promisor could show that performance of the promise had become inefficient, this would shift more of the risk of a change in conditions to the promisee, and thus would reduce the promisee’s incentive to rely. To be sure, if the law instead guarantees that promisees will be compensated whenever the promisor fails to perform, this could create incentives for excessive reliance on the part of the promisee (see the discussion of reliance incentives in connection with remedies for breach in Chapter 4600). If the incentives for excessive reliance can be constrained by other legal doctrines, however, the net effect on the promisee’s reliance incentives could still be positive. The argument that enforceability is needed to induce one party to take the risky step of beginning his or her own performance (when the other party’s return performance is not due until later) is really a special case of this argument, since beginning performance is one of the many ways in which parties may rely on a contract. More generally, there are many other ex ante effects that could be produced by a rule requiring compensation even when conditions have changed to make performance unprofitable. If the promisor and promisee differ in their attitudes toward risk, a rule requiring compensation may achieve a better allocation of risk between the two parties (see, for example, Polinsky, 1983). A rule requiring compensation may also increase the promisor’s incentive to tell the truth about the conditions that will affect his or her performance, thus increasing the promisee’s information about those conditions (see Shavell, 1991; Craswell, 1989b; Katz, 1996, pp. 1289-1291). A compensation requirement may also give the promisor an incentive to affect those conditions directly, if the probability of performance rests on factors that are within the

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promisor’s control. Generally speaking, all of the economic analysis of efficient remedies for breach (see Chapter 4600) is relevant here, since to make a promise enforceable is to set a non-zero remedy for the promise’s breach. The less-developed economic analysis of the conditions under which formation of a binding contract should be inferred (see Chapter 4300) is also relevant here.

Acknowledgments Richard Craswell is a professor of law at the Stanford Law School. Jack L. Goldsmith, Eric A. Posner, Cass R. Sunstein, and two anonymous referees provided helpful comments. Financial support was provided by the Lynde and Harry Bradley Foundation and the Sarah Scaife Foundation at the University of Chicago Law School.

Bibliography on Contract Law: General Theories (4000) Aghion, Philippe and Hermalin, Benjamin (1990), ‘Legal Restrictions on Private Contracts can Enhance Efficiency’, 6 Journal of Law, Economics, and Organization, 381-409. Allen, Franklin and Gale, Douglas (1992), ‘Measurement Distortion and Missing Contingencies in Optimal Contracts’, 2 Economic Theory, 1-26. Ayres, Ian (1993), ‘Preliminary Thoughts on Optimal Tailoring of Contractual Rules’, 3 Southern California Interdisciplinary Law Journal, 1-18. Ayres, Ian and Gertner, Robert (1989), ‘Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules’, 99 Yale Law Journal, 87-130. Ayres, Ian and Gertner, Robert (1992), ‘Strategic Contractual Inefficiency and the Optimal Choice of Legal Rules’, 101 Yale Law Journal, 729-73. Baird, Douglas G. and Weisberg, Robert (1982), ‘Rules, Standards and the Battle of the Forms: A Reassessment of “2-207”, 68 Virginia Law Review, 1217-62. Barnes, David W. and Stout, Lynn A. (1992), Economics of Contract Law, Minneapolis, West Publishing. Barnett, Randy E. (1992), ‘The Sound of Silence: Default Rules and Contractual Consent’, 78 Virginia Law Review, 821-911. Bebchuk, Lucien Ayre and Shavell, Steven (1991), ‘Information and the Scope of Liability for Breach of Contract: The Rule of Hadley v. Baxendale’, 7 Journal of Law, Economics, and Organization, 284-312. Bernstein, Lisa (1992), ‘Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry’, 21 Journal of Legal Studies, 115-57. Bernstein, Lisa (1993), ‘Social Norms and Default Rule Analysis’, 3 Southern California Interdisciplinary Law Journal, 59-90. Bernstein, Lisa (1996), ‘Merchant Law in a Merchant Court: Rethinking the Code’s Search for Immanent Business Norms’, 144 University of Pennsylvania Law Review, 1765-1821.

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Birmingham, Robert L. (1968), ‘Legal and Moral Duty in Game Theory: Common Law Contract and Chinese Analogies’, 18 Buffalo Law Review, 99-117. Brown, Patricia A. and Feinman, Jay M. (1991), ‘Economic Loss, Commercial Practices, and Legal Process: Spring Motors Distributors, Inc. v. Ford Motor Company’, 22 Rutgers Law Journal, 30160. Charny, David (1990), ‘Nonlegal Sanctions in Commercial Relationships’, 104 Harvard Law Review, 375-467. Charny, David (1991), ‘Hypothetical Bargains: The Normative Structure of Contract Interpretation’, 89 Michigan Law Review, 1815-79. Coleman, Jules, Heckathorn, Douglas D. and Maser, Steven M. (1989), ‘A Bargaining Theory Approach to Default Provisions and Disclosure Rules in Contract Law’, 12 Harvard Journal of Law and Public Policy, 639-709. Craswell, Richard (1989a), ‘Contract Law, Default Rules, and the Philosophy of Promising’, 88 Michigan Law Review, 489-529. Craswell, Richard (1989b), ‘Performance, Reliance, and One-Sided Information’, 18 Journal of Legal Studies, 365-401. Craswell, Richard (1992), ‘Efficiency and Rational Bargaining in Contractual Settings’, 15 Harvard Journal of Law and Public Policy, 805-37. Craswell, Richard (1993a), ‘Property Rules and Liability Rules in Unconscionability and Related Doctrines’, 60 University of Chicago Law Review, 1-65. Craswell, Richard (1993b), ‘The Relational Move: Some Questions from Law and Economics’, 3 Southern California Interdisciplinary Law Journal, 91-114. Craswell, Richard (1998), ‘Do Trade Customs Exist?’, in Krauss, Jody and Walt, Steven (eds), The Jurisprudential Foundations of Corporate and Commercial Law, Cambridge, Cambridge University Press. Craswell, Richard and Schwartz, Alan (eds) (1994), Foundations of Contract Law, New York, Oxford University Press. Danzig, Richard (1975), ‘Hadley v. Baxendale: A Study in the Industrialization of the Law’, 4 Journal of Legal Studies, 249-84. D’Ursel, Laurent (1985), ‘L’Analyse Économique du Droit des Contrats (Economic Analysis of Contract Law)’, 14 Revue Interdisciplinaire d’Etudes Juridiques, 45-88. Eisenberg, Melvin Aron (1992), ‘The Principle of Hadley v. Baxendale’, 80 California Law Review, 563-613. Farber, Daniel A. (1983), ‘Contract Law and Modern Economic Theory’, 78 Northwestern University Law Review, 303-339. Feinman, Jay M. (1983), ‘Critical Approaches to Contract Law’, 30 UCLA Law Review, 829-60. Feinman, Jay M. (1990), ‘The Significance of Contract Theory’, 58 University of Cincinnati Law Review, 1283-1318. Feinman, Jay M. (1993), ‘Relational Contract and Default Rules’, 3 Southern California Interdisciplinary Law Journal, 43-58. Gillette, Clayton P. (1993), ‘Cooperation and Convention in Contractual Defaults’, 3 Southern California Interdisciplinary Law Journal, 167-88. Gillette, Clayton P. (1990), ‘Commercial Relationships and the Selection of Default Rules for Remote Risks’, 19 Journal of Legal Studies, 535-81. Goetz, Charles J. and Scott, Robert E. (1980), ‘Enforcing Promises: An Examination of the Basis of Contract’, 89 Yale Law Journal, 1261-1322.

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Goetz, Charles J. and Scott, Robert E. (1985), ‘The Limits of Expanded Choice: An Analysis of the Interactions Between Express and Implied Contract Terms’, 73 California Law Review, 261-322. Goldberg, Victor P. (ed) (1989), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press. Goldberg, Victor P. (1984), ‘An Economic Analysis of the Lost-Volume Seller’, 57 Southern California Law Review, 283-97. Hadfield, Gillian K. (1994), ‘Judicial Competence and the Interpretation of Incomplete Contracts’, 23 Journal of Legal Studies, 159-84. Harris, Donald (1983), ‘Contract as Promise - A Review Article Based on Contract as Promise: A Theory of Contractual Obligation by Charles Fried’, 3 International Review of Law and Economics, 69-77. Harris, Donald and Veljanovski, Cento G. (1984), ‘The Use of Economics to Elucidate Legal Concepts: The Law of Contract’, in Daintith, Terence and Teuber, Gunther (eds), Law and the Social Sciences, Florence, European University Institute. Hermalin, Benjamin E. and Katz, Michael L. (1991), ‘Moral Hazard and Verifiability: The Effects of Renegotiation in Agency’, 59 Economica, 1735-1753. Hermalin, Benjamin E. and Katz, Michael L. (1993), ‘Judicial Modification of Contracts Between Sophisticated Parties: A More Complete View of Incomplete Contracts and Their Breach’, 9 Journal of Law, Economics, and Organization, 230-255. Hillman, Robert A. (1988), ‘The Crisis in Modern Contract Theory’, 67 Texas Law Review, 103-136. Holderness, Clifford G. (1985), ‘A Legal Foundation for Exchange’, 14 Journal of Legal Studies, 321344. Horwitz, Morton J. (1974), ‘The Historical Foundations of Modern Contract Law’, 87 Harvard Law Review, 917-956. Hviid, Morten (1996), ‘Default Rules and Equilibrium Selection of Contract Terms’, 16 International Review of Law and Economics, 233-45. Johnston, Jason Scott (1990), ‘Strategic Bargaining and the Economic Theory of Contract Default Rules’, 100 Yale Law Journal, 615-64. Köhler, Helmut (1989), ‘Zur Ökonomischen Analyse der Regeln über die Geschäftsgrundlage (On the Economic Analysis of the Rules of the Implicit Basis of a Contract)’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Allokationseffizienz in der Rechtsordnung, Berlin, Springer, 148-162. Korobkin, Russell (1998), ‘The Status Quo Bias and Contract Default Rules’, 83 Cornell Law Review, 608-87. Kronman, Anthony T. (1980), ‘Contract Law and Distributive Justice’,89 Yale Law Journal, 472-511. Kronman, Anthony T. (1985), ‘Contract Law and the State of Nature’, 1 Journal of Law, Economics and Organization, 5-32. Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little, Brown and Company. Lowry, S. Todd (1976), ‘Bargain and Contract Theory in Law and Economics’, 10 Journal of Economic Issues, 1-22. Macneil, Ian R. (1978), ‘Contracts: Adjustment of Long-Term Economic Relations Under Classical, Neoclassical, and Relational Contract Law’, 72 Northwestern University Law Review , 854-905.

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Macneil, Ian R. (1980), The New Social Contract: An Inquiry Into Modern Contractual Relations, New Haven, Yale University Press. Macneil, Ian R. (1981), ‘Economic Analysis of Contractual Relations: Its Shortfalls and the Need for a “Rich” Classificatory Apparatus’, 75 Northwestern University Law Review, 1018-63. Marini, Giovanni (1990), Promessa ed Affidamento nel Diritto dei Contratti (Promise and Reliance in Contract Law), Napoli, Jovene. Perron, Edgar du (1990), ‘De Rechtseconomische Analyse van het Verbintenissenrecht (A Law-andEconomics Analysis of the Law of Obligations)’, 39 Ars Aequi, 770-776. Poughon, Jean-Michel (1990), ‘Une Constante Doctrinale: l’Approche Economique du Contract’, 12 Droits. Revue Française de Théorie Juridique, 47-59. Romani, Franco (1985), ‘Appunti sull’ Analisi Economica dei Contratti (Notes about the Economic Analysis of Contract Law)’, Quadrimestre, 15-29. Schwab, Stewart J. (1988), ‘A Coasean Experiment on Contract Presumptions’, 17 Journal of Legal Studies, 237-268. Schwartz, Alan (1992), ‘Relational Contracts in the Courts: An Analysis of Incomplete Agreements and Judicial Strategies’, 21 Journal of Legal Studies, 271-318. Schwartz, Alan (1993), ‘The Default Rule Paradigm and the Limits of Contract Law’, 3 Southern California Interdisciplinary Law Journal, 389-419. Scott, Robert E. (1990), ‘A Relational Theory of Default Rules for Commercial Contracts’, 19 Journal of Legal Studies, 597-616. Simpson, A.W.B. (1979), ‘The Horwitz Thesis and the History of Contracts’,46 University of Chicago Law Review, 533-601. Symposium, ‘Default Rules and Contractual Consent’, 3 Southern California Interdisciplinary Law Journal, 1-444. Verkerke, J. Hoult (1995), ‘An Empirical Perspective on Indefinite Term Employment Contracts: Resolving the Just Cause Debate’, 1995 Wisconsin Law Review, 837-917. Wang, William K.S. (1982), ‘Reflections on Contract Law and Distributive Justice: A Reply to Kronman’, 34 Hastings Law Journal, 513-527. Witt, Ulrich (1986), ‘Evolution and Stability of Cooperation without Enforceable Contracts’, 39 Kyklos, 245-266. Wonnell, Christopher T. (1986), ‘Contract Law and the Austrian School of Economics’, 54 Fordham Law Review, 507-543.

Other References Atiyah, P.S. (1979), The Rise and Fall of Freedom of Contract, Oxford, Clarendon Press. Atiyah, P.S. (1981), Promises, Morals, and Law, Oxford, Clarendon Press. Barnett, Randy E. (1986), ‘A Consent Theory of Contract’, 86 Columbia Law Review, 269-321. Brudney, Daniel (1991), ‘Hypothetical Consent and Moral Force’, 10 Law and Philosophy, 253-70. Buckley, F.H. (1988), ‘Paradox Lost’, 72 Minnesota Law Review, 775-827. Burton, Steven J. (1993), ‘Default Principles, Legitimacy, and the Authority of a Contract’, 3 Southern California Interdisciplinary Law Journal, 115-66. Coleman, Jules L. (1980a), ‘Efficiency, Exchange, and Auction: Philosophic Aspects of the Economic Approach to Law’, 68 California Law Review, 221-49.

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Coleman, Jules L. (1980b), ‘Efficiency, Utility, and Wealth Maximization’, 8 Hofstra Law Review, 509-51. Fried, Charles (1981), Contract as Promise: A Theory of Contractual Obligation, Cambridge, Massachusetts, Harvard University Press. Fuller, Lon L. (1941), ‘Consideration and Form’, 41 Columbia Law Review, 799-824. Gauthier, David Peter (1986), Morals by Agreement, Oxford, Clarendon Press. Gordley, James (1991), The Philosophical Origins of Modern Contract Doctrine, Oxford, Clarendon Press. Gordley, James (1995), ‘Enforcing Promises’, 83 California Law Review, 547-614. Isaacharoff, Samuel (1996), ‘Contracting for Employment: The Limited Return of the Common Law’, 74 Texas Law Review, 1783-1812. Katz, Avery (1996), ‘When Should an Offer Stick? The Economics of Promissory Estoppel in Preliminary Negotiations’, 105 Yale Law Journal, 1249-1309. Muris, Timothy J. (1983), ‘Cost of Completion or Diminution in Market Value: The Relevance of Subjective Value’, 12 Journal of Legal Studies, 379-400. Perloff, Jeffrey M. (1981), ‘Breach of Contract and the Foreseeability Doctrine of Hadley v. Baxendale’, 10 Journal of Legal Studies, 39-63. Polinsky, A. Mitchell (1983), ‘Risk Sharing Through Breach of Contract Remedies’, 12 Journal of Legal Studies, 427-44. Posner, Richard A. (1980), ‘The Ethical and Political Basis of the Efficiency Norm in Common Law Adjudication’, 8 Hofstra Law Review, 487-507. Posner, Richard A. (1981), ‘A Reply to some Recent Criticisms of the Efficiency Theory of the Common Law’, 9 Hofstra Law Review, 775-94 Posner, Richard and Rosenfield, Andrew M. (1977), ‘Impossibility and Related Doctrines in Contract Law: An Economic Analysis’, 6 Journal of Legal Studies, 83-118. Quillen, Gwyn D. (1988), ‘Contract Damages and Cross-Subsidization’, 61 Southern California Law Review, 1125-41. Rea, Samuel A. Jr (1984), ‘Arm-Breaking, Consumer Credit and Personal Bankruptcy’, 22 Economic Inquiry, 188-208. Scanlon, Thomas (1982), ‘Contractualism and Utilitarianism’, in Sen, Amartya and Williams, Bernard (eds), Utilitarianism and Beyond, Cambridge, Cambridge University Press. Schwartz, Alan (1988), ‘Proposals for Products Liability Reform: A Theoretical Synthesis’, 97 Yale Law Journal, 353-419. Shavell, Steven (1991), ‘An Economic Analysis of Altruism and Deferred Gifts’, 20 Journal of Legal Studies, 401-21. Wolcher, Louis E. (1989), ‘Price Discrimination and Inefficient Risk Allocation Under the Rule of Hadley v. Baxendale’, 9 Research in Law and Economics, 9-31.

4100 CONTRACTUAL CHOICE Scott E. Masten Louis and Myrtle Research Professor of Business and Law, University of Michigan Business School © Copyright 1999 Scott E. Masten

Abstract This chapter discusses alternative theories of contract choice and design with special emphasis on (i) the interaction between contract design and contract enforcement and (ii) the explanatory power of alternative theories. After discussing the primary functions of contract, the entry reviews the assumptions and implications for contract design of the three dominant approaches to contracting in economics. An overview of the empirical literature on contracting and contractual choice identifies the main empirical regularities and their relation to the theory. A final section addresses implications for contract law and enforcement and directions for future research. JEL classification: D23, K12, D82 Keywords: Contracting, Contract Enforcement, Incentives, Transaction Costs

1. Introduction A contract, at its most basic level, is a legally enforceable agreement. Although economists - and occasionally lawyers - have used the term more expansively to describe essentially any transaction, the term contract as used in this chapter is reserved for formal, legal commitments to which each party gives express (though not necessarily written) approval and to which a particular body of law applies. ‘Breaching a contract’ differs from ‘canceling an order’, to use Stewart Macaulay’s (1963, p. 61) dichotomy. Ultimately, what distinguishes a contract from a mere transaction is the opportunity contracts afford transactors to invoke the formal dispute resolution machinery and coercive power of the state to enforce promises. Besides distinguishing true contracts from ‘implicit contracts’ or self-enforcing agreements, this definition of contract highlights the fundamental link between contract design, on the one hand, and contract enforcement, on the other: the choice of contract terms will depend in part on the legal rules and enforcement policies transactors expect courts to follow while, at the same time, the enforcement practices of efficiency-minded courts will depend on what courts perceive as the purpose and impediments to 25

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contracting. In short, the analysis of contract law and enforcement presupposes a theory of contracting behavior, and vice versa. Despite this interdependence, the literatures on contract design and contract enforcement have largely developed independently of one another. Economic theories of contracting, for the most part, give little explicit attention to enforcement issues, the presumption being that courts will see to it (subject only to verifiability constraints) that whatever terms contracting parties arrive at are fulfilled. Indeed, enforcing contracts as written is the court’s only function in mainstream contract theory (see, for example, Tirole, 1994). This judicial deference to contracts in economic theory contrasts with the far more intrusive role of courts in economic analyses of contract law, in which courts are called on to adjudicate disputes, fill gaps, and devise and implement default rules. Perspectives on contracting can be divided into three broad categories. The first consists of formal models associated with the principal-agent and asymmetric information literature, including theories of both complete and incomplete contracting; the second covers perspectives on contracting implicit in the law and economics literature on contract law and enforcement; while the third consists of what has come to be known as relational contracting theory, an approach often associated with transaction cost economics. Dimensions along which the theories differ include the functions of contracting, the impediments to contracting, and the role of courts and their implications for legal rules and contract enforcement. Last but not least, the theories differ in their ability to explain and predict actual contracting behavior.

2. Why Contract? As the definition in the introduction suggests, the essence of contract is commitment. Without some form of assurance that others will, when the time comes, uphold their end of a bargain, individuals will be justifiably reluctant to make investments, forego opportunities, or take other actions necessary to realize the full value of exchange. To be sure, reputation considerations - the prospect that trading partners will withhold future cooperation - often provide that assurance (Telser, 1980), especially in business transactions (Macaulay, 1963). But where the size or credibility of nonlegal sanctions is insufficient to constrain opportunism, contracting offers an additional recourse: by contracting, transactors expose themselves to legal sanctions for failing to honor their commitments. Beyond this basic commitment-enhancing function, contract theorists generally associate three broad motives with contracting: risk transfer, incentive alignment, and transaction cost economizing. In pure insurance or risk-transfer transactions, the objective is to shift risk to the less risk-averse

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transactor or ‘low-cost risk bearer’ (Cheung, 1969; Stiglitz, 1974). In incentive contracts, the aim is to align the parties’ (commonly, a principal and agent) individual incentives to take actions or reveal private information with their joint-surplus maximizing interests (for example, Hart and Holmstrom, 1987). Finally, transaction cost economists emphasize the use of contracts to reduce various costs of transacting, especially, ex post bargaining and ‘hold-up’ costs in transactions supported by relationship-specific investments (Williamson, 1975, 1979; Klein, Crawford, and Alchian, 1978) and ex ante sorting and search costs in contexts where additional information serves merely to redistribute rather than expand the available surplus (Kenny and Klein, 1983; Goldberg, 1985). While the essence of contracting is commitment, the design and interpretation of contractual agreements will depend on which of these three motives dominates.

3. Formal Economic Theories of Contractual Choice The search for contract terms that yield efficient outcomes is the subject of a prodigious theoretical literature in economics. The customary starting point for that inquiry is the complete contingent claims contract associated with the work of Arrow and Debreu (see, for example, Hart and Holmstrom, 1987). Although originally conceived as an analytical tool for modeling competitive equilibrium rather than as a theory of contracting per se (see Guesnerie, 1992), the efficiency properties associated with contingent trade in the Arrow-Debreu framework made complete contingent claims contracts - contracts specifying the physical characteristics, date, location, and price of a commodity for every future state of nature - appealing to contract theorists as an archetype against which to compare more realistic agreements: Arrow-Debreu complete contingent claims contracts represent what transactors would write in an ideal world free from ‘imperfections’. Mainstream contract theories developed specifically to analyze actual contracting practices fall into two categories depending on the nature and source of the ‘real world’ imperfections they emphasize. So-called complete contract theory analyzes the efficiency and contract design implications of the inability of courts to verify particular events or outcomes. Departures from the Arrow-Debreu ideal in complete contract theory thus derive from imperfections or limitations of adjudicators at the contract execution stage. Incomplete contract theory, in contrast, is concerned with the design and efficiency consequences of imperfections arising during contract formation, specifically, the limited capacity of transactors to anticipate, identify and describe optimal responses to future events.

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3.1 Complete Contracting The cornerstone of complete contract theory is the recognition that courts may not be able to verify some contingencies or outcomes and that contracting parties, therefore, may not be able to condition performance on every relevant contingency. The concern posed by nonverifiability is that, with the court no longer able to determine whether some aspect of promised performance has occurred, transactors stand to gain by strategically withholding information or by altering their behavior in ways that yield private benefits but reduce joint gains. In the standard terminology, the propensity to deviate from joint-surplus maximizing behavior in the presence of asymmetric information is called moral hazard when the distortion involves actions or information revelation ex post, and adverse selection where ex ante private information leads only those transactors with less desirable characteristics to transact (the so-called ‘lemons’ problem). The problem of contract design in the complete contracting framework consists of discovering a contingent payment schedule, or sharing rule, that is incentive compatible, that is, that satisfies the requirement that the contract leave the party with discretion over the unverifiable action at least as well off acting in the parties’ joint interests as taking any other feasible action. When only one party’s actions affect outcomes and that party is risk neutral, a contract that makes that party the residual claimant (and distributes expected gains to the other via a fixed payment) will be efficient. Nontrivial design tradeoffs arise when aligning one party’s incentives results either in inefficient risk sharing (if that party is also the more risk averse of the two) or in inefficient incentives for the other party (the case of double-sided moral hazard). In the latter settings, first-best outcomes will generally not be feasible. (Reviews of this literature can be found in Hart and Holmstrom, 1987, and Furubotn and Richter, 1998, among other sources.) Although contracts designed to elicit voluntary performance of unverifiable actions depart from the Arrow-Debreu ideal in leaving gains from trade potentially unrealized relative to the cooperative (nonstrategic) outcome, economists generally regard contracts optimally designed to deal with information asymmetries as complete in the sense that such agreements (i) still fully specify each party’s performance obligations for every possible contingency, and (ii) yield the best possible outcome given the information available to the courts at the time the agreement is carried out and thus ‘never need to be revised or complemented’ (Holmstrom and Tirole, 1989, p. 68). Despite the variety of settings in which risk sharing, moral hazard and adverse selection are potentially important (see below), complete contract theory’s performance as a positive theory has been disappointing. Aside from the broad prediction that efficient sharing rules will balance incentives for one party against inefficient risk bearing by that party or the incentives of trading

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partners, asymmetric information models yield few testable hypotheses. One reason for this is the ‘extreme sensitivity’ of optimal incentive schemes to slight changes in the relation between actual performance and verifiable information (Hart and Holmstrom, 1987, p. 105). Complete contract theory also fails to account for the observed simplicity of sharing rules in most real world contracts. Whereas the theory admits potentially detailed and complex payment rules specifying each party’s performance obligations for every possible contingency (in the case of discrete contingencies) and elaborate nonlinear pricing rules (in the continuous case), actual contracts incorporate few if any explicit contingencies and generally use simple, typically linear, pricing schemes (Holmstrom and Hart, 1987; Bhattacharyya and Lafontaine, 1995). Complete contract theory has also been faulted for its inability to distinguish between, and therefore account for the choice between, contracting and other institutional and organizational forms such as property rights and the firm. 3.2 Incomplete Contracting Contract theorists consider a contract incomplete, or to contain a ‘gap,’ if performance of the actual terms of the agreement would leave gains from trade unrealized given the information available to the parties and the courts at the time performance takes place (see, for example, Holmstrom and Tirole, 1989, p. 68; Tirole, 1994, p. 18). Under the assumption that transactors possess unlimited foresight and cognition, such an omission could never occur. Incomplete contract theory relaxes the extreme rationality assumption of complete contract theory and assumes that the limits on rationality that make courts less than fully omniscient apply to contracting parties as well: sophisticated but boundedly rational transactors will omit contingencies when the costs of anticipating, devising optimal responses to, and drafting provisions for improbable events outweigh the expected gains in efficiency from doing so. Departures from the Arrow-Debreu ideal may thus arise in incomplete contract theory from failures of the contracting parties to foresee and provide for contingencies in formulating their agreement, instead of or in addition to the inability of courts to verify performance. The prospect that contracts might leave gains unrealized raises an issue for the analysis of incomplete contracting that is not germane to complete contracting, namely, how, if at all, contracting parties respond to opportunities for mutually advantageous ex post adjustment. Two types of models can be distinguished: those that permit renegotiation ex post, and those that do not. (a) Models without Renegotiation Although linearity restrictions on sharing rules have often been imposed by complete contract theorists for tractability rather than theoretical or empirical reasons, exogenous restrictions on feasible contracts will, except under special conditions, lead to ex post inefficiencies.

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Accordingly, linear principal-agent contracts will in general be incomplete. (Not surprisingly, therefore, considerable effort has been applied to identifying the conditions under which linear contracts are sufficient for efficient outcomes; see, for example, Holmstrom and Milgrom, 1987; Bhattacharyya and Lafontaine, 1995.) Early principal-agent models mainly dealt with opportunities for mutually advantageous adjustment within linear contracts by ignoring them; contract terms were presumed to be definitive and immune to ex post bargaining, and any ‘residual loss’ from imperfect adjustment to changing events considered a component of ‘agency costs’ (Jensen and Meckling, 1976, p. 308; see also Matthewson and Winter, 1985; Allen and Lueck, 1992, 1993.) Because of their greater tractability and more realistic starting assumptions, linear agency models have been more successful than complete contract theories at generating predictions and explaining observed contracts. Settings in which moral hazard and adverse selection are likely to pose problems for contracting parties are numerous, and many relationships can be cast in principal-agent terms. Linear principal-agent models have been the primary framework for analyzing contract terms in franchising (Matthewson and Winter, 1985; Lal, 1990), agricultural share-cropping (Stiglitz, 1974; Eswaran and Kotwal, 1985), and product warranties (Priest, 1981; Cooper and Ross, 1985), among other settings. The linear agency model has also recently been extended to analyze multi-task settings in which agents perform either multiple activities or a single activity with multiple dimensions (Holmstrom and Milgrom, 1991). Formal tests of agency model predictions have proved difficult, however. The optimal sharing parameter that is the primary focus of these models depends on factors such as the relative risk aversion of the principal and agent and the relative effects of their actions on joint surplus. Because these factors are difficult or impossible to measure, acceptance of the model often turns on accepting the modeler’s risk preference and marginal productivity assumptions (Stigler and Becker, 1977; Allen and Lueck, 1995). More generally, heavy reliance by agency theorists on risk aversion to explain observed contracting practices has been criticized, especially in the context of commercial transactions, for diverting attention from other potentially more important considerations (see Williamson, 1985b, pp. 388-389; Goldberg, 1990). (b) Models with Renegotiation More recent models of incomplete contracting generally assume that transactors can negotiate to take advantage of any ex post gains on the grounds that (i) unrealized gains from trade create an incentive to renegotiate, and (ii) contract law generally allows modification of contract terms by mutual consent. Incorporating renegotiation into the analysis, however, requires a model of bargaining, a perennial difficulty for economic theory. The formal literature on incomplete contracting has generally circumvented that problem by assuming that the parties costlessly negotiate to

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the cooperative (Nash) outcome (Grossman and Hart, 1986; Hart and Moore, 1988; Lutz, 1995). The assumption of costless renegotiation assures ex post efficiency and thereby eliminates any role for contracts in establishing ex post incentives. Benefits may nevertheless accrue to contracting if either (i) transactors are risk averse or (ii) efficiency requires unverifiable ex ante investments. Even though the parties are free to modify their agreements by mutual consent, the ability of either party to enforce the contract’s original terms establishes the threat points in any subsequent negotiation. Hence, by contracting, transactors are able to influence the distribution of ex post surpluses and, thereby, the allocation of risk and expected return on investments. Incomplete contract theory has permitted formal analysis of alternative organizational and institutional arrangements, especially the existence and locus of property rights (for example, Grossman and Hart, 1986; Hart and Moore, 1990) for which the complete contract framework was unsuitable. In the eyes of some theorists, however, the gains in analytical scope come at the cost of generality. While sympathizing with the view that individuals are not capable of dealing with unlimited complexity, purists complain that, in the absence of an accepted model of bounded rationality, restrictions on feasible contract forms are unavoidably arbitrary and ad hoc (for example Tirole, 1994, pp. 15-17; Hart and Holmstrom, 1987, pp. 133, 148).

4. Contracting in Law and Economics In most respects, conceptions of contracting in law and economics conform to those in economic theory more generally. Like mainstream economics, the law and economics literature conceives of contracting as a device for communicating substantive performance objectives. As Goetz and Scott (1985, p. 265) describe it, contracting parties seek first ‘to negotiate a subjective understanding about the combination of underlying substantive rights that form the basis for mutually beneficial trade. What remains is an instrumental problem, that of formulating contractual terms that mirror the desired exchange.’ Like incomplete contract theory, law and economics also recognizes that limitations of language and foresight generally prevent transactors from drafting all-encompassing agreements, of which Arrow-Debreu contingent claims contracts are again the archetype (for example, Shavell, 1984; Schwartz, 1992a, 1992b; Ayres and Gertner, 1992, p. 730). As a consequence of these imperfections, contracts often contain gaps that leave performance under the contract potentially inefficient, thus creating opportunities for efficiencyenhancing adjustments. Where law and economics and economic treatments of incomplete contracting diverge is in the manner through which adjustments come about. In economic contract theories, courts mechanically enforce contract terms, and

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adjustments, if any, are accomplished through costless renegotiation. In law and economics, the courts, rather than the transactors, evaluate opportunities for adaptation and implement the necessary contractual modifications. In the typical scenario, one of the parties will find performance at the contractually specified price unprofitable and attempt to escape his contractual obligations, leading the other party to bring suit to enforce the contract. If the contract is incomplete and ex post bargaining is prohibitively costly, requiring performance as specified in the agreement will be inefficient on at least some occasions. By, instead, enforcing the contract in a way that corrects such defects, courts will enhance efficiency, first, by increasing the efficiency of performance ex post and, second, by reducing the need for transactors to formulate detailed agreements, and hence the cost of contracting, in the first place. In general, the law and economics literature on contract advises courts to complete incomplete contracts with terms the parties ‘would have bargained for’ themselves had the costs of anticipating and incorporating provisions for the event at hand been sufficiently low (see Chapters 4400 Implied Terms Interpretation; 4500 Unforeseen Contingencies - Risk Allocation; and 4600 Remedies). Since what the parties would have bargained for in the absence of imperfections encountered during contract formation is a complete contract, courts are essentially charged with discovering and implementing rules that yield the efficient outcome given the information available to (that is, verifiable by) the court (see Schwartz, 1992a, p. 281). Overall, law and economics offers a richer characterization of background legal rules and the role of courts in enforcing contracts from which economic theories of contracting could benefit. At the same time, legal scholarship on contracting can be faulted for not being more explicit about the purposes of contracting and the ramifications of contract law for contracting behavior. As Rubin (1996) observes, ‘When American legal scholars speak of “contracts” they typically do not mean contracts at all, but rather judicial decisions ... involving disputes about contracts. Contracts themselves, the transactions that create them, and the business decision to comply with them, renegotiate them, or breach them have rarely surfaced in the academic study of [contract]’ (as quoted in Williamson, 1996).

5. Relational Contracting Despite substantial differences in the roles they ascribe to courts, law and economics and economic contract theory operate under the ‘legal centralist’ assumption that courts perform their assigned functions in ‘an informed, sophisticated, and low-cost way’ (Williamson, 1983, p. 520). But whereas that function in economic theories of contracting entails enforcing explicit

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provisions, law and economics assigns courts the much more demanding responsibility of discovering contracting parties’ ‘real’ intentions and identifying opportunities for and implementing efficiency-enhancing adjustments. As Oliver Williamson (1985b, p. 201) has remarked, ‘Judgement based on detailed ex post knowledge of the particulars, including an examination of the magnitude of the profitability consequences that accrue, will often be the only way to ascertain whether an adjustment is warranted’ (compare Ayres and Gertner, 1989, pp. 116-117; Scott, 1990, pp. 600-601). The prescription that courts fill gaps in incomplete contracts with what the parties would have bargained for effectively presumes that courts possess such knowledge and the expertise to perform the substantive calculations the transactors would themselves have had to make to determine efficient performance. Law and economics’ confidence in the efficacy of court ordering and its emphasis on substantive performance contain a paradox, however: if courts are able to fill gaps accurately and costlessly, why would transactors ever incur the time and expense of drafting definite performance obligations in the first place? Instead, transactors could just indicate a vague intention to transact and let the courts fill in the details thereafter. In a world in which contract formation is costly and adjudication costless, a perfectly indefinite agreement, rather than comprehensive Arrow-Debreu bargains, becomes the ideal contract (see Charny, 1991, pp. 1840-1841). If transactors do specify definite performance obligations, it must be to reduce the cost or inaccuracy of court ordering. Explicit integration of adjudication costs into the analysis of contracting has two immediate implications for contract design. First, where transactors design contracts to avoid court ordering, the presumption that contract terms define the substantive outcomes the transactors wish to see take place is no longer justified. Transactors might reasonably prefer contract provisions that leave gains from trade unrealized, or that relegate sufficiently worthwhile adjustments to renegotiation or other forms of self help, over terms that specify the efficient course of action but increase the costs or likelihood of litigation. In such circumstances, express terms may have only an indirect, and possibly even a contradictory, relation to the parties’ substantive aims (for example, Masten and Snyder, 1993, pp. 60-63). Second, the existence of judicial imperfections opens the door to conduct designed to contrive cancellation, evade performance, or otherwise force a renegotiation of the existing terms. Unlike moral hazard, which is a passive response to price signals within an existing agreement, such behavior aims to exact a de jure modification of terms previously agreed to. Among the tactics available to a party seeking a redistribution of the gains from trade are suing for trivial deviations, ‘working to rule,’ and withholding relevant information in hopes of inducing breach (see Muris, 1981; Williamson, 1983, p. 526; Goldberg, 1985; Masten, 1988b). Contracts from this perspective do not so

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much define the terms of trade as determine the process through which the terms of trade are ultimately arrived at (Macaulay, 1985). As Victor Goldberg (1976, p. 428) has described it, the emphasis shifts from devising ‘a detailed specification of the terms of the agreement to a more general statement of the process of adjusting the terms of the agreement over time-the establishment, in effect, of a “constitution” governing the ongoing relationship’. Inasmuch as both regard contract terms as starting points for future negotiations, relational and incomplete contract theories bear a passing resemblance. The difference, however, is that renegotiation in the relational framework is costly and unilateral preservation of the contract’s original terms (including price) is neither certain nor free. An essential element of contract design, therefore, becomes structuring the relationship in a way that reduces the incentive to engage in wasteful efforts to evade performance or force a renegotiation (compare Williamson, 1983; Goldberg, 1985; Klein, 1992, 1995, 1996; Masten, 1988b). Contract terms will also be used to affect the extent of court ordering. Indefinite contracts that use terms such as ‘best efforts’, ‘gross inequity’, or ‘substantial performance’ to describe contractual obligations leave the parameters of acceptable performance ultimately to the courts. By contrast, contracts that specify precise performance obligations, define sanctions (such as liquidated damages or termination), and allocate discretion to invoke those sanctions unilaterally, shift the locus of decision making and adjustment, to the extent courts defer to written terms, from the courts to the transactors. Finally, a process orientation also highlights the interaction between judicial enforcement policies and contract design. To the extent that deviations between contract terms and transactors’ substantive intentions reflect efforts to economize on adjudication costs, judicial efforts to complete ‘incomplete’ agreements may frustrate rather than foster the parties’ intentions. The ability of contracting parties to achieve process objectives - to reduce court ordering through the use of more precise language, for example - depends on the extent to which courts are willing to defer to written terms.

6. Empirical Evidence on Contractual Choice Several reviews of the empirical literature on contracting have been published, the most recent of which are Shelanski and Klein, 1995; Crocker and Masten, 1996; Lyons, 1996, and Lafontaine and Slade, 1997, 1998. The following identifies some of the most prominent findings and regularities and their relation to the theories discussed above.

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6.1 Contracting and Contract Duration One of the most firmly established regularities in the empirical literature on contracting is the association between relationship-specific investments (or reliance) and the use and duration of contractual agreements. An early and well-known example is Joskow’s (1987) econometric analysis of the duration of nearly 300 coal contracts. Exploiting regional differences in the characteristics of coal and transportation alternatives and variations in contract quantity, Joskow’s study showed the duration of coal contracts to be significantly correlated with measures of physical- and site-specificity and dedicated assets. A more recent study of engineering subcontracting practices in the United Kingdom by Lyons’ (1994) suggests that specificity affects not only the duration of contracts but the decision to contract in the first place. The engineering firms and subcontractors in Lyons’ sample were significantly more likely to adopt formal contracts, over more flexible but less secure informal agreements, where investments in relationship-specific physical and human capital left the subcontractor vulnerable to ex post opportunism. Empirical research has also identified a correlation between long-term contracting and specificity in natural gas (Crocker and Masten, 1988); petroleum coke (Goldberg and Erickson, 1987); and ocean shipping contracts (Pirrong, 1993), among others. Contracting appears less attractive as a way of protecting reliance or relationship-specific investments, however, where the alternative to contracting is integrated ownership and production. Empirical research on integration decisions reveals a consistent preference for integration over contracting as the specificity of investments increases (for overviews, see Joskow, 1988; Shelanski and Klein, 1995; Crocker and Masten, 1996; and Chapter 0530 New Institutional Economics). Contracting thus appears to be only an imperfect response to the hazards posed by relationship-specific investments. Empirical research suggests, moreover, that the costs and limitations of contracting grow with the complexity and uncertainty of the transaction. In Lyons’ (1994) study of engineering transactions, for example, firms were less likely to use formal contracts for advanced technology projects than for relatively simple procurements. Meanwhile, Goldberg and Erickson (1987) and Crocker and Masten (1988) found that contract duration in petroleum coke and natural gas contracts decreased in periods of increased uncertainty, contrary to what would be expected if risk-sharing were the primary motive for contracting. Research on the determinants of make-or-buy decisions suggests that uncertainty and complexity diminish the attractiveness of contracting relative to integration as well (for example, Masten, 1984; Anderson and Schmittlein, 1984). Though clearly an important determinant, the protection of specific investments is not the sole motive for contracting. Unsupported assertions to the contrary notwithstanding, relationship-specific investments in franchising appear to be modest and unimportant as a motive for franchise contracting (see

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Lafontaine and Slade, 1997, 1998). Indeed, the viability of some contractual arrangements, such as franchising and equipment leasing, may depend on assets actually being redeployable at reasonably low cost (Klein, 1995; Masten and Snyder, 1993). Case studies have also shown benefits of contracting to accrue to the desire to control free-riding on the provision of information or services (for example, Rubin, 1978; Masten and Snyder, 1993) and to avoid unproductive search and sorting costs (Kenney and Klein 1983; Gallick, 1984). 6.2 Contract Design (a) Incentive Provisions The empirical literature offers broad support for the proposition that transactors choose contract terms to promote efficient adaptation and mitigate transaction costs. In contemporaneous studies of natural gas contracting, Masten and Crocker (1985) and Mulherin (1986) found that take-or-pay percentages in natural gas contracts varied with the alternative value of gas reserves, supporting an incentive interpretation over the alternative view that take-or-pay provisions serve distributional or risk-sharing purposes (for example, Hubbard and Weiner, 1986). Case studies describing the use of minimum purchase requirements for coal (Carney, 1978) petroleum coke (Goldberg and Erickson, 1987), and bauxite (Stuckey, 1983), among other products, corroborate this finding (see Masten, 1988a, pp. 91-92, for a discussion). In a related study, Crocker and Masten (1988) found that the prospect of inefficient adaptation associated with distortions in the size of take-or-pay provisions significantly reduced the willingness of parties to engage in long-term contracting. Incentive considerations also appear to be influential in determining sharing arrangements. Lafontaine (1992), for example, found that royalty rates across franchises tend to vary with the relative importance of franchisor and franchisee effort. Observed correlations between uncertainty and royalty rates (and the use of franchised versus company outlets) are inconsistent with the standard assumption of franchisee risk aversion, however. (Reviews of the empirical literature on franchise contracting can be found in Lafontaine and Slade, 1997, 1998). Risk sharing as a motive for contracting has fared poorly in other settings as well. Allen and Lueck (1992), for instance, conclude that the incidence of crop-share versus fixed-rent contracts between farmer-tenants and landowners are unrelated to the riskiness of crops. Similarly, Leffler and Rucker (1991) reject risk sharing as an explanation for why timber track owners and harvesters sacrifice the incentive advantages of lump-sum relative to royalty contracts in favor of the hypothesis that the use of royalty contracts on relatively remote and heterogeneous timber tracks reflects the desire to avoid wasteful pre-bid inspection under lump-sum contracts. Finally, Holmstrom and Milgrom (1991) interpret Anderson’s (1985) and Anderson and Schmittlein’s (1984)

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finding that importance of non-selling activities and difficulty measuring performance of sales agents explain manufacturer reliance on low-powered incentives as evidence that measurement costs in multitask settings are a critical determinant of the intensity of incentives in contractual relations (see also, Slade, 1996). (b) Relational Contracts Whereas most of the empirical contracting literature focuses on standard price and quantity provisions, research on relational contracting has sought to account for the widespread use of contracts that leave important terms like price and quantity indeterminate. Examples of such provisions include price renegotiation and ‘market out’ provisions in natural gas contracts (Crocker and Masten, 1991), ‘gross inequity’ provisions in long-term coal contracts (Joskow, 1985), termination-at-will and best-efforts clauses in franchise agreements (Hadfield, 1990), substantial performance requirements in construction contracts (Goetz and Scott, 1981), and other ‘open term’ agreements (for example, Gergen, 1992). Large-scale analyses of relational contract provisions have focused on methods of price adjustment. Crocker and Masten (1991), for instance, conclude from their study of price adjustment in natural gas contracts that circumstances favoring the use of long-term, fixed-quantity agreements favor the adoption of relatively indefinite price adjustment provisions over formulaic adjustment mechanisms that, although less costly to implement, are more likely to induce efforts to evade performance obligations in extreme situations. As Goldberg and Erickson (1987) note, greater reliance on renegotiation provisions in fixed versus variable quantity contracts is difficult to reconcile with incentive alignment motives. Crocker and Reynolds’ (1993) study of jet engine procurement contracts also found that price adjustment was likely to become less definite as performance horizons lengthened and technological uncertainty increased, while contractor litigiousness and the absence of alternative engine suppliers favored more definite price terms. The available evidence thus generally supports the notion that transactors’ choice of contract terms reflects a tradeoff between the specification costs and rigidities associated with specifying detailed performance obligations in uncertain or complex transactions, on the one hand, and the greater flexibility but higher expected cost of establishing the terms of trade ex post in less definite relational contracts.

7. Implications and Directions Economic research on contracting is important to both legal scholarship and practice. Contracting is a - perhaps the most - fundamental institution of legal as well as economic interaction (compare Williamson, 1996). At a practical level, the study of contracting stands to inform lawyers and lawmakers about

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the objectives of contracting parties and the sources of contractual failures. For lawyers, such knowledge can provide insights with which to help clients design more effective agreements. For legislatures and courts, understanding the functions and limitations of contracting is crucial to the formulation of appropriate legal rules and their application in individual cases. As noted previously, whether and how courts intervene in contractual relations will depend on the theory of contracting behavior to which they subscribe. Theories that place confidence in the ability of parties to effect private orderings either through ex ante specification of contingent performance or through low-cost, ex post negotiation will favor a policy of passive judicial enforcement, whereas theories that emphasize the behavioral and cognitive impediments to ex ante alignment and ex post negotiation without similar regard for the cognitive limitations of judges will tend to favor more active enforcement and intervention by the courts. As various commentators have noted, official contract law, as reflected in the United States in Section 2 of the Uniform Commercial Code and Restatement (2nd) of Contracts, has moved increasingly toward favoring more active judicial enforcement. Where once courts were discouraged from using extrinsic evidence in interpreting contractual obligations, modern contract law endorses an active enforcement policy, encouraging courts to interpret contractual agreements ‘in light of surrounding circumstances’. Despite this widely-noted shift, however, the evidence is that courts have been far from uniform in their approach to contract enforcement. In practice, courts as a group neither universally seek to discover the parties’ true intentions from the context of their agreement - as the Code and Restatement recommend - nor consistently defer to written terms (Goetz and Scott, 1985, p. 307; Schwartz, 1992a). Such variations, moreover, cannot be explained entirely by philosophical differences among courts; judicial enforcement policies appear to vary systematically across disputes, courts tending to enforce franchise and distributorship agreements more passively than contracts for intermediate goods between manufacturers and suppliers (see Hadfield, 1990, pp. 978-990; Schwartz, 1992a, pp. 271, 304-305; Farnsworth, 1990, p. 556). Further research on variations in judicial enforcement policies and the dimensions along which they vary is likely to shed additional light on the functions and limitations of contracting. Although there are indications that recent research on contractual choice has already begun to influence how courts think about contracting and resolve contract disputes (see, for instance, PSI Energy v. Exxon Coal, USA, 991 F.2d. 1265 (1993)), much more needs to be done before positive theories of contracting can provide a solid basis for normative prescriptions. Such basic questions as why transactors choose super-compensatory liquidated damages have yet to receive a fully satisfactory explanation. More subtle but important issues like the effects of contractual protections on the willingness of

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transactors to make relationship-specific investments are just beginning to receive scrutiny (for example, Saussier, 1998). Although theoretical tensions are likely to persist between those who value axiomatic rigor and those willing to invoke empirical regularities to develop testable predictions, on one issue at least, the two approaches appear to be converging, namely, that further progress on understanding contracting requires a better appreciation of the interactions of contract design and contract enforcement and the process functions of contracting (compare Tirole, 1994).

Acknowledgments Financial support from the Center for Research on Contracting and the Structure of Enterprises is gratefully acknowledged.

Bibliography on Contractual Choice (4100) Allen, Douglas W. and Lueck, Dean (1992), ‘Contract Choice in Modern Agriculture: Cropshare versus Cash Rent’, 35 Journal of Law and Economics, 397-426. Allen, Douglas W. and Lueck, Dean (1993), ‘Transaction Costs and the Design of Cropshare Contracts’, 24 Rand Journal of Economics, 78-100. Allen, Douglas W. and Lueck, Dean (1995), ‘Risk Preferences and the Economics of Contracts’, 85 American Economic Review, 447-451. Anderson, Erin (1985), ‘The Salesperson as Outside Agent or Employee: A Transaction Cost Perspective’, 4 Management Science, 234-254. Anderson, Erin and Schmittlein, David (1984), ‘Integration of the Sales Force: An Empirical Examination’, 15 Rand Journal of Economics, 385-395. Ayres, Ian and Gertner, Robert (1989), ‘Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules’, 94 Yale Law Journal, 96-114. Ayres, Ian and Gertner, Robert (1992), ‘Strategic Contractual Inefficiency and the Optimal Choice of Legal Rules’, 101 Yale Law Journal, 729-73. Baird, Douglas G. (1990), ‘Self Interest and Cooperation in Long-Term Contracts’, 19 Journal of Legal Studies, 535-596. Bernstein, Lisa (1996), ‘Merchant Law in a Merchant Court: Rethinking the Code’s Search for Immanent Business Norms’, 144 University of Pennsylvania Law Review, 1765-1821. Bhattacharyya, Sugato and Lafontaine, Francine (1995), ‘Double-Sided Moral Hazard and the Nature of Share Contracts’, 26 RAND Journal of Economics, 761-781. Carney, E.M. (1978), ‘Pricing Provisions in Coals Contracts’, in Rocky Mountain Mineral Law Institute, New York, Matthew Bender, 197-230. Charny, David (1990), ‘Nonlegal Sanctions in Commercial Relationships’, 104 Harvard Law Review, 373-467. Charny, David (1991), ‘Hypothetical Bargains: The Normative Structure of Contract Interpretation’, 89 Michigan Law Review, 1815-1879.

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Cheung, Steven N.S. (1969), ‘Transaction Costs, Risk Aversion, and the Choice of Contractual Arrangements’, 12 Journal of Law and Economics, 23-46. Cooper, Russ, and Ross, Thomas W. (1985), ‘Product Warranties and Double Moral Hazard’, 16 Rand Journal of Economics, 103-113. Crocker, Keith J. and Lyon, Thomas P. (1994), ‘What do “Facilitating Practices” Facilitate?: An Empirical Investigation of Most-Favored-Nation Clauses in Natural Gas Contracts’, 34 Journal of Law and Economics, 297-322. Crocker, Keith J. and Masten, Scott E. (1988), ‘Mitigating Contractual Hazards: Unilateral Options and Contract Length’, 19 Rand Journal of Economics, 327-343. Crocker, Keith J. and Masten, Scott E. (1991), ‘Pretia Ex Machina? Prices and Process in Long-Term Contracts’, 34 Journal of Law and Economics, 69-99. Crocker, Keith J. and Masten, Scott E. (1996), ‘Regulation and Administered Contracts Revisited: Lessons from Transaction-Cost Economics for Public Utility Regulation’,9 Journal of Regulatory Economics, 5-39. Crocker, Keith J. and Reynolds, Kenneth J. (1993), ‘The Efficiency of Incomplete Contracts: An Empirical Analysis of Air Force Engine Procurement’, 24 Rand Journal of Economics, 126-146. Eswaran, M. and Kotwal, A. (1985), ‘A Theory of Contractual Choice in Agriculture’, 75 American Economic Review, 352-67. Farnsworth, Alan (1990), Contracts (2nd edn), New York, Little, Brown, and Company. Furubotn, Eirik G. and Richter, Rudolf (1998), Institutions and Economic Theory: The Contribution of the New Institutional Economics. Ann Arbor, The University of Michigan Press. Gallanter, Marc (1981), ‘Justice in Many Rooms: Courts, Private Ordering, and Indigenous Law’, 19 Journal of Legal Pluralism, 1-47. Gallick, Edward C. (1984), Exclusive Dealing and Vertical Integration: The Efficiency of Contract in the Tuna Industry, Bureau of Economics Staff Report to the Federal Trade Commission, excerpted in Masten, Scott E. (ed), Case Studies in Contracting and Organization,Oxford, Oxford University Press. Gergen, Mark P. (1992), ‘The Use of Open Terms in Contract’, 92 Columbia Law Review, 997-1081. Goetz, Charles J. and Scott, Robert (1981), ‘Principles of Relational Contracts’, 67 Virginia Law Review, 1089-1151. Goetz, Charles J. and Scott, Robert (1983), ‘The Mitigation Principle: Toward a General Theory of Contractual Obligation’, 69 Virginia Law Review, 967-024 Goetz, Charles J. and Scott, Robert (1985), ‘The Limits of Expanded Choice: An Analysis of the Interactions between Express and Implied Contract Terms’, 73 California Law Review, 261-322. Goldberg, Victor P. (1976), ‘Regulation and Administered Contracts’, 7 Bell Journal of Economics, 426-448. Goldberg, Victor P. (1980), ‘Relational Exchange, Economics and Complex Contracts’, 23 American Behavioral Scientist, 337-352. Goldberg, Victor P. (1985), ‘Price Adjustment in Long-Term Contracts,’ 1985 Wisconsin Law Review, 527-543. Goldberg, Victor P. (1990). ‘Aversion to Risk Aversion in the New Institutional Economics’, 146 Journal of Institutional and Theoretical Economics, 216-222. Goldberg, Victor P. and Erickson, John R (1987), ‘Quantity and Price Adjustment in Long-Term

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Contracts: A Case Study in Petroleum Coke’, 31 Journal of Law and Economics, 369-398. Reprinted in Masten, Scott E. (ed) (1996), Case Studies in Contracting and Organization, Oxford, Oxford University Press. Grossman, Sanford J. and Hart, Oliver D. (1986), ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, 94 Journal of Political Economy, 691-719. Guesnerie, Roger (1992), ‘The Arrow-Debreu Paradigm Faced with Modern Theories of Contracting: A Discussion of Selected Issues Involving Information and Time’, in Werin, L. and Wijkander, H. (eds), Contract Economics, Cambridge, MA, Basil Blackwell. 12-41 Hadfield, Gillian K. (1990), ‘Problematic Relations: Franchising and the Law of Incomplete Contracts’, 42 Stanford Law Review, 927-992. Hallagan, William (1978), ‘Self-Selection by Contractual Choice and the Theory of Sharecropping’, 9 Bell Journal of Economics, 344-354. Hart, Oliver D. and Holmstrom, Bengt (1987), ‘The Theory of Contracts’, in Bewley, T.R. (ed), Advances in Economic Theory, Fifth World Congress, Cambridge, Cambridge University Press, 369-398. Hart, Oliver D. and Moore, John (1988), ‘Incomplete Contracts and Renegotiation’, 56 Econometrica, 755-785. Hart, Oliver D. and Moore, John (1990), ‘Property Rights and the Nature of the Firm’, 98 Journal of Political Economy, 1119-1158. Holmstrom, Bengt and Milgrom, Paul (1987), ‘Aggregation and Linearity in the Provision of Intertemporal Incentives’, 55 Econometrica, 303-328. Holmstrom, Bengt and Milgrom, Paul (1991), ‘Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design’, 7 Journal of Law, Economics, and Organization, 24-52. Holmstrom, Bengt, and Tirole, Jean (1989), ‘The Theory of the Firm’, in Schmalensee, Richard and Willig, Robert D. (eds), Handbook of Industrial Economics, New York, Elsevier Science Publishing, 61-133. Hubbard, R. Glenn and Weiner, Robert J. (1986.), ‘Regulation and Long-Term Contracting in U.S. Natural Gas Markets’, 35 Journal of Industrial Economics, 31-79. Hubbard, R. Glenn and Weiner, Robert J. (1991), ‘Efficient Contracting and Market Power: Evidence from the U.S. Natural Gas Industry’, 3 Journal of Law and Economics, 25-68. Jensen, Michael C. and Meckling, William H. (1976), ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, 3 Journal of Financial Economics, 305-360. Johnston, Jason Scott (1990), ‘Strategic Bargaining and the Economic Theory of Contract Default Rules’, 100 Yale Law Journal, 615-664. Joskow, Paul L. (1985), ‘Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric Generation Plants’, 1 Journal of Law, Economics and Organization, 33-79. Joskow, Paul L. (1987), ‘Contract Duration and Relationship-Specific Investments: Evidence from Coal Markets’, 77 American Economic Review, 168-185. Reprinted in Masten, Scott E. (ed) (1996), Case Studies in Contracting and Organization, Oxford, Oxford University Press. Joskow, Paul L. (1988), ‘Asset Specificity and the Structure of Vertical Relationships: Empirical Evidence’, 4 Journal of Law, Economics, and Organization, 98-115. Joskow, Paul L. (1988b), ‘Price Adjustment in Long-Term Contracts: The Case of Coal,’ 31 Journal

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of Law and Economics, 47-83. Joskow, Paul L. (1990), ‘The Performance of Long-Term Contracts: Further Evidence from Coal Markets’, 21 Rand Journal of Economics, 251-274. Kaufman, Patrick J. and Lafontaine, Francine (1994), ‘Costs of Control: The Source of Economic Rents For McDonald’s Franchisees’, 37 Journal of Law and Economics, 417-543. Reprinted in Masten, Scott E. (ed) (1996), Case Studies in Contracting and Organization, Oxford, Oxford University Press. Kenney, Roy W. and Klein, Benjamin (1983), ‘The Economics of Block Booking’, 26 Journal of Law and Economics, 497-540. Klein, Benjamin (1980), ‘Transaction Cost Determinants of “Unfair” Contractual Arrangements’, 70 American Economic Review, 356-362. Klein, Benjamin (1992), ‘Contracts and Incentives: the Role of Contract Terms in Assuring Performance’, in Werin, Lars and Wijkander, Hans (eds), Contract Economics, Cambridge, MA, Basil Blackwell, 149-173. Klein, Benjamin (1995), ‘The Economics of Franchise Contracts’, 2 Journal of Corporate Finance , 9-37. Klein, Benjamin (1996), ‘Why Hold-Ups Occur: The Self-Enforcing Range of Contractual Relationships’, 34 Economics Inquiry, 444-463. Klein, Benjamin, and Leffler, Keith B. (1981), ‘The Role of Market Forces in Assuring Contractual Performance’, 89 Journal of Political Economy, 615-641. Klein, Benjamin, and Murphy, Kevin M. (1988), ‘Vertical Restraints as Contract Enforcement Mechanisms’, 31 Journal of Law and Economics, 265-297. Klein, Benjamin, and Saft, Lester F. (1985), ‘The Law and Economics of Franchise Tying Contracts’, 28 Journal of Law and Economics, 345-361. Klein, Benjamin, Crawford, R.A. and Alchian, Armen A. (1978), ‘Vertical Integration, Appropriable Rents, and the Competitive Contracting Proces’, 21 Journal of Law and Economics, 297-326. Knoeber, Charles R. (1982), ‘An Alternative Mechanism to Assure Contractual Reliability’,12 Journal of Legal Studies, 333-343. Laffont, Jean-Jacques, and Tirole, Jean (1988), ‘The Dynamics of Incentive Contracts’, 56 Econometrica, 1153-1175. Lafontaine, Francine (1992), ‘Agency Theory and Franchising: Some Empirical Results’, 23 Rand Journal of Economics, 263-283. Lafontaine, Francine (1993), ‘Contractual Arrangements as Signaling Devices: Evidence from Franchising’, 9 Journal of Law, Economics, and Organization, 256-289. Lafontaine, Francine and Masten, Scott E. (1995), ‘Franchise Contracting, Organization, and Regulation’, special issue of the Journal of Corporate Finance. Lafontaine, Francine and Slade, Margaret E. (1997), ‘Retail Contracting: Theory and Practice’, 65 Journal of Industrial Economics, 1-25. Lafontaine, Francine and Slade, Margaret E. (1998), ‘Incentive Contracting and the Franchise Decision’, National Bureau of Economic Research Working Paper 6544. Lal, R. (1990), ‘Improving Channel Performance through Franchising’,9 Marketing Science, 299-318. Leffler, Keith B. and Rucker, Randal R. (1991), ‘Transaction Costs and the Efficient Organization of Production: A Study of Timber-Harvesting Contracts’, 99 Journal of Political Economy, 1060-1087. Libecap, Gary D. and Wiggins, Steven N. (1984), ‘Contractual Responses to the Common Pool:

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Prorationing of Crude Oil Production’, 74 American Economic Review, 87-98. Lutz, Nancy A. (1995), ‘Ownership Rights and Incentives in Franchising’, 2 Journal of Corporate Finance, 103-131. Lyons, Bruce R. (1994), ‘Contract Specific Investment: An Empirical Test of Transaction Cost Theory’, 3 Journal of Economics and Management Strategy, 257-278. Lyons, Bruce R. (1996), ‘Empirical Relevance of Efficient Contract Theory: Inter-Firm Contracts’, 12 Oxford Review of Economic Policy, 27-52. Macaulay, Stewart (1963), ‘Non-Contractual Relations in Business: A Preliminary Study’, 28 American Sociological Review, 55-70. Macaulay, Stewart (1985), ‘An Empirical View of Contract’, 1985 Wisconsin Law Review, 465-482. Macneil, Ian R. (1974), ‘The Many Futures of Contracts’, 47 Southern California Law Review, 691-816. Masten, Scott E. (1984), ‘The Organization of Production: Evidence from the Aerospace Industry’, 27 Journal of Law and Economics, 403-417. Masten, Scott E. (1988a), ‘Minimum Bill Contracts: Theory and Policy’, 37 Journal of Industrial Economics, 85-97. Masten, Scott E. (1988b), ‘Equity, Opportunism, and the Design of Contractual Relations’, 144 Journal of Institutional and Theoretical Economics, 180-195. Masten, Scott E. (1996), Case Studies in Contracting and Organization, New York, Oxford University Press. Masten, Scott E. and Crocker, Keith J. (1985), ‘Efficient Adaptation in Long-Term Contracts: Take-or-Pay Provisions for Natural Gas’, 75 American Economic Review, 1083-1093. Reprinted in Masten, Scott E. (ed) (1996), Case Studies in Contracting and Organization, Oxford, Oxford University Press. Masten, Scott E. and Snyder, Edward A. (1989), ‘The Design and Duration of Contracts: Strategic and Efficiency Considerations’, 52 Law and Contemporary Problems, 63-85. Masten, Scott E. and Snyder, Edward A. (1993), ‘United States v. United Shoe Machinery Corporation: On the Merits’, 36 Journal of Law and Economics, 33-70. Reprinted in Masten, Scott E. (ed) (1996), Case Studies in Contracting and Organization, Oxford, Oxford University Press; and 26 The Journal of Reprints for Antitrust Law and Economics, 1997. Matthewson, G. Frank, and Winter, Ralph A. (1985), ‘The Economics of Franchise Contracts’, 28 Journal of Law and Economics, 503-526. McAfee, R. Preston and Schwartz, Marius (1994), ‘Multilateral Vertical Contracting: Opportunism, Nondiscrimination, and Exclusivity’, 84 American Economic Review, 210-230. Milgrom, Paul and Roberts, John (1992), Economics, Organization and Management. Englewood Cliffs, NJ, Prentice Hall. Mulherin, J. Harold (1986), ‘Complexity in Long-Term Contracts: An Analysis of Natural Gas Contract Provisions’, 2 Journal of Law, Economics, and Organization, 105-117. Muris, Timothy J. (1981), ‘Opportunistic Behavior and the Law of Contracts’, 65 Minnesota Law Review, 575-580. Palay, Thomas M. (1984), ‘Comparative Institutional Economics: The Governance of Rail Freight Contracting’, 13 Journal of Legal Studies, 265-87. Palay, Thomas M. (1985), ‘Avoiding Regulatory Constraints: Contracting Safeguards and the Role of Informal Agreements.’ 1 Journal of Law, Economics, and Organization, 155-176.

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4200 LONG-TERM CONTRACTS AND RELATIONAL CONTRACTS Morten Hviid University of Warwick, Department of Economics © Copyright 1999 Morten Hviid

Abstract This chapter discusses the literature on long-term contracts and relational contracts. The central issues in the literature on long-term contracts are the effects of renegotiation and what these contracts can accomplish over and above a series of short-term contracts. The literature on relational contracts focuses on how self-enforceable terms can be supported without the use of enforceable contracts. Among the possible answers to this are repetition and norms. JEL classification: C72, D82, K12 Keywords: Long-Term Contracts, Renegotiation Proofness, Relational Contracts, Repeated Games, Norms

1. Introduction For contracts of a non-trivial duration, contract law faces the dilemma of, on the one hand, offering a means of commitment and, on the other, allowing for sufficient flexibility to adjust to changes in the environment. ‘This tension between the need to fix responsibilities at the outset and the need to readjust them over time permeates the long-term contractual relationship’ (Baird, 1990, p. 586). This tension is basic to both long-term and relational contracts. This entry discussed two classes of contracts, long-term contracts and relational contracts. Although closely related, neither is a subset of the other. Completely state-contingent long-term contracts are clearly not relational. Incomplete long-term contracts would in most cases be relational, although, as pointed out by Eisenberg (1995), they need not be. As regards relational contracts, ‘[t]wo features largely define what lawyers mean by a relational contract: incompleteness and longevity. Relational contracts govern continuing relations’ (Schwartz, 1992b, note 1, p. 271). However, as pointed out in Goetz and Scott (1981) a relational contract need not be a long-term contract, although in most cases it would be. 46

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The two literatures appear to address different issues and hence will be discussed separately below. The central issues in the literature on long-term contracts seems to be the effects or renegotiation as well as what can be accomplished by such contracts over and above what can be achieved by a series of short-term contracts. The literature on relational contracts assume that contract terms are not used and focus on how repeated interaction and social norms can ensure that obligations between parties can become self-enforceable.

A. Long-Term Contracts 2. Long-Term Contracts: General Summaries of the literature can be found in Bolton (1990), Hart (1987), Hart and Holmstrom (1987) and most recently in Salanié (1997, chs 6 and 7). For a recent survey focusing solely on labor contracts, see Malcolmson (1997). Following Salanié (1997, p. 150), a dynamic (long-term) contract is complete if ‘all variables that may have an impact on the conditions of the contractual relationship during its whole duration have been taken into account when negotiating and signing the contract’. This definition rules out any unforeseen contingencies which may arise during the duration of the contract. However, it does not rule out asymmetric information. If, for example, the principal can never observe the effort of an agent, the contract cannot stipulate a level of effort. According to the above definition, the contract is still complete if no information of future relevance will become available later on in the life of the contract. Some authors, such as Hart (1995) refer to this as a comprehensive contract, because ‘there will never be a need for the parties to revise or renegotiate the contract as the future unfolds’ (Hart, 1995, p. 22). For an early demonstration that long-term complete contracts can enable valuable commitment, see Grout (1984). In the case where complete contracts can be written, full commitment is always valuable, since a contract with full commitment can always mimic the outcome of any other contract with less commitment by committing to the same actions as lead to the outcome for the latter contract, see Salanié (1997, pp. 144-146). Commitment to a contract can either be broken by a unilateral deviation, namely breach, or multilateral deviation, namely renegotiation. In case of breach, one party has access to the legal system to either enforce the contract or to award damages. When using the legal system is costless, whether breach is actually possible depends on the breach remedies used by the court. If the remedy is specific performance, the contract can only be varied by mutual consent. If, as is more commonly the case, the remedy is expectation damages,

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one party can always decide to breach and pay the damages (see Chapter 4600 Contract Remedies: General). In the case of a multilateral deviation where both parties want to vary the contract term, it is in general not possible to hold the parties to the original contract by legal means. ‘[B]oth parties’ commitments are only as strong as their contracting partners’ desire to hold them to their original promises’ (Jolls, 1997, p. 203). Since commitment is valuable when complete contracts can be written, losses may occur if renegotiation at any point during the life of the contract cannot be prevented. Although Jolls (1997) does offer some suggestions for enforcing terms which both parties would later agree to vary, it would appear that renegotiation is difficult to rule out legally. This then leads to a focus on contracts which are renegotiation proof (see Dewatripont, 1989 and Bolton, 1990). One reason why there may be scope for renegotiation is that ex ante efficiency may require ex post inefficiency. For example, in order to separate out workers with different levels of unobservable productivity, the menu of contracts offered to the workers will generally not imply that all types get their first-best contract. However, once their type has been inferred from their choice of contract, it is (ex post) efficient to renegotiate these contracts. Doing so may make a renegotiated contract of a type A worker more attractive for a type B worker than the contract which ex ante was designed for type B and the original menu will no longer be fully separating. Thus removing the ex post inefficiencies may remove the incentives which ensured that the contract was ex ante efficient.

3. Renegotiation As pointed out among others by Bolton (1990, p. 304) ‘[i]t turns out that the role of and issues raised by renegotiation are somewhat different when the contracting problem is set in an environment of asymmetric information as opposed to an environment of symmetric but unverifiable information.’ The difference between the two cases relates to whether some ex post inefficiencies remain when renegotiation is possible. Asymmetric Information For the case of adverse selection, the value of commitment is very clear. Consider a dynamic contract between a principal and an agent, where initially the productivity of the agent is not known to the principal. In any separating equilibrium, the productivity of the agent will be known to the principal after the first period. For the ‘bad’ type of agent, separation involves a distortion leading to a lower utility in every period of the contract than would be the case if his true type was known. If the true type is really the bad type, the distortion

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can be removed after the first period when the agent’s type is known for sure. Hence if renegotiation is possible, it will take place - the contract is not robust against renegotiation. Moreover, since both parties want to renegotiate, it is difficult to see how the legal system can prevent this happening. Papers such as Dewatripont (1989) turn the focus on contracts which are renegotiation-proof, that is, contracts where there is never an incentive to renegotiation. With comprehensive contracting this is possible, because any incentive to renegotiate later could have been foreseen at the time of agreeing the original contract. As is shown in Dewatripont (1989), Hart and Tirole (1988), Laffont and Tirole (1987, 1990) the possibility of renegotiation slows down the speed of revelation. Essentially this is caused by a trade-off between speedy revelation and the damaging incentive to renegotiate. Moral Hazard For the case of moral hazard, the literature is less well developed. Fudenberg and Tirole (1990) consider a principal-agent model where there is a gap in time between the agent taking a hidden action and the outcome of this being known. If the principal can infer the agent’s action before the outcome is known, a renegotiation which perfectly insures the agent is optimal. However, if the agent realizes this, the incentive structure of the original contract is blunted. As in the case of adverse selection, information revelation has to be slowed down. In the moral hazard case this is achieved by the agent randomizing over its choice of action. The essential lesson from this model is that if renegotiation is possible after effort has been chosen, then the principal cannot make the agent choose the optimal effort for sure. Hence renegotiation again leads to an efficiency loss. Related papers in this area are Chiappori et al. (1994) and Ma (1991). Symmetric but Unverifiable Information Consider a contract on future trade between two parties. Because the information and hence the state of nature is unverifiable by a third party, a contract cannot be conditioned on this state. However, because information is symmetric, any negotiation of the sharing of the surplus in such a state will, given the symmetry of information, be efficient. Problems arise because the ex post sharing of the surplus need not be ex ante efficient. Contracts which are proof against renegotiation can still improve upon an allocation without any long-term contract by designing the environment of the renegotiation in the unverifiable state. Hart and Moore (1988) show how the ex ante contract can be constructed to affect the bargaining power of the two parties ex post. However, this literature is not as yet well developed, but other papers in this area are Aghion, Dewatripont and Rey, (1990) and Bolton (1990).

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4. Unforeseen Contingencies Because unforeseen contingencies may arise during the life of the contractual relationship, there is a need to fill in the consequent gap between obligations. Gap filling in general is discussed in Chapter 4000 (Contract Law). Renegotiation may be valuable as one would expect the contracting parties to be able to fill the gap at a lower cost than a third party, partly because the contracting parties can be assumed to have better information. As in the case of symmetric but unverifiable information, long-term contracts may allow the parties to at least partly design the environment under which the (re)negotiation takes place. In terms of modeling unforeseen contingencies, there is not as yet an agreed approach. What is clear is that at least for contract issues, simply treating unforeseen contingencies as events which occur with probability zero is not generally appropriate. If the contingency occurs with probability zero, the expected cost of not providing for it in a long-term contract is also zero, and hence the more flexible short-term contract would not appear to offer any advantage due to any unforeseen contingencies. For a survey of the state of the art as well as a discussion of incomplete contracts, see Dekel, Lipman and Rustichini (1998). The theory of residual control rights, developed in Grossman and Hart (1986) and Hart and Moore (1990), see also Hart (1995), offers one way in which we can approach the problem of modeling unforeseen contingencies. Residual control rights determine who has the right to decide on how a particular asset should be used whenever an unforeseen contingency occurs. Thus even if the actual event cannot be described, rules for who fills in the gap for a particular class of events can be described (see also Kreps, 1990). In general, in the case of unforeseen contingencies, the ability to renegotiate or put differently, contractual flexibility, may be efficiency enhancing rather than an added constraint.

5. Short-Term vs. Long-Term Contracts With asymmetric information, the possibility of renegotiation slows down info2mation revelation. This is equally true in the case where only a series of one-period (or spot) contracts can be signed, an effect known as the ratchet effect (see Freixas, Guesnerie and Tirole, 1985). What are then the fundamental differences between short-term and long-term contracts? The literature suggests that the performance of long-term contracts may differ from a series of short-term contracts for a number of reasons. The (transaction) costs of negotiating and policing one long-term contract may be lower than negotiating a series of short-term contracts. Long-term contracts

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may enable income smoothing if this is not available via credit markets. If regenotiation can be avoided, they also offer better commitment. Informational asymmetry may also favor long-term contracts. For a general discussion, see Hart and Holmstrom (1987). It is fairly obvious that differences in transaction costs may lead to differences in the performance of long-term and short-term contracts. Not only may the actual costs of writing the contracts be different, but if renegotiation is costly, the commitment aspect of long-term contracts may also be strengthened. This area does not appear to be well developed but see Dye (1985). In a principal-agent model of asymmetric information Malcomson and Spinnewyn (1988) show that, in the absence of renegotiation, long-term contracts can improve on short-term contracts only if they commit either the principal or agent to a payoff in some future circumstance which is lower than what could be obtained from a short-term contract negotiated if that circumstance occurs. Thus the long-term contract has to have some commitment value in order to be preferred to a series of short-term contracts. Similar results are obtained in Allen (1985). In the special case where the contracting parties have perfect information, Crawford (1988) shows that short-term contracting distorts investment decisions only when the efficient plan involves mainly sunk cost investment and the relationship plays a consumption smoothing role. In this case the main role for long-term contracts is to serve as a substitute for an efficient credit market. In a pure moral hazard principal-agent model, Chiappori et al. (1994) demonstrate that two conditions are necessary in order that there is no difference between what can be achieved by an optimal long-term contract and a series of spot contracts. Firstly, the long-term optimum must be renegotiation proof. This reduces the commitment value of a long-term contract. However, this is not sufficient. In addition, the spot contracts should provide efficient consumption smoothing. When the agent does not have access to credit markets, spot contracting does not allow for consumption smoothing and hence spot contracts cannot implement the long-term contract. However, if the agent has access to credit markets and the principal can monitor this, we do get spot implementation, a result also found in Fudenberg, Holmstrom and Milgrom (1990), Malcomson and Spinnewyn (1988) and Rey and Salanié (1990). The case where the agent has access to capital markets but where the access cannot be monitored is more complicated because the spot contract may involve more smoothing that the renegotiation-proof long-term contract. If consumption smoothing is a strong reason for preferring long-term contracts over short-term contracts, one might expect that in labor markets, the lower the wage, the more likely would be long-term employment contracts. This does not seem to be the case in reality. For this reason, Fudenberg, Holmstrom and Milgrom (1990) assume away any imperfect capital market

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influences and focus on problems caused by asymmetric information. They consider long-term contracts that cannot be renegotiated and set out the circumstances under which these have a value above a series of spot contracts or a contract which is renegotiation proof. Due to the asymmetric information, two types of adverse selection, which imply a value to the commitment of a long-term contract, can arise. The first case arises if the preferences of the principal and the agent over future contingent outcomes are not common knowledge. As was noted above, if more information about the agent becomes available over time, there may be scope for renegotiation. The second case arises when the outcome on some date $t$ conveys information on actions taken by the agent prior to that date. At date $t$, the principal, on the basis of this new information, may wish to punish or reward the agent for the past actions. However this is not possible if there is not a binding long-term contract. One of the main contributions of this paper is to make precise when there would be a benefit to ruling out renegotiation. The existing literature has demonstrated that even if renegotiation cannot be ruled out, long-term contracts may still dominate a series of short-term contracts. At the same time, the benefit of long-term contracts would be much enhanced if renegotiation could be at least limited.

6. Empirics Despite the huge problems of getting data, a substantial number of empirical studies have considered long-term contracts. A general survey and evaluation can found in Lyons (1996). An incomplete list of empirical case studies of long-term contracts include among others: Chisholm (1993) (the movie industry), Crocker and Lyon (1994), Crocker and Masten (1988, 1991) and Masten and Crocker (1985) (the design and duration of long-term contractual relationships for natural gas), Galassi (1992) (share contracts in early Renaissance Tuscany), Goldberg (1985a) (aluminium), Goldberg and Erickson (1987) (petroleum coke), Joskow (1985a, 1988, 1990) (contacts between electricity generators and coal suppliers), Lafontaine (1992) (franchising), Lyons (1994) (small subcontractors making specific inputs for customers in the engineering industry), Palay (1984) (rail freight).

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B. Relational Contracts 7. Relational Contracts: General The relational move appears to grow out of the empirical work by Macaulay (1963) with the origin of the term relational contract usually traced to MacNeil (1974). Given the impact of this work, it is surprising how few replications have been carried out to date. The best known of these is Beale and Dugdale (1975), but see also Kenworthy, Macaulay and Rogers (1996) and Esser (1996). The lack of replication is a concern because the modest sample sizes in these studies imply that the results are not generally statistically significant. For example, Macaulay’s sample was 68 businessmen and lawyers representing 43 companies and 6 law firms whereas Beale and Dugdale’s sample was 33 individuals in 19 firms of engineering manufacturers. Although in both cases the authors are careful to point out the potential weaknesses of their data, studies which rely on their results for motivation are less careful to point this out. The main empirical observation of relevance to the relational contract literature was that firms within the same industry tended to resort to neither contract terms nor contract law to settle disputes about obligations. Although persuasive, neither Macaulay (1963) nor Beale and Dugdale (1975, p. 47) offer any tests of statistical significance. Beale and Dugdale (1975, p. 47) do offer an insight into when the result did not hold, namely when firms in the sample were transacting with ‘outsiders’. ‘Firms frequently stated that they would take much greater care when contracting with relatively unknown parties, especially those outside the engineering trade’ (Beale and Dugdale, 1975, p. 47). From these studies it would appear that contracts have little relevance where the parties ‘knew’ each other. To aid a discussion of the contribution of relational contract scholarship, a clear definition of what is a relational contract would be helpful. However, although several have to date been offered, most of which are discussed in Eisenberg (1995), none appear to be universally accepted. Goetz and Scott (1981) argue that what makes a contract relational is that there are states of the world where obligations cannot ex ante be defined. ‘A contract is relational to the extent that the parties are incapable of reducing important terms of the arrangement to well-defined obligations. Such definitive obligations may be impractical because of the inability to identify uncertain future conditions or because of inability to characterize complex adaptations adequately even when the contingencies themselves can be identified in advance’ (Goetz and Scott, 1981, p. 1091). The central role for the relationship between the contracting parties for the duration of the contract would appear to be the manner in which a gap is filled.

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MacNeil, in a series of papers (MacNeil, 1974, 1978, 1981a, 1987a), highlights the importance of two principles of behaviour: solidarity and reciprocity. ‘Getting something back for something given neatly releases, or at least reduces, the tension in a creature desiring to be both selfish and social at the same time; and solidarity - a belief in being able to depend on another permits the projection of reciprocity through time’ (MacNeil, 1987a, pp. 274-275). The importance of these have been tested in Kaufmann and Stern (1988), who study how firms react to breach by a trading partner. They demonstrate how firms are initially very forgiving in order to maintain the relationship, but that once they judge that the partner has acted opportunistically, their attitude changes dramatically. For a discussion of this and other empirical work on relational contracts, see Lyons (1996, pp. 45-49). Relational contract theory can be seen as an attempt to generate a model able to explain when transacting parties do not resort to contracts and by what means they ensure that each party fulfils their obligations. The theory focuses on the relationship between the ‘contracting’ parties and posits that this leads to cooperation and to implicit obligations being self-enforcing. In the extreme, no formal contract is needed to ensure that all gains from a particular transaction are realized. The theory rests on repeated interaction within a particular well-defined group together with a set of norms governing the behaviour of the group members. Whereas the literature on long-term contracts focuses on the problems which arise because of incompleteness and the potential for renegotiation, the theory of relational contracts focuses on the relationship between the contracting parties which ensures that opportunistic behaviour does not arise. Unless we assume that individuals are naturally cooperative, the next step is to determine how cooperation might emerge anyway.

8. Endogenous Cooperation One way to understand the observations in Macaulay (1963), as well the attempts to define a relational contract, is as follows. If having the reputation of either keeping to a contract term, or modifying or bargaining to fill a gap in good faith, is sufficiently important (or valuable), the law is not needed to enforce this term. Reputation is valuable either when interacting with the same individual on several occasions or when interacting sequentially with several individuals. In a relational contract, the parties rely on each other to behave in a cooperative manner for the duration of the contract, rather than exploiting any opportunity which may come along. ‘Parties who enter contracts desire coordinated, and hence cooperative, actions on the part of their contracting opposites. Therefore, the principal measure of the success of our contract law is whether it in fact induces cooperation’ (Baird, 1990, p. 584).

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The remainder of this section considers briefly how and when cooperation can occur endogenously among, to follow MacNeil, creatures desiring to be both selfish and social at the same time. The discussion makes clear how norms can play an important role in this theory. The Folk Theorem and Repeated Games Repeated games consider the possibility of achieving cooperation through self-enforcing (possibly tacit) agreements. These are discussed more extensively in Chapter 0550 (Game Theory Applied to Law), see also Baird, Gertner and Picker (1995) and Hirshleifer (1994). Consider a game where the non-cooperative Nash equilibrium is Pareto dominated by another outcome. This is, for example, the case in the Prisoner’s Dilemma, or in a game where A must decide whether or not to lend B money and B must subsequently decide whether or not to pay A back. If the parties could write a binding contract, they could clearly implement a better outcome for both. If that is not the case, any (tacit) agreement to cooperate must be self-enforceable. Repeated interaction may enable cooperation, because of the potential for a current deviation to be punished in the future. For this to work, four conditions must be met. Any deviation must be observable and it must be punishable. This punishment must be credible so that it is clear that when required the punishment will be carried out, and the parties must be patient in the sense that the future matters to them. The folk theorem for repeated games, loosely speaking, states that if the players are sufficiently patient and the game is repeated for a sufficient number of periods, the players can cooperate to obtain a better outcome than the non-cooperative Nash equilibrium of the one-period game. Put differently, the short-term gain from deviation is more than offset by the present discounted value of the future punishment. The folk theorem generalizes to many different settings. Cases where there are uncertainty, informational asymmetries, differences in the identity of the players, overlapping generations of players and random matching between players can all give rise to folk theorem-type outcomes. Thus, for example, the repeated interaction does not have to be between the same two individuals over time. In order to cooperate, the parties have to ‘agree’ on two issues: which cooperative outcome should be support and which punishment should be used in case of a deviation. Although this agreement could be tacit, when we are talking about contractual relationships it is more natural to think of this as an explicit agreement. Not only are there typically many outcomes which could be supported, but each outcome may also be supportable by many different forms of punishment. Of the latter, the best known are Tit-for-Tat (each player in this period does what the other player did in the last period), the (Grim) Trigger Strategy (deviation is followed by non-cooperation in all future periods) and

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Stick and Carrot (severe punishment followed by forgiveness). Because there are many different potential punishments, norms may pay a crucial role in selecting which path is used. This is particularly important where the cooperation is between many different individuals over time. If A is willing to cooperate with or trust B because B cooperated with many other individuals in the past it is important that A understands if and when B is being punished. For more on this see Chapter 0780 (Non-legal Sanctions). Thus the theory would predict that cooperation is more likely between fairly homogeneous groups. There are cases where repetition does not admit cooperation. The most notable case is when the number of periods over which the game is played is finite and known, where the equilibrium of the one-period game is unique and where the exact characteristics of the players are known to all players. In the last period defection will occur because there is no future in which to punish this. But then cooperation in the penultimate period cannot be supported by a combination of a credible promise of cooperation in the last period combined with a threat of defection in the last period as a punishment. Much is made of this in Jolls (1997). However, if just one of the three conditions is violated, cooperation may emerge. If there is an uncertainty about whether this period is the last, then there is still a potential future and hence a future punishment to worry about if a player decides to deviate. If the stage game has multiple equilibria, cooperation may be possible because a credible threat consisting of the ‘worst’ equilibrium can be issued. If there is some small chance that one of the players is not a rational economic actor at all, but is an irrational type who will cooperate regardless, the rational type may prefer to maintain a reputation for being irrational. Some of the punishments which supports cooperative outcomes harm both the guilty and the innocent. In such cases, the innocent has an incentive to accept any request for forgiveness, which would destabilize the cooperative agreement as deviations from cooperation are not punished. Although there is no formal contract, this problem is one of renegotiation resembling that encountered in long-term contracts. A social norm entailing punishment for cheaters would clearly support cooperation. On the other hand, a social norm of forgiveness would not. Relational Contracts and Repeated Games Scott (1987b) represents an early, if incomplete, attempt to model long-term contracts as a repeated game. Unfortunately the paper does not fully utilize the then available theory on repeated games. Scott recognises that cooperation may arise without any contracts at all and points out that legal rules can affect both the formation of the contract (‘the initial risk allocation’) and later adjustments to the contract, but argue that the greater effect is on the initial risk allocation. This effect comes via implied terms and express invocations. Scott highlights

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the importance of norms, in particular the norm of ‘reciprocity’. The analysis is summarized as follows: Contracting parties use a mix of legal and extralegal mechanisms, as well as patterned and individualized responses, to ameliorate the information and enforcement deficits that threaten emergent patterns of cooperation. Nevertheless, contractual breakdowns are inevitable. Patterns of cooperation in contractual relationships are inherently unstable, especially where one party is threatened with substantial losses (or tempted with substantial gains). Where necessary adjustments are of lesser magnitude, however, social norms aimed at introducing long-term cooperation will often prompt adjustment, and legal rules provide appropriately remote, but harsh, deterrents and incentives. (Scott, 1987b, p. 2049)

Other attempts to model relational contracts using repeated games are found in Baird (1990), Baird, Gertner and Picker (1995), Campbell and Harris (1993), Hviid (1996, 1998) and, for an example of the use of experimental methods, Hackett (1994). One insight from the theory of repeated games is that successful cooperation does not necessarily involve observing either deviations or punishments. This does not reduce the importance of the punishment because it is what keeps opportunism in check. Contract law potentially affects the available punishments, their severity and the gains from deviation. Hadfield (1990) notes that in franchise contracts courts consistently fill gaps to the benefit of one side of the contract (the franchisor). This may severely hamper the ability of the franchisor to credibly promise to act in good faith. Contract terms also affect the ability to punish. The severity of the punishment can be increased by leaving the contract more incomplete than necessary (see Bernheim and Whinston, 1998; Hviid, 1998). Other examples are terms implying expensive third-party arbitration, rights to terminate the contract (for example, franchises), or demands of performance under the contract. All these terms can make non-cooperative behaviour potentially costly. Thus contract law and contract terms may matter even in relational contracts which are substantially relying on self-enforceable agreements and where the law is not seen to be used. Repetition may not in itself be sufficient to ensure cooperation. In some cases this depends on the available institutions. An interesting combination of repeated games and institutional design as a means to overcome incentives for short-term opportunistic behaviour is found in Greif, Milgrom and Weingast, (1994). They model the emergence of merchant guilds in the late medieval period as a response to the incentives of the ruler of a trade centre to opportunistically appropriate rents from some of the traders. In their model repetition as such is insufficient to ensure cooperative behaviour by a ruler because the ruler can abuse individual traders, whose threat of punishing the

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ruler by staying away from the centre is non-credible if most of the other relevant traders do not know about the abuse and hence continue to use the trading centre. Strong merchant guilds can credibly initiate a collective punishment (a boycott for a given period) by coordinating the actions of its members. One relevant lesson for relational contract theory is that institutions may still matter. Moreover, the institution of the guild had an effect even if a boycott was never observed in the same way that legal institutions may have an effect even if they are never seen to be active. Finally, what might on the face of it appear to be a mixture of relational and written contracts has been considered in Klein (1996), who argues that court enforcement and private enforcement need not be alternative contract enforcement mechanisms, but may be complements. The former may on its own generate too much rigidity, making it possible for one party to ‘hold-up’ the other when conditions change radically (one has to think of such radical changes as being insufficient to excuse performance, but radical enough that they were not covered by the original contract). The latter generates too much flexibility. The idea of Klein (1996) is that private enforcement creates a range of self-enforcement. So long as the change to the environment does not place the gains from a hold-up outside what can be negated by private punishment, the hold-up will not occur. Court-enforceable contract terms can be used to change this range, either by extending it, by shifting it, or by affecting the probability distribution over the value of a hold-up. It is in this way that court and private enforcement becomes complementary. It is worth noting that unless the definition of a relational contract is weakened, it does not seem that the framework in Klein (1996) provides an economic justification for relational contracts since the contract terms which have been agreed must be enforced, that is, there is nothing relational about that part of the contract. Moreover, if the courts fail to enforce the terms of a contract literally, then this may paradoxically create more scope for hold-ups.

9. Concluding Remarks The impact of the relational contract theory on the economic literature on incomplete long-term contracts as well as mainstream law appears to date to have been relatively modest. This may partly be because ‘it is impossible to locate, in the relational-contract literature, a definition that adequately distinguishes relational and non-relational contracts in a legally operational way - that is, in a way that carves out a set of special well-specified contracts for treatment under special well-specified rules’ (Eisenberg, 1995, p. 291; see also Craswell and Schwartz, 1994, p. 199). If this is not the case, there appears little point to making the distinction and given the lack of a common jargon

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between economics and law, it is not clear what would be achieved by relabelling contracts. The main contribution of the relational contract theory so far would appear to be to highlight the potential importance of the relationship between the contracting parties and the social groups to which these belong, including the importance of norms and non-legal sanctions. However, the success or failure of transacting does not solely depend on the relationship between the contracting parties, because contracts also play a significant role. A fruitful way to look at contracts would be as a combination of legally enforceable and self-enforceable obligations. This recognises that whereas some obligations need to be self-enforceable because third parties cannot verify the facts giving rise to a particular obligation, others need to be self-enforceable because of the (transactions) space costs of using the legal system. Moreover, in order to cope with unforeseen contingencies, the parties may either rely on each other to handle the new situation in good faith, or, by using the contract to allocate residual control rights, place the onus on a particular party. The paper by Klein (1996) is a promising step in that direction, offering the possibility of a more balanced view between incomplete contract theory and relational contract theory.

Acknowledgements I would like to thank David Campbell, Bruce Lyons and an anonymous referee for helpful comments on the first draft. They are naturally blameless for any remaining errors and shortcomings.

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4300 CONTRACT FORMATION © Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest

Bibliography Collected by the Editors Adams, Michael (1984), ‘Ökonomische Analyse des Gesetzes zur Regelung des Rechts der Allgemeinen Geschäftsbedingungen’, in Neumann, M. (ed.), Ansprache, Eigentums- und Verfügungsrechte, Berlin, Duncker and Humblot, 655-680. Adams, Michael (1986), ‘Zur Behandlung von Irrtümern und Offenbarungspflichten im Vertragsrecht (On Mistake and Information Revelation Duties in Contract Law)’, 186 Archiv für die Civilistische Praxis, 453-489. Barnes, David W. and Stout, Lynn A. (1992), Economics of Contract Law, Minneapolis, West Publishing. Barnett, Randy E. and Becker, Mary E. (1987), ‘Beyond Reliance: Promissory Estoppel, Contract Formalities, and Misrepresentation’, 15 Hofstra Law Review, 443 ff. Baudenbacher, Carl (1983), ‘Echtliche Grundprobleme der Allgemeinen Geschäftsbedingungen (Standard Term Clauses: Basic Problems of Economic, Liability and Procedural Law)’, in Zurich, Schulthess (ed.), Wirtschafts- schuld- und verfahrens. Bessone, Mario (1984), ‘Gli “standards” dei Contratti di Impresa e l’Analisi Economica del Diritto (The ‘Standards’ in Contracts and Economic Analysis)’, Giurisprudenza di merito, 982-987. Birmingham, Robert L. (1988), ‘The Duty to Disclose and the Prisoner’s Dilemma:’, William & Mary Law Review, 249-283. Bishop, William (1980), ‘Negligent Misrepresentation through the Economists’ Eyes’, 96 Law Quarterly Review, 360-379. Bishop, William (1981), ‘Negligent Misrepresentation: An Economic Reformulation’, in Burrows, Paul and Veljanovski, Cento G. (eds), The Economic Approach to Law, London, Butterworths, 167-186. Bouckaert, Boudewijn and Schäfer, Hans-Bernd (1995), ‘Mistake of Law and the Economics of Legal Information’, in Bouckaert, Boudewijn and De Geest, Gerrit (eds), Essays in Law and Economics II: Contract Law, Regulation, and Reflections on Law and Economics, Antwerpen, Maklu, 217-245. Braunstein, Michael (1989), ‘Remedy, Reason, and the Statute of Frauds: A Critical Economic Analysis’, Utah Law Review, 383-431. Campbell, David (1997), ‘The Relational Constitution of Contract and the Limits of Economics: Kenneth Arrow on the Social Background of Markets’, in Deakin, Simon and Michie, Jonathan (eds), Contracts, Co-operation and Competition: Studies in Economics, Management and Law, Oxford, Oxford University Press, 529-596. Caruso, Daniela (1991), ‘Note in tema di danni precontrattuali (Nota a Cass., 11 maggio 1990, n. 4051, Bellucci c. Min. difesa) (Notes about Precontractual Damages)’, 1 Il Foro Italiano, 188-200. Caruso, Daniela (1991), ‘Relazioni Precontrattuali e Teoria dei Giochi (Precontractual Relations and Game Theory)’, Quadrimestre, 810-832.

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Caruso, Daniela (1993), La Culpa in Contrahendo - L’Esperienza Statunitense e Quella Italiana (Culpa in Contrahendo - The American and Italian Experience), Milano, Giuffrè. Castermans, A.G. (1989), ‘Schadevergoeding bij Dwaling (Damages for Misrepresentation)’, Rechtsgeleerd Magazijn Themis, 136-146. Castermans, A.G. and Notermans, R. (1985), ‘Naar een Economische Analyse van de Mededelingsplicht bij Dwaling (Towards an Economic Analysis of the Duty to Inform in Misrepresentation Law)’, BW-krant Jaarboek 1985, BW-NBW: twee sporen, één weg, Leiden, Rijksuniversiteit Leiden, 141-155. Chisholm, Darlene C. (1996), ‘Continuous Degrees of Residual Claimancy: Some Contractual Evidence’, 3 Applied Economics Letters, 739-741. Coleman, Jules, Heckathorn, Douglas D. and Maser, Steven M. (1989), ‘A Bargaining Theory Approach to Default Provisions and Disclosure Rules in Contract Law’, 12 Harvard Journal of Law and Public Policy, 639-709. Craswell, Richard (1988), ‘Precontractual Investigation as an Optimal Precaution Problem’, 17 Journal of Legal Studies, 401-436. Craswell, Richard (1996), ‘Offer, Acceptance and Efficient Reliance’, 48 Stanford Law Review, 481-553. Curnes, Ellen J. (1987), ‘Protecting the Virginia Homebuyer: A Duty to Disclose Defects’, 73 Virginia Law Review, 459-481. Daintith, Terence C. (1987), ‘Oprettelse og Anvendelse af Langfristede Kontrakter (The Creation and Use of Longterm Contracts)’, in Blegvad, Britt-Mari and Collin, Finn (eds), Virksomheden Mellem ¢konomi og Jura (The Firm between Law and Economics), Samfundslitteratur. Dalzell, John (1942), ‘Duress by Economic Pressure’, 20 North Carolina Law Review, 237-277. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 67-72. Reprinted in Goldberg, Victor P. (ed.) (1989), Readings in the Economics of Contract Law, 188-193. De Geest, Gerrit (1995), ‘Contracting by Way of Non-Simultaneous Assent: An Economic Analysis of Irrevocable Offers, Clauses for the Benefit of a Third Party, Assignments and Testaments’, in Bouckaert, Boudewijn and De Geest, Gerrit (eds), Essays in Law and Economics II: Contract Law, Regulation, and Reflections on Law and Economics, Antwerpen, Maklu, 9-27. Diamond, Peter A. and Maskin, Eric (1979), ‘An Equilibrium Analysis of Search and Breach of Contract, I: Steady States’, 10 Bell Journal of Economics, 282-316. Diamond, Peter A. and Maskin, Eric (1981), ‘An Equilibrium Analysis of Search and Breach of Contract II: A Nonsteady State Example’, 25 Journal of Economic Theory, 165-195. Dnes, Anthony W. (1995), ‘The Law and Economics of Contract Modifications: The Case of Williams v. Roffey’, 15 International Review of Law and Economics, 225-240. Duggan, A.J. (1982), ‘An Economic Analysis of Standard Form Contracts’, in Cranston, Ross and Schick, Anne (eds), Law and Economics, Canberra, Australian National University, 145-162. Duggan, A.J. (1995), ‘Silence as Misleading Conduct: An Economic Analysis’, in Richardson, Megan and Williams, Philip (eds), The Law and the Market: Essays in Honour of Maureen Brunt, Melbourne, The Federation Press, 195-223.

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Eisenberg, Melvin Aron (1979), ‘Donative Promises’, 47 University of Chicago Law Review, 1-33. Eisenberg, Melvin Aron (1982), ‘The Bargain Principle and its Limits’, 95 Harvard Law Review, 741-801. Epstein, Richard A. (1975), ‘Unconscionability: A Critical Reappraisal’, 18 Journal of Law and Economics, 293-315. Feeny, David, Berkes, Fikret, McCay, Bonnie J. and Acheson, James M. (1990), ‘The Tragedy of the Commons: Twenty-Two Years Later’, 18(1) Human Ecology, 1-19. Fishman, Michael J. and Hagerty, Kathleen M. (1990), ‘The Optimal Amount of Discretion to Allow in Disclosure’, 104 Quarterly Journal of Economics, 427-444. Fuller, Lon L. (1941), ‘Consideration and Form’, 41 Columbia Law Review, 799 ff. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 40-45. Gallo, Paolo (1992), ‘Errore sul Valore, Giustizia Contrattuale e Trasferimenti Ingiustificati di Ricchezza alla Luce dell’Analisi Economica del Diritto (Mistake on Value, Contractual Justice and Unjust Enrichment)’, Quadrimestre, 656-703. Goldberg, Victor P. (1977), ‘Competitive Bidding and the Production of Pre-contract Information’, 8 Bell Journal of Economics, 250-261. Hatzis, Aristides N. (1997), The Absence of Theory: Common vs. Civil Contract Law, paper presented at the XIVth Annual Conference of the European Association of Law & Economics, held at Barcelona, September 4-6, 1997. Hatzis, Aristides N. (1998), An Economic Theory of Greek Contract Law, Ph.D. Thesis, University of Chicago Law School. Holm, Hakan J. (1995), ‘Computational Cost of Verifying Enforceable Contracts’, 15 International Review of Law and Economics, 127-140. Johnston, Jason Scott (1990), ‘Strategic Bargaining and the Economic Theory of Contract Default Rules’, 100 Yale Law Journal, 615-664. Katz, Avery (1990a), ‘The Strategic Structure of Offer and Acceptance: Game Theory and the Law of Contract Formation’, 89 Michigan Law Review, 215-295. Katz, Avery (1990b), ‘Your Terms or Mine: The Duty to Read the Fine Print in Contracts,’, 21 Rand Journal of Economics, 518-537. Katz, Avery (1993), ‘Transaction Costs and the Legal Mechanics of Exchange: When Should Silence in the Face of an Offer be Construed as Acceptance?’, 9 Journal of Law, Economics, and Organization, 77-97. Katz, Avery (1996), ‘The Economics of Promissory Estoppel in Preliminary Negotiations’, 105 Yale Law Journal, 1249-1309. Koboldt, Christian (1991), ‘Kommentar on Schanze, Stellvertretung und ökonomische Agentur-Theorie’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Ökonomische Probleme des Zivilrechts, Berlin, Springer, 76-86. Koch, Harald (1981), ‘Die Ökonomie der Gestaltungsrechte. Möglichkeiten und Grenzen der ökonomische Analyse des Rechts am Beispiel von Kündiging und Anfechtung (The Economics of Dispositive Right. Possibilities and Limits of the Economic Analysis of Law)’, in Bernstein, H., Drobnig, U. and Kötz, H. (eds), Festschrift für Konrad Zweigert zum 70. Geburtstag, Tübingen, Mohr, 851-877. Kornhauser, Lewis A. (1976), ‘Unconscionability in Standard Forms’, 64 California Law Review, 1151 ff.

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Kostritsky, Juliet P. (1989), ‘Illegal Contracts and Efficient Deterrence: A Study in Modern Contract Theory’, 74 Iowa Law Review, 115-163. Krauss, Michael I. (1986), ‘L’affaire Lapierre: vers une Théorie Economique de l’Obligation Quasi-Contractuelle (The Lapierre Case: Toward an Economic Theory of the Quasi-Contractual Obligation)’, 31 McGill Law Journal, 683-721. Kronman, Anthony T. (1978), ‘Mistake, Disclosure, Information, and the Law of Contracts’, 7 Journal of Legal Studies, 1-34. Kull, Andrew (1992), ‘Reconsidering Gratuitous Promises’, 21 Journal of Legal Studies, 39-65. Lehmann, Michael (1980), ‘Die Untersuchungs- und Rügepflicht des Käufers in BGB und HGB. Rechtsvergleichender Überblick - ökonomische Analyse (The Duty to Examine and Notify a Defect in the German Civil and Commercial Code. A Comparative Survey - Economic Analysis)’, Wertpapiermitteilungen, 1162-1169. Lehmann, Michael (1981), Vertragsanbahnung durch Werbung (Contract Formation by Advertising), München, Beck. MacNeil, Ian R. (1984), ‘Bureaucracy and Contracts of Adhesion’, 22 Osgoode Hall Law Journal, 5-28. Mather, Henry (1982), ‘Contract Modification under Duress’, 33 North Carolina Law Review, 615-658. Miceli, Thomas J. (1995), ‘Contract Modification when Litigating for Damages is Costly’, 15 International Review of Law and Economics, 87-99. Orlic, V. Miodrag (1993), Zakljucivanje Ugovora (Conclusion of Contracts), Institut za uporedno pravo, Beograd. Ott, Claus (1991), ‘Vorvertragliche Aufklärungspflichten im Recht des Güter- und Leistungsaustausches (Precontractual Obligation to Provide Information in the Law)’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Ökonomische Probleme des Zivilrechts, Berlin, Springer, 142-162. Ott, Claus (1995), ‘Comment: Contracting by Way of Non-Simultaneous Assent in the German Civil Code’, in Bouckaert, Boudewijn and De Geest, Gerrit (eds), Essays in Law and Economics II: Contract Law, Regulation, and Reflections on Law and Economics, Antwerpen, Maklu, 29 ff. Pacces, Alessio and Pardolesi, Roberto (1997), ‘Clausole Vessatorie in Crisi d’Identità. Appunti di Analisi Economica del Diritto (The Identity Crisis of Unfair Terms. Remarks of Economic Analysis of Law)’, in Furgiuele (ed.), Diritto privato, Padova. Parisi, Francesco (1987), Il Contratto Concluso Mediante Computer (The Formation of Contracts Via Computer), Cedam. Png, Ivan Paak-Liang and Lee, T.K. (1990), ‘The Role of Instalment Payments in Contracts for Services’, 21 Rand Journal of Economics, 83-99. Posner, Eric A. (1995), ‘Contract Law in the Welfare State: A Defense of the Unconscionability Doctrine, Usury Laws, and Related Limitations on the Freedom to Contract’, 24 Journal of Legal Studies, 283-319. Posner, Eric A. (1996), ‘Norms, Formalitiies, and the Statute of Frauds: A comment on “Discovering Contract”’, 145 University of Pennsylvania Law Review, 1971-1986. Posner, Richard A. (1977), ‘Gratuitous Promises in Economic and Law’, 6 Journal of Legal Studies, 411-426. Rasmusen, Eric and Ayres, Ian (1993), ‘Mutual and Unilateral Mistake in Contract Law’, 22 Journal of Legal Studies, 309-343.

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Robinson, Thorton (1983), ‘Enforcing Extorted Contract Modifications’, 68 Iowa Law Review, 699-707. Roth, Gabriel (1977), ‘Der Schutzzweck richterlicher Kontrolle von AGB’ (The Protection Goal of the Judicial Control of Standard Term Clauses)’, 4(2) Österreichische Zeitschrift für Wirtschaftsrecht, 32-37. Rottenberg, Simon (1985), ‘Mistaken Judicial Activism: Proposed Constraints on Creditor Remedies’, 4 Cato Journal, 335-350. Reprinted in Dorn, James A. and Manne, Henry G. (eds), Economic Liberties and the Judiciary, Fairfax, George Mason University Press, 1987, 335-349. Schanze, Erich (1991), ‘Stellvertretung und ökonomische Agentur-Theorie - Probleme und Wechselbezüge (The Law of Agency and Agency Theory - Problems and Relations)’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Ökonomische Probleme des Zivilrechts, Berlin, Springer, 60-75. Scheppele, Kim Lane (1988), Legal Secrets, Equality and Efficiency in the Common Law, Chicago, University of Chicago Press, 363 p. Schwartz, Alan (1977), ‘A Re-examination of Nonsubstantive Unconscionability’, 63 Virginia Law Review, 1053-1083. Shavell, Steven (1991), ‘An Economic Analysis of Altriusm and Deferred Gifts’, 20 Journal of Legal Studies, 401-421. Smith, Janet Kiholm and Smith, Richard L. (1990), ‘Contract Law, Mutual Mistake, and Incentives to Produce and Disclose Information’, 19 Journal of Legal Studies, 467-488. Spier, Kathryn E. (1992), ‘Incomplete Contracts and Signalling’, 23 (3) Rand Journal of Economics, 432-443. Stout, Lynn A. and Barnes, David D. (1992), Economics of Contract Law, Minneapolis, West Publishing. Trebilcock, Michael J. (1976), ‘The Doctrine of Inequality of Bargaining Power: Post-Benthamite Economics in the House of Lords’, 26 University of Toronto Law Journal, 359-385. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 78-92. Trebilcock, Michael J. (1980), ‘An Economic Approach to the Doctrine of Unconscionability’, in Reiter, Barry J. and Swan, John (eds), Studies in Contract Law, Toronto, Butterworths. Trebilcock, Michael J. (1988), ‘The Role of Insurance Considerations in the Choice of Efficient Civil Liability Rules’, 4 Journal of Law, Economics, and Organization, 243-265. Trebilcock, Michael J. and Dewees, Donald N. (1981), ‘Judicial Control of Standard Form Contracts’, in Burrows, Paul and Veljanovski, Cento G. (eds), The Economic Approach to Law, London, Butterworths, 93-119. Villa, Gianroberto (1988), ‘Errore Riconosciuto, Annullamento del Contratto ed Incentivi alla Ricerca di Informazioni (Known Mistake, Contract Avoidance and Incentives Towards Acquisition of Information)’, Quadrimestre, 286-300. Wils, Wouter P.J. (1993), ‘Who Should Bear the Costs of Failed Negotiations? A Functional Inquiry into Precontractual Liability’, 4 Journal des Economistes et des Etudes Humaines, 93-134.

4400 IMPLIED TERMS AND INTERPRETATION IN CONTRACT LAW George M. Cohen Edward F. Howrey Research Professor of Law, University of Virginia School of Law © Copyright 1999 George M. Cohen

Abstract This chapter examines the economic arguments for textualism and contextualism, the two primary methodologies used by courts to determine the intentions of contracting parties with respect to their performance obligations. Textualism, which is rooted in the idea of complete contracting, calls for a more restrictive approach to implied terms and interpretation than contextualism, which is rooted in the idea of incomplete contracts. The primary conclusions are that, as in other areas of contract law, the choice between the two interpretive methodologies depends on the transaction costs of drafting, the relative likelihood of court error, and the risks of opportunistic behavior. Neither methodology dominates so much that it should be uniformly employed, which is consistent with how courts actually behave. JEL classification: K12 Keywords: Contracts, Completeness, Interpretation, Implied Terms, Opportunism, Contextualism, Textualism

1. Introduction Questions of how courts interpret, and should interpret, contract terms and when courts imply, and should imply, terms to which the contracting parties have not explicitly agreed, loom large in contract disputes and in the legal literature on contract law. Law and economics scholars, however, have written far more extensively on other topics in contract law than on these questions. For example, Judge Posner’s treatise has no section specifically discussing interpretation or implied terms, and discusses contractual good faith in only two paragraphs (Richard Posner, 1998, pp. 103, 126). Other leading textbooks also have no discussion of interpretation or implied terms. One possible explanation for this discrepancy is that there is little need for research specifically on interpretation and implied terms because much of the economic analysis of other areas of contract law carries over straightforwardly to these

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questions. An alternative explanation is that economic analysis has less to say about interpretation methods than it does about other questions in contract law. This article, which will summarize and expand on the literature that does exist, aims to demonstrate that economic analysis has a good deal to say about interpretation questions, but the issues are complex and there are many fruitful avenues for further research. The argument that there is no real need for a separate economic analysis of interpretation and implied terms stems from the fact that the delineation of the topic is based on legal rather than economic considerations. In contract law, interpretation usually refers to problems arising from express contract terms that are reasonably susceptible of more than one meaning. Implied terms are those that are added to, or place limits on, expressly stated terms. The two are closely related, yet not identical. For example, if a contract contains a ‘best efforts’ clause, determining what that clause requires is a question of interpretation; if the contract contains no such clause, courts may have to decide whether to imply a best efforts obligation, and if they do, they have to determine the content of that obligation. On the other hand, some questions of interpretation do not involve questions of implication, for example, a dispute over the meaning of the word ‘chicken’. In some sense, all contract disputes involve questions of interpretation and implied terms. For example, force majeure clauses - usually discussed in the context of the (implied) impossibility defense - present questions of interpretation, and most contract formation, excuse, and damage rules are ‘implied terms’. But contract law has generally used the labels ‘interpretation’ and ‘implied terms’ more narrowly, to refer to questions of contract performance, rather than questions of formation, excuse, defense, or remedy. That is, the legal issue addressed by these doctrines is whether one or more parties have performed as the contract requires, or have breached. Thus, I will assume for purposes of this discussion that the parties have made an enforceable contract, there are no changed circumstances or ‘mistakes’ sufficient to give rise to an excuse claim, the applicable remedies in the event of breach are accepted, and there are no third-party effects. How do courts decide - and how should they decide - what the performance obligations are and whether the parties have met them?

2. Complete or Incomplete Contracts Economic analyses of contract law have tended to start with the idealized concept of a ‘complete’ contract, though this term has perhaps engendered more confusion than clarity. Traditionally, a complete contract has referred to one that provides a complete description of a set of possible contingencies and

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explicit contract terms dictating a performance response for each of these contingencies (Al-Najjar, 1995; Hart and Moore, 1988). Contingencies include changes in ‘exogenous’ economic variables, such as a production cost increase. But they also include ‘endogenous’ behavioral responses, such as falsely claiming a cost increase or seeking refuge from a now-disadvantageous bargain behind a contract term intended to serve a different purpose. Economic analyses generally conclude that if a contract is complete, there is no beneficial role for a court other than to enforce the contract according to its terms; that is, incompleteness is a necessary, though not sufficient, condition for an active court role in interpretation and implied terms. But because no real-world contracts are fully complete in this sense, the concept of completeness does not get us very far. The concept can be rescued in one of three ways. One way is to view completeness as a useful benchmark, similar to perfect competition. Just as some markets are close enough to being perfectly competitive that the perfect competition model is a useful predictor, so some contracts may be complete enough that no reasonable interpretation or implied term questions arise. The law refers to these contracts as ‘integrated’. But tying completeness to integration simply reduces to a tautology the statement that a complete contract obviates the need for interpretation or implied terms. The question is how do courts know when a contract is complete in this sense. One way courts can know a contract is complete is if the parties tell them. Thus, a second way to rescue completeness is to recognize that contracting parties can make a contract complete by using general ‘catchall’ clauses that state what happens in all unspecified states of the world (Hermalin and Katz, 1993, p. 236; Hadfield, 1994, p. 160, n.5). For example, a catchall clause might state: ‘The price term will be x, and will apply regardless of any change in circumstances or conduct by either party’. Alternatively, the parties could state their general desire not to have courts interpret or imply terms. But although contracting parties often use general clauses such as merger clauses, which direct a court to apply a particular interpretive methodology (that is, do not look beyond the writing), they do not seem to use catchall clauses that are broad enough to make contracts complete. Of course, clauses that are not stated as catchalls could be - and sometimes are - interpreted that way, but, to lawyers at least, if not economists, that act of interpretation then requires justification (Hadfield, 1994, p. 160). Even clauses that are stated as catchalls might require interpretation (Charny, 1991). Moreover, contracting parties often use contracting clauses that are the exact opposites of completeness catchalls: general clauses such as ‘good faith’ or ‘best efforts’ clauses signal contracting incompleteness, as opposed to completeness (Hadfield, 1994, p. 163). A third way to rescue completeness, more common in formal economic modeling, is to tie the concept of completeness to the efficient use of available

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information. A complete contract is one that makes full use of the private information available to the contracting parties (Hermalin and Katz, 1993, p. 235). The point of this definition is to make clear that parties can write efficient contracts that do not expressly specify the response to every contingency, yet obviate the need for court intervention (Hermalin and Katz, 1993, p. 242). But the fact that parties may in a simplified model be able to write ‘economically complete’ contracts does not answer the question of whether in a given legal dispute they have in fact written one. And the ability of private parties to write economically complete contracts in the real world is unclear. We do not seem to see, for example, contracts of the type described by Hermalin and Katz, in which the contract leaves the quantity and price unspecified, then after some period one party names the price and the other names the quantity. Perhaps the costs of writing these contracts (including the costs of strategic circumvention) are too high. Perhaps the current enforcement regime interferes with, or discourages, the parties, writing of such contracts, though this seems unlikely. It seems fair to say, however, that many if not most contracts are incomplete, or at least the question of their completeness is itself a legitimate question for judicial interpretation. The incompleteness may be intended by both parties, which creates so-called ‘relational contracts’ (Goetz and Scott, 1981), or ‘fiduciary contracts’ (Easterbrook and Fischel, 1983, p. 438). It may result from unintended ‘formulation error’ which occurs when, as a result of defective contractual instructions, the occurrence of some contingency produces surprising consequences (Goetz and Scott, 1985, p. 267, n. 11). It may result from strategic withholding of information by one party. Or incompleteness may result from court error. Whether a contract that the parties think is complete, but is misinterpreted by a court, should in fact be viewed as an ‘incomplete’ contract depends on how completeness is defined. If completeness is defined with reference to the obviation of interpretive questions, the definition must assume that completeness means that a contract’s terms are ‘unambiguous’, that is, the contract terms represent a confluence of the parties’ intentions and the court’s ability to interpret those intentions correctly (unless the contract is somehow self-enforcing). Incomplete contracts may be efficient contracts, even if the incompleteness is unintended. The costs of contractual completeness would often exceed the benefits, just as the costs of reducing crime or pollution or accidents to zero would exceed the benefits. Incomplete contracts will tend to be efficient when contracts are relatively complex, that is, when there are a large number of low-probability contingencies that could affect the value of contractual performance, and the efficient responses to those contingencies vary greatly and so cannot easily be specified in advance (Hadfield, 1994, p. 165, n.15). In these cases the transaction costs of negotiating, drafting, monitoring, and enforcing a complete contract are high.

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More generally, in the language of institutional economics, a complete contract is only one form of ‘governance mechanism’ for guiding the behavior of contracting parties (Al-Najjar, 1995). Alternative governance mechanisms include the courts and extralegal enforcement, such as social sanctions and reputation. In this approach, incomplete contracts will tend to be efficient whenever governance mechanisms superior to a detailed contract exist, that is, whenever the opportunity costs of completeness are high. In fact, contrary to the usual economic approach, the actual historical development of contracts is probably best described as starting as incomplete as possible, then becoming more complete and formal as governance mechanisms other than the written contract proved to be inadequate. The question of contract interpretation and implied terms is really a question of when the courts are a superior governance mechanism. Courts may be able through interpretation and implied terms to provide necessary flexibility - efficient adjustments to contingencies - that an incomplete contract otherwise lacks. Courts may also be superior to nonlegal institutions such as reputation because reputation effects may be weak due to such things as cognitive dissonance, optimism about the ability of a party with a poor reputation to change, the difficulty of knowing when a contracting partner has behaved badly, and the last period problem. In general, the role for courts in interpreting contracts and implying terms increases as contracts become more efficiently incomplete.

3. Incomplete Contracts and Contractual Intent Now suppose the contract is incomplete, as are most contracts that are the subject of litigation. What should a court do? The economists’ (and courts’) usual assumption is that courts should follow the intentions of the parties, but to admit incompleteness is to admit that the intention of the parties is uncertain, or at least disputed (some would say nonexistent). The next best solution is to adopt the term - or interpretive methodology - the parties would have chosen had they bargained over the matter, that is, presumed or hypothetical intent. But how is presumed intent determined? There are two general possibilities on which economic analyses have focused (Hadfield, 1992, 1994, p. 161). First, courts might presume that complete contracting is both feasible and desirable. This presumption has both a positive and a negative component. On the positive side, the express terms of the contract are presumed to be the best approximations of the parties’ intentions and deemed to create a complete contract. This strategy is usually referred to as textualism. On the negative side, if parties fail to write a complete contract, the incompleteness is presumed to be inefficient, whether unintended

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or strategic, and the court’s approach should be to deter this behavior and encourage complete contracting. This strategy is a variant of what has come to be known as penalty defaults (Ayres and Gertner, 1989), which is itself a variant of an old idea in the Austrian School of economics that individuals should bear the consequences of their actions so that they become more rational over time (for example, Wonnell, 1986, p. 520). The second general approach involves a presumption that contractual incompleteness is unavoidable and/or desirable, due to limitations of money, time, comprehension and foresight (Hadfield, 1992, p. 259). The courts then fill in the gaps by presuming the parties intended to contract with reference to some standard external to the written contract. Courts might presume parties contracted with reference to their current (course of performance) or prior (course of dealing) conduct, or to the conduct and understandings of similarly situated parties (trade usage or custom or business mores). Strategies that focus on these presumptions, which are featured predominantly in the Uniform Commercial Code, are usually referred to as contextualist. Alternatively, courts might presume the parties contracted with the expectation that courts would fill in any gaps with a joint maximizing term that would have been written by rational parties under conditions of low transaction costs (Goetz and Scott, 1981). In practice, the joint maximization strategy will often dissolve into contextualism, as courts lack the data necessary to do pure joint maximization. It is important to remember that all of these strategies involve presumptions. It is all too easy for courts or proponents of a particular strategy to criticize the alternatives as failing to hew closely enough to the parties’ intentions, when in fact the parties’ intentions in incomplete contracts are at least uncertain, and the question is which strategy is more likely to be successful at approximating these intentions. For example, suppose a buyer rejects goods delivered late after the market price drops below the contract price. A court might be called upon to decide whether to imply a good faith limitation on the buyer’s ability to reject. A textualist might argue no on the ground that such an implication would be contrary to the parties’ intentions as expressed in the time of delivery term. But the parties’ intentions - whether actual or hypothetical - may well be that a good faith obligation should be implied rather than that the time of delivery term should be interpreted as absolute. A proposition that textualism, contextualism, penalty defaults, or joint maximization best represents the parties’ intentions needs to be defended. Economic analysis can help to identify the conditions under which the various interpretive strategies are more likely to approximate the parties’ intentions, and whether courts are better off pursuing a pure interpretive strategy or a mixed one.

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4. Default versus Mandatory Rules and Contractual Intent The recognition of incomplete contracting and the uncertainty of contractual intent renders problematic another distinction that has played an important role in economic discussions of contracts, namely default rules versus mandatory rules. The term ‘default rule’ refers to several different characteristics: (1) if the parties specify some contract term, the court will enforce that term; (2) if the parties fail to specify some contract term, the court will fill in the gap and supply one; and (3) if the parties fail to specify some contract term but do not want the court to fill in the gap, the court will honor that intent (that is, the gap-filling rule itself is a default). UCC § 2-305 on open price terms is a good example of a rule that satisfies all three characteristics. Default rules are usually contrasted with mandatory rules, which term can also refer to three characteristics. Mandatory rules can refer to situations in which the court knowingly: (1) imposes a term that contradicts a term the parties specified; (2) refuses to fill in a gap that the parties left when the parties wanted the court to fill the gap; and (3) fills in a gap that the parties did not want the court to fill in. When economists refer to mandatory terms, they usually mean the first sense, that is the court rejecting a term the parties specified. An example would be a liquidated damage clause deemed to be a penalty, or a term deemed to be unconscionable. The usual critique of mandatory terms is that because they disregard the intentions of the parties, the parties who prefer these terms will be made worse off. For example, if a court imposes a stronger performance obligation on an obligor than the parties intended, then future obligors will extract a higher price, which is more than the obligee wanted to pay (else he would have paid for it originally) (for example, Easterbrook and Fischel, 1993, p. 431). This critique makes sense if contracts are assumed to be complete. But once we allow for the possibility of efficiently incomplete contracts and unclear intent, it becomes much more difficult to distinguish mandatory rules from default rules. Take, for example, the implied duty of good faith, or the duty of loyalty in fiduciary contracts. Are these defaults or mandatory rules? That depends on how well one thinks the duty of good faith tracks contractual intent. If one believes that parties may write incomplete contracts for which they expect courts to fill in the gaps, the duty of good faith or the duty of loyalty might easily be viewed as a default. If the parties want a particular obligation that conflicts with what courts ordinarily view as good faith or loyalty, and they specify that obligation, courts will generally enforce it. This is the view espoused by Easterbrook and Fischel (1993). On the other hand, if one believes that courts use the duty of good faith or the duty of loyalty to fill in gaps that the parties did not want to be filled, or to reject obligations the parties thought they had fully specified, then the duty of good faith looks more like a mandatory term. UCC § 1-102(3) evidences this ambivalence about the good faith obligation.

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The mirror image issue is presented by the doctrine of certainty, which says that courts may sometimes decline to fill gaps the parties have left in contracts. The doctrine could be viewed as a default if one is willing to presume that when the parties have left ‘too many’ gaps for the courts to fill, they do not have contractual intent, and if they do have such intent they will override the default by filling in the terms themselves. Alternatively, the doctrine could be viewed as a mandatory rule if one assumes that the courts use it to refuse to fill in gaps when the parties wanted them to. The point is that the labels ‘default’ and ‘mandatory’ are conclusions that can mask the assumptions being made about contractual completeness and intent, and so do not by themselves resolve the questions of implied terms and interpretation.

5. Unintended or Strategic Incompleteness: Encouraging Better Contracting If the contracting parties wanted to write a complete contract but failed in some way, the failure can be viewed as analogous to an accident in tort law. The accident may occur because one or both parties failed to take cost-effective ‘contract-based precautions’ (Cohen, 1992, p. 949). Alternatively, one of the parties might make a contract incomplete to serve his strategic bargaining interests by withholding information. In either case, courts can use the doctrines of interpretation and implied terms to encourage the parties to ‘facilitate improvements in contractual formulation’ (Goetz and Scott, 1985, p. 264). One way to encourage better contracting is to encourage more complete contracts, that is, the greater use of express written terms. If a court is willing to ‘insure’ parties through flexible interpretations and implied terms it creates a classic moral hazard problem: the parties have less incentive to write good contracts themselves, for example contracts with more precise language. Doctrines such as the parol evidence rule encourage parties to write more complete contracts by giving more weight to the written document and limiting the extrinsic evidence courts can consider. Strict application of these doctrines may thereby increase the accuracy of contract enforcement (reduce contractual accidents) by reducing the interpretive risks of relying on extrinsic evidence (Eric Posner, 1998, p. 546). As in tort law, the goal of encouraging better contracting makes economic sense if the precautions are cost-effective. That will be the case if one or both of the contracting parties face low ex ante transaction costs of drafting and monitoring express contract terms that successfully specify performance obligations in response to different regret contingencies, as well as if the expected losses from interpretive accidents are high (Eric Posner, 1998, pp. 543-547). Moreover, courts must be able to identify accurately situations in

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which precautions are cost-effective. Usually, the best courts can do is to use proxies to make reasonable comparative judgments. In particular, in investigating precautions, courts can compare the capabilities of contracting parties and they can compare the contract in dispute to other litigated contracts (Eric Posner, 1998, pp. 553-561). In comparing contracting parties, courts might conclude that one contracting party is the ‘least cost avoider’, or in this case the ‘cheaper contract drafter’, namely the party in a better position to clarify a term or to identify what should happen in the event of some contingency. This approach explains such interpretive rules such as contra proferentum, which encourage the party in the better position to draft a more complete contract to do so. Similarly, if one of the parties is a repeat contractor or is assisted by legal counsel and the other is not (as in many consumer contracts), imposing liability on the repeat and represented contractor in cases of contractual ambiguity or incompleteness will encourage that party to improve the terms of its contracts. In addition, if one of the parties has an informational advantage, imposing liability on that party could encourage similarly situated parties in the future to reveal the information. But there may not always be a ‘cheaper contract drafter’, or if there is, the necessary precautions might not be cost-effective. Such might be the case, for example, with a party who commits a ‘scrivener’s error’ in a written contract, especially if the error is one that the other party could reasonably have noticed. The alternative of comparing similar contracts rather than contracting parties can also yield some useful guidelines. For example, one piece of relevant evidence about ex ante transaction costs would be how common a particular term is in similar contracts. The more common a term, the more likely the costs of contracting over that term are low. Courts can then presume that most parties who wanted such a term would have contracted expressly for it and those who have not can be deemed negligent or strategic. Alternatively, one might argue that transaction costs are low for relatively ‘simple’ contracts or for ‘crucial’ terms. But even if courts are able through comparative analysis to identify simple contracts or common or crucial terms, there is a further difficulty: ease of contracting may not be a sufficient justification for imposing liability. The reason is that encouraging better contracting does not necessarily mean encouraging greater contractual completeness; it may mean encouraging greater contractual incompleteness through reliance on implied terms. Under a majoritarian default approach to implied terms, courts would minimize transaction costs by choosing the mix of express and implied terms that most contracting parties would want. The majority of contracting parties might want courts to use implied terms, especially in well-developed markets, because they believe that will save on the costs of contracting, even if the transaction costs of contracting are relatively low. Alternatively, the majority of contracting parties might believe that relying solely on express terms - even those that

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simply try to mimic implied terms - might be less reliable than relying on well-established implied terms either in conjunction with or instead of express terms; that is, they might fear court misinterpretation more than court misimplication. The only contracting parties who should be encouraged to contract more explicitly under this approach are those who have ‘idiosyncratic’ preferences. Thus, the fact that parties fail to contract expressly (or unambiguously) for a given term - even a common or crucial one - may simply be an expression of intent to be bound by the majoritarian understanding of that obligation. An example of the majoritarian default approach is the rule that contracting parties ‘in the trade’ are bound by trade usages, even if they did not know about them. This rule encourages the parties in a trade to develop such usages (which are majoritarian understandings) and to familiarize themselves rapidly with these usages, hence reducing the need for heavily lawyered documents (Warren, 1981). Thus, implied terms serve as a public good, a standard set of contract terms that parties either accept or reject. The same majoritarian approach could also apply to the interpretation of express terms. The ‘plain meaning rule’ could be viewed as a way of encouraging contracting parties to learn the common (one might even say implied) meaning of words, thus reducing the need for and costs of elaborate definition and explanation. Of course, the majoritarian approach to encouraging better contracting itself presents problems. For example, identifying the majoritarian default seems to call for an empirical inquiry, which courts are often ill-equipped to make, though to the extent that there is a recognized trade usage, or a course of dealing or course of performance, this problem is mitigated. Verkerke (1995) attempts to remedy this problem in the context of employment contracts by surveying employers about the discharge terms contained in their employment documents. He found that 52 percent of employers reported that their employment documents specified an ‘at will’ provision (the prevailing default), 15 percent reported that their documents contain a ‘just cause’ provision, and 33 percent reported that they do not have documents that address the issue explicitly (Verkerke, 1995, p. 867). He also found that larger firms and firms from more ‘liberal’ jurisdictions are more likely to contract explicitly for the at will rule. From these data, Verkerke concludes that the at will default is the majoritarian default. A more cautious conclusion would be that a broadly defined just cause provision is not a majoritarian default, but given the limitations many states have put on the at will doctrine and the possibility of unwritten (or written, but narrow) qualifications on the right to discharge, whether the majoritarian default is the strong form of the at will doctrine expressed in many employer documents or a more limited form is less clear. An additional problem with the majoritarian default approach is the need to determine when the parties have contracted around the default. Goetz and Scott (1985) argue that it is often difficult for courts to tell whether parties are

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using express terms to trump (opt out of) implied terms or merely to supplement them. That is, it may be difficult for courts to tell in a particular case whether the parties intended to incorporate implied terms by writing an incomplete contract, or whether they intended the express terms they used to create a complete contract; thus, the contractual ‘accident’ results from the parties’ unintended failure to resolve the tension between the express terms and implied terms. The more courts favor and encourage implied terms and common usages, the more costly it becomes for the parties who want to contract out of those terms to do so. As discussed above, ostensible default rules begin to look more like mandatory rules. The courts’ choice of interpretive strategy, therefore, may affect not only the parties’ incentives to contract more expressly, but also their ability to contract around the implied default rule. Goetz and Scott argue that the more likely it is that contracting parties will be unhappy with the court’s implied terms and interpretations - the more heterogeneous contracting parties are likely to be - the more inefficient an expansive approach to implied terms and interpretation will be. In contrast, where contracting parties are more likely to engage in homogeneous and repetitive transactions - that is, where the transactional variance is low - the more likely a contextual approach will be efficient because it will foster the development of more standardized terms by trade groups, lawyers, and the parties themselves. One could also justify the contextual approach in such cases on the ground that in ‘conventional’ contracts, court error is likely to be low (Eric Posner, 1998, pp. 553, 556). Implementing this notion is often more difficult than stating it, however. For example, Goetz and Scott suggest that in well-developed markets courts should generally allow context evidence to supplement express terms, but should generally not allow context evidence to override the plain meaning of express terms (Goetz and Scott, 1985, pp. 313-315). Eric Posner has recently criticized this argument on the ground that there is no theoretical justification for having a flexible approach with respect to incompleteness (implied terms) but a strict approach with respect to ambiguity (interpretation of express terms) (Eric Posner, 1998, pp. 559-560). On the one hand, it should not matter whether the parties use, for example, a best efforts clause or leave one out and let the court imply it; if the courts consider extrinsic evidence in one case, they should do so in the other. On the other hand, the ‘plain meaning’ of a best efforts clause requires a kind of context evidence, namely the general understanding of the clause. Thus, there may be no inconsistency in having a flexible approach to incompleteness and a plain meaning approach to ambiguity: both favor allowing a certain type of contextual evidence, namely general contextual evidence. The problem arises when the contextual evidence being considered is not general but specific to the contracting parties, such as course of dealing, course of performance, or prior negotiations. Here a flexible

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approach to incompleteness would allow the specific context evidence to trump the general, but the plain meaning rule would have the general context evidence trumping the specific. At this level of generality, Posner’s argument seems correct. Although one could imagine cases in which a court might want to use a flexible approach to incompleteness and a strict approach to ambiguity, it is difficult to make any general statements about such cases; in fact, one could just as easily imagine cases in which a strict approach to implied terms and a flexible approach to ambiguity would be appropriate. Goetz and Scott’s argument about the plain meaning rule perhaps should be read as limited to express terms that are commonly understood as general trumping terms that override implied terms, such as merger clauses, disclaimers, or clauses granting one party broad discretion. If the parties go to the trouble of using such a general trumping term, then arguably that should be a sufficient signal of their idiosyncracy. But even this interpretation is unsatisfactory because, as with the at will term discussed above, it may not be clear whether the parties simply intended to use the trumping clause to reject an overly broad implied term or whether they also meant it to convey the full measure of the parties’ obligations to the exclusion of all extrinsic evidence. The discussion in this section so far has assumed that ex ante transaction costs are low. The higher the ex ante transaction costs of drafting and monitoring become, the less likely it will be efficient for a court to adopt restrictive rules of interpretation and implied terms that encourage parties to contract more explicitly, because it will not be cost-effective for the parties to do so. Reliance on the types of contextual evidence discussed above now becomes relatively more cost-effective as the accuracy of the written contract declines. If courts take too restrictive a view of interpretation and implied terms, the development of cost-saving interpretive devices might be discouraged in favor of more complete, but costlier, writings (Burton, 1980, p. 373). Alternatively, too few contracts might be formed ex ante, as the promisor’s costs rise to cover an anticipated remedy that the promisee does not value at this cost. And too much performance might occur ex post, as the promisor performs even when the cost of doing so exceeds the value of performance (Easterbrook and Fischel, 1993, p. 445). Once again, stating the general principle may be easier than applying it. Classic examples of high-transaction costs contracts are principal-agent contracts usually referred to as ‘fiduciary’. These contracts typically involve complex tasks for which the principal cannot easily measure the agent’s effort or outcome, thus making express contracting difficult (Cooter and Freedman, 1991a, p. 1051; Easterbrook and Fischel, 1993, p. 426). Other examples include contracts between unsophisticated parties or long-term contracts. Even in high-transaction cost contracts, however, a more restrictive approach to interpretation and implied terms might be appropriate if the contracting parties’

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preferences with respect to certain obligations are likely to be idiosyncratic, or equivalently if the relevant context evidence is less reliable (Eric Posner, 1998, pp. 557-558). By the same token, the same concerns raised by high-transaction cost contracts might exist even in ordinary sales contracts. For example, if a contract allows for a 10 percent variation in the quantity for the (unstated) purpose of avoiding liability over loss during transportation, a question might arise whether the seller could take advantage of this provision to deliberately increase or decrease the quantity as the market price drops or rises. Although one could say that the buyer could contract to prevent such behavior by, say, limiting the application of the quantity variation provision to losses suffered in transit (Gillette, 1981, p. 655), it may be quite difficult to draft such a clause. What should happen, for example, if both a market price change and damage to the goods occur? What about damage to the goods before and after transit? Is it always desirable to have the parties provide explicitly for all these contingencies? The point is that a given contract may be viewed as low-transaction cost for some purposes and high-transaction cost for others.

6. Deterring Opportunistic Behavior Getting the mix of express and implied contracting terms right - that is, encouraging the optimally complete written contract - is only one consideration (and perhaps not the most important) that courts do or should face when deciding questions of interpretation or implied terms. A second approach to the question of how courts should interpret contracts and when they should imply terms focuses not on encouraging efficient contracting, but on deterring opportunistic contractual behavior (though obviously the two overlap). Opportunism can be broadly defined as deliberate contractual conduct by one party contrary to the other party’s reasonable expectations based on the parties’ agreement, contractual norms, or conventional morality (Cohen, 1992, p. 957). Alternatively, opportunism is an attempted redistribution of an already allocated contractual pie, that is a mere wealth transfer (Muris, 1981; compare Burton, 1980, p. 378). For example, a contract may require B to paint A’s portrait ‘to A’s satisfaction’ (Richard Posner, 1998, pp. 103-104). This provision allows A to reject the portrait even if others like it if it does not suit A’s taste. But if A rejects the portrait for reasons other than unhappiness with the painting’s quality - say because A remarries a spouse who does not want A’s portrait in the house - A acts opportunistically. The problem of opportunistic behavior is perhaps the key justification for court intervention in contracts. In general, ‘the threat of opportunism increases transaction costs because potential opportunists and victims expend resources perpetrating and protecting against opportunism’, which ‘do not help produce

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a commodity or service that the contracting parties mutually value’ (Muris, 1981, p. 524). More specifically, opportunistic behavior makes complete contracting extremely difficult. Even if contracting parties could anticipate all of the possible changes in economic variables, they would have a much harder time anticipating and protecting against opportunistic behavior by the other party. At the extreme, the more one contracting party is willing to contemplate the possible opportunistic behavior of his contracting partner, the less likely he will be to want to contract with that partner at all. Some degree of trust is necessary for contracting to occur. More important, many seemingly airtight contract terms can seem awfully leaky once a clever lawyer and a highly motivated client get through analyzing them. Just as cartel members can often find ways to cheat on cartels involving the most standardized products, so disappointed contractors can often find a way to act opportunistically in the most standardized contracts. Because contracting parties cannot solve all problems of opportunism on their own, courts can reduce transaction costs by imposing liability on the ‘most likely opportunist’. But there are difficulties with using courts to deter opportunism. In particular, opportunism is often ‘subtle’, that is, difficult to detect or easily masked as legitimate conduct (Muris, 1981, p. 525). Contract performance disputes arise when one party becomes unhappy with the contract. This unhappiness may stem from the occurrence of a risk that party had contractually agreed to bear. However, the disappointed party might be able to exploit some contract term to claim that the other party had breached or to allow the contested behavior, even though the term was intended to handle another situation. Alternatively, the disappointed party might be able to exaggerate or misrepresent the extent of a contingency that might excuse his performance, and so escape his contractual obligations. The problem that subtle opportunism poses for courts is often surmountable. In the fiduciary context, courts adopt, via the duty of loyalty, a strong presumption of wrongful misappropriation by an agent when that agent has a conflict of interest, engages in self-dealing, or withholds information from the principal (Cooter and Freedman, 1991a, p. 1054). More broadly, opportunism may be more possible whenever one party has a significant information advantage over the other. In other contexts, courts can find ‘objectively verifiable circumstances that act as surrogates for the existence of opportunism’ (Muris, 1981, p. 530). On the one hand, when the contract assigns a particular risk to one of the parties, and that risk materializes, the court should be skeptical of attempts by that party to escape his obligations via a different contract term. The classic example is a change in market price. If a buyer in a requirements contract suddenly experiences a large drop in ‘requirements’ after the market price has fallen below the contract price, or a large increase in requirements after the market price has risen above the contract price, the court

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should suspect opportunism or, in legal terms, a violation of the implied obligation of good faith. On the other hand, whereas a change in market price suggests opportunism, a change in economic circumstances either not contemplated by the contract or whose risk the contract places on the party seeking strict enforcement, suggests a lack of opportunism. To return to the requirements contract example, if the buyer’s requirements decrease or increase because of a change in costs or technology subsequent to the contract, the buyer’s behavior is likely not opportunistic (is in good faith) because the very purpose of the requirements contract is to assign some risk of variation in the buyer’s needs to the seller. Another example of objectively verifiable circumstances on which courts can focus is ex post transaction costs. If the market for substitute performance is thick, opportunism is less likely (Goetz and Scott, 1983). Opportunism can occur only when it is costly to switch to a new contracting partner, that is, when at least one party has made sunk, specific investments. Although this test may be useful in establishing general presumptions, it is of limited help in deciding specific cases. Litigated cases tend to be precisely those in which ex post transaction costs are likely to be high; otherwise, the cases would be settled. Although opportunism is often discussed as an ex post problem, opportunism can occur ex ante as well. For example, under a strict parol evidence rule, a party might intentionally make oral statements that the other party understands and relies on as part of the contract, then leave the provision out of (or put a contradictory provision in) the writing. One common situation is where a party tells the other to ignore the terms on the back of the first party’s forms, then later tries to enforce those terms. On the other hand, under a more flexible parol evidence rule, a party might intentionally ‘pad’ the negotiation record with statements that party knows will be rejected by the other party both orally and in writing, in the hopes that the first party can later convince the court that these statements were in fact part of the contract (a common practice in legislative history) (Eric Posner, 1998, pp. 564-565). This latter form of opportunism helps explain why courts tend to be much more skeptical of evidence that the parties can easily manipulate - especially prior negotiations - than evidence over which the parties have less control especially common usages. It may also explain the motivation behind the use of merger clauses as well as one reason why they should not be interpreted too broadly. It is difficult for a party to predict in advance which negotiation tidbit the other side might seize on later (Eric Posner, 1998, p. 572), so it is necessary to write a broad clause that excludes them all. The same is not true for less manipulable evidence, but it might be difficult to specify all such evidence in writing in advance, especially in a single ‘anti-merger’ clause. It is important to recognize once again that the opportunism approach is dependent on determining contractual intent, which is often uncertain. Stating that courts do and should deter opportunism does not by itself explain how

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courts do and should resolve the question of how to determine contractual intent; it simply opens the question up. Professor Muris, who first articulated the opportunism approach to good faith, recognized that to apply the approach courts need to consider ‘risk allocation’, which is a question of ‘interpretation’ that is ‘analytically prior to [the question] of opportunism’ (Muris, 1981, pp. 561-562, n.110). Nevertheless the opportunism approach may have something to say about how courts should go about determining intent. First, courts should hesitate to interpret a contract in such a way as to permit conduct that would ordinarily be understood as opportunistic. Second, courts should hesitate to attribute to contracting parties an intention not to have courts police against opportunistic behavior (compare Muris, 1981, p. 573, n.138). Because contextualism and textualism are both useful for deterring different types of opportunism, we should therefore expect - and we find - that courts are never completely committed to one or the other.

7. The Problem of Joint Fault or Multiple Contingencies In many contractual disputes, there are often precautionary steps that both parties could have taken to have avoided or mitigated the contractual loss. We have already considered one such precaution - drafting a better contract. Quite separate from the costs of drafting better terms are the costs of reducing the likelihood of, or harm from, some risk ex ante, and of mitigating losses ex post. Parties seeking to have the court imply or interpret a term in their favor may be attempting to avoid a risk that the contract assigned to them or to extricate themselves from a vulnerable position of their own making, which they could have avoided at low cost. In these cases, courts may have to make judgments about the relative fault of both parties to decide whose behavior it is more important to deter in a particular case. In particular, if one party is the least cost avoider of some contingency while the other party regrets the contract for other reasons and is opportunistically seeking to avoid its obligations, courts face a ‘negligence-opportunism tradeoff’ (Cohen, 1992, pp. 983-990). To take a classic example, suppose a builder promises to use a particular brand of pipe in building a house but inadvertently substitutes a different, but functionally equivalent brand, a fact not discovered by the owner until the house is nearly completed. The owner refuses to make the final payment on the house. The court must choose between placing liability on the negligent builder or the potentially opportunistic owner. There is an economic case to be made that opportunism - if sufficiently proved - is more costly behavior and deterrence of that behavior should take priority (Cohen, 1992). On the other hand, the more likely it is that the builder ‘built first and asked questions later’ (Goldberg,

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1985, p. 71), the more willing courts should be to find for the owner by implying a condition. To take another example of the negligence-opportunism tradeoff, suppose that a buyer rejects goods delivered late after a market price drop and the seller sues. There are two contingencies here: the price drop and the late delivery. The contract assigns the risk of the price drop to the buyer and the late delivery to the seller. Textualism will not resolve this dispute: either the price term or the time of delivery term cannot be read absolutely. It is not sufficient to say that only the seller has breached, because what constitutes a breach and the consequences of that breach are precisely what is at issue. Nor can it be said that only the seller could take precautions here because neither party could do anything about the price drop and the buyer did not cause the delay in delivery. If the buyer’s rejection is viewed as opportunistic behavior, then refraining from such behavior could be viewed as a ‘precaution’. Depending on the circumstances, there is an economic argument to be made for implying a good faith ‘limitation’ on the buyer’s ability to escape its obligations.

8. Court Error One of the main criticisms of courts’ taking too contextualist an approach to interpreting and implying contractual terms is the problem of court error and incompetence. At one extreme, if courts make no errors in importing contextualist evidence, then such evidence should always be allowed, at least if the cost of producing such evidence is not too high. At the other extreme, if courts make too many mistakes in interpreting or implying terms, then textualism becomes superior if the transaction costs of contracting are lower than the expected savings resulting from fewer court errors (Eric Posner, 1998, pp. 542-544). If courts make the methodological error of choosing contextualism in situations of high court error, then the parties will respond by attempting to contract around the court’s rules through detailed language or broad merger clauses, by avoiding courts (for example, arbitration) or contracts (for example, vertical integration), or by engaging in inefficient contractual behavior to adjust to the court’s erroneous legal standard. But the problem of court error does not necessarily favor textualism. In the first place, as Hadfield (1994) has argued, the feared inefficient responses to court error may not occur. Developing a formal model of good faith clauses in intentionally incomplete contracts in the presence of probabilistic court error, Hadfield concludes that the possibility of court error does not always caution against court intervention. If courts are of such low competence that the parties cannot reduce their marginal liability by improving their contractual efforts in a cost-justified way (that is, liability is essentially strict), then the parties will not change their behavior under the contract and will adjust to the anticipated

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court error by adjusting the price of the contract rather than by declining to contract. On the other hand, if courts are of higher, but still limited, competence, then enforcement of good faith clauses may lead to greater joint profits for the parties than nonenforcement. This will occur if the court error does not have too severe an adverse effect on the parties’ incentives, and if the private mechanisms for inducing optimal effort without court enforcement are relatively weak. In addition, Hadfield argues that courts of low competence should not follow bright line rules or precedent, but instead should use standards. By bright line rules she means rules requiring a certain level of conduct that is independent of changing economic conditions; for example, a bright line rule might say to a supplier in an output contract that to act in good faith it cannot reduce its output to zero unless continued production puts the firm on the verge of bankruptcy. By standards she means required actions that vary depending on the economic circumstances, such as a rule that says an agent subject to a best efforts clause must adopt reasonable sales methods. Bright line rules thus correspond to textualism, whereas standards correspond to contextualism. Bright line rules may compound rather than ameliorate court error by a court of limited competence, because a bright line rule setting forth a required action will so often be ‘wrong’. Thus, parties will respond to a bright line rule either by ignoring it or by conforming their behavior to the inefficient safe harbor established by the rule. Standards, by contrast, are more likely to encompass the ‘efficient’ response because courts using standards will set the minimum required action low and set the safe harbor high. Thus, contracting parties are likely to realize that their marginal liability can be reduced through increases in cooperative effort (because courts are likely to notice and take those efforts into account), and so the parties will be encouraged to take steps in the direction of optimal behavior. The point is that the presence of court error does not preclude the desirability of court flexibility. A similar argument might apply even outside the relational contract context. The argument for textualism here is that if transaction costs are low, court error will be minimized because the parties will be encouraged to put more terms in the writing. Textualist courts will interpret this writing more accurately than contextualist courts, which will sometimes erroneously rely on contextual evidence in addition to the writing (Eric Posner, 1998, pp. 545-546). The argument assumes that transaction costs include, as has been suggested above, not merely the cost of drafting, but the cost of drafting in such a way that courts make fewer interpretive mistakes. But low drafting costs may not be sufficient to ensure that court error is reduced under textualism. If, for example, drafting costs decrease (as they probably have due to technological progress) so that it is relatively easy for parties to add more terms to their writings, court error could in fact increase if more detailed contracts are more likely to have conflicting terms or courts are more likely to misinterpret a term to cover a

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particular contingency the parties did not intend to cover. Another aspect of court error that some argue supports textualism is error in interpretive methodology, namely the choice between textualism and contextualism itself. The contracting parties may prefer textualism and express that preference through, for example, merger clauses. But if courts make errors in determining the parties’ intentions generally, they will also err in determining the parties’ methodological preference. Courts may therefore choose contextualism too often (Eric Posner, 1998, pp. 547-548, 570-571). But once again, this conclusion depends on the assumption that if courts use textualism (this time to decide the parties’ methodological preference) they will err less often because the costs to the parties of accurately expressing their methodological intentions are low. One would think, however, that the costs to the parties of drafting a particularized methodological term are quite high. Methodological preference is only a second-order concern for the parties. It is difficult for the parties to predict how court error will likely impact the wide variety of possible disputes they might have, and methodological preference terms have no contractual use to the parties outside of litigation. As a result, it is not obvious a priori that choosing a textualist approach minimizes court error. Suppose, for example, that the parties generally prefer a textualist approach and expect interpretation x of some term. There are actually three ways the court could err. The court could take a contextual approach but reach interpretation x. Or the court could take a textual approach and reach interpretation y. Or the court could take a contextual approach and reach interpretation y. Although the parties prefer the textualist approach, it might be more important to them that the court gets the term right, however the court does it. If courts are more likely to choose the desired interpretation x using a contextual approach and interpretation y using a textual approach - either because the parties underestimate the courts’ competence with respect to that term or because their expressed preference for textualism inaccurately conveys the parties’ correct estimate of the courts’ competence in this instance - then error costs could be reduced if the court ‘mistakenly’ used a contextual approach. To give a simple numerical example, suppose the court can choose either a textualist or contextualist methodology. If it chooses textualism, the likelihood of interpreting the term the way the parties want is 0.4; if it chooses contextualism, the likelihood of interpreting the term the way the parties want is 0.6. Suppose further that ex ante the parties would value the court’s using textualism and choosing x at 100; would value the court’s using contextualism and choosing x at 80; would value the court’s using textualism and choosing y at 50; and would value the court’s using contextualism and choosing y at 10. Thus, the parties prefer textualism to contextualism, but prefer the right outcome more. The expected value if the court uses a textualist approach is (0.4 @ 100) + (0.6 @ 50) = 40 + 30 = 70. The expected value if the court uses a

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contextualist approach is (0.6 @ 80) + (0.4 @ 10) = 48 + 40 = 88 > 70. The point is that the possibility of court error does not always argue in favor of textualism. Both textualist and contextualist methodologies lead to court error. The real question is which methodology has the lowest error rate and at what cost. It is hard to answer this question in the abstract. This may help to explain why courts do not - and never will - use pure interpretive methodologies, but tend to switch back and forth depending on the circumstances.

9. Summary and Future Research To a large degree, the economic approach to interpretation and applied terms parallels the approach in other areas of contract law. Court intervention is most justifiable when transaction costs are high and the likelihood of court error is low. Transaction costs include not only the ex ante costs of drafting in such a way as to reduce court error, but the ex post costs associated with sunk specific investments that make possible opportunistic behavior, as well as the costs of alternative governance institutions such as extralegal sanctions. Most of the economic arguments that suggest a restrictive court approach to interpretation and implied terms have counterarguments. Therefore the institutional and contractual context matters greatly in deciding what approach efficiency-minded courts should take. The literature to date has mapped out the broad contours. Future work will have to do the hard digging. That means paying more attention to why people write the contracts they do and the circumstances that motivate nonperformance.

Bibliography on Implied Terms and Interpretation in Contract Law (4400) Al-Najjar, Nabil I. (1995), ‘Incomplete Contracts and the Governance of Contractual Relationships’, 85 American Economic Review Papers and Proceedings, 432-436. Barnes, David W. and Stout, Lynn A. (1992), The Economics of Contract Law, St Paul, MN, West Publishing Co. Burton, Steven J. (1980), ‘Breach of Contract and the Common Law Duty to Perform in Good Faith’, 94 Harvard Law Review, 369-403. Burton, Steven J. (1981), ‘Good Faith Performance of a Contract within Article 2 of the Uniform Commercial Code’, 67 Iowa Law Review, 1-30. Cohen, George M. (1992), ‘The Negligence-Opportunism Tradeoff in Contract Law’, 20 Hofstra Law Review, 941-1016. Cooter, Robert D. and Freedman, Bradley J. (1991a), ‘The Fiduciary Relationship: Its Economic Character and Legal Consequences’, 66 New York University Law Review, 1045-1075. Reprinted in Pardolesi, Roberto and Van den Bergh, Roger (eds) (1990), Law and Economics, Some Further Insights: 7th European Law and Economics Association Conference, Rome, Sept. 3-5, 17-50.

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Cooter, Robert D. and Freedman, Bradley J. (1991b), ‘An Economic Model of the Fiduciary’s Duty of Loyalty’, 10 Tel Aviv Studies in Law, 297 ff. Easterbrook, Frank H. and Fischel, Daniel R. (1993), ‘Contract and Fiduciary Duty’, 36 Journal of Law and Economics, 425-446. Gergen, Mark P. (1995), ‘A Defense of Judicial Reconstruction of Contracts’, 71 Indiana Law Journal, 45-99. Gillette, Clayton P. (1981), ‘Limitations on the Obligation of Good Faith’, 1981 Duke Law Journal , 619-665. Goetz, Charles J. and Scott, Robert E. (1983), ‘The Mitigation Principle: Toward a General Theory of Contractual Obligation’, 69 Virginia Law Review, 967-1024. Goetz, Charles J. and Scott, Robert E. (1985), ‘The Limits of Expanded Choice: An Analysis of the Interactions between Express and Implied Contract Terms’, 73 California Law Review, 261-322. Goldberg, Victor P. (1985), ‘Relational Exchange, Contract Law, and the Boomer Problem’, 141 Journal of Institutional and Theoretical Economics, 570-575. Reprinted in Goldberg, Victor P. (ed.) (1989), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press, 67-71, 126-127. Graham, Daniel A. and Peirce, Ellen R. (1989), ‘Contract Modification: An Economic Analysis of the Hold-Up Game’, 52(1) Law and Contemporary Problems, 9-32. Hadfield, Gillian K. (1992), ‘Incomplete Contracts and Statutes’, 12 International Review of Law and Economics, 257-259 . Hadfield, Gillian K. (1994), ‘Judicial Competence and the Interpretation of Incomplete Contracts’, 23 Journal of Legal Studies, 159-184. Hart, Oliver D. and Moore, John (1988), ‘Incomplete Contracts and Renegotiation’, 56 Econometrica, 755-785. Hansmann, Henry and Kraakman, Reinier (1992), ‘Hands Tying Contracts: Book Publishing, Venture Capital Financing, and Secured Debt’, 8 Journal of Law, Economics and Organization, 628-655. Hermalin, Benjamin and Katz, Michael L. (1993), ‘Judicial Modification of Contracts Between Sophisticated Parties: A More Complete View of Incomplete Contracts and Their Breach’, 9 Journal of Law, Economics and Organization, 230-255. Kahan, Marcel (1994), ‘The Qualified Case Against Mandatory Terms in Bonds’, 89 Northwestern University Law Review, 565 ff. Kahn, Charles and Huberman, Gur (1989), ‘Default, Foreclosure, and Strategic Renegotiation’,52 Law and Contemporary Problems, 49-61. Muris, Timothy J. (1981), ‘Opportunistic Behavior and the Law of Contracts’, 65 Minnesota Law Review, 521-590. Narasimhan, Subha (1986), ‘Of Expectations, Incomplete Contracting, and the Bargain Principle’, 74 California Law Review, 1123-1202. Posner, Eric (1995), ‘Contract Law in the Welfare State: A Defense of the Unconscionability Doctrine, Usury Laws, and Related Limitations on Freedom to Contract’, 24 Journal of Legal Studies, 283-319. Posner, Eric (1998), ‘The Parol Evidence Rule, the Plain Meaning Rule, and the Principles of Contractual Interpretation’, 146 University of Pennsylvania Law Review, 533-577. Snyderman, Mark (1988), ‘What’s So Good About Good Faith? The Good Faith Performance Obligation in Commercial Lending’, 55 University of Chicago Law Review, 1335-1370.

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Verkerke, J. Hoult (1995), ‘An Empirical Perspective on Indefinite Term Contracts: Resolving the Just Cause Debate’, 1995 Wisconsin Law Review, 837-918. Warren, Elizabeth (1981), ‘Trade Usage and Parties in the Trade: An Economic Rationale for an Inflexible Rule’, 42 University of Pittsburgh Law Review, 515-582. Williamson, Oliver E. (1985), ‘Assessing Contract’, 1 Journal of Law, Economics and Organization, 177-208.

Other References Ayres, Ian and Gertner, Robert (1989), ‘Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules’, 99 Yale Law Journal, 87-130. Charny, David (1991), ‘Hypothetical Bargains: The Normative Structure of Contract Interpretation’, 89 Michigan Law Review, 1815-1879. Goetz, Charles J. and Scott, Robert E. (1981), ‘Principles of Relational Contracts’, 67 Virginia Law Review, 1089-1150. Posner, Richard A. (1998), Economic Analysis of Law, Boston, MA, Little, Brown and Co. Wonnell, Christopher T. (1986), ‘Contract Law and the Austrian School of Economics’, 54 Fordham Law Review, 507-543.

4500 UNFORESEEN CONTINGENCIES. RISK ALLOCATION IN CONTRACTS George G. Triantis University of Virginia School of Law © Copyright 1999 George G. Triantis

Abstract Contracts allocate risks by providing for future contingencies with variable degrees of specificity: they partition future states of the world more or less finely and set obligations for each state in the form of prices, quantity, remedies for breach, and so on. The partitioning may be conditioned on quantitative or qualitative factors. Refined qualitative partitioning based on verifiable outcomes can exploit comparative advantages in precaution-taking and in hedging or diversification. The expected benefit from refined partitioning of remote contingencies may not be worth the contracting costs. In these cases, the court may promote efficient risk-bearing activity by setting the parties’ obligations in these states of the world ex post, as long as the court’s determination in each state is predictable. JEL classification: K12, D81 Keywords: Incomplete Contracts, Uncertainty, Risk Allocation, Unforeseeability, Commercial Impracticability, Contract Remedies

1. Introduction When the occurrence of an unforeseeable event would cause a promisor to bear an unexpectedly large loss in performing her contractual obligation, the parties might renegotiate and modify the promisor’s contract. In most cases, the law will enforce their agreement as modified. However, even in default of such adjustment, a set of common law doctrines may offer relief to the promisor. The unexpected loss triggering the relief might be an increase in the cost of performance (out-of-pocket or opportunity cost) or a decrease in the value of the reciprocal obligation of the promisee. The common law doctrines of impossibility and commercial impracticability release the promisor from her obligation on the grounds of an unforeseeable supervening event that increases the cost of either literal performance or damages liability to a level beyond the anticipated range of values at the time of contracting. The doctrine of frustration excuses when the supervening event impairs the ‘purpose’ of the

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agreement: in other words, the value that would be realized from the reciprocal performance of the other party. Mutual mistake about the subject matter of the contract excuses performance when new information comes to light that moves the value of the exchange to either party outside the range mutually anticipated by the parties at the time of contracting. Finally, under the rule in Hadley v. Baxendale, a promisor who breaches is released from liability for losses of the promisee that were unforeseeable. Thus, the release of contract obligations under these various common law doctrines hinges not only on whether the parties provided for the risk in their contract, but also on the unforeseeability of the contingency responsible for the threatened unexpected loss. Law and economics scholarship has examined at great length the efficiency of contractual allocations of risk in incomplete contracts. A subset of this literature has struggled with the relevance of unforeseeability in this analysis. This essay provides a review of the significance of the risk of unforeseeable contingencies in commercial contracting and the common law of contracts. The chapter begins with an outline of the means and ends of risk allocation in contracts and the determinants of a contract’s specificity in partitioning future states of the world (in economic terms, the contract’s completeness). The contractual allocation of risks has significant efficiency consequences because it sets investment incentives for each party (resource allocation) and exploits differences in their respective risk-bearing capabilities (risk-sharing). Contracts allocate risks in larger or smaller bundles that may be defined qualitatively or quantitatively. The price, quantity or remedy term of a contract may shift to the buyer the risk of cost increases within specified ranges. Or, these terms may be conditioned on outcomes produced by specified causes. Either the quantitative ranges or the qualitative causes may be broadly or narrowly defined (Triantis, 1992). Comparative advantages in precautions or risk-bearing may be exploited more fully when contracts partition future states of the world more finely. However, the higher contracting and verification costs of refined risk allocation may offset the expected benefits. In particular, the more remote the risk, the heavier the discount on the benefit from specific allocation and the less likely is a net benefit from specific treatment of risks. Most law and economics scholars treat the risk of unforeseeable contingencies as the limiting instance of remote risks: by definition, the cost of specifying ex ante the contractual obligations in the unforeseeable state of the world exceeds the expected benefit. Indeed, modern doctrinal statements of the excuses of frustration, impossibility and impracticability reflect this approach by referring to ‘the occurrence of an event [or contingency] the non-occurrence of which was a basic assumption on which the contract was made’, which seems to encompass those risks to which the parties attached a probability of near zero (Restatement (Second) of Contracts §§261, 265; Uniform Commercial Code §615). In these cases, the courts may promote efficient risk-bearing activity by setting the parties’

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obligations ex post, particularly if their determination is conditioned on verifiable outcomes and predictable.

2. Contract Partitions and Incompleteness Parties enter into executory contracts instead of present exchanges for two principal reasons: (1) to protect and thereby encourage relationship specific (or reliance) investments which increase the value of their exchange and (2) to transfer risks and thereby to exploit comparative advantages in risk-bearing. Accordingly, a distinction may be drawn between two types of contracts that define opposite ends of a spectrum: (1) exchanges of goods and services for which close substitutes are readily available in thick markets (‘market’ contracts) and (2) exchanges for which there are no such substitutes because of specific investments made by either or both parties before the exchange is complete (‘off-market’ contracts). By definition, the investment of a party to a market contract is not specific to the relationship; the availability of market substitutes protects the investing party from opportunism (Klein, Crawford and Alchian 1978; Williamson 1979). The gain from executory market contracts derives from the allocation of market risks, not the actual delivery of goods or services or the protection of reliance investments. The parties contract to exploit comparative advantages in risk-bearing that are due to differences in their respective degrees of risk aversion and in their ability to hedge or shift risks in their other contracts and activities. In contrast, off-market executory contracts both protect specific investments and allocate risks associated with uncertainty in the environment and the imperfect information of the parties. The allocation of risks in these contracts has a significant impact on various important investment decisions: the parties’ investment in information prior to contracting, the promisor’s decision to perform or breach, the promisee’s specific (reliance) investments, and either party’s precautions against the probability and impact of adverse risks that threaten the value of the exchange. Because of its impact on resource allocation, the task of allocating risks in off-market contracts is more complex than in market contracts. Enforcement of off-market contracts is also more difficult because of the obstacle of verification: the cost of proving breach and damages to a third-party enforcer, typically a court. Thus, each party has a greater temptation to avoid performing obligations that threaten to inflict large losses. Consequently, the parties may wish to dampen incentives to chisel by sharing risks more evenly under the contract and thereby reducing the variance in the returns of each party (Goldberg, 1985). Without attempting to describe fully the various tensions that exist among the objectives of risk allocation, this essay reviews contract terms, such as price and remedies, that partition the

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future according to qualitative or quantitative factors. This review sets the stage for a discussion of how foreseeability is relevant in the common law of contracts. Consider the following sales contract. Seller agrees to manufacture and deliver a specific good to Buyer one year later. Buyer maximizes the value of the good to him at delivery (V) by making a reliance investment of R. The cost to Seller of making and delivering the good is C. To keep the discussion simple, assume that Seller has no other use for the good, no third party would bid for the good and the exchange has no external effect on third parties. Therefore, the social gain (or loss) from the completed exchange is the difference: V - R - C. The parties contract under uncertainty and with imperfect information about the state of the world that will materialize at the time of delivery. V and C are stochastic and their respective distributions are neither perfectly positively nor perfectly negatively correlated. The latter assumption allows the parties to have conflicting interests with respect to the decision to terminate their contract. At the time of contracting, Seller and Buyer observe the same joint distribution of V and C, although the actual values at the time of contracting is private information. The terms of the contract divide the gain (or loss) from the exchange (V - R - C) between Buyer and Seller and the parties may decide to condition the division on the state of the world existing at delivery. A complete contingent contract would specify the parties’ obligations in each possible state of the world and the division of the gain (or loss) from the contract in each state. An efficient complete contingent contract sets optimal investment incentives and sharing of risks over each state of the world. Each state can be defined in both quantitative and qualitative terms: by the realized values of V and C and the factors that produced V and C. The motivating premise for contracts law and economics scholarship is that contracting and verification costs make complete contingent contracts infeasible. Shavell states that incompleteness is efficient to the extent that the bargaining costs are high to provide for that contingency, the contingency has a low probability of occurring, the cost of verifying its occurrence is high and the cost of settling disputes is low in the event that the contract does not provide for the contingency (Shavell, 1984). In practice, contracts are incomplete because they group states of the world into more broadly framed partitions (Schwartz, 1992). In the sales contract described above, for example, the terms governing price, quantity and remedy for breach would typically establish the rights and obligations of the parties according to more or less broadly framed quantitative states of the world. At one extreme, for example, if the contract has fixed price and quantity, and is specifically enforced, the contract does not distinguish between different outcomes: each party’s obligation is the same regardless of the realized state.

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3. Quantitative Partitions: Price and Remedy 3.1 Price To isolate the comparison among fixed and flexible price terms, assume for the moment that contracts are specifically enforced. On the one hand, a fixed price provides a certain revenue to the seller and a certain contractual obligation to the buyer. On the other hand, a flexible price can provide a hedge against fluctuations in the seller’s cost of performance or the buyer’s valuation of performance. As a general matter, the contract price may offset risks created by other contracts and activities of either party. This point is demonstrated by Polinsky in his comparison of fixed and spot prices in market contracts (Polinsky, 1987). To the extent that fluctuations in spot prices reflect changes in cost conditions in the industry that are experienced by the seller, a spot price contract reduces the risk of the seller (and shifts cost risk onto buyer). Conversely, to the extent that spot price fluctuations are driven by demand-side conditions that reflect changes in the value of the good to buyers, a spot price transfers the risk of such value fluctuations to the seller. Thus, Polinsky says: a spot price contract will ... tend to insure the seller against production cost ncertainty...although the upward slope of the industry supply curve and the less than perfect correlation between the seller’s costs and shifts in the industry supply curve reduces the value of a spot price contract as insurance against production cost uncertainty... A fixed price contract would insure the seller against... demand side uncertainties [that cause shifts in the industry demand curve]...A spot price contract will tend to insure the buyer against valuation uncertainty, while a fixed price contract will insure the buyer against supply side uncertainties. (Polinsky, 1987, p. 29)

Spot price contracts condition only on the revealed spot market price at the time scheduled for delivery. Other distinctions among states of the world existing at that time - such as idiosyncratic increases in seller’s costs - are ignored either because there are no benefits to such further partitioning or because the contracting and verification costs of doing so outweigh the benefits. In the absence of a spot market for a close substitute or in cases where the spot price provides a poor fit because of idiosyncracies of the seller or buyer, other flexible price terms may be more closely tailored to the conditions of the seller or buyer to achieve the desired allocation of risk. For example, the price may be adjusted by reference to the realized values or determinants of C and V (for example cost plus or royalty contracts) or to accessible indices correlated with the cost or value of performance (Joskow, 1988). Alternatively, the contract may provide that a price must be reset upon the occurrence of certain

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contingencies (Joskow, 1988). Each alternative has its own shortcomings. Realized values of C and V are often private information and not observable or verifiable. In longer term contracts, indices can fall out of line with C or V as easily as spot market prices. Yet, the renegotiation of off-market contracts raise the prospect of opportunistic appropriation of quasi-rents (Williamson, 1979). 3.2 Remedies The effect of the standard breach of contract remedies on investment incentives is well known. Under assumptions of perfect enforcement (including no insolvency risk) and no renegotiation, expectation damages set socially efficient performance incentives for the promisor, while reliance and restitution measures lead to moral hazard and excessive breach by the promisor. Specific performance produces insufficient breach. Expectation and reliance damages encourage too much reliance expenditure by the promisee (Shavell, 1980). Although the mitigation rule requires the promisee to take all reasonable loss avoiding measures after the breach occurs, information about the reasonableness of the promisee’s actions is difficult to verify. In contrast, restitutionary damages or no recovery (under a doctrine of excuse, for instance) are superior in inducing efficient amounts of reliance and mitigation by the promisee (Bruce, 1982; Goldberg, 1988). Thus, when the promisor’s liability cannot be conditioned on efficient investment levels on the part of each party because of contracting and verification costs, there is a tension between the goals of setting the correct incentives for the promisor and for the promisee. The next paragraph describes a further complication that arises when one or both of the contracting parties are averse to bearing risks. Breach of contract remedies allocate the risk of fluctuations in C and V. For example, suppose the contract has a fixed price that is payed in advance and consider the risk borne by the seller. If the contract is specifically enforced, then the seller bears the risk of fluctuations in C. If the sanction for breach is the payment of damages, the measure of damages (D) serves to divide the risks between the parties. For any given level of V, the seller bears the risk of cost fluctuations in the range C < D; the buyer risks losing V − D if C > D. Unless damages are punitive, neither party bears the risk of C > V; this is the range of efficient breach. Fluctuations in V matter to the seller if damages are a function of V (for example, under the expectation measure): the seller bears the risk of V when the cost of performance is greater than the fixed price. The correlation between C and V therefore is also significant to the seller. For example, if C and V are negatively correlated, a rise in C and fall in V may induce the buyer to repudiate the contract and thereby release the seller from her obligation. Thus, the standard breach of contract remedies divide the joint distribution of C and V and thereby establish incentives for breach, reliance, and investment in precautions against adverse changes in C or V. They can also exploit

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differences in the risk preferences of the parties. For example, a seller insures the buyer against the risk of cost increases under remedies of specific performance and expectation damages, which is an efficient risk-sharing arrangement if the seller is risk-neutral and the buyer is risk averse and does not hold a hedge against that risk (Polinsky, 1983; Shavell, 1984). If the remedy is conditioned on C and V (or their proxies), significant tradeoffs exist between the goals of efficient investment incentives and optimal risk-sharing. If the seller is risk averse, the measures of damages that optimize the sharing of cost risk create a moral hazard of underperformance by the seller. Of course, in other cases, only one of the performance or risk-sharing goals are relevant: for example, if the seller is risk-neutral (expectation damages are efficient) or if the seller is risk averse but has no control over the cost of performance (some measure less than expectation is efficient, depending on the buyer’s risk aversion). White suggests that discharge under an excuse doctrine should be analyzed under a unified approach as a breach sanctioned by damages equal to zero. She demonstrates that zero damages produce optimal risk-sharing only in very exceptional circumstances and always encourage excessive breach (White, 1988). However, the advantage of discharge comes from the effect on the buyer’s investment incentives, particularly reliance and precaution expenditures, which she removes from her analysis (Bruce, 1982; Goldberg, 1988). The role of these incentives becomes more salient when the allocation of risk by cause is discussed in Section 4. Even if a contract addresses risks only in quantitative terms, it might condition the remedy (as opposed to the calculation of damages) on the realized value of C. Instead of one measure of damages (for example expectation), the contract might provide for two measures depending on whether the cost of production falls within one region or another of the distribution. For example, if breach occurs when C < min (C',V) then the promisor pays expectation damages; if breach occurs when C > C' > V, then the promisor’s obligation is discharged. Even though optimal risk-sharing is the only objective (because C' > V), it is not clear that this partitioning of future states creates a superior risksharing arrangement, even if the seller is risk averse and the buyer is riskneutral. Even a risk-neutral buyer will offer to pay a lower price for the good when he faces the prospect of undercompensation in the event of breach. Therefore, in the region of the distribution of C when the seller is not excused, expectation damages will be larger than under a regime of single damages measure. This increases the variance of returns for the seller in that region, while decreasing it within the region of discharge. One would require more information about the seller’s utility function to know whether she would prefer this risk profile (Sykes, 1990). The theoretical discussion of the incentive and risk-sharing effects of remedies usually assumes perfect enforcement. If this assumption is relaxed, the benefits of the various remedies are compromised. The parties may set payment

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terms to achieve the allocation of risks that would be achieved by price and remedies in perfect enforcement. A payment or performance schedule allows either party to walk away from the contract at any point in time with a roughly adequate allocation of gains and losses. For example, Goldberg suggests that ‘there are a large number of reasons why a particular contract might not be completed and one way to protect one’s interests is to assure that at each point in time, the performance rendered and compensation received are not too far out of whack’ (Goldberg, 1988, pp. 113-114). Kull makes a similar point in discussing cases decided under the doctrine of frustration. Under the contract in Fibrosa S.A. v. Fairbairn Lawson Combe Barbour, the buyer promised to pay one-third of the price of textile machinery with its order and the balance against shipping documents. Kull suggests that the parties intended to allocate the risk of loss caused by the frustrating event (the German invasion of Poland) by allowing the seller to keep one-third of the price in the event of the buyer’s breach. This is a reasonable interpretation of the intention of parties who opt for a self-enforcing contract by letting losses lie where they fall. Indeed, a contract might assign the entire risk of the contract to the buyer by requiring full payment in advance or to the seller by providing for payment only upon delivery (Kull, 1991). White demonstrates that advance payments are efficient where negative damages (from buyer to breaching seller) are optimal because of the seller’s risk aversion, but the parties believe that a court would be more likely to allow the breaching seller to retain a deposit than to order negative damages (White, 1988).

4. Qualitative Partitioning of Remedies In the foregoing discussion, the obligations of the parties and the sharing of the returns from the exchange are conditioned on the realized values of V and C, or their respective quantitative proxies. In deciding how finely to partition the joint distribution of these variables, the parties weigh the benefit of more tailored risk allocation against the correspondingly higher costs of contracting and verification. The other dimension over which the parties may contract is qualitative: the cause of fluctuations in the cost and value of performance. Qualitative partitioning may be preferred because of the enhanced efficiency of risk allocation by cause or the lower contracting and verification costs. Force majeure clauses release the promisor upon the occurrence of specified events that impair the value of her contract. Common law doctrines of excuse are triggered when an unforeseeable event occurs that causes performance to be impossible or commercially impracticable, or that frustrates the value of the reciprocal performance. The discussion in this part focuses on the contractual specification of risk by cause and the next part addresses the judicial treatment of unspecified remote risks through the doctrines of excuse.

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4.1 Precautions Suppose that contingency x and contingency y can each cause the same increase in the cost of performance and have the same probability of occurring at the time of the contract. What reasons might justify allocating the risk of x to the seller (for example specific enforcement or expectation damages) and the risk of y to the buyer (for example excuse or remedy of restitution)? The cause of the increase in cost does not affect the optimal performance/breach decision or the efficient level of reliance. It is, however, relevant to efficient precautions and risk-sharing. Posner and Rosenfield set the framework for the analysis of efficient risk allocation in their influential article on the common law doctrines of excuse. The superior risk bearer is the party who is in the best position to accomplish the following measures: to minimize the probability of the adverse contingency, to minimize the extent of the loss to the promisee resulting from nonperformance either before it occurs (precaution) or after (mitigation), or to insure (by self or with third parties) against the residual risk of the loss that cannot be feasibly avoided (Posner and Rosenfield, 1977). The relative ability of each party to bear or insure against the residual risk is significantly more difficult to determine than the comparative advantage in taking precautions against the risk, and so we set aside the former for the moment. Comparative advantages in the taking of precautions are related almost by definition to the cause of the threatened loss from an increase in cost or decrease in the value of the contract. The question is not only whether it is feasible to partition by cause, but how specifically to do so. A cost increase may be due to a natural disaster (general cause), which may be a tornado, earthquake, flood or drought (specific cause). To the extent that the risk is endogenous, there may be benefits to specific allocation because it sharpens the assignment of responsibility for precautions. Irrigation systems are effective precautions against droughts, but not tornadoes. Of course, obligations may be conditioned not on the contingency but directly on the precautionary actions of the parties. For example, damages liability of the breaching promisor may be conditioned on the reasonableness of the actions of the parties under the circumstances (Shavell, 1980). This approach is signficantly less common in contracts than torts (Cooter, 1985; Cohen, 1994). Contracting parties might condition damages liability on the failure of the seller to take reasonable precautions against cost increases and the reasonable precautions of the buyer (including efficient level of reliance). However, as noted earlier, contracts are rarely written in these terms because reasonable behavior is typically based on unverifiable information - particularly because the ex ante probability of breach is difficult to prove ex post at trial. The cost of verifying information concerning actions before breach or repudiation explains why contracts condition on contingencies rather than the actions of the parties. The mitigation requirement in contract law does limit the

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recovery of the promisee to the loss that could not be avoided by reasonable measures taken only after the promisee learns of the promisor’s repudiation or breach. Although verification problems undermine the effectiveness of the mitigation rule in this regard, at least the assessment of the ex ante probability of breach is not a factor. There is some evidence that judges may choose between expectation and reliance measures of damages based on their assessment of the reasonableness of the conduct of the promisor and promisee in any given case (Cohen, 1994). However, complete discharge of obligations under the doctrines of excuse is conditioned on the occurrence of events, rather than the actions of the parties (as long as the event in question was not due to the fault of the promisor). 4.2 Residual Risk Posner and Rosenfield suggest that the ability to bear residual risk (after all cost effective precautions are taken) is a function of cost of appraising the risk, the transaction cost of obtaining third party insurance and the degree of risk aversion. As noted above, a party might also self-insure by hedging its risk under the contract against other contracts and activities. Corporate parties often have elaborate webs of commercial and financing contracts that spread and transfer the risks of their activities. Indeed, the rules of debtor-creditor relations provide important risk allocations that should be integrated into the discussion of risk-sharing in commercial contracts. If the cost of performance rises to a level such that the seller cannot perform, she breaches and becomes liable for damages. However, if the seller becomes insolvent as a result, the buyer will recover only a fraction of these damages. Even in the case where expectation damages are awarded, the buyer bears the risk of a cost increase that threatens its seller’s solvency and shares this risk with other unsecured creditors of the seller (Triantis, 1992; Treblicock, 1994). Thus, the ability to take precautions against a given risk is likely to be of greater significance than the ability to bear residual risk in the identification of the superior risk bearer in a contract. In addition, one party may be in a better position to hedge specifically the risk of a dramatic increase in the cost of performance that hinges on a specific cause. If, for example, the cause is an exogenous increase in fuel cost and the buyer of the good owns oil fields or shares in oil companies, the buyer may be the superior risk bearer even if risk averse (Triantis, 1992). The contingency itself may inflict a loss on the seller beyond the liability for contract breach. For example, suppose the seller is a farmer who contracts to deliver crops grown on his land for a fixed price. A natural disaster - flooding destroys those crops. At the same time, the market price for the crops has increased substantially since the time of contracting as a result of the disaster. If the seller is not excused, she bears two losses: the loss of crops and the liability resulting from the increase in the market price of the crops. If the seller is risk averse, it may be efficient to pass on the second loss to another party,

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such as the buyer. The parties may signal that they intend this result when they provide for the sale of crops grown on a particular tract of land (Posner and Rosenfield, 1977; Sykes, 1998). Another instance of this approach is the rule that the destruction of identified goods prior to delivery, without fault of either party, discharges contractual obligations (U.C.C. 2-613; Taylor v. Caldwell, where lease of a music hall was rendered impossible because destroyed by fire). In theory, the point may be generalized to any case in which the promisor makes a substantial specific investment toward performance that is lost when she is compelled by circumstances to breach. If the promisee has incurred less significant reliance costs, excuse might provide a more even sharing of the losses caused by the occurrence of the contingency. The reason that excuse is not generally available in these cases may be that a promisor’s wasted investment is less verifiable than the physicial destruction of an asset (for example lost crops or identified goods). In some cases, the superior risk bearer is easy to identify. For example, the risk of a cost increase from a given cause should shift to the buyer if the seller cannot affect its probability or the loss suffered by the buyer as a result of nonperformance, if the buyer has at least as good information about the probability and magnitude of loss as the seller and if the buyer is risk-neutral or can hedge the risk of loss against its risk exposure from other activities. As several commentators have noted, however, the various factors determining risk-bearing advantage may well point to different parties and the task of determining the superior risk bearer overall may be very complicated (White, 1988; Treblicock, 1988). This reflects similar tensions discussed above with respect to the choice of remedies for breach, but complicated here because of the focus on specific causes and effects.

5. Judicial (ex post) Partitioning The discussion describes loosely the complex task of risk allocation in commercial contracts. An important part of it is deciding how to partition future states of the world. As Sykes demonstrated in the case of a regime of excuse conditioned on C > C' (see above), the benefits from fine partitions of quantitative outcomes in contracts are questionable and therefore the unforeseeability of the tails of the relevant distributions is not likely to be a concern. On the other hand, when a contract partitions according to the qualitative cause of contingencies, the remoteness of the contingency matters. The benefit of dealing with the specific cause must be discounted by its low probability. In addition, by definition, the parties have less experience with low probability events and therefore information is more costly. As a result, the

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benefit of addressing a remote risk may not be worth its cost (Gillette, 1985, 1990). At the same time, however, some causes tend to be more verifiable than the realized quantitative measures of cost or value of performance. All other things equal, it is less feasible for the parties to incur the cost of allocating remote risks specifically. They therefore would bundle them in more broadly framed risks, in much the same manner as travellers budget unexpected incidentals without identifying them specifically (Gillette, 1985; Triantis, 1992). As uncertainty resolves during the term of the contract and remote risks become more likely or materialize, the benefit from more specific allocation becomes correspondingly greater in order to reduce or avoid the risk in the most cost-effective manner. Recontracting in light of the new information is likely to be impeded by transaction costs and strategic behavior. The common law, industry custom or contract provisions (for example gross inequities provision requiring renegotiation in good faith) may address these obstacles by imposing duties on both parties to cooperate in adjusting the terms of their bargain. There is some debate about the extent to which the law should require cooperative adjustment to preserve the value of the exchange (Gillette, 1990; Scott, 1990). Moreover, if a dispute should arise at a later date, a court will be presented with the difficult task of distinguishing between efficient modifications and those obtained by strategic behavior (Aivazian, Treblicock and Penny, 1984). However, the issue of consensual adjustment of contracts is covered elsewhere in the encyclopedia. Posner and Rosenfield suggest that the courts can complete the contract with respect to those remote risks the parties could not foresee at the time of contracting, according to the principles of efficient risk allocation (Posner and Rosenfield, 1977). The benefit of specific allocation may be reproduced if a court later allocates ex post the once-remote risk, but only if the ruling is predictable. The judicial allocation of losses cannot yield the intended efficiency benefits of efficient precaution and insurance unless it can be predicted ex ante (Kull, 1991; Triantis, 1992). As discussed above, the superior risk bearer analysis must play with sets of criteria that often cut in opposite directions and call for information that is often unverifiable. (Treblicock, 1988; Schwartz, 1992). As a result, parties may well contract ex ante to avoid the additional risk of judicial intervention or may overinvest in precautions. (Triantis, 1992; Trebilcock, 1994). In an important recent article, Schwartz argues that common law excuse rules conditioned on unobservable or unverifiable information will be unusable by courts and rejected by future contracting parties (Schwartz, 1992). The concern with conditioning judicial allocation of risk on verifiable factors, in particular, seems to be a persuasive explanation for the greater inclination of the courts to excuse performance in cases where it has become impossible (for example by the destruction of the subject matter or because of government regulation) rather than impracticable. (Schwartz, 1992). As a normative matter, the courts should intervene to

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allocate remote risks when the incompleteness of the contract is due only to contracting costs, and not to obstacles of verification.

Bibliography on Unforeseen Contingencies. Risk Allocation in Contracts (4500) Adams, Michael (1986), ‘Der Irrtum über Künftige Sachverhalte. Anwendungsbeispiel und Einführung indie ökonomische Analyse des Rechts (Error about Future Facts)’, RECHT, Zeitschrift für Juristische Ausbildung und Praxis, 14-23. Adams, Michael (1986), ‘Zur Behandlung von Irrtümern und Offenbarungspflichten im Vertragsrecht (On Mistake and Information Revelation Duties in Contract Law)’, 186 Archiv für die Civilistische Praxis, 453-489. Aivazian, Varouj A., Trebilcock, Michael J. and Penny, Michael (1984), ‘The Law of Contract Modifications: The Uncertain Quest for a Benchmark of Enforceability’, 22 Osgoode Hall Law Journal, 173-212. Reprinted in Goldberg, Victor P. (ed.), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press, 1989, 207. Ashley, Stephen S. (1975), ‘The Economic Implications of the Doctrine of Impossibility’, 26 Hastings Law Journal, 1251-1276. Barnes, David W. and Stout, Lynn A. (1992), Economics of Contract Law, Minneapolis, West Publishing. Bellantuono, Giuseppe (1995), ‘Polizza Fideiussoria, Reticenza e Obblighi d Informazione (Performance Bond, Non-Disclosure and Duties of Information)’, V Il Foro Italiano, 1905-1909. Birmingham, Robert L. (1969), ‘A Second Look at Suez Canal Cases: Excuse for Nonperformance of Contractual Obligations in the Light of Economic Theory’, 20 Hastings Law Journal, 1393-1416. Brinig, Margaret F. and Alexeev, Michael V. (1995), ‘Fraud in Courtship: Annulment and Divorce’, 2 European Journal of Law and Economics, 45-63. Bruce, Christopher J. (1982), ‘An Economic Analysis of the Impossibility Doctrine’, 11 Journal of Legal Studies, 311-323. Centner, Terence J. and Wetzstein, Michael E. (1987), ‘Reducing Moral Hazard Associated with Implied Warranties of Animal Health’, 68 American Journal of Agricultural Economics, 143-150. Centner, Terence J. and Wetzstein, Michael E. (1988), ‘Reducing Moral Hazard Associated with Implied Warranties of Animal Health: Reply’, 70 American Journal of Agricultural Economics, 413-414. Chami, Ralph (1996), ‘King Lear’s Dilemma: Precommitment versus the Last Word’, 52 Economics Letters, 171-176. Chami, Ralph and Fischer, Jeffrey (1996), ‘Altruism, Matching and Nonmarket Insurance’, 34 Economic Inquiry, 630-647. Chisholm, Darlene C. (1993), ‘Asset Specificity and Long-Term Contracts: The Case of the Motion-Pictures Industry’, 19 Eastern Economic Journal, 143-155. Chisholm, Darlene C. (1996), ‘Continuous Degrees of Residual Claimancy: Some Contractual Evidence’, 3 Applied Economics Letters, 739-741.

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Chisholm, Darlene C. (1997), ‘Profit-Sharing versus Fixed-Payment Contracts: Evidence From the Motion Pictures Industry’, 13 Journal of Law, Economics, and Organization, 169-201. Cohen, George M. (1994), ‘The Fault Lines in Contract Damages’, 80 Virginia Law Review, 1225 ff. Cooter, Robert (1985), ‘Unity in Tort, Contract, and Property: The Model of Precaution’, 73 California Law Review, 1 ff. Craswell, Richard (1988), ‘Precontractual Investigation as an Optimal Precaution Problem’, 17 Journal of Legal Studies, 401 ff. Eidenmüller, Horst (1995), ‘Neuverhandlungspflichten bei Wegfall der Geschäftsgrundlage (Renegotiation Duties Following a Fundamental Change of Circumstances)’, 16 Zeitschrift für Wirtschaftsrecht, 1063-1071. Farnsworth, Allan E. (1968), ‘Disputes over Omission in Contracts’, 68 Columbia Law Review, 860 ff. Frech, H. Edward III and Decanio, Stephen J. (1993), ‘Vertical Contracts: A Natural Experiment in Gas Pipeline Regulation’, 149 Journal of Institutional and Theoretical Economics, 370-392. Gemtos, Petros A. (1976), ‘Antimetopises tou Plethorismou os Oikonomikon kai Nomikon Provlema. Sygchronos Symvole eis ten Diereunesin ton Themeliakon Scheseon ton Pragmatologikon kai ton Kanonistikon Epistemon (The Treatment of Inflation as an Economic and Legal Problem. Contemporary Contribution to the Examination of the Fundamental Relations between the Positive and Normative Sciences)’, 30 Harmenopoulos, 830-846. Gillette, Clayton P. (1985), ‘Commercial Rationality and the Duty to Adjust Long-Term Contracts’, 69 Minnesota Law Review, 521 ff. Gillette, Clayton P. (1990), ‘Commercial Relationships and the Selection of Default Rules for Remote Risks’, 19 Journal of Legal Studies, 535 ff. Goldberg, Victor P. (1985), ‘Price Adjustment in Long-Term Contracts’, Wisconsin Law Review, 527-543. Reprinted in Speidel, Summers and White (1987), Commercial Law: Teaching Materials, fourth edition. Goldberg, Victor P. (1988), ‘Impossibility and Related Excuses’, 144 Journal of Institutional and Theoretical Economics, 100-116. Hansmann, Henry B. and Kraakman, Reinier H. (1992), ‘Hands-Tying Contracts: Book Publishing, Venture Capital Financing, and Secured Debt’, 8 Journal of Law, Economics, and Organization, 628-655. Hasen, Richard L. (1990), ‘Comment, Efficiency Under Informational Asymmetry: The Effect of Framing on Legal Rules’, 38 UCLA Law Review, 391 ff. Hatzis, Aristides N. (1998), An Economic Theory of Greek Contract Law, Ph.D. Thesis, University of Chicago Law School. Herrmann, Harald (1988), ‘Vertragsanpassung - Ein Problem des Freiheitsschutzes nach Vertragsschluß (Contract Adaptation - A Problem of Liberties’ Protection after Contract Conclusion)’, JURA, 505-511. Hurst, Thomas R. (1976), ‘Freedom of Contract in an Unstable Economy: Judicial Reallocation of Contractual Risks under UOC’ Section 2-615', 54 North Carolina Law Review, 545-583. Johnsen, D. Bruce, and (1995), ‘The Quasi-Rent Structure of Corporate Enterprise: A Transaction Cost Theory’, 44 Emory Law Journal, 1277 ff.

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Joskow, Paul L. (1977), ‘Commercial Impossibility, the Uranium Market and the Westinghouse Case’, 6 Journal of Legal Studies, 119-176. Joskow, Paul L. (1988), ‘Price Adjustments in Long-Term Contracts: The Case of Coal’, 31 Journal of Law and Economics, 47 ff. Klein, Benjamin, Crawford, Robert G. and Alchian, Armen A. (1978), ‘Vertical Integration, Appropriable Rents, and the Competitive Contracting Process’, 21 Journal of Law and Economics, 297 ff. Koller, Ingo (1979), Die Risikozurechnung bei Vertragsstörungen in Austauschverträgen (The Risk Allocation of Contract Disturbances in Bilateral Contracts), München, C.H. Beck, 474 p. Kornhauser, Lewis A. (1983), ‘Reliance, Reputation, and Breach of Contract’, 26 Journal of Law and Economics, 691 ff. Kronman, Anthony T. (1979), ‘Mistake, Disclosure, Information, and the Law of Contracts’, 7 Journal of Legal Studies, 1 ff. Kull, Andrew (1991), ‘Mistake, Frustration, and the Windfall Principle of Contract Remedies’, 43 Hastings Law Journal, 1 ff. Mackaay, Ejan and Fabien, Claude (1983), ‘Le Droit Civil aux Prises avec l’Inflation (Civil Law on Prices with Inflation)’, Revue de Droit de McGill, 284-334. Mackaay, Ejan and Fabien, Claude (1984), ‘Civil Law and the Fight against Inflation - A Legal and Economic Analysis of the Quebec Case’, 44 Louisiana Law Review, 719-754. Miceli, Thomas J. (1995), ‘Renegotiation of Listing Contracts, Seller Opportunism, and Efficiency: an Economic Analysis’, 23 Real Estate Economics, 369-383. Miceli, Thomas J. (1995), ‘Contract Modification when Litigating for Damages is Costly’, 15 International Review of Law and Economics, 87-99. Mousseron, Jean-Marc (1987), ‘La Gestion des Risques par le Contrat (Risk Management by Contract)’, Revue trimestrielle de Droit Civil, 481 ff. Pardolesi, Roberto (1996), ‘Regole di Default e Razionalità Limitata: per un (Diverso) Approccio di Analisi Economica al Diritto dei Contratti (Default Rules and Bounded Rationality: for a (Different) Economic Approach to Contract Law)’, Rivista Critica del Diritto Privato, 451-466. Perloff, Jeffrey M. (1981), ‘The Effects of Breaches of Forward Contracts Due to Unanticipated Price Changes’, 10 Journal of Legal Studies, 221-235. Phillips, Jenny (1978), ‘Comments on Posner’s and Rosenfield’s Paper’, in Skogh, Göran (ed.), Law and Economics. Report from a Symposium in Lund, Lund, Juridiska Föreningen, 95-96. Polinsky, A. Mitchell (1983), ‘Risk Sharing through Breach of Contract Remedies’, 12 Journal of Legal Studies, 427-444. Polinsky, Mitchell A. (1987), ‘Fixed Price versus Spot Price Contracts: A Study in Risk Allocation’, 3 Journal of Law, Economics, and Organization, 27-46. Posner, Richard A. and Rosenfield, Andrew M. (1977), ‘Impossibility and Related Doctrines in Contract Law: An Economic Analysis’, 6 Journal of Legal Studies, 83-118. Reprinted in Skogh, Göran (ed.) (1978), Law and Economics. Report from a Symposium in Lund, Sweden, 24-26 August 1977, Lund, Juridiska Föreningen, 57-94. Reprinted in Goldberg, Victor P. (ed.) (1989), Readings in the Economics of Contract Law, 200-212. Rasmusen, Eric and Ayres, Ian (1993), ‘Mutual and Unilateral Mistake in Contract Law’, 22 Journal of Legal Studies, 309-343.

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Ribhegge, Hermann (1994), ‘Ökonomische Theorie des Effizienten Vertragsbruchs und die Normativen Grundlagen der Ökonomischen Theorie des Rechts (The Economic Theory of Efficient Breach of Contracts and the Normative Foundations of the Economic Analysis of Law)’, 11 Homo Oeconomicus, 113-141. Schwartz, Alan (1976), ‘Sales Law and Inflations’, 50 Southern California Law Review, 1 ff. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 138-142. Schwartz, Alan (1992), ‘Relational Contracts in the Courts: An Analysis of Incomplete Agreements and Judicial Strategies’, 21 Journal of Legal Studies, 271 ff. Schwartze, Andreas (1988), ‘Die Beseitigung des Wegfalls der Geschäftsgrundlage: Zur wirtschaftlichen Effizienz und zur juristischen Konsistenz eines ökonomischen Modells’ (The Abolition of the Frustration of Contract: On Economic Efficiency and Legal Consistency of an Economic Model)’, Recht und Risiko, 155-170. Scott, Robert E. (1990), ‘A Relational Theory of Default Rules for Commercial Contracts’, 19 Journal of Legal Studies, 597 ff. Seita, Alex Y. (1984), ‘Uncertainty and Contract Law’, 46 University of Pittsburgh Law Review, 75-148. Shavell Steven (1980), ‘Damages Measures for Breach of Contract’, 11 Bell Journal of Economics, 466 ff. Shavell Steven (1984), ‘The Design of Contracts and Remedies for Breach’, 20 Quarterly Journal of Economics, 121 ff. Smith, Janet Kiholm (1987), ‘Trade Credit and Informational Asymmetry’, 42 Journal of Finance, 863-872. Smith, Janet Kiholm and Cox, Steven R. (1985), ‘The Pricing of Legal Services: A Contractual Solution to the Problem of Bilateral Opportunism’, 14 Journal of Legal Studies, 167-183. Smith, Janet Kiholm and Smith, Richard L. (1985), ‘A Theory of Ex Post Versus ex ante Price Determination’, 23 Economic Inquiry, 57-67. Smith, Janet Kiholm and Smith, Richard L. (1990), ‘Contract Law, Mutual Mistake, and Incentives to Produce and Disclose Information’, 19 Journal of Legal Studies, 467-488. Speidel, Richard E. (1980), ‘Excusable Nonperformance in Sales Contracts: Some Thoughts About Risk Management’, 32 South Carolina Law Review, 241 ff. Speidel, Richard E. (1981), ‘Court-Imposed Price Adjustements Under Long-Term Supply Contracts’, 76 Northwestern University Law Review, 369-422. Spier, Kathryn E. (1992), ‘Incomplete Contracts and Signalling’, 23 (3) Rand Journal of Economics, 432-443. Spindler, Gerald (1988), ‘Geschäftsgrundlage und Steuerrechtsänderungen (Changes of tax law and their impact on long term contracts - an economic analysis)’, in Finsinger and Simon (eds), Recht und Risiko. Juristische und ökonomische Analysen, München, Florentz, 288-325. Stout, Lynn A. and Barnes, David D. (1992), Economics of Contract Law, Minneapolis, West Publishing. Sykes, Alan O. (1990), ‘The Doctrine of Commercial Impracticability in a Second-best World’, 19 Journal of Legal Studies, 43-94. Sykes, Alan O. (1998), ‘Impossibility Doctrine in Contract Law’, in Newman, Peter (ed.), The New Palgrave Dictionary of Economics and the Law, London, Macmillan.

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Trebilcock, Michael J. (1988), ‘The Role of Insurance Considerations in the Choice of Efficient Civil Liability Rules’, 4 Journal of Law, Economics, and Organization, 243 ff. Trebilcock, Michael J. (1994), The Limits of Freedom of Contract, Cambridge, Cambridge University Press. Triantis, Alexander J. and Triantis, George G. (1998), ‘Timing Problems in Contract Breach Decisions’, 41 Journal of Law and Economics, 163 ff. Triantis, George G. (1992), ‘Contractual Allocation of Unknown Risks: A Critique of the Doctrine of Commercial Impracticability’, 42 University of Toronto Law Journal, 450-483. Trimarchi, Pietro (1989), ‘Der Wegfall der Geschäftsgrundlage aus allokativer Sicht - Kommentar (The Frustration of Contract from an Allocative Perspective - Commentary)’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Allekationseffizienz in der Rechtsordnung, Berlin, Springer, 163-167. Trimarchi, Pietro (1991), ‘Commercial Impracticability in Contract Law: An Economic Analysis’, 11 International Review of Law and Economics, 63-82. Vandegrift, Donald (1997), ‘Decision Costs, Contract Excuse and the Westinghouse Commercial Impracticability Case’, 4 European Journal of Law and Economics, 41-54. Veljanovski, Cento G. (1988), ‘Impossibility and Related Excuses: Comment’, 144 Journal of Institutional and Theoretical Economics, 117-121. Walt, Steven (1990), ‘Expectations, Loss Distribution and Commercial Impracticability’, 24 Indiana Law Review, 65 ff. Warren, Elizabeth (1981), ‘Trade Usage and Parties in the Trade: An Economic Rationale for an Inflexible Rule’, 42 University of Pittsburgh Law Review, 515 ff. White, Michelle J. (1988), ‘Contract Breach and Contract Discharge due to Impossibility: A Unified Theory’, 17 Journal of Legal Studies, 353-376. Williamson, Oliver E. (1979), ‘Transaction Cost Economics: The Governance of Contractual Relations’, 22 Journal of Law and Economics, 233 ff. Wladis, John D. (1988), ‘Impracticability as Risk Allocation: The Effect of Changed Circumstances Upon Contract Obligations for the Sale of Goods’, 22 Georgia Law Review, 503 ff.

Cases Fibrosa S.A. v. Fairbairn Lawson Combe Barbour, Ltd., 143 App. Cas. 32 (1942) Hadley v. Baxendale, Ex. 341, 156 Eng. Rep. 145 (1854) Taylor v. Caldwell, 122 Eng. Rep. 309 (K.B. 1863)

4600 CONTRACT REMEDIES: GENERAL Paul G. Mahoney Professor of Law and Albert C. BeVier Research Professor, University of Virginia School of Law © Copyright 1999 Paul G. Mahoney

Abstract This chapter surveys and analyzes the substantial literature on optimal remedies for contract breach in a variety of settings. It begins with a standard analysis of the behavioral effects of expectation and reliance damages, then discusses the application of these damage measures in a world where courts are not perfectly informed about the parties’ valuations of the contract. When valuation problems are extreme, courts may turn to alternative remedies such as specific performance, or parties may attempt to solve the problem themselves through liquidated damages clauses. The chapter considers whether these solutions to the valuation problem alleviate or exacerbate opportunistic behavior by the parties. It also highlights the recent contributions that game theory and options theory have made to the understanding of remedial choices. JEL classification: K12 Keywords: Contract Damages, Remedies

1. Introduction The principal remedy for breach of contract in Anglo-American law is an award of money damages. The preferred measure of damages is the expectation measure, under which the promisee receives a sum sufficient, in theory, to make him indifferent between the award and the performance. Other damage measures, and other remedies such as specific performance and rescission, are available in special circumstances. This chapter discusses the basic design of the remedial system.

A. The General Problem 2. Sanctions and Incentives A contract is an exchange of promises or an exchange of a promise for a present performance, and the parties enter into it because each values the thing 117

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received more than the thing foregone. These values are based on expectations about the future because some or all of the contractual performance will occur in the future. When the future diverges from what a party expected, he may conclude that the performance he will receive under the contract is no longer more valuable than the performance he must provide. He has, in the terminology of Goetz and Scott (1980), experienced a ‘regret contingency’ and now would prefer not to perform and not to receive the promised performance from the other party. Absent a system of contract remedies, a party who regrets entering into a contract will not perform unless he fears that the breach will result in sanctions by the other party (who might have required security for the performance) or by third parties (who might revise their opinion of the breacher and reduce their economic and/or social interactions with him accordingly). The economic function of contract remedies, then, is to alter the incentives facing the party who regrets entering into the contract, which will directly affect the probability of performance and indirectly affect the number and type of contracts people make, the level of detail with which they identify their mutual obligations, the allocation of risks between the parties, the amount they invest in anticipation of performance once a contract is made, the precautions they take against the possibility of breach, and the precautions they take against the possibility of a regret contingency. An administratively simple system of remedies would aim to reduce the probability of breach to near zero. That could be achieved by the routine (and speedy) grant of injunctions against breach backed by large fines for disobeying the injunction or by imposing a punitively large monetary sanction for breach. This would give promisees a high degree of confidence that the promised performance will occur and induce a high level of investment in anticipation of performance. In the standard parlance, this would be a ‘property’ rule because it would entitle the promisee to the performance except to the extent the promisor is able to negotiate a modification on terms acceptable to the promisee.

3. Efficient Contracts and Efficient Nonperformance Were it possible to enter into complete state-dependent contracts (that is, contracts that identified every possible contingency (state) and specified the required actions of the parties for each), parties would be willing to be bound to contracts even were the sanction for breach punitive. Such contracts would require performance in some states but excuse it in others, in such a way that each party would be willing ex ante to be absolutely bound to perform the required actions in all states. Shavell (1980) defines a ‘Pareto efficient complete contingent contract’ as a complete state-dependent contract to which no mutually beneficial modifications could be made, viewed at the time of

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contracting. We will call such contracts ‘efficient’. In doing so, we will assume unless otherwise stated that the parties are risk neutral, each party’s objective is to maximize his wealth, post-contractual renegotiation is prohibitively costly, performance is all or nothing (that is, partial performance is not possible), and the contracts do not create uncompensated gains or losses for third parties. Under what conditions would an efficient contract excuse performance? Shavell demonstrates that the contract would require performance in all circumstances except those in which nonperformance would result in greater joint wealth. An example will illustrate the point. Imagine that Seller agrees to manufacture and sell to Buyer a machine that Buyer will use in its own manufacturing process. The value of the machine to Buyer is $300; however, Buyer has an opportunity to make certain alterations to his manufacturing plant, at a cost of $50, which will increase the value of the machine to $375. Such investments by a promisee in anticipation of performance are called ‘reliance expenditures’ or ‘reliance investments’ in the literature, and we will use the terms interchangeably. Assume for the moment that the future can be represented as a set of two possible states; Seller’s production cost is $200 in one state and $400 in the other. An efficient contract would require Seller to make the machine in the low-cost state but not in the high-cost state. In the high-cost state, the joint wealth of the parties is greater if Seller does not perform than if it does. This can be seen by comparing the cost of performance to Seller ($400) with the benefit to Buyer ($300 or $375, depending on whether Buyer makes the reliance investment). The contract price is irrelevant as it is transferred from Buyer to Seller and does not affect their joint wealth. Both parties can be made to prefer this contract to one that requires performance in both states. They can allocate between themselves the extra wealth created by the efficient contract, and there will be some allocations under which each party’s expected gain exceeds the expected gain from the contract that always requires performance. By choosing such an allocation, each party will be better off at the time of contracting and willing to be bound to perform or not perform as required. In the literature, a breach that occurs in circumstances in which an efficient contract would excuse performance is called an ‘efficient breach’.

4. Barriers to Efficient Contracting; Remedies as a Substitute for Efficient Contracts To reiterate, faced with an efficient contract, courts would have the simple task of requiring strict adherence to its terms. Unfortunately, the writing of efficient contracts is no easy task. It is costly to bargain over remote contingencies and the parties may lack the foresight to deal with all possible states. Moreover, the

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parties may not have equal access to the information necessary to tell which state occurs. In the above example, Seller may know whether the cost of manufacturing the machine is $200 or $400, but Buyer may have no way to verify Seller’s assertion. Given these barriers to efficient contracting, the law faces a more complex problem than that of compelling adherence to efficient contracts. Instead, it must take incomplete contracts and augment them by damage measures that induce behavior that mimics reasonably closely the behavior that an efficient contract would require. A particular damage measure can be termed ‘efficient’ with respect to a particular decision if it creates an incentive for the relevant party to make the same decision it would under an efficient contract. Because standard damage measures allow a promisor to breach and pay compensatory (rather than punitive) damages, they are called ‘liability’ rules in contrast to property rules as defined above.

5. Other Approaches An alternative framework for the design of damage measures is offered by Barton (1972). He poses the problem as one of designing damage measures that would induce the parties to make the same decisions regarding performance or breach, and reliance prior to performance or breach, that they would make were the parties divisions of a single, integrated firm and had the sole objective of maximizing the value of the firm. Shavell and Barton each show that the objective of an efficient regime of contract damages is to cause the parties to maximize their joint wealth, although one might prefer Shavell’s conceptual approach on the grounds that Barton’s assumes away the problem by positing a wealth-maximizing firm. A more recent perspective on contract damages is to consider money damages as an option under which, for example, Seller may purchase Buyer’s entitlement to Seller’s performance. The option expires on the date fixed for performance and its strike price is the damage award (which may from the parties’ perspective be a random variable). The value of the option is reflected in the contract price (see Mahoney, 1995; Ayres and Talley, 1995). This literature derives from the more general use of option theory to analyze decision making under uncertainty (see Dixit and Pindyck, 1994). We will make occasional reference to the options perspective below.

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B. The Standard Damage Measures 6. A Taxonomy of Damage Measures The preferred measure of contract damages is the amount of money that will make the promisee indifferent between performance and damages. It should be noted at the outset that this formulation of the measure of damages is not fully accurate; there are a number of limiting doctrines, discussed in Chapter 4620, that often reduce money damages below the promisee’s subjective valuation of the performance. There is also some evidence that courts award greater damages for breaches that appear opportunistic (see Cohen, 1994). As courts express it, however, the preferred measure of damages is the amount necessary to put the aggrieved party in the same position as if performance had occurred, which is known as the expectation measure. Fuller and Perdue (1935) provide the standard taxonomy of contract damage measures. They identify three different ‘interests’ of the promisee that are affected by a breach - expectation, reliance, and restitution - and state that the most common damage measures provide compensation for one of the three. The expectation interest is measured by the net benefit the promisee would receive should performance occur, as described above. The restitution interest consists of any benefit the promisee has provided the breaching party. For example, if a seller agrees to make monthly deliveries of a commodity in return for fixed payments due 60 days after each delivery and the buyer repudiates the contract after receiving and retaining two deliveries but making no payments, restitutionary damages would restore to the seller the value of the delivered goods. The reliance interest is measured by the promisee’s wealth in the pre-contractual position. Reliance damages provide compensation both for any benefit conferred on the breaching party and for any other reliance investments made by the promisee in anticipation of performance to the extent such investments cannot be recovered. In most instances, the restitution measure will provide the lowest recovery and the expectation measure the highest. One complication is how to treat other contractual opportunities that Buyer passed up in order to enter into the contract with Seller. Analytically, these seem similar to reliance investments and are often treated as such. In a competitive market, where Buyer could have entered into another contract at an identical price had he not contracted with Seller, the reliance measure and the expectation measure will converge approximately. ‘Approximately’, because the value of the alternative contract is a function of the probability that it will be performed (see Cooter and Eisenberg, 1985) and of the damage remedy if it is not performed, and thus the problem is somewhat circular. When analyzing the difference between expectation damages and reliance damages below, we will assume that they

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differ and that Buyer’s expectation interest exceeds his reliance interest. We will also assume that the reliance interest equals or exceeds the restitution interest, although we will relax that assumption in Section 12 below.

7. Incentives Within an Existing Contract: The Decision to Perform or Breach The expectation measure leads to efficient decisions to perform or breach an existing contract, given a fixed level of reliance (see Barton, 1972; Shavell, 1980; Kornhauser, 1986). This can be illustrated using the example set out above. Assume that the contract price for the machine is $250 and that Buyer makes an irrevocable decision to invest $50 in reliance, an investment that has no value absent the contract. When production costs are $200, Seller will manufacture the machine and Buyer will pay $250 for it. Buyer then obtains a machine worth $375 to him for a total expenditure (contract price plus reliance expenditure) of $300. The transaction increases Buyer’s wealth by $75. When production costs are $400, Seller will breach. The expectation measure seeks to make Buyer as well off as if Seller had performed. Seller’s breach relieves Buyer from his obligation to pay the contract price. Accordingly, if Seller pays Buyer damages of $125, Buyer will be in the same position as if Seller had performed, having paid out a non-recoverable $50 in reliance and received $125, for a net increase in wealth of $75. So long as Buyer is awarded $125 in the event of breach, Seller will breach only when the cost of performance exceeds $375, the value of the performance to Buyer. Compare this result to that obtained under the reliance measure. Under the reliance measure, Seller must compensate Buyer for his $50 reliance investment. Assume for a moment that there is a third possible state under which Seller’s cost of production is $350. Performance would be efficient because its value to Buyer exceeds its cost to Seller. Seller will perform given expectation damages, because the damage award of $125 exceeds the net loss from performance ($350 cost minus the $250 contract price). Given reliance damages, however, Seller will breach and pay $50 rather than perform at a loss of $100. More generally, it is obvious that given expectation damages, only when the production cost reaches $376 will Seller become better off by breaching and paying damages then by performing and losing the difference between his production cost and the contract price. The expectation measure, unlike the reliance measure, causes Seller to internalize fully the effect on Buyer’s wealth of Seller’s decision to perform or breach.

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8. Incentives within an Existing Contract: The Decision to Rely While the expectation measure produces efficient decisions to breach given reliance, it does not produce efficient levels of reliance. In general, expectation damages result in excessive reliance expenditures, because they cause Buyer to act as if performance were always forthcoming. In the example, Buyer will always spend $50 to increase the value of performance from $300 to $375, because either (1) the performance will be forthcoming or (2) Buyer will be compensated for the lost $375 in value. In the high-cost state, however, the parties’ joint wealth would be greater if Buyer refrained from investing. Seller would be liable for damages of $300 less the $250 contract price, or $50. By contrast, if Buyer relies, he receives $125 in damages as shown above and increases his wealth by $75 net of the reliance expenditure. Unlike the no-reliance case, where Buyer gains $50 and Seller loses $50, here Buyer gains $75 and Seller loses $125. The difference reflects the fact that the $50 expenditure is wasteful in the high-cost state. Expectation damages, then, do not cause Buyer to internalize fully the effect on Seller’s wealth of Buyer’s decision to make a reliance investment. The reliance measure is subject to the same objection. Under the reliance measure, Buyer will recover $50 if it invests that amount in reliance. Once again, Buyer’s investment decision will be made as if the investment is not risky, even though it is (because performance is inefficient in some states). Indeed, reliance damages create a perverse incentive for Buyer in some circumstances. Assume for a moment that Seller’s production cost is $310. Under the reliance measure, Seller will pay damages of $50 rather than perform and suffer a loss of $60 ($310 minus the $250 contract price). Breach deprives Buyer of a $75 gain (showing again that any measure of damages less than the expectation measure induces inefficient breach decisions). Buyer may be able to avoid breach, however, by making an additional (and we will assume wasteful) reliance expenditure of $11. Now reliance damages amount to $61, and Seller performs. Thus the excessive breach problem can be cured in part, but at the cost of excessive reliance. In general, as Shavell (1980) demonstrates, the reliance measure will result in greater (inefficient) reliance expenditures than the expectation measure. There is no measure of damages that results both in efficient decisions to perform or breach and efficient decisions to make or not make reliance expenditures. However, expectation damages do better than reliance damages at inducing efficient breach decisions, and do no worse than reliance damages at inducing efficient reliance decisions. Accordingly, given the various assumptions outlined above, the expectation measure is preferable on efficiency grounds. The analysis to this point has assumed risk neutrality. A risk-averse Buyer would have additional cause to prefer the expectation measure, because it eliminates variability from Buyer’s outcome. At the same time, the expectation measure introduces greater variability into Seller’s outcome than does the

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reliance measure. It is accordingly possible that where both parties are risk averse, they may find that a sum of damages greater than the reliance measure but less than the expectation measure offers the highest joint utility level. The precise formulation of the damage amount would depend on the parties’ comparative levels of risk aversion (see Polinsky, 1983). It seems plausible that courts have not tried to alter damage measures to accommodate risk aversion (except to the extent specific performance can do so, as discussed in Section 10 below) because of the administrative and error costs that would result. The analysis has also assumed that renegotiation at the time of breach is prohibitively costly. Were negotiation costless, the damage rule would be irrelevant, as the parties would in all cases bargain to Pareto efficient breach/performance and reliance decisions, as per the Coase Theorem (Coase, 1960). In the more plausible situation where renegotiation is costly but not always prohibitively so, the choice of remedy is necessarily more difficult. Some critics have therefore argued that much of the literature on damage remedies is beside the point, as the choice of remedies should be informed principally by an analysis of transaction costs (see Friedmann, 1989; MacNeil, 1982). Friedmann analyzes potential transaction costs in a variety of contractual settings and argues that over compensatory remedies (remedies that provide compensation to the promisee in excess of the expectation interest) will generally be efficient.

9. Incentives at the Stage of Contract Formation Friedmann and MacNeil are surely correct to argue that a better understanding of the costs of postcontractual renegotiation is necessary for making efficient remedial choices. It is also, however, worth paying attention to the effect of remedies on precontractual negotiations. The price Seller will require to enter into a contract is increasing in the damage measure. Returning to our example, when Buyer makes a $50 reliance expenditure and Seller breaches, again assuming no opportunity costs, Buyer’s wealth decreases by $50. Buyer can be no worse off from entering into the contract so long as the remedy for breach is at least $50. Will Buyer be willing to pay more for the more generous expectation measure, and will Buyer and Seller prefer the resulting contract to one that provides for reliance damages only? As Friedman (1989) notes, the difference in remedies affects the contract price, the quantity contracted, and the quantity actually consumed, with effects that vary with market structure and utility functions. In general, however, the range of contract prices for which the contract increases both parties’ wealth will be greater under a reliance measure than an expectation measure. That is, the reliance measure will create a greater bargaining range, which might increase the number of contracts entered into.

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The choice of remedies where precontractual as well as postcontractual incentives are analyzed remains an underdeveloped area. Friedman (1989) provides a formal analysis of expectation and reliance for two contexts in which those measures diverge. The first is the case of a breaching buyer who has contracted to purchase from a monopolist selling at a single price. The second is the case of a breaching buyer in a competitive market where the seller does not know its production cost in advance but the buyer does. Friedman demonstrates that neither damage remedy dominates the other under those conditions. Friedman’s analysis is limited, however, by his assumption that reliance is fixed and exogenous. The situations he analyzes, moreover, have the desired formal characteristics (expectation and reliance measures diverge) but are probably not very common. A possible alternative would be to start by assuming that the expectation and reliance measures diverge without specifying market structure in detail. A model could then be developed in which the choice between expectation and reliance damages affects the structure of the contract, the decision to breach, and the decision to rely. The equilibrium and comparative statics of such a model might shed light on the type of market conditions under which expectation or reliance damages would be more nearly optimal. It would also be valuable to consider carefully whether there are plausible conditions under which the cost of negotiating around an inefficient damages measure at the time of contracting is greater or less than the cost of renegotiating at the time of performance.

C. Alternative Damage Measures 10. Specific Performance Disappointed promisees are not in all cases limited to an award of damages; under appropriate circumstances, they may seek the equitable remedy of specific performance. A decree of specific performance requires the breaching party to perform according to the contract. The principal criterion for awarding specific performance is a demonstration that money damages are insufficient to compensate the promisee for the lost performance. Traditionally, this was most often found when the breaching party was a seller who had agreed to sell a ‘unique’ good. Real estate has long been presumed in many jurisdictions to be unique, while other goods such as artworks and heirlooms are often found to be unique. Specific performance is analogous to a punitive sanction that seeks to deter breach absolutely. In order for it to have that effect, we must assume that renegotiation is costly. It would then seem clear that expectation damages are preferable to specific performance, because the latter would sometimes result

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in performance even though nonperformance would result in greater joint wealth. On the other hand, it should be clear that the assumption that courts can adequately calculate a sum of money sufficient to make the promisee indifferent between damages and breach is not always accurate, particularly where cover is not possible. In such circumstances we must rely on a lost surplus measure of damages, and the calculation of Buyer’s consumer surplus is necessarily subjective. This is not a fatal objection if we believe that courts will guess correctly on average, but if they systematically underestimate Buyer’s surplus, the monetary remedy will result in too much breach, just as specific performance results in too much performance. Kronman (1978) started the law and economics debate on specific performance by employing a framework similar to that of the prior paragraph. He notes that specific performance is a property rule in the sense defined in Section 2 above; it effectively assigns the promisee an absolute entitlement to the goods from the moment the contract is made. This does not make sense in most instances because renegotiation (meaning a transfer of the property right back to the promisor) is costly and the result will be an inefficiently high level of performance. The danger of undercompensation, which would result in an inefficiently low level of performance, is normally lower because there is often a substitute price available. When, however, there is no substitute price available (the case of ‘unique’ goods), the danger of under compensation likely outweighs the cost of renegotiation. Accordingly, the legal rules, in a rough manner, promote efficiency. Schwartz (1979) argues that undercompensation is not merely an isolated problem limited principally to goods for which there is no obvious substitute, but is built into the structure of money damages. The reluctance of courts to award damages that are uncertain, difficult to measure, or unforeseeable (see Chapter 4620), or to provide compensation for emotional harm resulting from a breach, makes money damages systematically under compensatory. Schwartz argues that the resulting inefficiencies are likely greater than those resulting from renegotiation costs, and accordingly that specific performance, rather than money damages, should be the default remedy. Bishop (1985) adopts a similar analytic approach but argues that both Kronman and Schwartz have overgeneralized their arguments. He breaks down contract breaches into a number of categories depending on the identity of the breaching party (buyer or seller), the type of contract, and the alternative transactions available to buyer and seller. He also identifies another cost of awarding specific performance. Because the value of a specific performance award (including the amount the promisor will pay to be released from performance) will in some cases exceed the value of performance to the promisee, the promisee will be tempted to behave opportunistically in hopes of causing a breach and satisfying the conditions for specific performance. Bishop

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argues that in some categories the problem of excessive breach resulting from undercompensation will dominate, and in others the problem of excessive performance resulting from renegotiation costs and opportunism will dominate. The relative magnitudes of the inefficiencies generated by costly renegotiation and undercompensation are ultimately empirical questions and to date the literature does not provide data from which we could confidently identify the preferred remedy. Accordingly, Mahoney (1995) takes a different approach to the problem, using the option methodology outlined above. The methodology is first employed to confirm the argument made by Craswell (1988) that were renegotiation costless and money damages perfectly compensatory, risk-averse contracting parties would always prefer money damages to specific performance. The intuition is that entering into a contract with a money damages remedy is analogous to holding a hedged position in a commodity, whereas the identical contract with a specific performance remedy is analogous to holding an unhedged position. The variance of possible outcomes is greater for both parties with the unhedged contract and they will accordingly prefer money damages. In the face of costly renegotiation and undercompensation, we can still make some sense of the case law using the option heuristic. Many contracts involving ‘unique’ goods are prompted by the desire of the buyer to speculate on the future value of the land, artwork, and so on, and speculation involves holding an unhedged position. Thus buyer and seller would likely prefer specific performance. Other cases in which specific performance has been consistently awarded (long-term contracts to supply a fuel input to a public utility or other regulated entity) can be explained by noting that the buyer is likely more risk averse with respect to price fluctuations than is the seller, and specific performance better accommodates that distinction.

11. Liquidated Damages We began the analysis of damages by arguing that court-awarded damages function as a substitute for complete state-dependent contracts. The court’s application of an efficient damages rule creates appropriate incentives to perform or not perform, rely or not rely, and so on, and thereby saves the parties the trouble of drafting their contract to provide for all contingencies. Some parties, however, choose to create a tailor-made incentive structure by specifying the amount of damages payable in the event of breach. Courts have adopted a skeptical attitude toward these so-called liquidated damages clauses. In general, courts will enforce a liquidated damages clause only if (a) at the time of contracting, the damage that the promisee will suffer in the event of breach (that is, the promisee’s expectation) is uncertain, and (b) the amount of liquidated damages is both a reasonable estimate of (the mean of) those

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damages and not disproportionate to the actual (ex post) damages. A larger amount is called a ‘penalty’ and is unenforceable. This attitude is puzzling to most law and economics scholars. Absent some reason to believe that one or both parties misunderstood the terms of the agreement, we would normally assume that they went to the trouble to specify liquidated damages because the resulting contract is Pareto superior to a contract that calls for the ordinary court-awarded damages. The courts’ approach might increase the net wealth of the parties, but only if the existence of a penalty is strong evidence that the contract does not represent the parties’ actual intent, perhaps because one defrauded the other. The focus of scholarship in the area, therefore, has been to ask under what circumstances rational, well-informed parties would agree to a penalty clause. Goetz and Scott (1977) note, in terms similar to those of the later specific performance debate, that damages measures do not adequately compensate for the subjective value the promisee attaches to performance, particularly when close substitutes for the performance are unavailable or the timing of the performance is critical. In those circumstances, normal damage measures will lead to excessive breach. The promisee could purchase third-party insurance that would pay off in the event of breach in an amount sufficient to make him whole. In some circumstances, however, the probability of breach is determined not just by exogenous variables beyond the parties’ control, but also the level of care taken by the promisor. For example, a delivery service can affect the probability of timely delivery by the level of care it takes with the package. In such circumstances, the promisor can insure more cheaply than a third-party because the promisor can alter its level of care in response to the insurance clause. In other circumstances, the promisor may be better informed about the probability of breach than a third-party insurer. The delivery service, for example, may be better informed than the promisee or any third-party insurer about the breakdown rate of its trucks. In such cases, the promisor can use its willingness to agree to a penalty clause as a means of credibly signaling a low probability of breach. It is accordingly not true that the mere existence of a penalty clause is a strong indicator of fraud or mistake; there are plausible conditions under which a penalty clause would make both parties better off. Schwartz (1990) supplements this analysis by considering the effects of a penalty clause on pre-contractual incentives. He notes that the price that the promisor will charge is increasing in the damage measure. To the extent promisees insist on inefficiently large penalties, therefore, they will either pay too much or enter into too few contracts. The promisee accordingly has an incentive to demand a penalty clause only when it would increase the joint wealth of the parties.

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Other commentators have argued that penalty clauses can create externalities. Aghion and Bolton (1987), for example, demonstrate that a supply contract containing a penalty clause for buyer’s breach can restrict entry by competing sellers. We might at first conclude that buyer would have no incentive to agree to a contract that limited competition from other sellers. A well-designed penalty, however, will merely redistribute wealth from the new entrant to the contractual buyer and seller. To see why, assume a contract between Buyer and Seller with a contract price of $200, and Seller’s cost of performance is $150. At a later time, Entrant appears, who can provide the good for $100. Seller’s expectation damages will be $50, so absent a penalty Buyer can profitably breach if Entrant offers a price of $149 or less. Assuming that Entrant does not face competition, Entrant will demand a price of $149. Now imagine that Buyer must pay a penalty of $80 upon breach. Now it is not profitable for Buyer to breach unless Entrant offers a price of $119 or less. Entrant can still profitably sell at that price, and will do so. Thus the penalty transfers wealth from Entrant to Seller (which Seller can agree ex ante to share with Buyer). Aghion and Bolton’s analysis works only if Entrant has market power. The externality arguments for the most part are not sufficiently general to provide a compelling explanation for the judicial hostility toward penalty clauses. Moreover, while they can provide support for part of the judicial approach (disallowing liquidated damages that are not a fair ex ante estimate of actual damages), they cannot explain the failure to enforce liquidated damages that are excessive ex post.

12. Rescission/Restitution Courts divide contract breaches into ‘partial’ and ‘total’ breach. A partial breach gives the promisee the right to seek a remedy but not to refuse his own performance. The classic example is when a builder constructs a house that contains a minor deviation from the agreed architectural plan. The builder must compensate the owner for the difference in value (in theory, the difference in subjective value to buyer, but it will usually be difficult to convince a court that this differs substantially from the difference in market value). The owner may not, however, refuse to accept delivery of the house and to pay the agreed price. A total breach, by contrast, permits the promisee to refuse to render his own performance. In effect, a total breach permits the promisee to rescind the contract. As courts express it, a promisee can respond to a total breach by seeking expectation damages or by rescinding and seeking recovery of any value he has provided to the breaching promisor. The latter alternative is equivalent to the restitution measure of damages (although in some circumstances the promisee

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may seek return of the performance in specie rather than its monetary equivalent). Restitution is also a remedy in quasi-contractual situations, such as when parties partly performed a contract that is voidable for mutual mistake, but the following discussion will be limited to restitution damages as a remedy for breach. In the typical case, expectation damages will exceed restitutionary damages and the promisee will seek the former. There are two instances, however, in which we would expect the promisee to seek the latter. The first is when the promisee is risk averse and prefers the certainty of the return of money or property that he has given the promisor to the uncertainties of a jury’s assessment of his expectation and the additional litigation costs that would be incurred in the attempt. The second is when the contract was a losing deal for the promisee, so that his expectation is negative. Where the promisee has provided something of value to the promisor that cannot be easily returned, but can be valued in a judicial proceeding, the promisee may be better off receiving that value in cash than receiving the promised performance. This might be thought a remote possibility, but it occurs in a number of reported cases. The textbook example is one in which a builder agrees to build a house for an owner and the builder’s costs turn out to be greater than expected, making the contract a losing one for the builder. The owner, however, later decides it does not want the house and repudiates the contract when the house is partly completed. The builder’s expectation is negative because of the unexpectedly high costs of construction, so the builder seeks restitution. Restitution in this instance is measured by the value the builder has conferred on the owner, or the market value of the nearly-completed house. By hypothesis, this exceeds the contract price. When promisees have attempted to recover reliance damages for a losing contract, courts have concluded that the expectation measure puts an upper bound on the recovery (see L. Albert & Son v. Armstrong Rubber Co.). By contrast, some courts have permitted a promisee to recover restitution damages in excess of expectation (see Boomer v. Muir). This seeming inconsistency has been largely ignored in the law and economics literature. The most useful discussions appear in a symposium issue of the Southern California Law Review in 1994. In it, Kull (1994) provides an analysis of restitution that is similar in many respects to Bishop’s analysis of specific performance. Money damages are not always an adequate substitute for performance and the damage calculation is in any event uncertain. Thus where the promisee has provided something of value to the promisor that can easily be returned, the promisee may prefer to rescind the transaction, putting both parties back in the pre-contractual position. For example, the promisee may have paid in advance for a good or service that the promisor fails to provide. Taking litigation costs into account, the promisee may prefer to rescind the transaction and retrieve the

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advance payment. One example of a situation in which it seems likely that rescission and restitution will minimize the costs associated with breach is where a seller delivers goods that do not conform to the contractual specifications. The perfect tender rule, recognized under the common law and the Uniform Commercial Code, permits a buyer to reject nonconforming goods even if the variation is minor. As noted by Priest (1978), the administrative costs involved in calculating the difference in value between the goods as delivered and as promised will likely exceed the cost of returning the goods to Seller and money to Buyer. The costs associated with salvaging the nonconforming goods might also be minimized by the perfect tender rule, as in many instances it will be cheaper for Seller to find another purchaser for the goods than it will be for Buyer to adapt the goods to Buyer’s own use. On the other hand, where the contract is a losing one for the promisee and the promisee has conferred a benefit on the promisor that cannot easily be returned, the remedy of rescission and restitution is potentially over compensatory. Kull argues that the threat of opportunistic behavior (that is, socially wasteful efforts to exploit an inefficient remedy to obtain an unbargained-for benefit) will be substantial for such contracts. The promisee can turn a loss into a gain by inducing breach by the promisor (or convincing a court that mutual uncooperativeness constituted or resulted from such a breach). By contrast, the perfect tender rule permits a buyer to behave opportunistically by unreasonably claiming that goods are defective when their market value has declined, but because the goods can be returned to Seller, the parties are spared the additional cost of a court proceeding to determine their value.

D. Calculation of Expectation and Reliance Damages 13. A Categorization of Approaches to Calculating Damages There is consensus that the expectation measure is in most circumstances superior to reliance or restitution damages. A separate but no less important question is how expectation and reliance are to be defined and measured in typical contractual settings. Parties’ valuations are often unknown to one another and to the court, and promisees have an incentive to overstate their valuations, making the calculation of expectation damages difficult in some settings. Cooter and Eisenberg (1985) present a very helpful categorization and analysis of alternative calculation methods. They identify five broad categories and note that the calculation of money damages in reported cases usually falls into one of these categories. They are:

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(i) Substitute Price. Often there is a spot market for the contractual performance at the time and place that performance was due, most obviously if the performance consists of the delivery of a marketable commodity. In such an event, Buyer can respond to Seller’s breach by cover, or the purchase of the commodity on the spot market. (Seller can respond to a breach by Buyer by selling on the spot market.) The difference between the contract price and the price at which cover occurred or could have occurred is then a measure of the cost of making Buyer (or Seller) indifferent between the contract and the substitute performance. We should note, however, that the substitute price measure can be overcompensatory when a promisee chooses not to cover but instead to sue for the difference between the contract price and the spot price. That choice itself suggests that the promisee may value the commodity at less than its market price. (ii) Lost Surplus. When cover is unavailable, Buyer’s expectation can be thought of as the lost consumer surplus from the contract. In our ongoing example, if Buyer cannot cover, he loses the difference between his valuation of the machine ($300 or $375, depending on reliance) and the $250 contract price. The analysis of Seller’s lost producer surplus from Buyer’s breach is analogous. The lost surplus measure is feasible only when a court can obtain credible evidence of the promisee’s valuation. (iii) Opportunity Cost. If a market exists for the performance, Buyer could have entered into a contract to buy the machine from any one of a number of competing sellers. The value to Buyer of the best alternative contract available at the time of the contract with Seller is an important component of his reliance. This value cannot be measured objectively because Buyer did not enter into this hypothetical contract and we do not know whether the hypothetical contractual party would have performed. Assuming that the probability of performance of the alternative contract is high, however, then the difference between the spot price at the time and place of breach and the price of the foregone contract is a good measure of reliance (augmented by any out-of-pocket expenditures in reliance on the contract with Seller). In a competitive market, the next-best price and the contract price should be the same, and the opportunity cost measure will equal the substitute price measure (a conclusion consistent with Fuller and Perdue’s conclusion that expectation and reliance damages are equal in a competitive market). (iv) Out-of-Pocket Cost. This is the amount of reliance investment, less any salvage value of that investment. Out-of-pocket cost is the most common measure of reliance damages; a more complete measure of reliance damages is out-of-pocket cost plus opportunity cost. (v) Diminished Value. So far we have ignored partial performance. In the real world, however, performance is often rendered but is defective or incomplete. In such cases an appropriate measure of Buyer’s lost expectation is the

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difference between Buyer’s valuation of the promised performance and his valuation of the actual performance. As these alternative methods of calculation should make clear, the measure of damages is usually straightforward and uncontroversial where cover is possible. The accepted measure of damages in such cases is the difference between the cover price and the contract price, which is easy to apply and provides appropriate incentives regarding the decision to perform or breach. The difficult questions arise when there is no perfect substitute for the performance (or there is room for debate about whether the substitute is adequate) or where the manner or timing of the breach causes harm that cannot be remedied by cover. We will provide two examples of cases that arise frequently and that have been the much discussed in the literature, in which there is debate over the appropriate means of measuring the non-breaching party’s expectation.

14. Example 1: Anticipatory Repudiation Common law judges and scholars initially found anticipatory repudiation - a definitive statement by a promisor, made prior to the time for performance, that he intended to breach - extraordinarily vexing. Some concluded that any such statement must be without legal effect; the performance was due on a particular date and breach could therefore only occur on that date (Williston, 1901). Courts eventually came to the view that the promisee could treat the repudiation as a breach (Hochster v. De La Tour), but found it more difficult to decide how damages should be measured. The most famous early case, Missouri Furnace v. Cochrane, held that the appropriate measure was the difference between the contract price and the spot price at the time specified for performance. The Uniform Commercial Code, by contrast, encourages prompt cover, presumably in the futures market. As noted by Jackson (1978), the legal literature on anticipatory repudiation from the early part of this century is voluminous. Jackson argued that in applying the Uniform Commercial Code’s provisions on cover to anticipatory repudiation, courts should fix damages at the difference between the contract price and the futures price at the time of repudiation. He noted that the Missouri Furnace method is systematically overcompensatory. Imagine, for example, that Seller breaches a contract to supply a commodity in the future and that the spot and futures prices at the time of repudiation are higher than the contract price. Over a large number of contract breaches, however, the spot price at the time of performance will sometimes be higher, and sometimes lower, than the contract price (in present value terms). Whenever it is lower, Buyer will not bring a damages action because he has been made better off by the breach. He is under no obligation to share this gain with Seller. When the spot price is higher than the contract price, Buyer will

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recover the difference between the two. Averaged over a large number of contracts, buyers in the aggregate receive more than would be required to make them as well off as they were under the contract. Awarding the difference between the contract price and the futures price, by contrast, puts each buyer in the position he occupied prior to the repudiation and at a lower average cost to sellers. We might simplify Jackson’s argument by noting that the Missouri Furnace rule replaces a forward contract by an option with a strike price equal to the forward price. Because the value (prior to expiration) of an option with a strike price of X is always greater than the value of a forward contract with a contract price of X, the Missouri Furnace damage measure is overcompensatory.

15. Example 2: The Lost-Volume Seller Sellers in a competitive market have often argued that the Substitute Price measure of damages, which awards them the difference between the contract price and the spot price, is undercompensatory. In many instances, there is little or no difference between the contract price and the spot price, and accordingly the damage award is trivial. Sellers contend, however, that they are not ‘made whole’ by selling in the spot market; the seller had the capacity to sell to both the substitute buyer and the original buyer at the market price, and the breach reduced their sales volume by one unit. Thus in place of two sales and two profits, they have received only one sale and one profit. Courts have often awarded the so-called ‘lost-volume seller’ an amount of damages equal to its ordinary profit on one sale. In the well-known case of Neri v. Retail Marine Corp., Retail Marine, a dealer in boats, agreed to sell a boat to Neri at a fixed price. Retail Marine ordered the boat from the manufacturer but Neri repudiated the contract. Retail Marine sold the boat to another customer for the same price and successfully sued Neri for the profit it would have made on the sale to him. The court concluded that Retail Marine, as a dealer, had an ‘inexhaustible’ supply of boats, and Neri’s breach deprived it of a profitable sale. There is a substantial law and economics literature on the lost-volume seller. An early contribution appeared in an anonymous student-written comment (Anonymous, 1973). The comment noted that in a perfectly competitive market, each seller would choose output by equating marginal cost with demand and the demand curve would be presumed horizontal. At the chosen output, the firm’s marginal cost would be rising and therefore any additional sale would be at a cost in excess of the price. Because the seller could not, in fact, satisfy additional buyers at the market price, the breach and resale would create no ‘lost volume’ in a perfectly competitive market. A seller with market power (that is, one facing a downward-sloping demand curve) might be able to make additional sales at a profit. However, by hypothesis, such a seller

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could eliminate the ‘lost volume’ by reducing its price and making an additional sale. Thus the standard contract price minus cover price measure would fully compensate such a seller. Goetz and Scott (1979) provide an additional argument against awarding lost profits to the retailer who has market power. They note that the breach removes the breaching buyer as a competing seller. The buyer presumably breaches because it no longer wants the good at the contract price. In lieu of breaching, however, the buyer could complete the purchase and then resell the good. This resale, if made in the same market in which the retailer operates, shifts the demand curve facing the retailer to the left by one unit. Once again, if we compare the retailer’s position after the breach to its position assuming no breach but resale by buyer, there is no lost volume. Goldberg (1984) disputes Goetz and Scott’s analysis. He first argues that the observation that a non-breaching buyer could sell in competition with the retailer is unrealistic. In fact, he argues, the buyer, lacking expertise, would have to engage the services of a retailer. The retailer’s usual markup is a reasonable estimate of the fee the retailer would charge for his services. Accordingly, the award of lost profit to the retailer approximates the result that would obtain if the buyer purchased and resold. Goldberg also argues that it is inaccurate to say that the retailer ‘saves’ the marginal cost of a sale when the original buyer breaches and then incurs that marginal cost when the substitute buyer appears. He contends that the retailer’s cost of servicing an additional buyer consists principally of the cost of ‘fishing’ for a buyer, or convincing the marginal buyer to purchase (represented, perhaps, by costs of advertising, wages paid to salespeople, and so on). That cost is irretrievably lost once a contract is concluded with the original buyer and must be incurred again in order to induce another buyer to purchase. More recently, Scott (1990) argues that Goldberg’s equation of marginal cost with the cost of ‘fishing’ is inaccurate; for some goods, the cost of delivery and preparation for delivery are significant, and those costs are not incurred twice when a buyer defaults. Cooter and Eisenberg (1985) provide an analysis similar to Goldberg’s, but focus on the seller with market power. They argue that many sellers hold price at a constant level reflecting expected demand and marginal cost over some period, rather than constantly adjusting price to reflect realized demand. Such sellers can lose volume in a particular period. Goldberg also notes that consumer demand is decreasing in the damage measure. Accordingly, were the legal rule to shift suddenly from a substitute price damages measure to one awarding lost profits, the demand curve facing the retailer would shift downward, offsetting the benefit of the higher damage awards. Whether consumers and producers would prefer the resulting contract to one that provides only substitute price damages again depends on comparative levels of risk aversion.

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It appears that the literature on the lost-volume seller is at an impasse. The identification of the best damages rule turns on complex and contestable claims about market structure. A better avenue of inquiry would be to pay attention to actual contractual practice. Many sellers of custom goods require non-refundable deposits, which in effect contracts for a lost-profits measure. Other sellers (such as many computer retailers) permit a buyer to return an item for a full refund for some period after delivery, which in effect contracts for an even more lenient approach than the substitute price measure. It seems likely that greater ground will be gained by empirical analysis of the characteristics of markets in which varying cancellation/return policies are used than by further refinements of the theoretical arguments.

E. Conclusions 16. The Puzzle of Overcompensatory Remedies and Some Suggestions for Further Research Most of the prior analysis could be summed up as follows: when courts and contracting parties are well-informed about each party’s valuation of the contract, money damages measured by the promisee’s valuation (or expectation) provide reasonably good incentives for efficient pre- and post-contractual behavior. Problems arise, however, when there are significant informational asymmetries between the parties and/or between each party and the court. Such asymmetries raise two pervasive issues in contract law. The first is subjective value. The existence of potentially over compensatory remedies such as specific performance, liquidated damages and restitution can be attributed to judicial recognition that money damages measured by the promisee’s expectation will sometimes undercompensate, because courts use objective indicators of value that may diverge from the promisee’s subjective valuation. Only a few brief attempts have been made, however, to explore subjective value as a unifying theme in contract remedies (see De Alessi and Staaf, 1989; Muris, 1983). The second issue is opportunism. The possibility that a remedy, although designed to be perfectly compensatory, will in fact undercompensate (overcompensate) may encourage the breaching party (non-breaching party) to use the defect in the remedy to gain bargaining leverage over the other party. The risk of opportunism is the likely reason why courts have not responded to the problem of subjective valuation by instituting overcompensatory remedies across the board. A worthwhile avenue for additional work would be a careful comparison of the ways in which courts have or have not managed to reduce the risk of opportunism across a range of remedial choices. A promising approach to this

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question appears in the liability rule versus property rule literature. When neither party knows the other’s true valuation of the contract, each has an incentive to over- or understate his valuation in an attempt to capture as much as possible of the gains from contract modification or cancellation. The result is to make agreement more costly. The costs imposed by asymmetric information, which we will call ‘bargaining costs’, are a subset of the cost of reaching a deal. The key question is whether the choice of remedy affects bargaining costs. A specific application to liquidated damages is offered by Talley (1994). He uses the mechanism design branch of game theory to analyze the effects of different enforcement rules on bargaining costs, concluding that enforcement of liquidated damages that exceed actual damages ex post creates significant bargaining costs. By refusing to enforce penalty clauses, courts may make it more likely that the parties will bargain to an efficient outcome. The argument is unique in offering a plausible economic justification of the ex post component of the liquidated damages rule. Ayres and Talley (1995), employ game theory to argue that bargaining costs are generally lower under liability rules than under property rules. The intuition is as follows. Going back to our contract between Seller and Buyer, imagine that Seller wishes to breach, and believes Buyer’s valuation of the contract to be uniformly distributed on the interval [$300, $400]. Consider a rule that provides for damages of $500 in response to Seller’s breach. Buyer’s offer to rescind the contract for a payment of $400 would provide Seller with no new information - Seller already knows that Buyer’s valuation is no greater than $400. Now consider a rule providing for damages of $350. Buyer might now conceivably offer to cancel the contract in return for a payment from Seller (if Buyer’s valuation is less than $350), or it might offer Seller a payment to forego breach (if Buyer’s valuation is more than $350). Thus the type of offer that Buyer makes conveys information about its valuation and ameliorates the bargaining costs resulting from asymmetric information. Johnston (1995) offers an analogous argument to show that bargaining costs can be lower under a ‘standard’, in which an entitlement is dependent on a discretionary judicial determination, than under a ‘rule’, in which the entitlement is more precisely defined. Kaplow and Shavell (1995) criticize Ayres and Talley’s analysis on the grounds that it is not a marginal analysis. They argue that in most contexts in which bargaining is impossible or prohibitively costly, liability rules will dominate property rules for the reasons outlined in our discussion of expectation damages above. Thus for liability rules to dominate property rules where bargaining is possible does not prove that they generate lower bargaining costs; the latter point would be proved conclusively only if liability rules dominate property rules to an even greater extent where bargaining is possible than where it is impossible.

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It is perhaps unfortunate that the game-theoretic analysis of bargaining costs has been used principally to analyze the relative efficiency of liability and property rules. The more general question is the design of remedies that will create optimal incentives for the parties to reveal their actual valuations or other private information about the state of the world. A liability rule (that is, a rule under which the damage award may be greater or less than the promisee’s valuation) might create superior incentives compared to a property rule (that is, one under which the damage award is at or beyond the endpoint of the promisee’s valuation), but we should be able to make similar comparisons between different liability rules. The discussion to date has covered liability and property rules generally, whether located within the law of property, torts and contract. There is accordingly room for a more focused look at bargaining costs in contractual settings, with an additional emphasis on ex ante mechanisms other than judicially-crafted damage rules that might help to reduce ex post bargaining costs.

Acknowledgements Paul G. Mahoney thanks Eric Talley and two anonymous referees for helpful comments.

Bibliography on Contract Remedies: General (4600) Anonymous (1973), Comment: Microeconomics and the Lost-Volume Seller, 24 Case Western Reserve Law Review, 712 ff. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 1979, 213-220. Aghion, Philippe and Bolton, Patrick Bolton (1987), ‘Contracts as Barriers to Entry’, 77 American Economic Review, 388-401. Ayres, Ian and Talley, Eric L. (1995), ‘Solomonic Bargaining: Dividing a Legal Entitlement To Faciliate Coasean Trade’, 104 Yale Law Journal, 1027-1117. Barton, John H. (1972), ‘The Economic Basis of Damages for Breach of Contract, 1 Journal of Legal Studies, 277-304. Bishop, William (1985), ‘The Choice of Remedy for Breach of Contract’, 14 Journal of Legal Studies, 299-320. Reprinted in Goldberg, Victor P. (ed.), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press, 1989, 122-125. Coase, Ronald H. (1960), ‘The Problem of Social Cost’, 3 The Journal of Law and Economics 1-44. Cohen, George M. (1994), ‘The Fault Lines in Contract Damages’, 80 Virginia Law Review, 1225-1349. Cooter, Robert D. and Eisenberg, Melvin Aron (1985), ‘Damages for Breach of Contract’, 73 California Law Review, 1432-1481.

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Craswell, Richard (1988), ‘Contract Remedies, Renegotiation, and the Theory of Efficient Breach’, 61 Southern California Law Review, 629-670. De Alessi, Louis and Staaf, Robert J. (1989), ‘Subjective Value in Contract Law’, 145 Journal of Institutional and Theoretical Economics, 561-577. Dixit, Avinash K. and Pindyck, Robert J. (1994), Investment Under Uncertainty, Princeton, New Jersey, Princeton University Press. Friedman, David D. (1989), ‘An Economic Analysis of Alternative Damage Rules for Breach of Contract’, 32 Journal of Law and Economics, 281-310. Friedmann, Daniel (1989), ‘The Efficient Breach Fallacy’, 18 Journal of Legal Studies, 1-24. Fuller, Lon L. and Perdue, William (1935), ‘The Reliance Interest in Contract Damages’, 46 Yale Law Journal, 52-98. Reprinted in Goldberg, Victor P. (ed.) (1989), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press, 77-79. Goetz, Charles J. and Scott, Robert E. (1977), ‘Liquidated Damages, Penalties and the Just Compensation Principle: Some Notes on an Enforcement Model and a Theory of Efficient Breach’, 77 Columbia Law Review, 554-594. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 194-207. Goetz, Charles J. and Scott, Robert E. (1979), ‘Measuring Sellers’ Damages: The Lost-Profits Puzzle’, 31 Stanford Law Review, 323-373. Goetz, Charles J. and Scott, Robert E. (1980), ‘Enforcing Promises: An Examination of the Basis of Contract’, 89 Yale Law Journal, 1261-1300. Goldberg, Victor P. (1984), ‘An Economic Analysis of the Lost-Volume Retail Seller’, 57 Southern California Law Review, 283-298. Reprinted in Goldberg, Victor P. (ed.) (1989), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press, 106-113. Jackson, Thomas H. (1978), ‘“Anticipatory Repudiation” and the Temporal Element in Contract Law: An Economic Inquiry into Contract Damages in Cases of Prospective Nonperformance’, 31 Stanford Law Review, 69-119. Johnston, Jason S. (1995), ‘Bargaining Under Rules versus Standards’, 11 Journal of Law, Economics and Organization 256-281. Kaplow, Louis and Shavell, Steven (1995), ‘Do Liability Rules Facilitate Bargaining? A Reply to Ayres and Talley’, 105 Yale Law Journal 221-233. Kornhauser, Lewis A. (1986), ‘An Introduction to the Economic Analysis of Contract Remedies’, 57 Colorado Law Review, 683-725. Kronman, Anthony T. (1978), ‘Specific Performance’, 45 University of Chicago Law Review, 351-382. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds), The Economics of Contract Law, Boston, Little Brown, 181-194. Kull, Andrew (1994), ‘Restitution as a Remedy for Breach of Contract’, 67 Southern California Law Review, 1465-1518. Macneil, Ian R. (1982), ‘Efficient Breach of Contract: Circles in the Sky, 68 Virginia Law Review 947-969. Mahoney, Paul G. (1995), ‘Contract Remedies and Options Pricing’, 24 Journal of Legal Studies; 139-63. Muris, Timothy J. (1983), ‘Cost of Completion or Diminution in Market Value: The Relevance of Subjective Value’, 12 Journal of Legal Studies, 379-400. Reprinted in Goldberg, Victor P. (ed.) (1989), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press,

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128-132. Polinsky, A. Mitchell (1983), ‘Risk Sharing through Breach of Contract Remedies’, 12 Journal of Legal Studies, 427-444. Priest, George L. (1978), ‘Breach and Remedy for the Tender of Nonconforming Goods Under the Uniform Commercial Code: An Economic Approach’, 91 Harvard Law Review, 960-1001. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 167-175. Schwartz, Alan (1979), ‘The Case for Specific Performance’, 89 Yale Law Journal, 271-306. Schwartz, Alan (1990), ‘The Myth that Promisees Prefer Supracompensatory Remedies: An Analysis of Contracting for Damage Measures’, 100 Yale Law Journal, 369-407. Scott, Robert E. (1990). ‘The Case for Market Damages: Revisiting the Lost Profits Puzzle’, 57 The University of Chicago Law Review, 1155-1202. Shavell, Steven (1980), ‘Damage Measures for Breach of Contract’, 11 Bell Journal of Economics, 466-490. Talley, Eric, L. (1994), ‘Contract Renegotiation, Mechanism Design, and the Liquidated Damages Rule’, 46 Stanford Law Review, 1195-1243. Williston, Samuel (1901), ‘Repudiation of Contracts’, 14 Harvard Law Review, 317-331 (Part I), 421-441 (Part II).

Cases Hochster v. De La Tour, 118 Eng. Rep. 922 (Q.B. 1853). Missouri Furnace v. Cochrane, 8 F. 463 (C.C.W.D. Pa. 1881). Neri v. Retail Marine Corp., 30 N.Y.2d 393 (1972). L. Albert & Son v. Armstrong Rubber Co., 178 F.2d 182 (2d Cir. 1949). Boomer v. Muir, 24 P.2d 570 (Cal. App. 1933).

4610 PENALTY CLAUSES AND LIQUIDATED DAMAGES Gerrit De Geest Professor at the University of Ghent Researcher at the Economic Institute/CIAV, Utrecht University

Filip Wuyts, M.Sc. © Copyright 1999 Gerrit De Geest and Filip Wuyts

Abstract This chapter surveys the economic literature on stipulated damages. In the literature there seems to be a consensus that liquidated and underliquidated damages should be respected. Liquidated damages can be a rational option, especially if parties have more information about the possible losses than judges. Underliquidated damages may can serve as a technique to let parties share the risk of increased production costs. Penalty clauses, on the other hand, have been the subject of a fierce controversy for a long time. Most authors seem to defend the prohibition of penalty clauses. Yet it can be argued that they should be allowed under some conditions. JEL classification: K12 Keywords: Stipulated Damages, Underliquidated Damages, Remedies, Breach of Contract

1. Introduction Sometimes parties to a contract ex ante agree upon how much compensation will have to be paid should one of them breach the contract. These stipulated damages are called ‘liquidated damages’ when they are ex ante reasonable estimations of the true losses. They are called p) monetary units. A defective item causes him a loss of F/l. The utility function U is defined over the monetary income. It expresses the risk aversion of the consumer and therefore increases with decreasing rates: U' > 0, U'' < 0. The expected utility is:

EU = (1 − ()@U(q − p) + (@U(q − p − F / l + w) Assuming a constant profit on the side of the suppliers, the product price becomes dependent on the magnitude of the promised warranty: p = p(w). A Pareto-optimal allocation requires marginal utility to be identical in situations both with and without a product defect. We therefore have: w* = l. This resource allocation will be achieved automatically in the long run in a competitive market, see Figure 1 for illustration. Every point of the diagram represents a price-warranty combination. Price-warranty combinations along the vertical axis insure the seller against product risks because no warranty compensation has to be paid at all, whereas the buyer will be fully insured if a combination from the vertical line w = l is taken. Free market entry drives the product price down to unit cost level: c + (@w. The straight line V = 0 represents this zero-profit level. The slope of this zero-profit line depends on the failure probability of the product. It is steep if the probability of failure is high, and relatively flat if the probability is low. The tangency point between the indifference curve EU1 and the zero-profit line represents the competitive equilibrium. This equilibrium is stable. A firm considering a smaller warranty level has to be aware that the consumers will look for lower prices in case of lower warranty levels. Reducing the warranty level from l to l' lowers the firm’s cost and therefore the product price by (@(l − l'). For such an offer a risk-neutral consumer would bid for a price which is (@(l − l') monetary units smaller. He would therefore be indifferent with respect to the choice of either offer. Risk-averse consumers would not only fear the pure monetary effect, but also the risk exposure which is caused by the now only partial warranty. Therefore they would refuse the new offer. Our first result is: warranties protect risk-averse consumers against manufacturing flaws. The consumers prefer a ‘full’ warranty, unrestricted in magnitude and duration.

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Figure 1 Insurance against product defects

3. Warranties as a Signal of Quality Signalling literature can be traced back to Spence (1973) who wrote an article on ‘Job Market Signalling’. Grossman (1981, p. 479) argued that ‘when firms have tools available which they can use to convey information they will do so’. With warranties we have such a tool of information transfer. Assume there are two types of manufacturers. Type L produces at low unit costs cL but has a large rate of defective units (L, whereas type H has higher unit costs cH but a smaller quota of defective items (H. Let us assume that the customers know about the average market failure rate, but keep them uninformed about the firm-specific quota. Let us suppose furthermore that there are enough potential suppliers of each type to satisfy the demand within the whole market. When offering the product without a warranty, firms of type L would get the whole market demand at price p = cL, because the customers are not able to distinguish between these two types of firms. It is not useful for customers to buy at price p = cH. By charging this price, low quality firms may pretend to sell items of high quality. Firms of type H may start to advertise, in order to inform the consumers about the high quality of their products. Similarly to statements about price, as long as the right to make untrue statements is not sanctioned, advertising signals can be imitated by low quality suppliers (however, in a long-term relationship advertising may signal quality. For more information on this topic

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(see Nelson, 1974; Schmalensee, 1978; Kihlstrom and Riordan, 1984; Milgrom and Roberts, 1986). It is because of the legal system that warranty commitments become credible signals. Putting aside those cases in which a firm is dissolved before the defects of its sold products are revealed, the legal order enforces warranty claims. Therefore, a firm which promises a warranty has to be aware of the resulting warranty costs in the future. Since low-quality suppliers face higher defect rates, they have to expect higher warranty costs. It is therefore cheaper for firms of type H than for firms of type L to use the warranty signal. Hence, they will do so and offer a full warranty, which is preferred most by the buyers anyway. Nevertheless, when they observe the supplementary warranty of competing high-quality suppliers, firms of type L will also offer a warranty. The competitive outcome as to which type of producer finally succeeds in serving the market then depends on the answer to the question : will the higher warranty costs of low quality firms be lower than the original differences in unit costs of production? Referring to the model of the previous paragraph, we know that risk-averse consumers prefer being fully insured against the monetary loss of a product defect: w = l. They favour a full warranty when contracting with either type H or L firms. Their expected utility therefore equals: EUi = U(q − pi) If and only if pH < pL, which means that cH + (H @ l < cL + (L @ l , firms of type H will be able to serve the market. Look at Figure 2 for an illustration. The diagram includes the zero-profit lines of two representative firms of type L and H. The point of intersection determines a specific partial warranty provision. Given this warranty provision, both firms face the same costs. Expanding the warranty further, the sharper warranty-cost increase for firms of type L creates a competitive disadvantage: the additional warranty costs in comparison to high-quality suppliers exceed the original unit cost difference. Therefore according to this example - firms of type H offer their products at the cheapest price. The tangency point A between the zero-profit line VH and the indifference curve EUH represents market equilibrium. Notice that the diagram contains two overlaying systems of indifference curves. The system EUH informs us about the expected utility of representative customers if they contract with firms of type H, the system EUL informs us about contracts with type L. The intersecting curves EU ' and EU represent the L

H

same level of expected utility. Since they intersect at a full-warranty price, consumers do not care about the firm-specific defect rate. Under full warranty the same price leads to the same expected utility, irrespective of which type of firm will sell. To distort the equilibrium, low-quality firms therefore have to

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make an offer in the south-eastern area of the EU L' curve. Since such offers would cause losses, firms of type L refrain from doing so. Therefore the tangency point A characterizes a stable competitive equilibrium. Figure 2 Signalling high quality

The outcome is Pareto-optimal. Since the consumers prefer to be insured, the tangency points A and B are the only candidates for a Pareto optimum condition under the restriction of zero profits. A dominates B because the expected utility of the representative consumer is higher with lower prices. The assumptions of the original model can be altered in several respects: 1. The individual losses differ. Risk-averse consumers prefer a warranty coverage which compensates for their individual losses. Firms will then come up with offers varying in warranty coverage. Low-quality firms serve customers with small individual losses, whereas high-quality firms serve the more sensitive customers. The outcome is Pareto-optimal. It does not deviate from an outcome that would occur, if firms had truthfully disclosed their failure rate and offered an insurance against defective items (see Spence, 1977, p. 570). 2. A monopolist serves the market. The monopolist will increase warranty coverage as long as the marginal buyers’ willingness to pay increases with this coverage (Grossman, 1981, p. 475). Problems arise in cases where the individual losses differ: the social planner will look at inframarginal buyers to control warranty coverage, whereas the monopolist observes the marginal buyers’ willingness to pay (Spence, 1975). 3. The market structure is oligopolistic. Gal-Or (1989) showed that the informational content of warranties is limited, as multiple equilibria may exist.

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4. Warranties as an Incentive to Invest in Quality It was Priest (1981, pp. 1307-1319) who emphasized the ‘Investment Theory of Warranty’. According to his interpretation a warranty is a device which controls the efforts taken by the manufacturer and the consumer to maintain a functioning product. The only relevant variable in a unilateral case - as discussed here - is the effort of the manufacturer to keep the failure rate optimal. Similar to the situations in the previous paragraphs, the customers are interested in being fully insured against the loss caused by a potential product breakdown: w = l. The seller, who, by assumption, is also the manufacturer, thus internalizes the buyer’s potential losses. The manufacturer therefore has to choose a level of quality investment x* which minimizes unit costs of production plus expected losses:

c(x) + ((x)@l Assuming c'(0) = 0, c' > 0, c'' > 0, (' < 0, ('' > 0, there is an optimal positive level of quality investment. This level will be chosen by the manufacturer. His investment will thereby be guided by the following consideration: the effect of a quality investment is to reduce the defect rate. Evaluated in monetary terms, this effect has to be weighed against avoided losses. For any additional quality investment to be taken, the loss-reducing effect has to be larger than the costs of this investment. 5. Underestimated Failure Rates Spence (1977, p. 563) already showed that no warranties will be offered in a competitive market where risk-neutral customers systematically underestimate the failure rate (. In case of risk-averse consumers only a partial warranty will be offered. Let r(() be the failure rate which is perceived by the buyers: r(() < (. Expected utility can then be expressed as: EU = [1 − r(() @ Uq − p(w)] + r(() @ U[q − p(w) − l + w] Maximization with respect to w then leads to the outcome: U ′ ( q − V − c + (1 − Π ) ⋅ w − l ) U ′ (q − V − c − Π ⋅ w )

=

[1 − r ( Π )] r ( Π ) >1 [1 − Π ] Π

Hence the representative consumer prefers a partial warranty: w* < l . Figure 3 illustrates the special case in which the underestimation of the failure rates leads to the outcome that consumers are no longer interested in warranties. The slope of the zero-profit line VL = 0 indicates the true quota of defective items of supplier L. However, consumers expect a failure rate that

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corresponds to the slope of zero-profit line VL' = 0 . They believe that the quota is one third of the true quota. Clearly, their system of indifference curves has to be constructed according to the wrongly assumed quota. The first-best choice of these consumers would be a price-warranty combination as is shown by point P with a full warranty. However, these customers have to realize that the desired contract is not offered in the market. Offering this contract would create losses for firm L, because the true rate of defective items is higher than the customers expected. The minimum price firm L would claim for a full warranty contract is determined by point Q. The representative consumer values this offer with expected utility EU ' and concludes that there is a more valuable L

contract (utility EU L' ' ) without a warranty indicated by point T. Figure 3 Underestimated Failure Rates

Given this situation, we now assume that high-quality firms of type H are also in the market and sell the same product with a smaller rate of defective items. The corresponding system of indifference curves is characterized by the EUH-lines. Compared with firms of type L the offer of the H type is of higher social value, because the full-warranty price of these firms determined by point R is less than the full-warranty price of firm L determined by point Q. Consequently, it is to be expected that firms of type H serve the market. However, just as the customers underestimate the rate of defective items of

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firms L, the rate of defective items of firms H is underestimated by a factor of '

3 (see line VH = 0). The current offer of firms L, selling the product without a warranty as indicated by point T, leads to utility EU L'' . The full-warranty contract indicated by S creates the same utility. Moreover, S is also a point on the indifference curve EU H'' . Therefore we have: EU L'' = EU H'' . The curve EU H'' intersects the ordinate at a price level which is less than cH. Consequently, as cH is the minimum price firms H have to charge for their goods without a warranty, the consumers expect that the utility of the offer characterized by point U is less than EU L'' . So, offer T is preferred to U. The awkward consequence of this example is that the consumers choose the wrong firms and the wrong warranty contracts. Therefore, we have to ask the question, whether the amount market failure can be corrected. Basically there are three ways of legal interference. The most restrictive kind of intervention is to introduce a mandatory legal warranty over the typical lifetime of a product. However, this type of interference should only be applied in situations where the rate of failure is exclusively determined by the firm. If it is also influenced by inherent attributes of failure inclination on the side of the buyer (Wilson, 1977; Rothschild and Stiglitz, 1976), by the intensity of use (Emons, 1989a) or by buyers’ care (Priest, 1981; Kambhu, 1982; Cooper and Ross, 1985) then partial warranties would be better. The second type of legal intervention is a disclosure rule which obliges the sellers to reveal the true failure rate before the purchase is made (Grossman, 1981). I expect that a third alternative will solve the problem with lower social costs: if firms are allowed comparative advertising, then the firm discriminated against will undertake the job to inform the buyers about the true quota of failure.

B. Warranties in a Bilateral Context 6. Warranties in a One-Shot Relationship Observations in reality contradict the picture of long-lasting, fully compensating warranties (see Priest, 1981, p. 1319, for a detailed empirical investigation of warranty contracts). Warranties are always limited in duration. Mostly, the warranty periods cover only part of the lifetime of a product. Often the warranty periods are restricted to one year. Warranties which last for three or more years can rarely be found, although the lifetime of consumer durables often exceeds ten years.

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With respect to the scope of warranties - German standard form contracts predominantly specify subsequent improvement or subsequent delivery - one often detects clauses which exclude the warranty with regard to certain uses or which make the validity of the warranty dependent on the buyer’s intermediate input. Exclusions in warranties are typical for retailing and commercial uses. Often these exclusions are directed against aggressive use or the non-compliance with regular maintenance. Commonly, the operation of certain fragile parts falls under the warranty but the warranty coverage expires if attempts are made to open the product. On the other hand, parts housed deep within the product, inaccessible to the consumer’s influence, are often protected by an extended warranty. This short overview makes it clear that the organization of warranty contracts is essentially determined by the consumer’s potential influence on parts of the product. However, the consumer’s influence on the failure rate has not yet been investigated. Therefore, we have to extend the analysis to bilateral warranty problems, situations in which both parties, the manufacturer as well as the user, control the product’s failure rate. According to the investment theory of Priest (1981) every bilateral warranty problem is a mixture of different unilateral problems and hence can be reduced to its elementary ingredients. This view presupposes that it is a certain type of defect which points to the responsibility of, respectively, the seller or buyer. If this approach was correct, then the optimal warranty contract would have to stipulate a full warranty for those product risks which are under the control of the manufacturer and a full warranty exclusion for those risks which are under the control of the consumer. However, in addition to the elementary unilateral problems and their combinations, there is a real bilateral problem which cannot be decomposed. The optimal control of many of the product risks calls for a certain combination of seller’s and buyer’s care. Take for instance the case of a car engine. Its safe functioning requires the necessary mechanical and electronical adjustments on the part of the manufacturer as well as responsible behavior on the part of the driver. The breakdown probability increases if any of the parties fail to perform their duties. The problem of bilateral investments is addressed in articles by Kambhu (1982), Cooper and Ross (1985), Mann and Wissink (1988), Emons (1988). All these models assume that warranty promises are enforceable. Clearly, if warranties could not be enforced, sellers would cheat on the warranty and the outcome would be minimum product quality. Therefore, I also assume an enforceable warranty. Let the damage function d be dependent on the manufacturer’s quality investments x and the consumer’s costs of care-taking y:

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d(x, y) = ((x, y) @ l Let furthermore: (x < 0, (xx > 0, (y < 0, and (yy > 0. The representative consumer is risk-neutral. Let us assume that his willingness to pay for an intact item is q and that his utility is measured in money terms and equals his willingness to pay. Then the expected utility is: EU = q − ( @ (l − w) − y − p The seller’s profit is:

V = p − x − (@w Maximization of the joint surplus with regard to x and y leads to the following first order conditions: − (x(x, y) @ l = 1

and − (y(x, y) @ l = 1 Now we have to answer the question whether the parties will control their quality and maintenance as described with the first order conditions. Thereby we assume two steps of decisionmaking. During the first step the parties compete, when unobserved by the other party, and choose a certain level of investment. Afterwards they cooperate, when fixing a warranty compensation which maximizes the joint surplus. For the first step the following first-order conditions are relevant: − (x(x, y) @ w = 1

and − (y(x, y) @ (l − w) = 1 A comparison with the Pareto conditions reveals a degree of tension. Pareto optimal quality investments of the manufacturer require a warranty level of w = l, whereas Pareto optimal care-taking of the consumers presupposes a level of w = 0. Therefore, a joint surplus-maximizing allocation is impossible (compare Cooper and Ross, 1985, p. 107), and a ‘second best’ solution will be the outcome. Let the functions x+(y, w) and y+(x, w) describe which level of investments a party will choose given the warranty promise w and the investment of the other party x or y, respectively. Let the pair [xE(w), yE(w)] denote the point of intersection of both functions. It represents the Nash equilibrium of the noncooperative part of the game. When jointly arriving at a conclusion about the level of the warranty, both parties anticipate their reciprocal pattern of unobserved behavior (Cooper and Ross, 1985, p. 109). They consequently maximize their joint surplus under the restriction of the Nash equilibrium, described above: max EU + V = q − Π ⋅ l − x − y w

subject to x = x° ( w)

and

y = y° ( w)

The first-order condition requires:

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xE'(w) @ [ − (x(x, y) @ l − 1] + yE'(w) @ [ − (y(x, y) . l − 1] = 0 According to the first-order conditions of unobserved party behavior we have: − (x(x, y) = 1/w and − (y(x, y) = 1/(l − w), respectively. Therefore the first-order condition is:  l   l  x° ' ( w)  − 1 + y° '( w)  − 1 = 0 w  l−w 

On condition that xE' > 0 and yE' < 0 the outcome will always be a partial warranty which, on the one hand, is greater than zero, but, on the other hand, is less than l. If the degree of warranty coverage w/l converges to one, the first term of the above equation vanishes. The derivative is therefore negative. If the degree of coverage converges to zero, the second term disappears. Hence the derivative is positive. However, as is indicated by the equations of party behavior, the conditions of xE' > 0 and yE' < 0 are not always fulfilled. Its validity depends on the magnitude and the sign of (xy (complementary or substitutionary investments). The outcome of the bilateral model is: 1. Parties who feel unobserved when carrying out their product investments normally agree to a partial warranty. 2. This voluntary agreement solves the bilateral problem in a suboptimal manner. Kambhu (1982) raises the question whether or not it is possible to design legal rules which solve the problem of suboptimal incentives. He starts from the assumption that any warranty rule has to be ‘balanced’, which means that the seller, in making the warranty payment , loses the same amount of money as the buyer gets. According to Kambhu (1982) no legal warranty rule exists which offers both parties the Pareto-optimal incentives. This result becomes quite clear if one considers the restrictions under which the legislator has to develop the warranty rule. He has to accept that the legal consequence of the rule cannot depend on unobservable constituent facts. Deviating from the above analyses, Emons (1988) examines the case of a voluntary warranty in which the quality investments of the manufacturer and the consumer’s precautional measures do not continuously vary. He distinguishes two levels of f respectively, quality investments and care-taking. His conclusions are: if risk-averse consumers in a competitive market benefit from a full warranty more than from an incentive-compatible warranty, only a second-best solution is feasible, because the consumers will exert a low level of care. However, if the benefit of full insurance is lower and if the incentive-compatible warranty is extensive enough not to destroy the seller’s

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quality-assuring incentive, then the levels of quality and care will be optimal. The last result of Emons (1988) is crucially predetermined by the assumption of discontinuous variables. With continuous variables a full warranty coverage is necessary to assure the optimal quality investment of the seller. However, this coverage will eliminate the consumer’s incentive to handle the good carefully. Mann and Wissink (1988) discussed the case of a voluntary money-back warranty. The buyer is allowed to return the product within a period specified beforehand. The authors conclude that under extreme conditions the double-sided moral-hazard problem is solved by the first-best levels of care-taking. However, the assumptions of the model used are not realistic. On the one hand, the authors implicitly presuppose a very short period of exchange. This is assumed because buyers do not derive any benefit from the use of the product. On the other hand, the model presupposes that within this period the buyers detect all possible shortcomings of the product. So it seems that the authors really investigate the case of a search good.

7. Warranties in a Long-Term Relationship: The Model The outcome of the above analysis is that in a one-shot relationship with enforceable warranties the first-best levels of parties’ investments in quality and care-taking, respectively, cannot be achieved in general. This section now aims to examine the question whether the market outcome will improve if buyers purchase from sellers who have a good reputation. Deviating from the analysis of the last paragraph I assume unenforceable warranties. This assumption, which complicates the incentive problem, is used to show how reputation really works. Consumer durables are the type of goods for which warranties are most important. Consumers remember the experiences they had with typical brands. These experiences are shared with other customers by word-of-mouth communication. Therefore, companies which have sold brands that customers disliked, may lose part of their reputation and therefore future sales. The mere possibility of future losses may give the seller the incentive to make adequate quality investments. The following model (see Wehrt, 1995b) assumes a perfect competitive market. A multitude of sellers offer the same product with different warranty commitments in the market. However, the brands differ with respect to the unobservable quality investments and therefore varying failure probabilities. Consumers also influence the failure probabilities by their care investments. Satisfied consumers award their sellers with a certain reputation. This reputation is earned, if during the previous period the seller at least delivered the quality he had signalled with the price beforehand and if he kept the given

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warranty promise. A firm’s reputation in period t is therefore a function of the quality-warranty package of the previous period: Rt = (xt-1, wt-1). The earned reputation allows the firm to ask a price in the next period which corresponds to its reputation: pt(Rt) = pt(xt-1, wt-1). Firms which have never earned a reputation or which have abused it are avoided by the consumers. A reputational equilibrium can be defined by four conditions (compare Shapiro (1983)): 1. Every buyer chooses the quality-warranty package and the level of care-taking which maximizes his consumer surplus. 2. Buyers’ expectations come true: a seller whom the buyers expect to meet a certain level of quality investments and to keep his warranty promise, performs in this way: (xt, wt) = Rt = (xt-1, wt-1). 3. In every partial market defined by a certain level of promised quality and warranty, supply equals demand. 4. Market entrance and market exit are not profitable. The consumers are assumed to behave in a risk-neutral way. They can be distinguished by their willingness to pay q and the certain loss l that a breakdown of the purchased item causes. Thus the expected utility is: EUql = q − ( @ (l − w) − y − p where q 0 [0, 4), l 0 [0, q] According to the first equilibrium condition, a consumer of type ql maximizes his expected utility with respect to the variables y, x, w. Therefore, we have three marginal conditions: − (y(xql ,yql ) . (l − wql ) = 1

− (x(xql ,yql ) . (l − wql ) = px

((xql ,yql ) = pw The optimal values of the three variables yql, xql, wql do not vary with respect to a consumer’s willingness to pay q, but as the appearance of the individual loss l in the first two conditions shows, they depend on l. Consumers with identical individual losses are members of the same class. They prefer a certain level of quality, warranty and own care-taking. Therefore, a firm with a certain reputation serves the consumers of a certain class. The reputational equilibrium also requires that sellers have no incentive to abuse their reputation once it has been built up. A seller who exploits his reputation earns profits only during the next period. After that period the customers will avoid him. Therefore that seller’s profit is

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V1 = p(x, w) − x0, where x0 determines the cost of the minimum quality. If the firm keeps its reputation Rt permanently, it will earn profits during all the subsequent periods. Using the interest rate r, the discounted future profits can be stated as:

V2 = {p(x, w) − x − (@w} @ (1 + r) / r Defending the reputation requires profits V2 to be at least as high as profits V1. Therefore we have:

p(x, w) > x + (@w + r {x + (@w − x0} In the above, the term in the third position of the inequality stands for the quality premium the seller earns from complying with his reputation. On the other hand, according to equilibrium condition 4, the profitability of market entrance has to be prevented. A seller who enters the market will earn the following stream of profits:

V3 = x0 − x − (@w + {p(x, w) − x − (@w} / r These profits are not allowed to exceed zero. Thus the above inequality has to hold with ‘ 0]. All injuries caused by the product have a monetary equivalent of L that is suffered by risk-neutral buyers who are identical and unable to influence the risk of injury. In light of these assumptions, the total cost or ‘full price’ P of the product is given by (1) P = p + s + r(s)L. If perfectly informed consumers bear the injury cost L in the event of accident, they pay a purchase price of p + s for the product but recognize that this cost is increased by the expected accident cost r(s)L. Consequently, consumers make their purchase decisions on the basis of the full price P rather than the price they pay to purchase the product, so consumer demand QD = QD(P). Sellers then compete by offering the amount of safety and warranty coverage that minimize P. Under these conditions, it does not matter whether a perfectly informed consumer or the seller is liable for the injury (for example, Hamada, 1976). If the consumer is liable, the seller must choose the amount of safety investments to minimize P, which from equation (1) implies that the seller chooses the amount s* defined by 1 = − r'(s*)L. (2) In other words, the seller invests in safety until the last dollar spent reduces expected injury costs by one dollar. Such a product is optimally safe. If the seller is fully liable for the consumer's injuries, it sells the product and warranty at a price of p + s + r(s)L = P. Once again, the seller must minimize the full price, so it chooses the optimal amount of safety investment s*. Whether the consumer or producer is liable for the product-caused injury therefore does not affect product safety or the full price.

3. The Significance of Imperfectly Competitive Markets An early, influential justification for tort regulation was based on the notion that manufacturers can take advantage of their market power by supplying unsafe products (Priest, 1985). However, the results obtained from the basic model are unaffected if the market is not perfectly competitive (for example, Epple and Raviv, 1978). A seller’s market power can be represented by the amount it can increase the product’s full price above the competitive level. By

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increasing the product price by this amount, the seller increases its profits per sale by that same amount. Alternatively, by reducing safety investments below the optimal level s*, the seller can also increase the product’s full price as each $1 of reduced safety investment necessarily increases expected accident costs r(s)L by more than $1. This strategy does not affect the seller’s profits per sale, however, because the product must sell for a reduced price equal to the unit cost of p + s (any price above cost is equivalent to an increase in the product price). Hence a monopolist can make higher profits by selling perfectly informed consumers an optimally safe product at a supracompetitive price. Similar reasoning shows that if it would be efficient for the seller to bear full liability under the warranty, then a monopolist would maximize profits by offering a full warranty while selling the product at a supracompetitive price (for example, Heal, 1977). It is possible, though, for market structure to affect product safety. The basic model assumes a constant marginal cost of safety investment (the term s) per unit of product. Consequently, a manufacturer’s decision regarding safety investments does not depend upon its output level (as reflected by equation (2) above), implying that product safety will be unaffected by the reduced quantity of output that occurs in imperfectly competitive markets. Many product risks are likely to depend upon the quantity of products sold or consumed by an individual, however. As Marino (1988a, 1988b) points out, toxic chemicals may present a health hazard due to their cumulative effect on consumers. Conversely, consumers may develop a tolerance from cumulative exposure, thereby reducing the risk. The higher prices, and reduced consumption, of products sold in imperfectly competitive markets would affect these kinds of product risk. In addition, when the cost of safety investments depends upon a manufacturer’s output level, the amount of safety investments made by a monopolist depends on the cross-effects of safety investments and output on the monopolist’s costs (Spulber, 1989, pp. 407-410). Whether sellers in imperfectly competitive markets supply products that are insufficiently safe therefore is a difficult empirical question. But if such market failures exist, they probably are better addressed by the antitrust laws.

4. The Role of Consumer Information About Product Risk The analysis so far has assumed that consumers are perfectly informed of risk, an assumption typically made by early economic analyses of products liability (for example, McKean, 1970a; Oi, 1973). But as Goldberg (1974) argued, product safety becomes a regulatory problem only if consumers are inadequately informed. Subsequent economic analyses focused on the effects of imperfect information. When imperfectly informed consumers are liable for their injuries, they

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must estimate their expected injury costs, denoted E[r(s)L], and hence the full price, denoted E[P]. Consequently, equation (1) above is changed to E[P] = p + s + E[r(s)L]. (1') In this setting, a seller must minimize E[P] if consumers are to buy its product, so sellers choose the amount of safety investment s that minimizes E[P]: 1 = − E[r'(s)L]. (2') Thus, when consumers are imperfectly informed of product risk, the seller invests in safety until the last dollar spent on safety reduces the consumer’s estimate of expected injury costs by one dollar (Spence, 1977). If consumers underestimate the decrease in expected injury costs, they will undervalue risk reduction and demand less than the optimal amount of safety; that is, if − E[r'(s)L] < − r'(s)L, then s < s*. A similar result occurs when consumers cannot observe manufacturer safety investments, because consumers who cannot tell the difference between a low-risk and high-risk product treat the differential in safety as if − E[r"(s)L] = 0 when in fact − r'(s)L > 0. Manufacturers have no incentive to incur the higher cost of producing the low-risk product, so they supply only high-risk products, an outcome analogous to the ‘lemons problem’ analyzed by Akerlof (1970). Imperfect information need not result in overly unsafe products. If consumers overestimate the way in which increased safety investments reduce risk, they will attribute too great a value to safety investments and demand more than the optimal amount of safety. Although this outcome is inefficient, it seems unwise to construct a regulatory regime, with its attendant administrative costs, in order to reduce product safety. Hence there is a pressing need to regulate market transactions only if consumers undervalue safety investments.

5. Market Mechanisms that Promote Product Safety Landes and Posner (1987, pp. 280-281) argue that it is too costly for consumers to obtain perfect information about product risks, and imperfectly informed consumers tend to underestimate the small risks ordinarily posed by products, causing them to undervalue safety investments. In assessing this argument, we must recognize that the cost consumers incur to get risk-related information, and their need for it, depends upon a variety of market mechanisms. For example, manufacturers have an incentive to provide optimally safe products if there is a large enough proportion of well-informed ‘shoppers’ in the market (Schwartz and Wilde, 1983a). The information held by some consumers therefore may benefit others who undervalue product safety. Similarly, consumers who communicate among themselves by ‘word of mouth’

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advertising may increase the amount of high-quality goods in the market (Rogerson, 1983). Consumers also can purchase product-related information from intermediaries, and such information may come from sellers. Brand names, for example, are a method sellers use to implicitly guarantee superior quality (Klein and Leffler, 1981), because product quality must be sufficiently high if the seller is to attract repeat purchases (for example, Shapiro 1982, 1983). For the same reason, sellers can convey indirect information about product quality through advertising and prices (Milgrom and Roberts, 1986). The way in which price signals quality is highly dependent on the market context, however, as in some settings low prices signal high quality, whereas in other settings high prices signal high quality (Tirole, 1990, pp. 110-12). In addition, prices signal product quality only if consumers have at least some brand-specific information about quality, although this information need not be perfect (Wolinsky, 1983). As long as consumer experience with a product brand provides enough information so that consumers are more likely to believe the brand is of high quality when in fact it is, high-quality firms will attract more customers (Rogerson, 1983). The need to protect their reputation or brand name may force sellers to provide more safety than is suggested by the analysis in the prior section. Nevertheless, it is unlikely that unregulated market transactions will yield optimally safe products when consumers are imperfectly informed of product risk. A seller’s reputation can remain intact even though its product is not optimally safe, because consumers often have little or no ability to learn from product use about the product’s safety characteristics. Many risks are latent and do not become manifest for years (like carcinogens). In addition, many safety characteristics are not observable during normal product use (such as whether a motor vehicle is optimally designed to minimize the risk of injury for different types of accidents). Given the very low probabilities of most product-caused injuries and the fact that optimally safe products typically pose some risk of injury, very little information will be conveyed by a consumer’s experience of ‘no accident’ or ‘accident’. For example, suppose an unsafe product doubles the risk of injury from 1 in 10,000 to 2 in 10,000. Based upon their experience, it could take consumers a long time (involving numerous iterations of Bayesian updating) to discover the increased risk. Another problem is that the price-quality relationship depicted by signalling models is based on equilibrium conditions for products that vary in one dimension of quality. Even within the confines of such a simplified market, it is doubtful that consumers ordinarily will have enough information about the market context to draw the correct inferences about product safety. And once one allows for the (realistic) possibility of disequilibria in markets for products that are heterogeneous in more than one dimension, it becomes even less likely that consumers will be able to obtain good information about product safety from

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prices. Indeed, one empirical study found that price might serve as a quality signal for only one type of product - frequent but unimportant purchases (Caves and Greene, 1996). Given the limited amount of information provided by market mechanisms, it is puzzling why sellers do not voluntarily disclose risk-related information, particularly since such disclosures would be credible due to the legal prohibition against fraud. Because only high-quality sellers would benefit from voluntary disclosure, consumers could infer from the fact of nondisclosure that a seller is not offering an optimally safe product. All sellers therefore would have to disclose, forcing them to provide optimally safe products. It is possible that high-quality sellers do not voluntarily disclose risk-related information because consumers tend to overreact to negative information about products (see the sources cited in A. Schwartz, 1988, p. 381). Consequently, any seller that discloses risk-related information could cause consumers to believe that its product is unsafe, so high-quality sellers are better off by not disclosing. Burrows (1992) provides other reasons why sellers might not voluntarily disclose information about product risk, and Geistfeld (1997) explains why a system of voluntary disclosure would function much like a tort regime of negligence.

6. Do Consumers Undervalue Product Safety? As the previous discussion suggests, individuals often process risk-related information in a manner that does not correspond to the standard economic model of decisionmaking. A substantial literature on cognitive psychology seeks to understand how individuals assess risks (for example, Kahneman, Slovic and Tversky, 1982). Based on these studies, A. Schwartz (1988, 1992) concludes that consumers tend to overestimate product risks, whereas Latin (1994) concludes that consumers usually underestimate risk and thus undervalue product safety. Both agree these studies find that individuals tend to overestimate risks that are brought to their attention (which may explain why sellers do not voluntarily disclose risk-related information). Latin, however, persuasively argues that most product risks are not salient because product-caused injuries are a rare occurrence for most individuals, leading consumers to infer (erroneously) from the more common or representative experience of safe product use that risk is not present or worth worrying about. Consequently, as Landes and Posner claimed, imperfectly informed consumers tend to underestimate product risks. Although consumer understanding of product risk is relevant to the regulatory problem, it should also be recognized that consumers can undervalue product safety even if they are perfectly informed of product risks. Suppose consumers are risk averse and find it worthwhile to purchase a fully compensatory health insurance policy. Suppose also that the product-caused

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injury would be fully covered by this policy. Insurance companies ordinarily do not adjust premiums to reflect the riskiness of products purchased by their policyholders (Hanson and Logue, 1990). As the consumer’s health insurance premium is unaffected by her consumption choices, neither it nor the expected cost of injury (which is fully insured) are relevant to the consumer’s purchase decision. The full price to the consumer consequently is given by P = p + s, and sellers minimize this full price by setting s = 0. Simply put, fully insured consumers have no need for risk reduction, so it does not pay for sellers to invest in product safety. Of course, this example is extreme (because insurance policies rarely provide full coverage), but the conclusion is general: fully informed consumers will undervalue product safety when they can externalize some of their injury costs onto an insurance company.

7. Product Warranties and the Use of Seller Liability to Promote Safety As discussed in Section 2, when the seller is fully liable for product-caused injuries, the price at which the product sells on the market equals the full price, forcing the seller to provide the cost-effective amount of product safety. In these circumstances, imperfectly informed consumers only need to find the product that sells for the lowest price in order to get the optimally safe product. Seller liability therefore remedies the consumer’s informational problem in a straightforward way, creating the possibility that imperfectly informed consumers might be able to rely on warranties to obtain optimally safe products. For example, assume as in Grossman (1981) that the manufacturer is the least-cost insurer and that consumers are unable to observe manufacturer safety investments. In this setting, insurance costs are minimized if the manufacturer provides a warranty that fully compensates the consumer for any product-caused injuries. A manufacturer that provides full warranty coverage must also provide an optimally safe product in order to minimize the market price (which equals the full price) of its product. A manufacturer that does not provide the optimally safe product therefore would signal this fact to consumers due to the product’s higher market price, so to avoid this outcome such a manufacturer cannot offer a full warranty. Imperfectly informed consumers would infer this type of behavior, though, and assume that products without full warranty coverage must not be optimally safe. Manufacturers accordingly have no choice but to offer imperfectly informed consumers optimally safe products with full warranty coverage. Thus, when sellers are the least-cost insurers, imperfectly informed consumers can use product warranties to attain efficient outcomes: by choosing warranties that impose full liability on sellers, consumers can ensure that

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products will be optimally safe and insurance costs will be minimized. Full warranties (or seller liability in tort) might not result in such equilibria, though, if sellers purchase insurance to cover their liability under the warranty. A study directed by the US Department of Commerce found that liability insurance in the 1970s was rarely priced in a manner that reflected the degree of risk posed by the manufacturer-policyholder’s products (Inter-Agency Task Force on Products Liability, 1977). Although such insurance reduces the manufacturer’s incentive to invest in product safety (as the increased accident costs do not increase premiums), developments in the liability-insurance market have significantly restored this incentive. Based on estimates of firms’ total liability costs, Priest (1991) found that self-insurance costs accounted for 4.9 percent of the total in 1970 and increased to 51.7 percent in 1979. The amount of uninsured risk exposure faced by firms probably increased in the 1980s. Moreover, products liability insurance policies now commonly rely on pricing elements that are responsive to the level of risk posed by the policyholder’s products (G. Schwartz, 1990, pp. 320-321). Hence there are good reasons for expecting that the prospect of liability gives sellers an incentive to invest in safer products.

8. Are Product Sellers the Least-Cost Insurer? Despite the safety benefits of seller liability, warranties that make sellers fully liable for product-caused injuries are unlikely to be efficient because sellers rarely are the least-cost insurer for all product risks. Although manufacturers are likely to have a comparative advantage in insuring against some risks, like those involving repair of complicated machinery, consumers typically will have a comparative advantage in insuring against other risks (Priest, 1981). In particular, risk-averse consumers ordinarily will have a comparative advantage in insuring against many of the risks associated with physical injury, because the cost consumers incur in making their own insurance arrangements ‘first-party insurance’ - often is lower than the cost sellers incur in making insurance arrangements to cover product-caused injuries suffered by consumers - ‘third-party insurance’. In part, first-party insurance is cheaper because it is more capable of minimizing the costs of moral hazard and adverse selection (Epstein, 1985; Priest, 1987). The primary reasons for the cost differential between the two insurance mechanisms stem from the event that triggers coverage and the scope of coverage. Coverage under many first-party insurance policies, such as health insurance, is triggered by the fact of loss (like medical expenses), making the cause of injury irrelevant in most cases. The fact of injury or loss usually is easy to prove (submitting bills), so policyholders typically do not have to hire a lawyer to receive insurance proceeds. By contrast, the third-party insurance

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supplied by product sellers is triggered only if the product caused the injury. Often, many products are causally implicated in an accident, and a potentially contentious factual inquiry may be needed to resolve the liability question (Geistfeld, 1992). Some items of damages, particularly those pertaining to pain-and-suffering damages and future economic loss, are also costly to determine. The resultant litigation expenses increase the cost of third-party insurance, which probably explains why the administrative costs of third-party insurance per dollar of coverage exceed the administrative costs of first-party insurance (Geistfeld, 1992, pp. 639-642). With respect to the scope of coverage, third-party insurance provides compensation for pain-and-suffering injuries whereas first-party insurance typically does not. It might be inefficient for consumers to insure against pain-and-suffering injuries (for reasons given in Section 20 below). If so, it would be more efficient for consumers to suffer these injuries without compensation (a form of first-party insurance), providing another cost advantage for first-party insurance. In other respects, the scope of coverage provided by third-party insurance is not extensive enough, as it does not cover losses unrelated to product use. To cover these contingencies (like medical expenses due to illness), individuals need to purchase other insurance. But since first-party insurance coverage is usually triggered by the fact of loss rather than its cause, individuals who have such insurance might receive double compensation when injured by products: the first-party insurer is obligated to pay whenever the policyholder suffered an insured-against loss; and the seller is obligated to pay (due to the collateral-source rule) even though the consumer received other insurance proceeds. Double recovery can be avoided if the first-party insurer exercises a contractual or statutory right to indemnification out of the tort recovery received by the policyholder, but the separate legal proceeding often is complicated and expensive due to the need to determine which part of the tort award or settlement is covered by the policy. For this and other reasons, many insurers do not exercise this right. Insurance provided by product sellers therefore may be an inefficient form of double insurance or otherwise increase the administrative cost of first-party insurance policies, providing another reason why consumers may reduce their insurance costs if they disclaim seller liability under the warranty. Sellers therefore will typically not be the least-cost insurer for all product risks. Hence, imperfectly informed consumers ordinarily will not be able to rely on full warranty coverage to ensure that products are optimally safe and insurance costs are minimized. It is still an open question, though, whether tort regulation would be efficiency-enhancing.

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9. The Regulatory Problem To account for differences in the cost faced by consumers and manufacturers in insuring against product losses, LI will denote the consumer’s cost of compensating the injury and LW the seller’s cost of compensating the injury under the product warranty. Whether the seller is liable for the injury may affect product safety, so the seller’s safety investment will be denoted by sI when the consumer insures against the injury and by sW when the seller is liable under the warranty. Finally, we will assume that any insurance costs faced by the consumer equal the actuarially fair amount r(sI )LI . (The other extreme - the case in which premiums do not depend on risk - was discussed in Section 6.) There are two possible full prices to consider: PI = p + sI + r(sI )LI .

(3)

(4) PW = p + sW + r(sW)LW. Consumers will disclaim seller liability when doing so would reduce the full price (that is, when PI < PW), and otherwise will purchase full warranty coverage (when PI > PW). To illustrate how the difference in insurance costs affects the analysis, suppose consumers are unable to observe manufacturer safety investments. For reasons given in Section 4, manufacturers will set sI = 0. Consumers, however, will infer such behavior on the manufacturer’s part, recognizing that the full price is given by PI = p + r(0)LI . By contrast, when the manufacturer is fully liable under the warranty, it provides an optimally safe product. Hence PW = p + sW* + r(sW*)LW. Even though product safety increases when the manufacturer is fully liable under the warranty (sW* > sI = 0), if the consumer has a comparative advantage in compensating the injury (LI < LW), it is possible that PI < PW. Consumers therefore may be better off with the less-safe products and reduced insurance costs than with the safer products and more expensive insurance provided by full product warranties. Thus, there often is a tradeoff between safety and insurance considerations when consumers are imperfectly informed: although increasing the amount of seller liability can lead to safer products, it is also likely to increase the average cost of compensating an injury. This inefficiency does not necessarily create a need for tort regulation, however (Geistfeld, 1995a). As long as imperfectly informed consumers can accurately compare PI and PW, as in the example just given, they will choose warranties that strike the appropriate balance between the costs and benefits of seller liability. At best, a tort rule could achieve a similar balance, but more likely it will not. Inefficiencies in product markets therefore need not create an efficiency-enhancing role for tort liability.

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Imperfectly informed consumers will not choose appropriate warranties, though, when they underestimate product risk and thus underestimate the product’s full price. (If E[r(s)] < r(s), then E[PI ] < PI .) In this case, consumers sometimes choose warranties that disclaim manufacturer liability when it would be inefficient do so (that is, when E[PI ] < PW < PI ). A tort rule that imposes full liability on sellers would be efficiency enhancing in this situation. It is also possible, however, that consumers disclaim manufacturer liability when it would be efficient to do so (because E[PI ] < PI < PW). Consequently, tort regulation is not necessarily efficiency enhancing when consumers underestimate product risk. The type of market failure that might justify tort regulation accordingly depends upon conditions that cause consumers to disclaim seller liability when it would be inefficient to do so. This conclusion is not affected by extending the analysis to include the possibility that consumers can affect the risk of injury by exercising care while using the product. As long as sellers cannot observe the amount of consumer care, full warranty coverage is likely to reduce the consumer’s incentive to take costly efforts to avoid (the fully insured) injury. Yet, the reduction in warranty coverage reduces the manufacturer’s incentive to make costly safety investments, so the warranty must balance conflicting safety and insurance considerations (Cooper and Ross, 1985a; Emons, 1988). Holding manufacturers liable in tort for product-caused injuries does not solve the informational problem, however, so this form of tort regulation cannot improve upon a warranty that efficiently allocates liability given the informational constraint. An additional consideration arises if consumers have different risk profiles due to differences in product use, abilities to reduce risk for a given level of care, or damages. Although ‘low-risk’ and ‘high-risk’ consumers may demand products of different qualities, manufacturer liability can force sellers to provide only one level of quality. According to Oi (1973), that outcome is inefficient because low-risk (that is, low-damage) consumers are forced to subsidize high-risk consumers. Absolving sellers of liability would eliminate this inefficiency, because sellers could then provide products of different quality at different prices in a manner that sorts low-risk and high-risk consumers into the appropriate product markets. However, Ordover (1979) shows that in order for such separating equilibria to occur, low-risk consumers must differentiate themselves from high-risk consumers by purchasing incomplete warranty coverage. There may be cases in which the benefits of successful differentiation are less than the benefits of mandated seller liability. Hence tort regulation is not necessarily inefficient even though some consumers would be better off without such regulation.

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10. The Choice Between Negligence and Strict Liability We have been analyzing seller liability in terms of a rule that holds sellers strictly liable for injuries caused by product use. Most product accidents are governed by a rule of negligence, however, which makes sellers liable for injuries caused by products that are not reasonably safe. According to the economic interpretation of negligence, a product is not reasonably safe if it contains less than the optimal amount of safety s* defined by equation (2) above. Because each dollar of safety investment below s* increases expected accident (and thus liability) costs by more than one dollar, sellers minimize total costs by making total safety investments equal to s*. Thus, a negligence standard that is properly defined and perfectly enforced gives sellers an incentive to supply optimally safe products, the same incentive created by strict liability. Negligence differs from strict liability in that consumers under a negligence rule bear liability for injuries caused by optimally safe products, giving them the opportunity to enter into insurance arrangements that minimize the cost of injury compensation. In theory, then, a negligence regime can yield optimally safe products while enabling consumers to minimize insurance costs. Nevertheless, negligence will not lead to efficient outcomes, when consumers are imperfectly informed of product risk (Shavell, 1980; Polinsky, 1980). Because sellers are not liable for injuries caused by their (optimally safe) products, the product sells for p + s*. Consumers in a negligence regime therefore need to estimate expected injury costs r(s*)LI in order to determine the product’s full price P. Consumers who underestimate product risk will underestimate the full price, increasing their demand above the amount they would choose if they were perfectly informed. Thus, even though products are optimally safe, consumers will purchase too many products (and there will be too many firms in the industry). This overconsumption increases the total number of injuries above the efficient amount whenever optimally safe products pose a positive risk of injury. Another problem with a negligence rule is that it often will be difficult (and expensive) for the plaintiff to show that the product should have been made differently. Consider, for example, the complicated issues that must be resolved in order to determine whether a product is optimally designed. The cost of litigating these issues may undermine the safety incentives of negligence liability. Prior to filing suit, injured consumers who are not well-informed about manufacturer safety investments often will be unable to determine whether the product is reasonably safe. These consumers (or their contingent-fee attorneys) may be unwilling to incur the cost of proceeding with the lawsuit, enabling some manufacturers with suboptimally safe products to escape liability. Under these conditions, a proportion of manufacturers choose to be negligent (Simon, 1981).

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Another reason for expecting that the negligence standard will not be perfectly enforced stems from the possibility that judges and juries will make mistakes. The complicated issues in products liability cases (many of which are discussed below) make court error possible. Hylton (1990) shows that a negligence standard with court error and costly litigation can lead to over- or underdeterrence. Overdeterrence can occur because sellers of optimally safe products may be held liable due to court error. By increasing product safety, the seller decreases the risk of injury, thereby reducing the likelihood that it will be subjected to a lawsuit and an erroneous imposition of liability. But even though court errors can increase product safety, the increased legal uncertainty has deleterious effects (also discussed later). Moreover, overdeterrence may involve the withdrawal of socially beneficial products from the marketplace. Strict liability, by contrast, is less costly for plaintiffs and easier for courts to administer, which increases the likelihood that it will be perfectly enforced. In addition, strict liability can lead to the efficient level of risk even though consumers are imperfectly informed. Hence strict liability has a better potential for reducing product risk. Negligence, on the other hand, allows for a greater range of insurance arrangements and accordingly has more potential to reduce the average cost of compensating an injury. The choice between negligence and strict liability therefore reflects the same safety-insurance tradeoff described earlier: increased seller liability (that is, strict liability) is likely to increase safety and per-injury insurance costs, whereas decreased seller liability (negligence) is likely to reduce safety and the average cost of compensating an injury.

11. Empirical Studies of the Effect of Seller Liability on Product Safety Whether seller liability reduces product risk is a difficult empirical question, because the available accident data are not sufficiently refined and the injury rate is affected by a number of other factors such as changes in technology and the composition of products and users. Indeed, data limitations undermine the conclusions one can draw from attempts to measure the impact that seller liability has had on product safety. For example, Priest (1988a) compares the amount of products liability litigation to death rates and the rate of product-related injuries requiring emergency room treatment, concluding that the expansion in litigation had no discernible effect on accident rates. Although Priest acknowledges that the study is exploratory, Huber and Litan (1991, p. 6) assert that it raises ‘serious doubts that the benefits of expanded seller liability have been large’. But as Dewees, Duff and Trebilock (1996, p. 203) point out, Priest’s study does not necessarily show anything about the relationship between seller liability and accident rates. The accidents in the study could be caused by a number of factors unrelated to manufacturer safety investments.

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Moreover, increased seller liability should reduce the number of ‘defective’ (suboptimally safe) products, but the injury data are not segregated into accidents involving defective and nondefective products, making it difficult to draw useful conclusions from the study. For example, the prior level of tort liability could have significantly increased the number of nondefective products on the market. Greater consumption of these nondefective products (due to increased wealth, for example) could increase the overall injury rate, even though the expansion in seller liability reduced product risk by reducing the amount of defective products on the market. Higgins (1978) relies on accidental fatalities in the home as a proxy for product-caused injuries. The econometric analysis finds that producer liability reduces the frequency of these accidents in states with low levels of educational attainment and increases it in states with high levels. If low educational attainment corresponds to imperfectly informed consumers, this study partially supports the claim that producer liability increases safety when consumers are not well informed of risk. However, in addition to the previously mentioned problems of relying on such aggregated accident data, this study is problematic because it measures the impact of producer liability in a state by reference to the year when its highest court expanded producer liability by eliminating the contractual requirement of privity. It is doubtful that this expansion in seller liability was significant enough to produce observable results, particularly since the numerous exceptions to the privity doctrine meant that sellers were already exposed to considerable liability for injuries suffered by victims with whom there was no direct contractual relationship. Graham (1991) attempts to determine the relationship between products liability and passenger-car death rates. The regression does not detect any beneficial impact of liability on aggregate death rates, with the extent of liability measured by an index based on the annual number of crashworthiness cases reported in the LEXIS database. Measuring liability rules by published judicial opinions is particularly problematic, however, because most lawsuits are settled prior to trial. A very effective liability rule, for example, could cause all cases to settle, giving sellers a strong incentive to reduce risk. Yet Graham’s model would not impute this risk reduction to the liability rule. Moreover, MacKay (1991) argues that federal regulations of automobile design have forced all manufacturers toward a common standard, which undermines the attempt to derive a simple causal link between products liability and traffic accidents. Other studies have circumvented these data problems (and created others) by asking producers how their behavior has been influenced by liability. Eads and Reuter (1983) conducted interviews with nine large manufacturers, concluding that products liability significantly influences product-design decisions. Based on interviews with 101 senior-level corporate executives from the largest publicly held companies in the United States, Egon Zehnder

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International (1987) found that over half of these companies had added safety features as a result of liability concerns. About 20 percent of the companies chose not to introduce new products on account of products liability. Two other studies conducted by the Conference Board surveyed risk managers and CEOs of major corporations, finding that products liability concerns led to significant safety improvements while also causing a significant number of firms to discontinue product lines or not introduce new products (Weber, 1987; McGuire, 1988). The Egon Zehnder survey is probably the most reliable due to its excellent response rate; the Conference Board surveys had poor return rates and may have been influenced by a variety of biases (G. Schwartz, 1994a, pp. 408-410). A different approach to evaluating the effects of seller liability examines the impact of prominent products liability lawsuits on stock prices. Viscusi and Hersch (1990) find that news stories reporting on products liability suits significantly decrease a firm’s stock value. Similarly, Jarrell and Peltzman (1985) (criticized by Hoffer, Pruitt and Reilly, 1988) and Rubin, Murphy and Jarell (1988) find that safety-related administrative actions (product recalls) substantially reduce stock prices. In all of these studies, adverse publicity concerning product safety costs the firm more due to the reduced stock value than does the associated liability or recall costs. These findings suggest that firms suffer a loss of reputation when there is an adverse event (litigation or administrative action) pertaining to the safety of its product. As described earlier, a firm’s reputation for safety is important when consumers are not well-informed of product risk. These studies therefore indirectly confirm that individuals are not perfectly informed of product risks. Moreover, the loss in stock value gives firms an additional incentive to avoid products liability litigation, providing another reason for believing that seller liability increases safety.

12. The Impact of Tort Liability on Innovation The political debate regarding products liability reform in the US has often involved the claim that tort liability reduces innovation and consequently undermines the competitiveness of domestic products in a global economy. Although tort liability probably has reduced some types of innovation, the welfare effects of that reduction are unclear. Moreover, tort liability has also induced beneficial innovation, making it even more difficult to assess the net impact of tort liability on innovation. Tort liability can increase a producer’s cost, relative to a rule of no liability, by forcing the firm to increase its safety investments. Tort liability also requires that firms make disclosures in product warnings so that imperfectly informed consumers can better estimate accident costs (see Section 18 below). Insofar as tort liability increases safety investments and consumer estimates of accident

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costs, there is an increase the product’s full price. Consequently, tort liability is likely to encourage safety innovations much in the same way that other cost-driven price increases, such as those stemming from labor scarcity, induce innovation. An increase in cost enhances the profitability for the firm of any innovation which reduces that cost. The resultant increase in firm demand for such technical change should produce more innovation, a theory of technical change called ‘induced innovation’. This theory has substantial analytical and empirical support for innovations unrelated to product safety (Thirtle and Ruttan, 1987). There is no apparent reason why the theory is not also applicable to safety innovations. For example, an optimal research and development (R&D) program without a fixed budget will expend resources until the marginal cost of additional research equals the marginal benefit. The benefit depends on the potential cost savings from the research, savings that are increased as firms face increased tort liability. Expansions in tort liability therefore should increase R&D expenditures for safety technologies. This conclusion is consistent with the analytical results obtained by Daughety and Reinganum (1995), and the empirical study by Egon Zehnder International (1987) which found that over half of the surveyed companies had increased their R&D expenditures as a result of liability concerns. Insofar as the increased R&D expenditures have yielded more safety innovations, tort liability has promoted safety innovation. A liability rule that increases the product’s price can also have a negative effect on innovations unrelated to product safety. Assuming that the increased price reduces consumer demand, both theory (Binswanger, 1974) and historical evidence (Schmookler, 1966) indicate that the reduced profitability of the product line discourages innovation. But insofar as the change in demand reflects consumer response to a product price that more accurately reflects accident costs, the reduced innovation may be welfare enhancing. Viscusi and Moore (1991a, 1991b, 1993) study the effect of liability costs on innovation, finding that firms with new products have higher liability insurance costs. Econometric analysis shows that increased seller liability increases safety incentives, but at some point further increases in liability reduce innovation by making new products unprofitable (ibid., 1991b, 1993). One study (1993) shows that 10 industry groups were at or near this threshold in the mid-1980s, indicating that the incentive effects of seller liability vary across industries. This variable effect is confirmed by case studies of different industries regarding the impact of tort liability on innovation (Ashford and Stone, 1991; Craig, 1991; Graham, 1991; Johnson, 1991; Lasagna, 1991; Martin, 1991; Swazey, 1991). Products liability can also affect innovation due to its influence on the structure of business organization. If a firm suspects that a product may pose risks that are long term and likely to result in widespread injury, it has an incentive to avoid paying damages by divesting production tasks that involve

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such products. To insulate itself from legal liability, the parent company must divest early in the R&D stage. This dynamic is consistent with an empirical study of the US economy which found that increased seller liability appears to have increased the number of small corporations in hazardous sectors between 1967 and 1980 (Ringleb and Wiggins, 1990; see also Merolla, 1998). The cost of innovation for products involving such risks will be increased by the need to divest an operation that can more cost-effectively (absent liability concerns) be administered within a single organization. The increased cost in turn provides some disincentive for innovation.

13. The Relationship Between Tort Liability and the Market for Liability Insurance A report published by the US Attorney General’s Tort Policy Working Group concluded that increased tort liability was a major cause of the so-called ‘liability insurance crisis’ that occurred in the mid-1980s (US Department of Justice, 1986). The liability-insurance market was in turmoil during this period: premium revenues tripled and the supply of coverage severely contracted (Viscusi, 1991a). It is not evident why a contraction in the liability-insurance market would be caused by legally mandated expansions in seller liability, however, as expansions in tort liability should increase the demand for liability insurance. This conundrum has attracted much attention, leading to a number of different explanations for the liability-insurance crisis (surveyed in American Law Institute, 1991a, pp. 66-97). For our purposes, the most interesting finding to emerge from this literature pertains to the way in which legal uncertainty affects the cost of liability insurance. A standard liability-insurance policy covers a product seller’s legal liability for personal injury or property damage that ‘occurs’ to third parties during the policy year. Often a number of years pass before legal liability is incurred by the policyholder (who is then indemnified by the insurer). During the period between the issuance of the policy, manifestation of injury, and conclusion of the lawsuit, any changes in tort law may affect the costs the insurer will incur under the policy. Thus, in order to forecast its expected costs for a group of policies, a liability insurer needs to predict how tort standards, damage rules, and insurance law (like the interpretation of an ‘occurrence’) will change over time. In periods of legal stability, the insurer can be fairly confident about its predicted liability exposure. However, as Abraham (1987) and Trebilcock (1987) emphasize, there were various sources of legal uncertainty that liability insurers faced in the 1980s, making it difficult to predict the likelihood or magnitude of covered losses. In theory, this increased uncertainty increased the variance of the insurer’s expected loss and thus the cost of bearing that risk

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(Venezian, 1975). Empirical studies also show that legal uncertainty increases the cost of liability insurance. Kunreuther, Hogarth and Meszaros (1993) surveyed actuaries, underwriters and insurers, finding that they will add an additional cost above the expected value of loss when there is uncertainty (or ‘ambiguity’) regarding the probability or magnitude of the insured-against loss. Similarly, in an econometric study involving a large number of insurance policies issued during 1980-84, Viscusi (1993a) concludes that risk ambiguity tended to exert a positive influence on actual premium rates, controlling for the regulated rate. Winter (1991) provides a theoretical explanation for why this uncertainty can also affect the industry supply of liability insurance. It seems likely, then, that any increased legal uncertainty created by the tort system contributed to the liability-insurance crisis in the 1980s. In response to this and an earlier insurance crisis in the 1970s, a number of states enacted legislation limiting a seller’s tort liability. Most of these measures also reduced legal uncertainty (for example, by placing caps on the most unpredictable elements of damages). Viscusi (1990a) finds that both the profitability and availability of liability insurance were enhanced during 1980-84 by prior legislative reforms that limited firms’ liability. Viscusi et al. (1993) find that the reforms adopted by the states between 1985 and 1988 reduced liability costs and the premiums for liability insurance. This study also concludes that its findings are consistent with the possibility that the fact of comprehensive reform is more consequential than its components. One way to explain such an outcome is that the enactment of legislative reform reduces legal uncertainty by indicating that the legal climate is not hospitable to expanded tort liability for product sellers. In such a climate, liability insurers may be more confident that they will not be exposed to unanticipated expansions in legal liability, thereby reducing the cost of legal uncertainty that is built into premiums for liability insurance. But even if the reductions in seller liability mandated by these legislative reforms reduced liability costs and premiums, it does not follow that the reforms were efficient. Croley and Hanson (1991) argue that the rise in liability-insurance costs reflected a more efficient level of deterrence due to the internalization of costs that had been externalized prior to the expansion of seller tort liability. Indeed, due to the higher cost of third-party insurance, increased seller liability should have a pronounced effect on insurance costs. Moreover, because increased tort liability will decrease demand when consumers underestimate risks (see Sections 10 and 11 above), Manning’s (1996) empirical finding that tort liability reduced consumer demand for childhood vaccines does not necessarily establish, as he claims, that consumers place no value on this form of tort insurance. Instead, the relevant question for policy purposes is whether the increased insurance costs of tort liability, and any decline in consumer demand, are justified by a reduction in product risk.

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14. Introduction to the Economic Analysis of Products Liability Doctrines Depending on the issue involved, the current products liability regime in the US relies upon contracting, negligence, or strict liability to allocate liability for product-caused injuries. The prior analysis of the costs and benefits of these methods therefore can be used to analyze the efficiency properties of various products liability doctrines. Consequently, the ensuing discussion will delineate the role of contracting, negligence, and strict liability while raising a number of previously undiscussed considerations relevant to the economic analysis of products liability law. Epstein (1980) provides a more comprehensive overview of products liability law and discusses the economic implications of various doctrines. The American Law Institute (1991b) provides more extensive economic analysis of the main products liability doctrines. Although this focus on US law is limiting, the doctrines to be disscused have influenced the development of products liability laws in other countries, particulary the European Community and Japan.

15. The Focus of the Legal Inquiry and Its Implications for the Choice of Liability Rules Sellers are liable for their negligent conduct resulting in product-caused injuries. In the vast majority of states and the European Community, sellers are also liable for injuries caused by product ‘defects’. Although this rule is commonly called ‘strict products liability’, it is not the same as strict liability because liability depends upon the existence of a defect. In most states, defect is defined by reference to the product itself. As discussed in the ensuing sections, the choice between negligence and strict liability follows from the definition of defect and is not based on the efficiency properties of these tort rules. Other states and the European Community define defect by reference to consumer expectations. Although it is easier to give this approach an economic interpretation, it too does not rely upon efficiency considerations in making the choice between negligence and strict liability. More precisely, the consumer expectations test can operate like a rule of strict liability, since an optimally safe product is defective if it does not conform to consumer expectations. This outcome occurs when consumers underestimate risk, as products will always be more dangerous than consumers expect them to be. Conversely, when consumers are well-informed of product risk, the product always conforms to consumer expectations and consequently absolves the seller from tort liability. The consumer expectations test therefore limits tort liability to the cases in which it has the greatest potential to be

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efficiency-enhancing (when consumers underestimate risk), but it does not rely upon an economic rationale for its choice of strict liability over negligence.

16. Manufacturing Defects Manufacturing defects are physical deviations from a product’s intended design, thereby implicating the quality control of manufacturing and inspection processes. These processes usually cannot be made perfect, so some products containing manufacturing defects will reach the marketplace. Whenever such a defect causes physical injury, the seller is liable even if it employed the most efficient quality-control measures. Defining defect by reference to the product accordingly results in a rule of strict liability for these cases. Jurisdictions that rely on the consumer expectations test also employ strict liability for these cases by assuming that consumers do not expect a product to contain a manufacturing defect. Most agree that strict liability is the better rule for these cases. G. Schwartz (1979, pp. 459-462), for example, argues that most manufacturing defects are attributable to negligence, but it often will be difficult for plaintiffs to prove that the seller or one of its agents did not use appropriate quality-control measures. Thus, even though negligence in principle would eliminate tort liability whenever increased deterrence is not desirable - that is, when efficient quality-control measures already are being used - the benefit in these few cases is less than the costs that would be created for all cases if the plaintiff had to prove that the defect was caused by inadequate quality control. Strict liability may also be more efficient because it gives sellers a better incentive to foster advances in technology that reduce the incidence of manufacturing defects (Landes and Posner, 1985).

17. Design Defects A product that conforms to the manufacturer’s design specifications is defective if the design is defective. Unlike manufacturing defects, which can be determined by reference to deviations from product design, there is no readily available definition of design defect. Consequently, courts had to develop such a definition. Many jurisdictions define defect by reference to consumer expectations. This test, however, suffers from an inherent ambiguity. The inquiry could address consumer expectations of product risk. As previously noted, because consumers who underestimate risks will always find a product to be more dangerous than they expect, sellers are subjected to liability even if the product

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design satisfies the cost-benefit test. This logic explains the controversial result in Denny v. Ford Motor Company, and is consistent with the rule that consumer expectations justify holding sellers strictly liable for manufacturing defects. Alternatively, the inquiry could address consumer expectations of product safety. Consumers who underestimate risk ordinarily expect less safety than is contained in a product. For example, consumers who are unaware of risk expect there to be no safety investments, implying that any amount of product safety surpasses consumer expectations, even if the product is less safe than would be efficient. That consumer expectations tend to establish a safety standard below that of the cost-benefit test was recognized in the influential case Barker v. Lull Engineering Company. Whether consumer expectations should be defined by reference to risk or safety is an issue that can only be resolved by determining why consumer expectations matter, an issue that courts have not adequately addressed. The choice between risk and safety does not matter, though, for jurisdictions that define defectiveness by reference to reasonable consumer expectations. A reasonable consumer expects that sellers would reduce product risk in the most cost-effective manner. Hence a product design does not conform to consumer expectations only if the seller failed to take measures that efficiently reduce product risks. The consumer expectations test therefore can be turned into a negligence test for design defects. Note, though, that the logic needed to justify a negligence rule for design defects is inconsistent with the rationale for making sellers strictly liable for manufacturing defects, since reasonable consumers also expect that sellers ordinarily are unable to eliminate all manufacturing defects. The other approach for defining a design defect is based on the risk-utility test. The traditional formulation of this test is not limited to the factors relevant to the issue of whether the product design efficiently minimizes product risk (A. Schwartz, 1988; Viscusi, 1990b). However, the Restatement (Third) of Torts: Products Liability states that ‘the test is whether a reasonable alternative design would, at reasonable cost, have reduced the foreseeable risks of harm posed by the product, and if so, whether the omission of the alternative design ... rendered the product not reasonably safe’ (American Law Institute, 1997, p. 19). The risk-utility test therefore has evolved into a cost-benefit test. Because this test absolves sellers from liability (there is no defect) when the design efficiently minimizes risk, these cases, in effect, are governed by a negligence rule. The biggest problem with a negligence standard for design defects relates to the court’s ability to evaluate the technical engineering issues involved in product design (Henderson, 1973; A. Schwartz, 1988). An erroneous finding of design defect is particularly problematic, because tort liability potentially attaches to the entire product line. Consequently, any legal uncertainty in this area will have significant repercussions, suggesting that design-defect litigation

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has significantly influenced developments in the market for liability insurance (Viscusi, 1991b). Courts could avoid these difficult issues by defining defectiveness on the basis of relative safety, but that type of approach is unlikely to yield efficient outcomes (Boyd and Ingberman, 1997a). First consider a rule which holds that a product is not defectively designed if it conforms to industry custom. Because conformance to custom immunizes firms from tort liability, custom reflects market equilibria absent tort regulation. As such equilibria are often characterized by inefficiently low safety levels, adherence to custom is not ordinarily sufficient to establish that the product is properly designed (see Section 9 above). Now consider an alternative rule that defines a product as being defectively designed whenever a safer product is available on the market (‘state of the art’). A seller whose product is defective under this definition is fully liable for all injuries, so it usually minimizes costs by choosing the efficient amount of safety. The seller, however, could avoid liability altogether by increasing its safety investments above the efficient amount if doing so would make its product safer than others on the market. This liability rule therefore might give sellers an incentive to provide an inefficiently high amount of safety. Hence efficient safety levels ordinarily will not be obtained if courts determine defectiveness solely on the basis of relative safety considerations pertaining to custom or state of the art. The difficulty of determining whether a product is defectively designed has led the courts to limit the scope of tort liability for design defects. Usually courts are unwilling to consider whether a product is defective no matter how it is designed, recognizing that they cannot competently evaluate the total costs and benefits of a product except in the most extreme cases (Henderson and Twerski, 1991). For example, courts will not consider whether a subcompact car is defectively designed merely because larger (more expensive) cars are safer. Instead, design-defect litigation tends to involve modifications to existing product lines (like redesigning the gasoline tank in a subcompact car to reduce risk). Limiting the scope of tort liability in this manner allows the market to determine the viability of product lines (subcompact cars versus larger, safer cars), which enhances the likelihood that product lines can be varied to better satisfy consumers with different preferences. Under strict liability, by contrast, manufacturers make design choices by reference to the average consumer, thereby reducing the variety of product lines offered in the market and the likelihood that heterogeneous consumers can find products that closely match their preferences (Oi, 1973).

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18. Warning Defects A product can be defective because it does not adequately warn or instruct the consumer about product risks. As was true for design defects, the courts had to develop a definition for this type of defect, with most choosing to define warning defects in terms of a cost-benefit or risk-utility test. In principle, to satisfy this test the warning must provide the minimal amount of information necessary for the representative consumer to estimate the product’s full price, which can occur only if the warning increases the consumer’s information by describing unavoidable material risks and cost-effective methods of use that reduce risk (Geistfeld, 1997). Courts have recognized that warnings which satisfy these criteria are not defective and accordingly absolve the seller of liability, even if the warning did not disclose a risk that injured the plaintiff. The liability standard for warning defects therefore operates like a rule of negligence. By contrast, the consumer expectations test functions like a rule of strict liability for nondisclosed risks that are not sufficiently appreciated by the ordinary consumer. One implication of this approach is that the seller is liable even if the risk was not scientifically knowable at the time of sale. In order to make this and other cost-related considerations relevant to the liability determination, the test must adopt the expectations of a consumer who reasonably expects sellers to disclose risks whenever it would be cost-effective to do so. At present, the most problematic aspect of this form of tort liability relates to the cost of disclosure. A warning is defective if it does not disclose, sufficiently describe, or properly emphasize the risk which caused injury. Even if the benefit of a proposed warning alteration is slight, courts often find the warning to be defective on the ground that the cost of the requested disclosure is minimal or nonexistent (Henderson and Twerski, 1990). This is a mistake. Empirical studies have found that the amount and format of hazard information contained in a product warning affects consumers’ ability to recall the information, so that added disclosures can reduce the effectiveness of other disclosures in the warning (for example, Magat and Viscusi, 1992). Additional disclosures also increase the time consumers must spend to read warnings. Because these costs of disclosure are not sufficiently recognized by the courts, sellers have an incentive to disclose more than the optimal amount of risk information, thereby reducing the effectiveness of the warning for most consumers. For example, upon reading disclosures that offer little or no benefit, most consumers may rationally decide that the cost of reading the entire warning is not worth the effort. Some courts have recognized that the risk-utility test for warnings should account for information-processing costs. This position is taken by the Restatement (Third) of Torts: Products Liability (American Law Institute,

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1997, p. 32). Indeed, ignoring the way in which information costs affect consumer behavior is inconsistent with the various rules regarding an adequate warning (Geistfeld, 1997, p. 328). As virtually all jurisdictions have adopted these rules, there is ample precedent for courts to rely upon information costs when evaluating warnings. If they do, jury instructions can be formulated that would significantly improve the likelihood that jurors will properly evaluate warnings (ibid, pp. 329-37), although some argue that jurors and judges cannot competently evaluate information-processing costs (Latin, 1994, p. 1284). Another reason for believing that the warning doctrine is not currently producing efficient outcomes pertains to the method of disclosure. The most effective form of risk communication probably involves symbols and common formats (A. Schwartz, 1992; Viscusi, 1993b). The public-good nature of effective risk communication may require a regulatory rather than judicial solution. For this reason, strict liability is unlikely to result in efficient warnings, contrary to the argument of Croley and Hanson (1993). Cooter (1985) shows that strict liability may lead to inefficiently strong warnings because the manufacturer only considers how disclosure affects profits rather than social welfare. This result is hard to understand, however. For risks that are unavoidable or inherent in the product, disclosure will not reduce risk (or liability costs) unless it induces the buyer not to purchase the product. In some situations, disclosure would induce only high-risk buyers to opt out of the market, so the seller could reduce average liability costs by disclosing. But if disclosure does not reduce average liability costs, the seller has no incentive to disclose even when disclosure would be efficient. By contrast, when disclosure pertains to care that the consumer must exercise in order to reduce risk, the strictly liable seller has an incentive to disclose the efficient amount of information - that which minimizes average liability (injury) costs. Strict liability also gives sellers an incentive to discover the efficient amount of information (Shavell, 1992). But since sellers are liable for risks that were not scientifically knowable at the time of sale, strict liability could result in inefficient outcomes. Firms that otherwise are financially viable may be forced into bankruptcy by unanticipated liability costs that could not have been discovered by a cost-effective R&D program (A. Schwartz, 1985). Negligence avoids this problem, but different formulations of the negligence rule are possible and not all of them induce sellers to acquire the efficient amount of information (Shavell, 1992). And because plaintiffs often will have a hard time proving that a seller was negligent for not having discovered information, sellers apparently do not have a sufficient incentive to research product risk (Wagner, 1997).

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19. Defenses Based on Consumer Conduct In most states and the European Community, recovery is reduced for plaintiffs whose misuse of the product combined with the defect in causing the injury. Whether ‘comparative fault’ is less efficient than barring the plaintiff from recovery depends upon a variety of factors (Shavell, 1987, pp. 83-104), but it seems unlikely that comparative fault reduces the consumer’s incentive to use the product properly under ordinary circumstances. Survey evidence shows that for product-associated injuries that are serious but do not result in latent injuries, long-term institutionalization, or death, only 7 percent of victims in the US take action to initiate a liability claim if the injury did not occur at work, and 16 percent take action if the injury occurred at work (Hensler et al., 1991, p. 127). For the vast majority of cases, then, individuals do not expect to recover any damages from the seller, so comparative fault plays little, if any, role in the individual’s decision regarding product use. Denying recovery to those individuals who misused the product for other reasons, or due to inadvertence, would reduce the seller’s incentive to invest in product safety. This seems to be a large price to pay in exchange for the occasional benefit of denying recovery to those plaintiffs who intentionally misused the product because they expected to receive some compensation from the seller, particularly since the compensation that such individuals receive depends upon proof of defect and is likely to be substantially reduced by comparative fault principles. A more worrisome question is whether a product that is nondefective in normal use can become defective when misused. Many jurisdictions require sellers to design products to account for foreseeable misuse. Landes and Posner (1987, pp. 299-301) argue that this doctrine could be efficient if properly limited. Difficult issues also surround the defense of assumption of risk, which in some jurisdictions bars a plaintiff from recovering. The defense could be efficient if it limits seller liability to those cases in which consumers are not well-informed of risk. But merely because a consumer is aware of a risk does not imply that she is well-informed, particularly since perfect information involves an understanding of how different safety configurations affect risk (and price). Moreover, availability of the defense gives sellers an incentive to make design defects visible or to disclose the risk in the warning. Latin (1994) argues that warnings ordinarily are less effective at reducing risk than are design changes.

20. Nonmonetary Damages Plaintiffs can recover monetary damages for nonmonetary injuries such as pain and suffering. These damages may be inefficient. Nonmonetary injuries alter the individual’s utility function (the victim receives less utility for any given

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level of wealth following the accident), which can affect the marginal utility of wealth in different ways. These different effects are important, because an individual maximizes welfare by purchasing insurance (a transfer of money from the noninjured state to the contingent, injured state) until the marginal utility of wealth in the ‘injury’ and ‘no injury’ states of the world are equalized. For nonmonetary injuries that increase the marginal utility of wealth, individuals prefer a positive amount of insurance compensation. The insurance proceeds reduce the marginal utility of wealth in the injured state so that it equals the marginal utility of wealth in the noninjured state. But for injuries that decrease the marginal utility of wealth (like when the victim is comatose), negative insurance is efficient, as the individual would be better off by transferring money from the injured state (unconscious) to the noninjured state (healthy and conscious), where more utility can be derived from each dollar (Cook and Graham, 1977). Because consumers (potential victims) do not prefer to pay for insurance against these kind of injuries, fully compensatory tort awards for nonmonetary injuries may be inefficient. Survey evidence is consistent with this view (Calfee and Winston, 1993). Many point to pain-and-suffering damages as a primary source of inefficiency in the current system (for example, Danzon, 1984; Calfee and Rubin, 1992; A. Schwartz, 1988). One proposed remedy is to eliminate tort damages for nonmonetary injuries (thereby eliminating the insurance inefficiency) while requiring that firms pay a fine to the state equal to the amount needed for efficient deterrence (Shavell, 1987; Polinsky and Che, 1991). Eliminating pain-and-suffering damages within the current system is unlikely to be efficient, however. The absence of widespread first-party insurance for these injuries does not necessarily indicate a lack of consumer demand, but could stem from supply-side problems related to the cost of moral hazard and adverse selection (Croley and Hanson, 1995). Moreover, the analysis which shows that pain-and-suffering damages are inefficient unrealistically assumes that there is no deterrence value to the tort award; that consumers are optimally insured against all other tortiously caused injuries; and that sellers are forced to internalize the cost of all tortiously caused nonmonetary injuries. Revising the analysis to account for more realistic assumptions shows that pain-and-suffering tort damages in the current system could be efficient if courts were to instruct juries on how to calculate the appropriate award, which is based on consumer willingness to pay to eliminate the risk (Geistfeld, 1995b).

21. Punitive Damages Punitive damages have become a focal point in the debate over products liability reform in the United States, even though they are awarded infrequently

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(Daniels and Martin, 1990; Rustad, 1992). Punitive damages can be efficient when victims with valid legal claims do not sue, enabling sellers to escape liability in some cases (Cooter, 1989a). For example, if only 50 percent of all victims sue, compensatory damages must be doubled if the seller is to internalize the full cost of injury. Punitive damages can also be used to deter sellers from sending misleading signals of product quality (Daughety and Reinganum, 1997). The optimal adjustment to the compensatory damages award can be positive or negative, however, because it depends upon a variety of other factors such as the possibility of court error (Polinsky and Shavell, 1989), the impact of litigation costs on social welfare (Polinsky and Rubinfeld, 1988), insolvency (Knoll, 1997), and risk aversion (Craswell, 1996). It is doubtful that punitive damage awards are set on the basis of these economic considerations, as juries typically are given little or no instruction on how to compute the appropriate award. It is also doubtful that punitive damages are awarded when it would be efficient to do so (American Law Institute, 1991b, pp. 243-248). The legal standards governing the availability of punitive damage awards have been substantially, if not wholly, influenced by intentional torts (for which punitive damages were available under the early common law). These standards create problems in the products liability context, where the critical issue is not whether the manufacturer’s actions were deliberate (they usually are), but whether the manufacturer knew it was selling a defective product. By focusing on deliberate conduct rather than on the seller’s awareness of defect, the inquiry can easily lead to unwarranted punitive damages. If hindsight shows that the manufacturer erred in concluding that the cost of a safety improvement outweighed the benefit of risk reduction, then even if the manufacturer thought the product was optimally safe, the legal standard for punitive damages may be satisfied. In choosing not to decrease risk out of cost concerns, the manufacturer engaged in ‘wanton’ or ‘wilful’ conduct that ‘consciously disregards the rights or safety of others’. Any type of cost-benefit balancing involving the risk of injury therefore might be subjected to punitive damages, so manufacturers in design-defect cases often are unwilling to admit that they made safety decisions on the basis of cost considerations (G. Schwartz, 1991a). This is a perverse result given that the legal test for design defects relies on cost-benefit balancing, and indicates that the punitive damages standard undermines the accuracy of legal determinations of design defect.

22. The Enforceability of Contractual Waivers of Seller Liability Contract terms that disclaim a seller’s liability for product defects ordinarily are not enforceable unless the disclaimer pertains to cases in which a product damages itself, causing economic loss such as lost profits, but does not cause

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personal injury or damage to any other property. Contracting probably is a more efficient way to allocate these damages (‘economic losses’), because buyers have better control over and information regarding the magnitude of loss (Jones, 1990). Moreover, allowing sellers to disclaim liability for economic loss is unlikely to have significant deterrence effects, as the seller remains liable for any physical injury or property damage caused by the product defect. In some jurisdictions, sellers can also disclaim liability for physical loss if the buyer is a commercial party. These buyers tend to be sophisticated and knowledgeable about the consequences of risk allocation, so contracting in these situations is more likely to be efficient. A number of scholars argue that it would be efficient if courts were to enforce a greater variety of contractual limitations of seller liability (for example, Epstein, 1989; Rubin, 1993). But unless the contracting process is structured to give consumers risk-related information, these proposals raise the same safety-insurance tradeoff presented by any proposal to limit a seller’s tort liability. One way contracting can increase risk-related information is if the enforceability of a disclaimer is conditioned on the requirement that the seller provides a separate price quotation of its liability costs under a rule of strict liability. Such a price tells consumers something about the product’s safety and enables them to compare safety across brands (Geistfeld, 1988; A. Schwartz, 1988). Nevertheless, imperfectly informed consumers are still likely to disclaim seller liability when it would be inefficient to do so (Geistfeld, 1994). Giving consumers the opportunity to sell their ‘unmatured tort claims’ to third parties also has interesting possibilities (Cooter, 1989b; Choharis, 1995), although this reform may also lead to inefficient reductions in seller liability (A. Schwartz, 1989a). But even though these proposals do not resolve the regulatory problem, measures like them that enhance information and facilitate contracting are a promising approach to efficient reform (A. Schwartz, 1995).

23. Directions for Future Research It is commonplace to say that more empirical research is needed, but developments over the past decade provide a good opportunity for studying the relationship between tort liability and injury rates. Prior empirical studies of this issue suffer from the common problem of being unable to adequately define when seller liability expanded by an amount significant enough to be captured by statistical analysis. The evolutionary nature of common-law change makes such a definition elusive. The change in liability standards has been more abrupt since the mid-1980s, however, as the insurance crisis has spawned numerous reforms that limit seller liability. Because these widespread reforms occurred over a short period of time and were the result of legislative

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enactment, the timing of the change in liability can be readily defined, which should make it easier to uncover any statistical relationship between seller liability and injury rates. Regarding issues amenable to theoretical analysis, it would be useful to discover whether prices signal product safety under market conditions that are more realistic than those previously studied. A pressing issue concerns the relationship between liability and innovation, which relative to its importance is the most understudied aspect of products liability. There are also a number of products liability doctrines that have not been subjected to rigorous economic analysis. For example, an issue of present concern relates to the conditions under which suppliers of raw materials should be liable for injuries caused by the final product. Those who grapple with the issue have done so largely without the benefit of economic analysis, making it difficult to understand how lawmakers could place much reliance on efficiency considerations in deciding how to resolve the issue. Absent more widespread economic analysis of the range of doctrines that comprise products liability, it seems likely that efficiency considerations will continue to exert an uneven influence on the development of this area of the law.

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Speir, John P. (1990), ‘Efficiency Implications of the Sindell-Rexall Rule’, 10 Cato Journal, 603-607. Spence, A. Michael (1975), ‘Monopoly, Quality and Regulation’, 6 Bell Journal of Economics, 417-429. Spence, A. Michael (1977), ‘Nonprice Competition’, 67 American Economic Review, 255-259. Spence, A. Michael (1978), ‘Consumer Misperception, Product Failure and Product Liability’, 44 Review of Economic Studies, 561-572. Spulber, Daniel F. (1989), Regulation and Markets, Cambridge, MA, MIT Press. Swazey, Judith P. (1991), ‘Prescription Drug Safety and Product Liability’, in Huber, Peter W. and Litan, Robert E. (eds), The Liability Maze: The Impact of Liability Law on Safety and Innovation, Washington, DC, The Brookings Institution, 291-333. Sykes, Alan O. (1989), ‘Reformulating Tort Reform (Book Review of Peter Huber, “Liability: The Legal Revolution and Its Consequences”)’, 56 University of Chicago Law Review, 1153 ff. Symposium (1970), ‘Products Liability: Economic Analysis and the Law’, 38 University of Chicago Law Review, 1-141. Thoman, Lynda (1994), ‘Strict Liability and Negligence Rules when the Product is Information’, 44 Economic Letters, 205-213. Tietz, Gerald F. (1993), ‘Strict Products Liability, Design Defects and Corporate Decisionmaking: Greater Deterrence Through Stricter Process’, 38 Villanova Law Review, 1361-1460. Tirole, Jean (1990), The Theory of Industrial Organization, Cambridge, MA, The MIT Press. Trebilcock, Michael J. (1987), ‘The Social-Insurance-Deterrence Dilemma of Modern North American Tort Law: A Canadian Perspective on the Liability Insurance Crisis’, 24 San Diego Law Review, 929-1002. Trebilcock, Michael J. (1990), ‘Comment (on Viscusi, ‘The Performance of Liability Insurance in States with Different Products-Liability Statutes’)’, 19 Journal of Legal Studies, 845-849. Twerski, Aaron D. (1983), ‘The Role of the Judge in Tort Law: From Risk-Utility to Consumer Expectations: Enhancing the Role of Judicial Screening in Product Liability Litigation’, 11 Hofstra Law Review, 861 ff. US Department of Justice Tort Policy Working Group (1986), Report on the Causes, Extent, and Policy Implications of the Current Crisis in Insurance Affordability and Availability, Washington, DC, Government Printing Office. Venezian E.C. (1975), ‘Insurer Capital Needs Under Parameter Uncertainty’, 42 Journal of Risk and Insurance, 19 ff. Viscusi, W. Kip (1984), Regulating Consumer Product Safety, Washington, DC, American Enterprise Institute for Public Policy Research. Viscusi, W. Kip (1985), ‘Consumer Behavior and the Safety Effects of Product Safety Regulation’, 28 Journal of Law and Economics, 527-553. Viscusi, W. Kip (1986), ‘The Determinants of the Disposition of Product Liability Claims and Compensation for Bodily Injury’, 15 Journal of Legal Studies, 321-346. Viscusi, W. Kip (1988a), ‘Product Liability and Regulation: Establishing the Appropriate Institutional Division of Labor’, 78 American Economic Review. Papers and Proceedings, 300-304.

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Viscusi, W. Kip (1988b), ‘Product Liability Litigation with Risk Aversion’, 17 Journal of Legal Studies, 101-121. Viscusi, W. Kip (1988c), ‘Pain and Suffering in Product Liability Cases: Systematic Compensation or Capricious Awards?’, 8 International Review of Law and Economics, 203-220. Viscusi, W. Kip (1989a), ‘Toward a Diminished Role for Tort Liability: Social Insurance, Government Regulation, and Contemporary Risks to Health and Safety’, 6 Yale Journal on Regulation, 65-107. Viscusi, W. Kip (1989b), ‘The Interaction between Product Liability and Workers’ Compensation as Ex Post Remedies for Workplace Injuries’, 5 Journal of Law, Economics and Organization, 185-210. Viscusi, W. Kip (1989c), ‘Prospective Reference Theory: Toward an Explanation of the Paradoxes’, 2 Journal of Risk and Uncertainty, 235-264. Viscusi, W. Kip (1990a), ‘The Performance of Liability Insurance in States with Different Products-Liability Statutes’, 19 Journal of Legal Studies, 809-836. Viscusi, W. Kip (1990b), ‘Wading Through the Muddle of Risk-Utility Analysis’, 39 American University Law Review, 573-614. Viscusi, W. Kip (1991a), ‘The Dimensions of the Product Liability Crisis’, 20 Journal of Legal Studies, 147-177. Viscusi, W. Kip (1991b), Reforming Products Liability, Cambridge, MA, Harvard University Press. Viscusi, W. Kip (1991c), ‘Product and Occupational Liability’, 5(3) Journal of Economic Perspectives, 71-91. Viscusi, W. Kip (1993a), ‘The Risky Business of Insurance Pricing’, 7 Journal of Risk and Uncertainty, 117-139. Viscusi, W. Kip (1993b), Product-Risk Labelling: A Federal Responsibility, Washington, DC, American Enterprise Institute for Public Policy Research. Viscusi, W. Kip and Hersch, Joni (1990), ‘The Market Response to Product Safety Litigation’, 2 Journal of Regulatory Economics, 215-230. Viscusi, W. Kip and Magat, Wesley A. (1987), Learning About Risk: Consumer and Worker Responses to Hazard Information, Cambridge, MA, Harvard University Press. Viscusi, W. Kip and Moore, Michael J. (1991a), ‘Rationalizing the Relationship between Product Liability and Innovation’, in Schuck, Peter H. (ed.), Tort Law and the Public Interest: Competition, Innovation, and Consumer Welfare, New York, W.W. Norton & Co., 105-126. Viscusi, W. Kip and Moore, Michael J. (1991b), ‘An Industrial Profile of the Links between Product Liability and Innovation’, in Huber, Peter W. and Litan, Robert E. (eds), The Liability Maze: The Impact of Liability Law on Safety and Innovation, Washington, DC, The Brookings Institution, 81-119. Viscusi, W. Kip and Moore, Michael J. (1993), ‘Product Liability, Research and Development, and Innovation’, 101 Journal of Political Economy, 161 ff. Viscusi, W. Kip, Magat, Wesley A. and Huber, Joel (1987), ‘An Investigation of the Rationality of Consumer Valuations of Multiple Health Risks’, 18 Rand Journal of Economics, 465-479. Viscusi, W. Kip, Zeckhauser, Richard J., Born, Patricia and Blackmon, Glenn (1993), ‘The Effect of 1980s Tort Reform Legislation on General Liability and Medical Malpractice Insurance’, 6

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Journal of Risk and Uncertainty, 165-186. Wade, John W. (1983), ‘On the Effect in Product Liability of Knowledge Unavailable Prior to Marketing’, 58 New York University Law Review, 734-764. Wagner, Wendy E. (1997), ‘Choosing Ignorance in the Manufacture of Toxic Products’, 82 Cornell Law Review, 773-855. Ward, John O. (1988), ‘Origins of the Tort Reform Movement’, 6(3) Contemporary Policy Issues, 97-107. Weber, Nathan (1987), Product Liability: The Corporate Response, New York, Conference Board. Weicher, John C. (1981), ‘Product Quality and Value in the New Home Market: Implications for Consumer Protection Regulation’, 24 Journal of Law and Economics, 365-397. Weinrib, Ernest J. (1985), ‘The Insurance Justification and Private Law’, 14 Journal of Legal Studies, 681-687. Welling, Linda (1991), ‘A Theory of Voluntary Recalls and Product Liability’, 57 Southern Economic Journal, 1092-1111. Wheeler, Malcolm E. (1984), ‘The Use of Criminal Statutes to Regulate Product Safety’, 13 Journal of Legal Studies, 593-618. Wilde, Louis L. (1992), ‘Comparison Shopping as a Simultaneous Move Game’, 102 Economic Journal, 562-569. Williams, Stephen F. (1993), ‘Second Best: The Soft Underbelly of Deterrence Theory in Tort’, 106 Harvard International Law Journal, 932 ff. Williamson, Oliver E. (1995), ‘Legal Implications of Imperfect Information in Consumer Markets: Comment’, 151 Journal of Institutional and Theoretical Economics, 49-51. Winter, Ralph A. (1988), ‘The Liability Crisis and the Dynamics of Competitive Insurance Markets’, 5 Yale Journal on Regulation, 455-499. Winter, Ralph A. (1991), ‘The Liability Insurance Market’, 5(3) Journal of Economic Perspectives, 115-136. Wolinsky, Asher (1983), ‘Prices as Signals of Product Quality’, 50 Review of Economic Studies, 647-658. X (1987), ‘Note: Designer Genes That Don’t Fit: A Tort Regime for Commercial Releases of Genetic Engineering Products’, 100 Harvard Law Review, 1086-1105. X (P.M.K. and W.J.S.) (1983), ‘Note: Enforcing Waivers in Products Liability’, 69 Virginia Law Review, 1111-1152.

Other References Binswanger, Hans P. (1974), ‘A Microeconomic Approach to Induced Innovation’, 84 Economic Journal, 940-58. Schmookler, Jacob (1966), Invention and Economic Growth, Cambridge, MA, Harvard University Press. Thirtle, Colin G. and Ruttan, Vernon W. (1987), The Role of Demand and Supply in the Generation and Diffusion of Technical Change, Chur, Harwood Academic Publishers, 173 p.

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Cases Barker v. Lull Engineering Company, 573 P.2d 443 (Cal. 1978) Denny v. Ford Motor Company, 87 N.Y.2d 248 (N.Y. 1995)

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5200 PRICE REGULATION: A (NON-TECHNICAL) OVERVIEW Janet S. Netz Department of Economics, Purdue University © Copyright 1999 Janet S. Netz

Abstract This chapter surveys the literature on various forms of price regulation. After explaining why natural monopolies should be regulated, I describe rate of return regulation, the traditional approach to regulating prices. I then discuss the resulting problems, primarily the incentive of the firm to overinvest in capital. I discuss peak load pricing and Ramsey-Boiteux pricing as regulatory mechanisms for multi-product firms. I then describe more recent attempts to design regulatory mechanisms that are not subject to the types of disincentives associated with cost-based price regulation. These forms of regulation include price-cap and profit-sharing regulatory mechanisms. I also discuss the regulation of networks, where a regulated firm competes with rivals and supplies them with an essential input, generally access to a network. I conclude by describing how regulation has been practiced. JEL classification: L51, K23 Keywords: Price Regulation, Price-Cap Regulation, Incentive Regulation

A. Overview 1. Introduction Economists have long recognized that the market outcome for natural monopolies leaves much to be desired. In particular, price is higher and output is lower than the social optimum. Recognition of this problem, among other issues, has led to a long history of attempts to regulate natural monopolists and to a vast literature discussing the problems of attempts at regulation. (Regulation has been enacted for a variety of other reasons, as well. For example, regulation may be motivated by distribution concerns, as the market outcome for natural monopolies redistributes surplus away from consumers to producers. In other cases regulation may occur at the behest of the firms themselves, who may be seeking protection from too much competition (see Chapter 5000 General Theories of Regulation for a discussion of the political

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and economic forces that have led to regulation). The goal of this survey is to lay out the economic (efficiency) problems caused by natural monopolies, the various forms of regulation that have been attempted, and their economic effects. The chapter is organized as follows. In Section 2, I present the basic issue: that is, why regulate at all? I focus on the natural monopoly problem, though much price regulation occurs outside industries that are natural monopolies. I briefly discuss examples of price regulation that move the outcome towards the social optimum. This section can be skipped by those familiar with the theory of natural monopolies. Perhaps the most widely used early form of price regulation was really rate-of-return regulation, which I describe in Section 3. Though under this model the regulator specifies an allowed rate-of-return, in practice rate-of-return regulation is implemented when the regulator specifies the allowed prices that a regulated firm may charge that the regulator estimates will give the firm the allowed rate-of-return. As summarized in Section 4, Averch and Johnson (1962) show that such an approach to regulation encouraged the utility to overinvest in capital and to expand into other markets in order to increase its rate base and hence increasing the aggregate amount of profits it could earn subject to the regulatory constraint. In Section 5, I describe extensions to the Averch-Johnson model, as well as summarize empirical estimation of these negative effects. In Section 6, I discuss the multi-product regulated firm. While many of the issues discussed in Part B in the context of a single-product firm apply, the fact that firms produce many products complicates regulation. The largest complication arises because of the existence of common costs; that is, costs that are used to produce more than one product. The issue is discussed in Section 7. In Sections 8 and 9. I discuss two of the most common approaches to regulating a multi-product firm, peak-load pricing and Ramsey-Boiteux pricing. I conclude Part by discussing how the resulting price structure can cause the regulatory regime to be unstable (unsustainable.) Regulation theory has more recently focused on designing regulatory mechanisms that do not provide the utility with the adverse incentives described above. In Part D, I consider alternative forms of price regulation that fall under the rubric ‘incentive regulation’, focusing on price-cap regulation in Sections 12 and 13 and on other forms of incentive regulation such as profitsharing in Section 14. In Section 15 I highlight some of the attempts to compare incentive regulation to other forms of regulation, both in terms of their welfare effects and on the feasibility of implementation. Section 16 discusses the few empirical attempts to measure the impact of incentive regulation. In Part E, I discuss one of the most recent developments in regulation: regulation of access pricing in situations where an incumbent firm provides access to an essential facility, generally a physical network, to rivals. I conclude in Part F by discussing price regulation in practice, including the several recent waves of deregulation.

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I make no claims that this is an exhaustive survey; indeed, in the interests of brevity, many subject areas will be almost completely omitted. Also, because other chapters in this encyclopedia cover the topics, I will omit discussion of: the theory of regulation, or why different forms of price regulation might be implemented (see Chapter 5000, General Theories of Regulation), as well as regulation in particular sectors (see Chapters 5660, Regulation of the Securities Market; 5700, Insurance Regulation; 5850, Regulation of Banking and Financial Markets; 5900, Transportation; 5930, Telecommunications; and 5940, Public Utilities). I attempt to balance discussion of the theoretical work that has been done in the area with empirical analysis of the effect of various types of price regulation mechanisms.

2. The Problem: Natural Monopolies As mentioned above, the market does not achieve production and allocative efficiency if technology is such that the industry structure is one of natural monopoly. In essence, a natural monopoly arises if technology and demand are such that it is cheaper for one firm to serve the market than for several firms to serve the market. (See Panzar, 1989, for a complete, technical discussion of the technology that lead to a natural monopoly. The conditions, especially for a multi-product firm, are considerably more complicated than the simple graph I present. (See Chapter 5400, Regulation of Natural Monopolies for a more complete discussion.) To illustrate the problem, consider Figure 1, which illustrates a natural monopoly arising from economies of scale over the relevant range of production for a firm that sells a single-product. Figure 1 Market Outcome versus Regulated Outcomes

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The average total cost curve (ATC) is shown to be everywhere declining (and hence the marginal cost curve, MC, is beneath the average total cost curve). Thus, the industry is a natural monopoly; any market structure involving several firms would involve the unnecessary duplication of fixed costs. Assume that the firm (and regulator) can charge only a single price; that is, price discrimination is not allowed. If the firm is not regulated, it will maximize profits by setting marginal revenue equal to marginal cost, leading to price PM and output QM. Productive efficiency requires producing at the minimum point of the average total cost curve; clearly the market outcome does not satisfy this condition. Allocative efficiency requires that production occurs where the marginal cost curve crosses the demand curve; again, the market outcome does not satisfy this condition. Relative to the social optimum, social welfare has been reduced by areas A, B, C and D (termed the deadweight loss). Price regulation can theoretically lead to the social optimum if regulators specify that price be set equal to PE, where the E subscript denotes ‘efficient’. (However, price regulation is not the only solution. See, for example, Demsetz, 1968, and Williamson, 1976, who discuss how competition for the market, rather than within the market, can lead towards the social optimum.) Then allocative efficiency is met. The outcome has moved towards productive efficiency; pure productive efficiency cannot be achieved simply because demand is not of sufficient magnitude for production to occur at the minimum average total cost curve. However, a firm that charges PE and produces at QE will not generate sufficient revenue to cover costs of production; in particular, the firm will be short by the amount of its fixed cost. Thus, the regulator must alter the regulatory mechanism in order that the firm remains in the market. To ensure that the market is served, the regulator might offer the firm a subsidy equal to its fixed costs. (The general equilibrium effects of the scheme used to raise the subsidy may distort other markets, so that efficiency in the regulated market may obtain at the expense of inefficiency in other markets.) (If a natural monopoly arises via subadditive costs as defined in Panzar, 1989, but without economies of scale over the entire range of production, then marginal cost pricing would not require a subsidy.) If provision of a subsidy is not politically feasible, the regulator may alternatively specify that the firm charge PF, the price where the average total cost curve crosses the demand curve (the F subscript indicates ‘feasible’). At this price the firm charges the lowest price possible, subject to the constraint that it cover all costs. This regulatory mechanism increases social welfare by areas A, B and C, relative to the market outcome. Society is still losing area D, but this may be acceptable relative to the political cost of providing the firm with a subsidy equal to the firm’s fixed costs. A variety of other pricing schemes are available that may be feasible and may succeed in achieving the social optimum. In general, these pricing

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schemes relax the assumption made above that the firm can charge only a single price. Consider, for example, an alternative scheme that may be available if price discrimination is allowed. The regulator could require the firm to sell at price PF to those consumers who are willing and who can afford that price, and charge PE to those customers who are willing and who can afford PE but not PF. Revenues earned from customers paying PF will cover the variable costs of serving them and all of the fixed costs; revenues earned from customers paying PE would cover the variable costs of serving them. Of course, a practical problem immediately arises. How could the firm classify consumers into the two pricing categories? No consumer would willingly admit that she was willing to pay the higher price. Furthermore, the product must be one that cannot be resold. If it could, then even if the firm could distinguish between types of consumers, the consumers facing the lower price would buy and resell to the consumers facing the higher price. Price discrimination can be adopted only in situations where the firm can identify customers by type and can prevent resale of the product. Alternatively, consider that a firm may charge different prices for different amounts of the good purchased. A common such scheme, called a two-part tariff, is one where each customer pays a monthly fixed price for access equal to the total fixed costs divided by the total number of customers and then the customer pays an additional fee equal to the marginal cost for each unit consumed. The fixed fee covers the fixed cost of operation and the per unit fee covers variable costs. Since total revenues cover total costs, the firm would not require a subsidy. This pricing scheme is efficient only if consumer surplus, which is the value the consumer places on consuming the product less the cost the consumer must pay, for the consumer with the smallest demand is greater or equal to the fixed price. Otherwise some consumers will exit the market, in which case the scheme does not achieve the social optimum. Other types of non-linear pricing exist, as well, which may or may not achieve, or have the objective of achieving, efficiency. For example, block pricing, where consumers pay one price for the first block of the product that they use (say, the first 500 kilowatt hours of electricity used), then a different price for the second and subsequent blocks. Standard or declining block pricing refers to declining prices for subsequent blocks, inverted block pricing refers to increasing prices for subsequent blocks. (Block pricing of either kind is a common feature of gas, electricity and water price structures.) If used alone, a declining block pricing scheme optimally charges a price on the first block sufficiently high to cover the fixed costs of operation and charges a price equal to marginal cost on subsequent demand. (This is simply a variation of the scheme described above where some consumers pay PF and some pay PE.) Alternatively, block pricing can be used in conjunction with a fixed fee of the type discussed above. In a declining block pricing scheme, efficiency may be

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enhanced over the two-part tariff described above if the two-part tariff has a sufficiently high fixed fee so as to induce some consumers to exit the market. In a declining block pricing scheme with a fixed fee (that is, a multi part tariff), the higher price on initial units can be used to reduce the fixed fee, which increases efficiency by inducing more customers to remain in the market. Inverted block pricing is incompatible with efficiency, and is generally adopted to redistribute income (as in many developing countries; Maddock and Castano, 1991, study the effects of the inverted block structure adopted in Medellin, Colombia for electricity rates on redistribution, the stated objective of the policy, and find that the policy is effective at redistributing income, though of course at a cost to efficiency) or to encourage conservation (as in several municipalities in California for water during the droughts of the 1980s; some succeeded in reducing demand so successfully that they were forced to raise rates in order to generate sufficient revenue to cover costs!). See Train (1991) for a full description of block pricing. In sum, price regulation of some form can increase social welfare relative to the market outcome. It is theoretically possible to achieve the social optimum, where the marginal cost and demand curves cross, though in practice it may only be possible to move towards the social optimum, not to achieve it.

B. Rate-of-return Regulation and its Problems, or the Unintended Consequences of Regulation 3. Introduction to Rate-of-return Regulation Price regulation, as practiced in the US, has often involved rate-of-return regulation. Under such regulation, the regulatory agency sets prices in such a way that the utility earns the allowed (‘fair’) rate-of-return on its investment. While this form of regulation is seemingly simple, and seems as if it would achieve feasible average cost prices, in practice average cost prices are not achieved because the regulatory mechanism gives the firms an incentive not to minimize cost. (In the simple analysis presented above, a competitive rate-ofreturn to the utility was built into the average total cost curve, as total costs must include an adequate return on investments. Thus, average cost pricing at PF is an example of rate-of-return regulation, where the allowed rate-of-return is equal to the competitive rate-of-return.) Before turning to the effects of regulation, I briefly describe the institutions that were adopted in the US to implement regulation (see Kaserman and Mayo, 1995, for a detailed description of the regulatory process). While historically most other countries chose public ownership as the common method for controlling natural monopolies, the US generally chose to separate the

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ownership of the firm from the government agencies that regulated them. (Utilities that serve the majority of demand are investor owned. Typically utilities are granted a franchise (monopoly) over a geographic area, and are subject to regulation.) Because of the movement towards privatization worldwide, the structure of the regulatory bodies may be of more general interest as other countries establish regulatory agencies to oversee newly privatized firms. In the US, local (retail) electricity and natural gas distribution, local phone service, and private water systems (this last is the most commonly municipally owned utility in the US), are regulated by an independent state public utility commission or PUC. (Long-distance phone rates (until very recently) and wholesale electricity and natural gas transactions are regulated in a similar manner, but by a federal agency, since under the US Constitution interstate transactions fall under the purview of the federal government.) State PUCs consist of from one to seven commissioners, who may be appointed (most commonly) by the governor with legislative approval or elected, depending on the state, and a professional staff. Prices are set to allow utilities to earn a fair rate-of-return on their capital investment. (The level and structure of prices may also be set to accomplish other goals, such as subsidizing some consumer groups over others.) Rulings by the US Supreme Court mandate that state PUCs provide regulated firms with a fair rate-of-return, whatever the PUCs other goals in setting prices may be. In Smyth v. Ames (169 US 466, 1898), the Court stated that ‘The company is entitled to ask for a fair return upon the value of that which it employs for the public convenience’. At the same time, the Court ruled that consumers deserved protection, as well: ‘while the public is entitled to demand ... that no more be extracted from it ... than the services are reasonably worth’. The Supreme Court ruled further in Federal Power Commission v. Hope Natural Gas Co. (320 US 591, 1944) that regulated firms are entitled to a ‘just and reasonable’ rate-of-return, so that the firm is able ‘to operate successfully, to maintain its financial integrity, to attract capital, and to compensate its investors for the risks assumed’. In order to set the price structure to generate the fair rate-of-return, the PUC first determines the utility’s revenue requirement, which consists of the sum of operating expenses, current depreciation, taxes, and the allowed rate-of-return times the rate base. The rate base is the value of assets, often measured as the original cost of equipment less accumulated depreciation. (This measure has the advantage of being easy to calculate, though a variety of other methods are used, often involving the replacement cost of capital.) The rate-of-return must be chosen high enough to raise capital, but low enough to prevent the use of market power. The PUC then forecasts demand and, based on the revenue requirement and the quantity forecast, the agency stipulates the prices that the regulated firm is

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allowed to charge. Often the utility proposes a rate structure and, based on information from a ‘test year’, typically the latest year for which the necessary data are available, demonstrate that the price structure would yield the revenue requirement. Ex post, depending on the rate-of-return actually earned by the utility, the firm or consumer groups or the regulatory agency may request or undertake a rate hearing to alter prices if the earned rate-of-return deviates substantially (in either direction) from the allowed rate-of-return. In addition, the staffs of the commissions often periodically monitor the firms’ performance, in which case they may request that the commission hold a new rate hearing. The method used to gather information and to decide new rates is rather like a court hearing. A variety of groups may give testimony, including the commission staff, the firm, consumer groups and rival firms. In some states consumers are formally represented at regulatory hearings by the Office of Public Utility Counsel. A rate hearing consists of the presentation of evidence to the commission. There are formal rules of procedure à la a judicial proceedings. The commission announces a hearing, then publishes the rules of discovery (that is, the rules by which parties are granted access to the factual data of other parties) and a timetable for the hearing. Typically, first the utility is required to file written testimony supporting its rate change. Then, typically 30 to 90 days later, other parties (rivals, consumers, and so on) are allowed to present testimony supporting or opposing the utility’s proposed rate change. Rate hearings often have two phases, the first determining the revenue requirement and the second designing the rates that will allow the utility to earn the revenue requirement. One area of contention regards costs incurred by the utility. Operating expenses are typically non-controversial. However, as shown in the next section, regulated firms have an incentive to invest in capital beyond the efficient level. Thus, public utility commissions determine whether costs, typically capital costs, are prudent. Typically, a firm that is expanding capacity will construct the new plant, and only once the construction is completed will the rate base change. If the new capital was automatically added to the rate base, then firms may have the incentive to invest in plants that are bigger than necessary in order to inflate the rate base and increase profits. Regulators have the authority to determine the prudence of expenditures on addition to capital. Prudence is determined by whether the capital is necessary to provide the service and whether it is cost effective relative to alternatives. The fact that capital investment may be disallowed encourages the firm to invest wisely. (Most states have to authority to require advance approval of capital budgets; yet even with advance approval, there is no guarantee that the investment will be allowed into the rate base.) The most commonly used example of disallowances involves the building of nuclear power plants. Public Utility Commissions have in fact allowed several utilities to go bankrupt as a result of

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disallowances.

4. The Averch-Johnson Model Averch and Johnson (1962) model the regulated firm as seeking to maximize profits subject to a constraint on the earned rate-of-return, and show that if the regulated rate-of-return is higher than the cost of capital (it must be equal to or higher than the cost of capital if the firm is going to produce at all), then the regulated firm (1) will not minimize costs and (2) may expand into other markets, even if it operates at a loss in these markets, and hence may drive competitive firms out of the market (or discourage them from entering). The firm will not minimize cost because, so long as the regulated return on capital is higher than the cost of capital, the firm makes a profit for each additional unit of capital. (Indeed, Baron, 1989, points out that the regulated firm would like the price to be set as low as possible, to increase the quantity sold. That gives the firm the opportunity to employ as much capital as possible, and every additional unit of capital employed gives the firm a profit.) This gives the firm an incentive to invest more in capital than is efficient given the actual cost of capital relative to other input prices. Consider, for example, an unregulated firm. This firm will, for each quantity produced, combine labor and capital (assuming these are the only inputs) in such a way that the last dollar spent on labor gives the same output value as the last dollar spent on capital. That is, each input is used until the cost of the last unit employed is equal to the revenues that can be earned with that input’s output. A regulated firm, on the other hand, not only earns revenues by selling the output produced by capital, but also on the capital itself. Hence, each unit of capital provides higher revenue to a regulated firm than to an unregulated firm, encouraging the regulated firm to employ a larger amount of capital than will an unregulated firm. The regulated firm then uses too much capital relative to labor, producing at higher than minimum cost. The degree to which a firm overcapitalizes depends on its ability to substitute between inputs. The more substitution the technology allows, the more inefficient a firm will be. Now consider a multi-product firm that may operate in several markets, assuming that the regulatory body allocates at least some of the capital used for production in the other markets to the firm’s rate base (as was commonly done in practice, given the problem of allocating common costs; see Section 7). Based on the same logic described above, the firm has an incentive to increase its use of capital, and now may do so in other markets. Suppose that in its initial market the regulated firm has invested in the optimal (from its point of view) amount of capital. The firm now considers investing in additional markets. As an extreme, suppose that this firm is not competitive in another

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market: that is, its costs are above rival firms. Then it will lose money on each unit that it sells in the market. However, suppose for each unit of capital that it uses to produce the profit- losing product, it earns revenue because it loosens the rate-of-return constraint. Then the firm will operate in the new market until the extra revenues earned per additional unit of capital are offset by the cost of capital, other inputs, and the loss from sales of the product. That is, a firm will operate in a second, non competitive market, so long as (s1! r2) x2, where s1 is the allowed rate-of-return in the original market, r2 is the cost of capital in the other market, and x2 is the amount of capital used in the other market that is allowed into the rate base, is less than the losses from operating in the market. (Averch and Johnson, 1962, argue that the descriptive evidence suggests that AT&T behaved along the lines predicted by their model in terms of both overinvesting in capital and moving into other markets.) Thus, not only will the firm’s input use be distorted in the regulated market, but inefficiencies can spill into competitive markets as competitive firms are driven out of business or are prevented from entering markets in which they have lower costs. (Braeutigam and Panzer, 1989, examine this issue more rigorously, arriving at the same conclusion.) In sum, rate-of-return regulation as practiced provides firms with the incentive to overinvest in capital, both in the regulated market itself, and by inefficient diversification into other markets.

5. Extensions, Reinterpretations and Tests of the Averch-Johnson Model The Averch-Johnson model led to a variety of work applying the basic idea to other settings. One intellectually unappealing aspect of the Averch-Johnson model is the fact that the regulator does not recognize the firm’s strategic response and hence modify the regulatory mechanism to mitigate the capital disincentives. Baron (1989) recasts the Averch-Johnson model in terms of a mechanism adopted to deal with the regulatory body’s incomplete information on the firm’s costs or on demand. If the regulator could observe the production function and factor prices, the regulator could set price equal to the efficient marginal cost (that is, the marginal cost that arises from the optimal use of capital relative to labor), thus eliminating the production inefficiency. However, suppose that the regulator does not observe the production function and/or factor prices. Then in essence, the regulator adjusts price as a function of the cost incurred by the firm. In Baron’s view, the Averch-Johnson outcome is plausible in a setting where the regulator and the firm have different information about costs and demand or the regulator cannot observe all actions of the firm. In such a setting, the Averch-Johnson approach could arise endogenously. Along similar lines, Woroch (1984) analyzes investment by firms using a non cooperative model of the firm regulator relationship, and

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allows the regulatory mechanism to arise endogenously as well. He allows firms to invest strategically. Woroch finds that achieving ‘credibility’ of regulation, which requires that the regulator issue a welfare maximizing response to the capital investment, may lead to an outcome that is indistinguishable from the Averch-Johnson model. In other words, the AverchJohnson model may be recast in different, perhaps more plausible, frameworks, but the disincentives caused by regulation may still arise. Bailey and Coleman (1971), Baumol and Klevorick (1970), Bawa and Sibley (1980), Davis (1973), Klevorick (1973) and Logan, Masson and Reynolds (1989) extend the Averch-Johnson model to incorporate regulatory lag. These authors recognize that, in practice, rate hearings occur with a lag after a change in cost or demand. Under regulatory lag, a firm can appropriate increased profits from cost reduction for the time period between the innovation and the rate hearing (and likewise, the firm absorbs any losses). This reintroduces to the firm the incentive to reduce costs, though the incentive is not as large as it would be if the firm appropriates gains from cost reductions forever. Encinosa and Sappington (1995) and Lyon (1991, 1992) examine a firm’s incentive to over- or under-invest in capital under a situation where regulators review a firm’s capital investments and can (and do) disallow some capital expenditures. The Averch-Johnson model was based on a more certain environment where the firm knows that it will earn the allowed rate-of-return on its entire capital investment. More recently, regulatory agencies have become tougher in allowing capital expenditures into the rate base. It has been typically accepted that regulatory hindsight, especially if regulators punish bad ex post outcomes rather than bad ex ante decisions, will lead to underinvestment in capital. Lyon (1991), on the contrary, finds that hindsight review can be used to reduce the firm’s tendency to build large, risky projects, moving the firm closer to the cost-minimizing input choice. In addition, Encinosa and Sappington (1995) find that rewards as well as penalties are optimal. Lyon (1992) examines prudency reviews in the context of contracts for variable inputs, and finds that prudency reviews will cause a firm to increase its capital stock and to rely more heavily on spot market purchases for variable inputs; while the firm earns lower profits, the welfare effects on consumers are ambiguous. The Averch-Johnson model has also been included a dynamic setting including adjustment costs of investment. For example, El-Hodiri and Takayama (1981) show that the long-run level of capital stock increases when a rate-of-return constraint is imposed. Moretto (1989) adjusts the AverchJohnson model in two dimensions: to incorporate an adjustment cost approach to investment and to allow for uncertainty over the revenue function. The Averch-Johnson effect may not obtain; it holds only when the rate of growth of the marginal adjustment cost is concave. In contrast to El-Hodiri and Takayama (1981) and Appelbaum and Harris (1982) but along the lines of

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Moretto (1989), Dechert (1984) adopts a dynamic adjustment-cost model and finds that underinvestment may obtain, in contrast to the Averch-Johnson overinvestment result. The factor driving is result is whether a firm is operating in the increasing return or decreasing return portion of average cost. (This holds for the static Averch-Johnson model as well.) Dechert (1984) argues that natural monopolies arise under economies of scale, in which case profits are not concave, at least not over the entire input range; in contrast, other Averch-Johnson models assume concavity of the profit function. (Note, however, that natural monopolies can obtain outside the increasing returns portion of the average total cost curve; see Panzar, 1989, for an explanation.) The importance of whether costs are increasing or decreasing may explain the mixed empirical evidence regarding the Averch-Johnson model. A fair bit of empirical work has been done trying to test the Averch-Johnson model, mostly focusing on electricity production. The results of these tests have been mixed. Nemoto, Nakanishi and Madano (1993) find that seven of nine Japanese electric utilities do significantly overinvest, while Tawada and Katayama (1990) find much weaker support for the Averch-Johnson effect in the same industry. Indeed, they find that production was efficient in some time periods, despite the form of regulation. In the US, Courville (1974), Hayashi and Trapani (1976)and Spann (1974) all find support for the Averch-Johnson effect in electric utilities. Hayashi and Trapani (1976) also find that tightening regulation increases the distortion. Boyes (1976), on the other hand, does not find support for the Averch-Johnson effect, also using data on electric utilities in the US. Hsu and Chen (1990) find empirical evidence of the presence of an Averch-Johnson effect for the Taiwan Power Company. Oum and Zhang (1995) find empirical support for the hypothesis that the introduction of competition in the US telephone industry induces incumbents subject to rate-ofreturn regulation to use capital closer to the optimal level, reducing the AverchJohnson effect. Thus, theoretical models support the Averch-Johnson findings of a tendency towards overinvestment in capital by firms subject to a rate-of-return constraint, though introducing some modifications of the framework in order to make it more realistic, such as regulatory lag and cost disallowances, mitigates the overinvestment effect to some extent. There is somewhat more empirical support for the Averch-Johnson effect than against it. As I will discuss in Part D, the form of regulation has changed a great deal, much of it in response to the debate over the Averch-Johnson overcapitalization effect in the face of rateof-return regulation.

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C. The Multi-product Regulated Firm 6. Introduction to Multi-product Issues The discussion thus far has focused on a single-product firm (except during the discussion that a regulated firm has an incentive to enter other markets in order to increase its rate base). In reality, of course, most regulated firms produce a variety of products. Even in the case of a single commodity, say electricity, it is more proper to think of the firm providing electricity during certain time periods. In other words, the market for electricity during the day is separate from the market for electricity during the evening and night-time. Before discussing various price mechanisms for regulating the multi-product firm, an important concept must be addressed: how to allocate common costs, that is, costs common to production of several products, to individual products? (If the goal of regulation is to maximize social welfare, that is, to achieve allocative and productive efficiency, separating costs across services is meaningless. It is generally done by regulators, however, when they have an interest in the distribution of surplus across groups; that is, regulators often desire to determine whether a given customer group is covering the costs of servicing them.) After describing the problem, I discuss two of the more commonly used regulatory mechanisms, peak-load pricing and Ramsey-Boiteux pricing.

7. The Common Cost Problem Consider an example, following Braeutigam (1989), where a firm produces two products with constant marginal costs of m1 and m2 and has total fixed costs F, giving a simple total cost function of TC = F + m1 y1 + m2 y2 . Analogously to the discussion of a single-product firm, the social optimum requires that each product be priced at its marginal cost; however, the firm will then not earn sufficient revenues to cover costs. Recall that a simple solution in the singleproduct case was to require that the firm price at average cost. The problem here is that the calculation of the average cost for each product necessitates a division of the fixed costs across the two products. While infinitely many ways exist to divide the fixed costs, some will lead to higher levels of social welfare than others. Thus the more interesting problem is how to allocate fixed costs in the optimal manner. In practice, a variety of weighting schemes have been used, including weighting by gross revenues, by physical output levels, or by directly attributable costs. (Directly attributable costs typically include all variable costs, and may also include some portion of fixed costs, if some fixed costs are associated with the production of only one of the products.) Alternatively,

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sometimes the Allais rule is used, where marginal cost proportional mark-ups are used, with the mark-up being determined in such a way as to raise sufficient revenue that the firm breaks even. Attributing costs in this manner is typically referred to as fully distributed cost. In practice, once the common cost is assigned to the different outputs, prices are set so that revenues from each output cover costs. There are several problems with this approach to dividing costs for a multiproduct firm, including the fact that such division is inherently arbitrary and, from an economic point of view, not very sensible. As summarized by Laffont and Tirole (1996), the drawbacks include the fact that, since it is cost-based, firms do not have a strong incentive to minimize costs; that the price structure is inappropriate as prices are too low for inelastic demand services and too high for elastic demand services (see the discussion of Ramsey-Boiteux pricing in Section 9); that it does not use non-linear pricing; and that some forms encourage inefficient entry. Economists have developed several pricing approaches to maximize social welfare given the constraint that the multi-product firm must break even. These pricing schemes do not require allocation of common costs. (Ex post one could calculate the proportion of the common cost that is paid for by each output; however, ex ante the only necessary information needed is the total amount of fixed cost.) I discuss two of the most common methods: peak-load pricing and Ramsey-Boiteux pricing.

8. Peak-load Pricing Peak-load pricing is a particular regulatory mechanism that is appropriate when the firm provides a non-storable good during different time periods and is constrained to choose a single capacity level. (See Crew, Fernando and Kleindorfer, 1995, for a survey on peak-load pricing theory.) Formulating prices for different time periods relates to the common cost problem: optimal prices depend on how much of the capacity cost, a common cost, is allocated to each time period. Consider the following simple model. A production period (a day or year) is divided into T equal increments. During each period t, xt units of a variable input are used. Let K denote the total amount of capital used. K is the common cost, the cost of the production facility that operates in all periods. Let yt = f(xt,K) represent the production function, and let Pt = Pt(yt) denote the inverse demand curve (the notation and example are based on Braeutigam, 1989). Steiner (1957) assumed that the production function was Leontief; in other words, yt = min(xt, K), where, for notational simplicity, I have assumed one unit of capital and one unit of the variable input produce one unit of output. (The qualitative results hold for an fixed proportion of capital to the variable

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input.) Let the cost of the variable input be given by b, and let ß be the rental cost of capital. Assuming that the firm is constrained by the regulatory authority to meet demand in all periods, it will choose capacity to equal the maximum amount demanded. Then the total cost function can be written as T

TC = b ∑ yt + β max yt t =1

In other words, total cost is equal to the cost of the variable input times the total amount of the variable input used in all time periods plus the rental cost of capital times the maximum output produced in any period. The social optimum requires that price be set equal to marginal cost in each period. Based on the total cost function, this means that the price in every nonpeak period is optimally set equal to the cost of the variable input, Pnon-peak = b. (Marginal cost in a non-peak period is given by dTC/dyt = b, the derivative of the first term in the cost function, since the second term does not contain output in any period except the peak period.) Price in the peak period is set equal to the cost of the variable input and the cost of capacity, Ppeak = b + ß. In other words, consumers during the peak period are responsible for both their variable costs and total capacity costs. Given that the technology exhibits constant returns to scale, peak-load pricing leads not only to the social optimum, but also allows the firm to earn sufficient revenues to cover total costs, obviating the need for a subsidy. However, Panzar (1976) shows that this result is not robust to changes in technology. Suppose that the production function is given in a general form as yt = f(xt, K), so that the firm can substitute to some extent between the variable and the capital inputs. The production function is assumed to be subject to diminishing returns (that is, increases in either input increase output, but at a declining rate). Let the total variable cost function be written as V(yt, b, K). This function gives the minimum total variable costs required to produce output yt, given input prices b and capacity K. First, pricing in each period is given by Pt = MV/Myt. This condition indicates that price in each period is equal to the marginal variable cost. In this case, prices in off peak periods will not be equal since marginal cost varies with output. For example, suppose that output in period 2 is larger than output in period 1. Given the assumptions on the production function that an increase in inputs increases output at a declining rate, the marginal variable cost will be higher in period 2 than in period 1, and therefore so will the price in period 2. Second, optimal pricing requires that S tt=1 MV/MK =!ß. This condition shows that the firm will choose capital such that the total variable costs saved equals the cost of employing the last unit of capital. The model using Leontief production did not have a second condition, because the firm had no choice in capital. The firm was required to produce enough to satisfy demand in each

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period (a regulatory constraint), and technology was such that satisfying the regulatory constraint dictated the amount of capital used. In the production function used here, the firm can substitute between the variable input and the capital input, choosing the cheapest ratio of the two, depending on their relative prices. Thus, while peak-load optimal prices can be derived from a more flexible production function, it no longer remains true that only the peak consumers pay for capacity costs. However, it remains true that peak-load pricing raises sufficient revenues to cover costs. The existence of uncertainty over demand or supply can complicate the application of peak-load pricing. Koschat, Srinagesh and Uhler (1995) derive peak-load prices when demand in different periods is stochastic and test the implications of the theory using data on local telephone service. They find that ignoring uncertainty in demand can lead to inefficient prices and inefficient industry-wide capacity choices. Perhaps most interestingly, they find that spot pricing of phone calls, so that prices are high during actual congestion rather than during times of expected congestion, can be considerably more efficient. Kleindorfer and Fernando (1993) also consider peak-load pricing under uncertainty in demand, but add to the analysis by considering uncertainty in supply as well, focusing particularly on electricity (where uncertainty in supply is a common problem). In this setting, the regulatory agency must account for a variety of costs that arise when supply and demand do not clear.

9. Ramsey-Boiteux Pricing The peak-load pricing mechanism described above, by assuming constant returns to scale, led to prices that were not only socially optimal, but under which revenues covered costs. Thus, peak-load prices are efficient and feasible. However, without constant returns to scale, marginal cost pricing will not raise sufficient revenue that the firm will cover total costs. As an alternative, Ramsey-Boiteux prices can be used to satisfy the constraints that the firm charge a single price for each product and that the firm raises enough revenue to cover total costs. (Ramsey, 1927, introduced this pricing scheme as an optimal form of taxation that raised the required revenues at the lowest deadweight loss cost. Boiteux, 1956, applied the idea to the determination of regulated prices.) Assuming the demands for the different products are independent, RamseyBoiteux prices are the solution to the following constrained maximization problem, max p CS ( y) + p ⋅ y − C( y, w ) s.t. p ⋅ y − C( y, w ) ≥ 0,

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where CS(y) is consumer surplus as a function of the entire output vector y; p is the price vector; and C(y, w) is total cost as a function of outputs and the vector of input prices w. The social planner (regulator) maximizes social welfare, defined as the sum of consumer surplus and firm profits, subject to the constraint that profits be non negative. Solving the maximization problem leads to the following relationship:

p i & Cy pi

i

eii '

p j & Cy pj

j

ejj,

œ i, j,

where Cyi is the marginal cost of product i, pi is the price of product i, and eii is the elasticity of demand for product i. This relationship, one of several formulations of the Ramsey-Boiteux pricing rule, shows that optimal prices are such that the price-cost margin multiplied by the product’s elasticity of demand be equal across all products produced by the firm. Thus, the price of the more inelastic good is higher than the price of the elastic good. How is it that prices set according to this pricing rule maximize social welfare, subject to the constraint that firms earn zero economic profits? (Dierker, 1991, formally proves that Ramsey-Boiteux prices are second best prices.) First, note that maximizing social welfare is equivalent to minimizing the deadweight loss. Then the optimality of Ramsey-Boiteux pricing can best be explained graphically. Figure 2 illustrates two related markets. In the upper panel, the firm is constrained to set the same price in each market. Price P is chosen such that the areas A and B equal the fixed costs faced by the firm, so that the firm just breaks even. In the lower panel, the firm is allowed to choose separate prices for each market, and the areas C and D also add up to fixed costs. The shaded areas in both panels are the deadweight loss arising from the fact that price deviates from marginal cost. The two shaded areas in the lower panel are in sum smaller than the two shaded areas in the upper panel, reflecting the fact that the prices chosen in the lower panel minimize the deadweight loss. Intuitively, this comes about because demand in the left panels is inelastic; thus, price can be increased in this market with a relatively small deadweight loss, since as price rises, demand does not decline too much. On the other hand, increasing price in the right panels where demand is elastic induces a large decline in quantity, and hence a large deadweight loss.

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Figure 2 Deadweight Loss with a Single Price (top panel) Deadweight Loss with Ramsey-Boiteux Prices (lower panel)

The description of Ramsey-Boiteux pricing presented above assumes that demand for the two products be independent. This may be an overly strong assumption, but the approach can be extended to the case where demands for the products are interdependent; see, for example, Dreze (1964), Rohlfs (1974) and Zajac (1974b). In this case, one must take into account the cross partial derivatives; that is, the impact of the price of one good on the quantity demanded of the other good(s). Dreze (1964) derives the Ramsey-Boiteux pricing rule when demand is not interdependent, and arrives at a pricing rule similar in form to that above. More precisely,

p i & Cy pi

i

(ei & eji) '

p j & Cy pj

j

(ej & eij),

œ i, j,

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where eij is the elasticity of good i with respect to the price of good j. In essence the net elasticity, ei ! eji, gives the effect of i’s price on its own demand less the effect on demand for the other product. (Note that this form of the RamseyBoiteux pricing rule reduces to the original form if the cross elasticities are zero. An alternative formulation of the Ramsey-Boiteux rule when demand is interdependent involves ‘superelasticities’, which account for substitution and complementarity among goods. See, for example, Laffont and Tirole, 1993.) Ramsey-Boiteux prices have also been derived in more complicated settings. For example, Horowitz, Seeto and Woo (1996) assume that costs are unknown to both the regulator and the firm. Passmore (1984) assumes demand is uncertain and that the firm chooses capacity simultaneously with prices. Berry (1992) incorporates risk in marginal cost. Braeutigam (1979b) incorporates competition in some products produced by the firm. Brock and Dechert (1983) and Braeutigam (1983) extend Ramsey-Boiteux pricing to a dynamic setting. The previous work has assumed that the regulator sets prices. But a Ramsey-Boiteux price structure may endogenously arise when firms choose prices, depending on the regulatory regime. Logan, Masson and Reynolds (1989) develop a regulatory mechanism under which the firm is allowed to choose prices subject to a rate-of-return constraint. Regulators review performance, and there is a higher probability that regulators will request a new rate hearing as the firm’s return deviates from the constrained rate. If regulators do not review negative returns too quickly relative to positive returns, the model predicts that the firm’s prices will converge to RamseyBoiteux prices and that productive efficiency will obtain. The model indicates that relatively simple regulatory mechanisms that do not require much information lead to Ramsey-Boiteux efficient prices. (As discussed in Section 12, price-cap regulation, in some circumstances, also leads firms to choose prices that converge to Ramsey-Boiteux prices.) A number of empirical studies have been undertaken to compare regulated prices to Ramsey-Boiteux prices; that is, to determine whether regulated prices are set at the optimal (from a constrained efficiency maximization point of view) level. Matsukawa, Madono and Nakashima (1993) examine pricing by Japanese electric utilities. They find that the prices do not satisfy the RamseyBoiteux pricing rule, and that moving towards Ramsey-Boiteux prices may require a large increase in residential electricity rates and a slight decrease in industrial electricity rates. Liu (1993) examines local telephone pricing in Taiwan and also finds that prices do not satisfy the Ramsey-Boiteux pricing rule. In the US, DeLorme, Kamerschen and Thompson (1992) find that electricity generated via nuclear power is not priced according to the RamseyBoiteux rule either, but rather that prices respond to political influences. To my knowledge, no empirical study has found regulated prices that conform to the Ramsey-Boiteux ideal. Perhaps the most obvious explanation

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is that regulators have a goal that is different from minimization of the deadweight loss subject to a break even constraint. For example, Sheehan (1991b) argues vehemently that Ramsey-Boiteux pricing is inappropriate for telecommunications regulation, in part because it does not protect ‘captive’ consumers from the use of market power. Friedlaender (1992) considers regulation of a firm that serves two markets, one of which is competitive so that prices are at marginal cost, and one of which is ‘captive’ so that consumers in this market have no alternative supplier. Then the captive sector bears the entire revenue burden. She applies her model to freight transportation by railroad, and shows that the application of Ramsey-Boiteux pricing would cause the price to captive coal shippers to rise to ‘socially unacceptable levels’ since they would be forced to bear the entire revenue requirement. Ashraf and Sabih (1992) extend the Ramsey-Boiteux model to incorporate ‘life-line’ rates (that is, the idea that all households should be able to afford a minimum amount of telephone service) and still find empirically that the pricing structure of electricity in Pakistan deviates from the amended Ramsey-Boiteux prices. Thus, while Ramsey-Boiteux prices have a number of desirable characteristics from a strict efficiency point of view, in practice efficiency and other concerns lead regulators to deviate from them, often to a substantial degree.

10. Non-linear Pricing and Sustainability Non-linear pricing (including two-part tariffs, block pricing, peak-load pricing, and Ramsey pricing) lead to issues of sustainability. That is, given non-linear pricing, can the regulated monopoly continue in existence? Two issues in particular arise: the likelihood of cream-skimming and of bypass. Cream-skimming refers to entry of firms into the high-profit markets served by the regulated monopolist. Without entry, the profits earned in one market are used to ‘subsidize’ prices in another market, either for efficiency reasons as in peak-load and Ramsey-Boiteux pricing or for fairness reasons as in business phone rates subsidizing residential rates. An entrant observes profits to be made in the high-price market, and may be induced to enter that market only. (This is named cream skimming because the entry skims the cream (high profits) and leaves the milk (low profits).) For example, in the US, MCI was interested only in entering the long distance market, from which AT&T was obtaining revenues to keep prices for local calls substantially below cost. (Note that such entry may not be efficient. Price in the high-profit market is above theincumbent’s marginal cost, allowing firms with higher marginal cost, but a marginal cost less than the regulated price, to enter the high-profit market.) In addition, high rates in some markets or during some time periods may

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induce consumers, typically large commercial consumers, to bypass the regulated monopoly and obtain the product elsewhere. (Cream skimming is often characterized as bypass, since, for example, MCI was able to bypass the long- distance network owned by AT&T.) Again, the regulated firm sees a reduction in revenues in the high price market that were used to subsidize rates in other markets. The existence of cream-skimming and bypass combine to make the regulated monopoly less financially viable, since they are deprived of a large source of revenue yet often continue to be obligated by regulators to provide service to at least some segments of the market at low prices. Regulators in such a situation must consider several questions. For example, how much bypass should be allowed? (Recall that regulators often control entry in these situations.) Which firms should be allowed to enter? How should prices be restructured in the face of entry and bypass? The theoretical literature discussing these issues is somewhat limited. Einhorn (1987) considers a case where the potential entrants have access to a bypass technology to which the regulated monopolist does not have access. He shows that the optimal pricing structure involves the monopolist charging a usage price below marginal cost to the largest users, that is, those users most likely to bypass the monopolist. (These consumers still generate net revenue to the firm since they also pay a fixed fee.) Curien, Jullien and Rey (1998) find, similarly to the earlier work, that smaller users are charged a price above marginal cost while larger users are charged a price less than marginal cost. When bypass is regulated, too little bypass occurs, while competitive bypass (that is, free entry) leads to too much bypass. In any case, distributional effects occur, with large users gaining at the expense of either small users or taxpayers, depending on how the loss of revenue is financed (by raising prices to small users or subsidizing the monopoly with tax dollars). Laffont and Tirole (1990a) consider optimal pricing strategies given the possibility of bypass under conditions of asymmetric information. They assume two sources of asymmetric information: that the firm cannot distinguish between high and low demand customers and that the firm has superior knowledge about its technology relative to the regulator. (Einhorn, 1990b, considers asymmetric information only in the latter dimension.) The first assumption prevents a charge to high-demand customers below marginal cost, as arises in Einhorn (1987) and Curien, Jullien and Rey (1998), because the customers cannot be typed, and hence third degree price discrimination is not an option. Laffont and Tirole (1990a) find that bypass should be prevented when the regulated monopolist is efficient, and support the finding of Einhorn (1987) and Curien, Jullien and Rey (1998) that charging high demand consumers a price below marginal cost is optimal since keeping these customers contributes towards covering fixed costs through the fixed fee of a two-part tariff. They also find that low-demand consumers may benefit from

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the possibility of bypass, if bypass constrains the monopolist (that is, the monopolist reduces prices in order to deter entry). Some empirical work has been done that is related to cream-skimming and bypass. One common theme has been regarding natural gas prices in regional markets. For example, De Vany and Walls (1996) and Walls (1994) find that local bypass and access to pipeline transportation lead to natural gas prices that move with field prices, as one would expect due to arbitrage. Parsons and Ward (1995) find that larger long-distance phone companies are more likely to bypass the local phone companies switched services than are smaller long-distance companies. Finally, Donald and Sappington (1995) find that as bypass activity increases, regulators are less likely to adopt incentive regulation (which is discussed in the next section), since bypass activity reduces the gains a regulated monopolist can attain by investing in cost reduction. This concludes the discussion of regulation as traditionally practiced in the US I now turn to the more recent advances in price regulation, where the UK has led the way as it moved from a system of largely nationalized firms to regulated, privatized companies.

D. Incentive Regulation 11. Introduction to Incentive Regulation In large part, the problems arising in the Averch-Johnson model are due to the fact that the regulated firms do not have an incentive to operate at minimum cost. (As discussed in Section A5, a variety of circumstances exist to mitigate the Averch-Johnson effect, such as regulatory lag and prudence reviews. However, while the deviation from cost-minimization may be reduced, in most if not all formulations of rate-of-return regulation it is not eliminated.) Prices are set such that revenues cover operating costs plus the allowed rate-of-return on investment. Thus, any cost savings will be passed on to consumers via a lower regulated price. Similarly, the firm need not worry about rising costs, because those costs will be covered with a higher regulated price. Part of the motivation behind incentive regulation is to provide the firm with the motivation to behave in a manner more consistent with the social optimum (Crew and Kleindorfer, 1996, present an overview of incentive regulation in the UK and the US). One of the earliest forms of incentive regulation, price-cap regulation, was designed to eliminate the cost disincentives other forms of price regulation had caused; an additional benefit arose because price-cap regulation reduces regulatory administrative costs (at least in theory). Thus, any cost savings are, at least in part, retained by the firm, reinstating the incentive of the firm to minimize cost. (On the other hand, because firms have more price flexibility,

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they also have a greater opportunity to exercise market power.) In addition, in a pure price-cap regime, the regulated market is effectively decoupled from other markets, eliminating the inefficient incentives firms subject to rate-ofreturn regulation face in regards to entering markets in which they are not competitive. Finally, price-cap regulation may have added benefits in industries where technology is changing rapidly. Maintaining rate-of-return regulation in such situations is administratively difficult, as the regulator must convene more frequent rate hearings and has less past information on costs on which to base pricing decisions. Price-cap regulation requires less information regarding technological change to implement. (This may explain why telecommunications regulation adopted price-cap regulation more quickly than other industries. Einhorn, 1991a; Mitchell and Vogelsang, 1997; and Sappington and Weisman, 1996a provide comprehensive treatment of incentive regulation in the telecommunications industry.) Price-cap regulation was adopted in the United Kingdom in 1984 to regulate the recently privatized telecommunications industry; the United Kingdom now applies this form of regulation to gas, electricity water, as well as telecommunications. (Beesley and Littlechild, 1989, and Armstrong, Cowan and Vickers, 1994 describe incentive regulation in the United Kingdom.) It has also been adopted for use in the US, primarily in telecommunications, at the state and federal level. By 1993, thirty states had adopted a form of price-cap regulation for some industries, though generally the mechanism included an aspect of profit-sharing, as discussed in Section 14. The FCC plan divided AT&T’s products among three baskets, each subject to a price-cap, in order to reduce or eliminate cross subsidization between the baskets. Several other countries have also adopted this form of regulation, including Australia, France, Hong Kong, the Netherlands, Mexico, Germany, Sweden and Denmark. To give an idea of how price-cap regulation works in general, consider the following scenario. The regulatory agency chooses two values in setting the price-cap. The initial price-cap is chosen, P0; then the regulator chooses an adjustment term, x, so that subsequent price-caps are equal to P0! x. The adjustment term may occur at any point in time specified by the regulator; often it is an annual adjustment. During the time the price-cap is in effect, the regulated firm may either choose a price below or equal to the price-cap. (Note that the firm is granted a high degree of pricing flexibility; in particular, the firm typically acquires substantial flexibility over the structure of prices. Thus, price-cap regulated firms are relatively free to abandon cross subsidies that may have been imposed under rate-of-return regulation. In the US, subsidies to, for example, rural areas, continue in a different form: telecommunications firms are taxed, the proceedings used for direct subsidization, rather than accomplishing subsidization via the price structure.) The firm can request a rate hearing, which it might do, for example, if its costs were higher than the

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price-cap. At some specified point in the future, either price-cap regulation continues with a hearing to establish a new price-cap, or the regulatory mechanism reverts to a rate-of-return approach.

12. Price-cap Regulation Cabral and Riordan (1989) set out a fairly simple model of price-cap regulation. (Vogelsang and Finsinger, 1979, derive a regulatory mechanism that is similar to price-cap regulation.) One of the key assumptions is that marginal cost is a function of an investment in cost reduction, denoted as e (for effort). A lag occurs between the investment in cost reduction and its realization, and the effect of e on cost reduction may be certain or uncertain, so long as higher effort increases the likelihood that marginal cost will fall. Let C denote the firm’s original marginal cost; the price-cap is P0! x and is set below C; and let M(C) denote the unconstrained monopoly price for a marginal cost of C. Then the price actually charged by the regulated firm, which is a function of the price-cap and of marginal cost and is denoted as B(P0! x,C), is equal to max {C, min{P0 ! x, M(C)}. If costs are above the price-cap, the firm asks the regulator for a rate hearing and essentially chooses to revert to rate-of-return regulation. If costs are below the price-cap, but not so low that the price-cap is not binding, then the firm prices at the cap. Finally, if costs are low enough that the monopoly price is less than the price-cap, M(C) < P0! x, then the firm prices at the monopoly price. The firm’s maximization problem with respect to investments in cost reduction can be written as

[(

)

] [(

)]

max e π ( P0 − x, e) = B P0 − x, C( e) − C( e) ⋅ D B P0 − x , C( e) − e,

where D[B] is the demand curve as a function of the price charged by the regulated firm. Cabral and Riordan (1989) derive several illustrative results. First, in the certainty case (that is, when the firm knows by how much marginal cost will be reduced for a given investment e), they show that if the price-cap is too tight, then the firm has no incentive to invest in cost reduction because the return to innovation is too small relative to the cost. Essentially the firm opts for rate-ofreturn regulation. Second, they show that if the price-cap is binding, then an increase in x, that is a tighter price-cap, marginally increases the investment in cost reduction. The increased incentive is caused by the fact that the tighter the price-cap, the more units the firm is selling; the aggregate increase in profits for a decline in marginal cost is higher than it would be for the same decline in marginal cost at a higher price-cap, since at the higher price-cap, a smaller quantity would be sold. In the case of uncertainty (that is, when the firm does not know the cost that will result from a given level of effort e), the results are

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not as tight. They are able to show that for low values of x, the optimal choice of effort increases as does x (that is, a tighter price-cap leads to more cost reduction). In summary, Cabral and Riordan (1989) show that a firm regulated under a price-cap mechanism will have an incentive to invest in cost reduction, depending on the level of the price-cap. However, if the price-cap is too low, the firm may have no incentive to invest in cost reduction. Clemenz (1991) extends the work of Cabral and Riordan (1989) by deriving the effect of price-cap regulation on consumers and by deriving the socially optimal price-cap. (Clemenz, 1991, notes that the impact on consumers is important since, unlike economists, regulators may place a higher weight on consumer welfare than producer welfare.) Cabral and Riordan’s (1989) basic results are confirmed: in a finite horizon model, price-cap regulation gives the firm larger incentives to reduce cost than does rate-ofreturn regulation and achieves higher social welfare. These conclusions are even stronger in an infinite horizon setting. Clemenz (1991) also shows that price-cap regulation is capable not only of raising welfare in general but also in increasing consumer surplus. Sibley (1989) and Lewis and Sappington (1989) derive the optimal regulatory policy in a given environment characterized by asymmetric information; the optimal regulatory mechanism is similar to price-cap regulation. Sibley (1989) assumes the firm has full information about technology and demand while regulators have no information; he also assumes that regulators can observe lagged expenditures by the firm, prices, and outputs. Sibley’s (1989) scheme is derived such that it leads to efficient pricing and input usage; the optimal scheme is remarkably similar to a price-cap regime. Lewis and Sappington (1989) present a model in which the regulated firm has private information about its capabilities and cost-reducing activities. The endogenously-determined optimal regulatory policy includes a form of pricecap regulation as a component (firms are offered a choice between price-cap regulation and a regulatory regime that shares gains with consumers). They suggest that while price-cap regulation may be superior in some environments, it may not be in others, and hence should be considered as part of the optimal regulatory regime. A number of papers have considered the effect of price-cap regulation on the structure of prices. In the multi-product setting, price-cap regulation is generally implemented by imposing a price index on a basket of goods, giving the firm the freedom to adjust the price structure. A possible additional benefit arising from price-cap regulation is that the firm will choose prices across products in a way that will lead prices to have a Ramsey-Boiteux structure, which allows the firm to cover costs in the most efficient manner (that is, at the smallest deadweight loss). Bradley and Price (1988) and Vogelsang (1989) have demonstrated this result. Others, however, have shown that the result is not general. For example, Neu (1993) finds that prices approach a Ramsey-

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Boiteux structure only in certain situations, such as under static conditions. By example he shows that under a number of parameter conditions relating to differential growth in demand, differential price elasticities, and different shares across services, prices will diverge from the Ramsey-Boiteux structure. Fraser (1995) finds that cost increases for a firm’s products can cause prices to diverge from the Ramsey-Boiteux structure if the cost increases or demand elasticities are not uniform. However, if additional cost changes do not occur and the previous period outputs are used as weights in the price-cap, then prices will converge to the Ramsey-Boiteux structure. He concludes that only when cost changes are recurring will price diverge from the Ramsey-Boiteux structure on a continuing basis. Bradley (1993) points out that, since the definition of commodity bundles is largely endogenous (for example, should day time rates end at 4pm, 5pm, or 6pm?) and under the influence if not sole discretion of the regulated firms, the definitions may be manipulated in such a way that Laspeyres quantity based price-caps may very well not lead to an efficient Ramsey-Boiteux price structure. (The role of indices is discussed in the next section.) Thus, price-cap regulation can give firms a larger incentive to invest in cost reduction than does rate-of-return regulation and the price structure may approach the second best Ramsey-Boiteux prices, and there is some evidence that price-cap regulation is, or can be, part of the optimal regulatory mechanism.

13. Problems and Extensions of Price-cap Regulation While the discussion above casts a positive light on price-cap regulation and its effects on innovation and efficiency, subsequent theoretical work and experience from the implementation of price-cap regulation suggest that it is not the panacea that it once seemed. Problems arise in terms of the proper calculation of the price index, the optimal pricing structure, the impact on quality, and the end game and renegotiation problems. Typically the price-cap is implemented as requiring that a price index of the different products be below the price-cap; at issue are the weights used to form the price index. Law (1993) shows that Laspeyres index price-cap regulation under revenue weights causes the firm to price in order to manipulate the weights in such a way that reduces consumer and increases producer welfare in the first period and may reduce consumer welfare in the second period. Foreman (1995) extends the analysis to indicate when and why such weight manipulation incurs. Suppose the price-cap is set in the following way

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pt i

i

pt&1

i

i

×

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pt&1 xt&1

i ji (pt&1 xt&1) i

# 1 % CPI & x,

where pti is the price of good i in period t, xti is the quantity sold of good i in period t, CPI is the consumer price index, and x is the productivity change. The second term in brackets is the weight; it is defined as last period’s revenues from good i as a fraction of last period’s total revenues. In essence, by considering the effect of price charged today on the index set tomorrow, the firm may be able to earn higher profits tomorrow. For example, by setting a low price for a service today, the weight on the service tomorrow will be reduced when demand is inelastic (as is typical for telecommunication services). The more inelastic demand, the more sensitive are relative revenue shares to small price changes. Even small price changes manipulate the weights sufficiently that profits increase but social welfare declines. He shows that replacing the revenue weights with quantity weights reduces the effect of weight manipulation, especially as demand becomes less elastic. (Further discussion of index issues is contained in Cowan, 1997; Diewert, 1993; and Vickers and Yarrow, 1988a.) Sappington and Sibley (1992) consider another type of index manipulation; they analyze the effect of price-cap regulation as the FCC planned to implement for AT&T on the firm’s incentive to engage in strategic, non-linear pricing. In their model, the firm sells a single-product and can use two-part tariffs. The price-cap index is represented as

pt %

Et Qt&1

# p0,

where E is the fixed part of the two-part tariff, p is the per unit charge, and Q is the quantity sold. In other words, average revenue in period t, based on prices charged in t and on quantities sold in t!1, must be below the price-cap. They show that incentives are created for the firm to offer a two-part tariff rather than a uniform price, and that such pricing can reduce consumers’ and total surplus. They identify two welfare-improving modifications. First, the index could be specified as a function of the quantities sold in the initial period (replace Qt!1 with Q0). This eliminates the incentive of the firm to reduce the usage charge today (increasing Qt!1) so that the fixed fee can be increased in the future. The second alternative, which increases welfare even more (and never

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reduces consumer surplus) is to require the firm to allow consumers the option to purchase under the original tariff terms before price-cap regulation was implemented. Armstrong and Vickers (1991) consider another aspect of the role of price structure in a price-cap regulatory scheme. They are interested in whether a multi-product monopolist should be allowed to price discriminate across customer classes, and find that the answer depends on whether a price-cap index is calculated using weights in proportion to demands at uniform prices or whether there is a cap applied to average revenue. Armstrong, Cowan and Vickers (1995) consider how a firm facing a price-cap based on average revenue sets the price structure. (Unlike Sappington and Sibley, 1992, the price-cap is based on prices and quantities this period, so the incentive to set prices this period with an eye to how it would affect the cap next period is eliminated.) They also consider a case where the firm must offer consumers the option of buying at the uniform price. The firm prefers the average revenue constraint to the option constraint, and, of course, likes uniform pricing the least. Consumers overall prefer the option constraint, while ranking the average revenue constraint the least. However, welfare under the various schemes is ambiguous. The effect of price-cap regulation on quality seems to be a potentially large problem since a decline in quality is in essence a disguised increase in price. (Fraser, 1994, reports that since July 1992, the Australian regulatory body AUSTEL has included quality of service in its evaluation of whether prices have risen in its regulation of Telecom Australia.) Fraser (1994) considers the effect of price-cap regulation on reliability of supply in electric supply; in other words, he incorporates possible changes in the degree of quality when a firm is regulated under a price-cap. He considers two regulatory regimes: in one, the regulator does not incorporate changes in reliability; and in the other, changes in reliability are incorporated into the price-cap. In the latter case, a weighted average of the change in price and the change in reliability must be less than the cap. When reliability is not included in the index, the firm may protect profits by lowering reliability if cost increases must be absorbed (the price-cap is binding). However, when the price-cap is not binding, the firm may increase reliability, given the positive relationship between reliability and price. Including reliability in the price index eliminates the problem of lower reliability when the price-cap is binding, but introduces a new problem of over pricing when the price-cap is not binding. Thus, whichever way the price-cap is formulated, price-cap regulation affects the quality of the service. Implementation of price-cap regulation has revealed two related, large problems: what is to prevent the regulator from renegotiating the regulatory compact, and how is the end game problem resolved. Part of the reason pricecap regulation works to achieve reductions in cost is by allowing the firm to keep (at least some of) the gains from cost reduction. For this incentive to

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work, the regulator must credibly commit not to intervene during the period in which the price-cap is to be in effect. However, such a commitment may not be credible, especially if profits from cost savings rise ‘too much’. If profits rise greatly, the regulatory agency may face pressure from consumer groups to revise the level of the price-cap. In the UK, the electricity distribution regulator decided in June 1995 to revise price-caps, only two months after they had been set, in part because of the gains in productivity (see Studness, 1995) and ‘previously unsuspected financial strength’. Thus, the commitment not to intervene for five years did not even last three months. If regulated firms believe that price-caps will be revised to appropriate the gain from cost savings, or even if there is a chance that revision may occur, then their incentive to invest in cost savings is reduced. Isaac (1991) considers the problems that may arise when a firm will be regulated under a price-cap for some known, finite period of time, after which rate-of-return regulation will be implemented. He identifies several potential end game problems. First, the firm may manipulate the system by shifting costs into the future. Second, the regulator faces two commitment problems: a commitment not to change the price-cap or intervene in price setting during the price-cap period, and also not use the rate review when moving to rate-ofreturn regulation to appropriate profits earned by the firm during the price-cap regime. (He discusses these problems in light of the experience of regulation of the Tucson Electric Power Company during the 1980s.) While several authors have identified these issues as potential problems, not much theoretical work has tackled the issue, with the exception of Armstrong, Rees and Vickers (1995). They derive a model of price-cap regulation with an endogenously determined length of time until the next review. (Most models assume that the price-cap lasts for an exogenously given amount of time and do not consider the effects of a future change in regime on behavior under the current regime.) They identify the following trade off: the longer the amount of time between reviews, the more likely it is the price will be low at the next review, as firms have a higher pay off to investing in cost reduction because they retain profits for a longer period, but the longer is the amount of time during which the price is high. The higher the initial cost when price-cap regulation is implemented, the more likely the former effect is to dominate the latter. They also demonstrate that demand elasticity and the effectiveness of investments in cost reduction are key determinants of the optimal interval between hearings. Weisman (1993) theoretically analyzes the effect of renegotiation on firm behavior. Given a non zero probability that the regulator will rewrite the regulatory contract and assuming that the probability increases in the regulated firm’s profits, the firm has an incentive to engage in pure waste. In that way the firm may be able to reduce the likelihood of the regulator imposing more stringent regulation. (Sappington, 1980, shows a similar result with respect to

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Vogelsang and Finsinger’s 1979 regulatory mechanism.) Thus, while price-cap regulation does have the benefit of increasing the incentive to firms to invest in cost reduction, it induces a variety of new problems. I now turn to other forms of incentive regulation that may offer improvements to straight price-cap regulation.

14. Alternative Forms of Incentive Regulation While price-cap regulation is the most commonly discussed and used form of incentive regulation, a few alternatives have been considered as well. The most common alternative is some form of profit-sharing, under which the firm retains some fraction of its profits and rebates the remaining fraction to consumers. Indeed, given the practical problems that arose under price-cap regulation in the UK, profit-sharing regulation was often put forward as a superior regulatory regime that should be adopted. Mayer and Vickers (1996) point out that many of the existing problems would remain under profit-sharing and other, more serious, problems would arise in addition. An alternative often used in the US is a combination price-cap/rate-ofreturn/profit-sharing approach to regulation. For example, most US states that have adopted price-cap regulation have included a provision whereby the firm is also subject to a rate-of-return constraint, the form of which Braeutigam and Panzar (1993) term ‘sliding scale’. (In 1992, 22 of 48 states with regional Bell operating companies used a form of sliding scale/price-cap regulation, while 19 states continued with traditional rate-of-return regulation.) Under these provisions, the firm is allowed pricing flexibility below the price-cap, provided that the rate-of-return is not above its cap. (In some states adjustments may be made if the firm’s rate-of-return falls below a floor, as well.) As the rate-ofreturn rises above the cap, the firm is entitled to a smaller and smaller portion of the increase in profits, typically refunding the rest to consumers. One immediate implication pointed out by Braeutigam and Panzar (1993) is that such an approach eliminates one benefit to price-cap regulation: savings in administrative costs. Under such a hybrid approach, the regulator will still need to calculate rates of return, with all its attendant problems. Lyon (1996b), using numerical techniques, shows that adding a profitsharing mechanism to price-caps always increases expected welfare relative to pure price-caps. Welfare may be increased by large amounts of profit-sharing and by allowing firms a greater share of gains than of losses. Profit-sharing is particularly beneficial if the firm’s initial costs are high and cost innovations are difficult to achieve. However, Weisman (1994) shows that the firm prefers profit-sharing to pure price-cap regulation. In essence, this form of regulation gives the regulatory agency an incentive not to take adverse actions against the

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firm, since such actions also harm the regulatory agency via the profit-sharing arrangement. Weisman (1993) considers a ‘modified price-cap’ regulatory regime, which he views as more accurately describing the type of price-cap regulation that has been implemented in the US. Under this regime, the regulator sets a price-cap in the regulated (‘core’) market and allows the firm to retain only part of the profits generated. However, the firm also operates in unregulated (‘non core’) markets as well. To undertake profit-sharing, costs must be allocated across the core and non core markets. Given the difficulty in allocating costs (see the discussion in Section C7), distortions are generated. This type of pricecap/profit-sharing regulation can reduce welfare compared to rate-of-return regulation applied to one market (which also requires that costs be allocated across regulated and unregulated markets). (Braeutigam and Panzar, 1989, early recognized that price-cap regulation can in principle cause a firm to produce efficiently in non core markets and enter these markets only if efficient. However, they analyze a regulatory regime of pure price-cap regulation without profit-sharing, so the problem of allocation of common costs is totally eliminated.)

15. Comparison of Incentive-based Regulation to Other Forms of Price Regulation Cabral and Riordan (1989) and Clemenz (1991) derive models of price-cap regulation and then proceed to compare the outcomes to several alternative regulatory regimes. Cabral and Riordan (1989) compare cost-based (rate-ofreturn) regulation with regulatory lag and price-cap regulation. Because there is regulatory lag in their formulation of cost-based regulation, the firm has some incentive to reduce cost. Any increase in profits between the time of cost reduction and the time of the new rate hearing are kept by the firm. However, the longer regulatory lag and the price flexibility increase the incentive to reduce costs relative to the incentive under rate-of-return regulation with regulatory lag. Cabral and Riordan (1989) also compare the level of price under the two alternatives. Under cost-based regulation, at each rate hearing the price is set to cover costs. If the price-cap is initially set below the price that would obtain under cost-based regulation (as it must if the firm is to have an incentive to reduce costs), then for a period prices will be lower under price-cap regulation than under cost-based regulation. However, in future periods the price under price-cap regulation may be higher. Continuing in the same vein, Pint (1992) considers two differences in pricecap regulation and rate-of-return regulation. She points out that, under pricecap regulation as implemented in the UK, hearings occur at fixed intervals and

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use all information available since the previous hearing, while under rate-ofreturn regulation as implemented in the US, hearings occur only when requested (typically by the firm) and utilize information from a single test year (usually the most recent year for which complete data is available). Assuming that regulation of either form is binding, the firm chooses the level of capital stock, the level of managerial effort (which reduces costs), and, under rate-ofreturn regulation, when to request a new rate hearing. Both forms of regulation lead to an over investment in capital and underinvestment in effort, especially during periods when cost data are gathered for hearings. Pint (1992) shows that rate-of-return regulation can be improved by using fixed intervals between hearings (continuingto use test year data) if the intervals are not too short, and the welfare gains are primarily realized by the firm. If data on costs since the last hearing are used in conjunction with fixed intervals, welfare increases dramatically, with gains going to consumers (indeed, profits fall). Thus, two aspects of price-cap regulation are seen to increase welfare. (Weisman, 1993, and Baron, 1991, also discuss the degree to which price-cap regulation in practice differs from rate-of-return regulation. Weisman, 1993, points out that in practice (in telecommunications in the US) price-cap regulation involves an element of cost-based regulation. As a result, greater distortions may arise under the hybrid form of regulation than result from pure cost-based regulation.) Several papers use simulation techniques to compare various regulatory regimes and the degree to which welfare may be increased. Schmalensee (1989a) considers a variety of regulatory regimes, including price-cap regulation, imposed on a risk-neutral, single-product monopolist. He considers what he terms linear regimes, which can be written as P = ? + ?(C ! a), where P is the regulated price, ? is the base price, ? the cost sharing fraction, C is observed cost, and a is the expected unit cost under the pre reform regulatory regime. That is, any change in cost is passed on linearly to price; the higher is ?, the more responsive price is to changes in cost. He finds that price-cap regulation is inferior to cost-based regulation over a wide range of plausible parameter values. While, as many have shown, price-cap regulation provides a higher incentive to invest in cost reduction, if uncertainty is sufficiently high, the price-cap must be set at such a high level to keep the firm profitable that welfare declines. Gasmi, Ivaldi and Laffont (1994) also use simulation techniques to compare welfare under a variety of regulatory regimes, including a price-cap mechanism and price-cap regulation in conjunction with profitsharing. They characterize their main findings as: (1) pure price-cap regulation leaves substantial rents to the firm; (2) introducing downward price flexibility improves the efficiency of price-cap regulation relative to Schmalensee’s (1989a) best linear regulatory regime; and (3) profit-sharing often yields welfare near the optimal regulated level by partially correcting the distribution distortion of a pure price-cap scheme.

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Several works have theoretically examined the performance of price-cap regulation with other types of regulation, and have found it useful to deviate from pure price-cap regulation. For example, performance may be enhanced by offering alternative regulatory mechanisms or alternative pricing schemes, respectively. Lewis and Sappington (1989) suggest that firms should be offered a choice between a variation on price-cap regulation and a profit-sharing form of regulation, with gains going to consumers. Sibley (1989) finds that the regulator uses slagged profits to design its own two-part tariff, and the firm will offer its two-part tariff as well as the regulator’s two-part tariff as an option to consumers. Finally, Schmalensee (1989a) finds that several regulatory mechanisms that are simpler than price-caps can achieve the same gains, particularly if the regulator weights consumer surplus highly. To recapitulate, theoretical work suggests that some form of incentive regulation can be used to improve the outcome relative to traditional cost-based methods of regulation. However, analysis also shows that, as implemented, incentive regulation often does not replace cost-based methods, and thus new problems arise. Whether incentive-based regulation is superiod to cost-based regulation in practice remains to be seen.

16. Empirical Analysis of the Effect of Incentive Regulation The increasing use of incentive-based regulation has provided economists with a wide range of natural experiments for empirically analyzing the effect of incentive-based regulation on prices, costs and welfare. (Sappington and Weisman, 1996b, concentrating on the telecommunications industry, identify some of the problems that can arise in attempting to do such empirical work, and suggest ways to avoid these problems.) Kridel, Sappington and Weisman (1996) review empirical work on incentive regulation in telecommunications, while Xavier (1995) provides a descriptive narrative of the impact of price-cap regulation in telecommunications, especially in Australia, the UK, and the US. In general, the results have been very encouraging. Productivity, investment in infrastructure, and new service offerings have increased. Prices have generally remained stable or declined slightly, and quality has not declined. However, there is no evidence that incentive-based regulation has led to reduced administrative costs. Face (1988) examines the use of price-cap regulation for Michigan Bell, estimating that costs savings in 1982 amounted to about $40 million relative to that which would have occurred under rate-of-return regulation. Majumdar (1997) focuses on the impact of incentive regulation on productivity for the case of US local exchange carriers. He finds that pure price-cap regulation leads to

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an increase in technical efficiency, but only with a lag; price-cap regulation in conjunction with profit-sharing leads to a smaller but immediate impact on technical efficiency; and finally that a pure profit-sharing scheme actually harms technical efficiency. Mathios and Rogers (1989) find that prices in states that regulated AT&T using a price-cap are 7 to 10 percent lower than in states that use rate-of-return regulation. They use variation in state regulatory mechanisms with a simple price-cap/not price-cap dummy variable. The results are sugges tive, but more detailed analysis taking into account the detailed differences in the different state regulatory mechanisms would be desirable. Despite the variety of problems identified by the theory regarding the implementation of incentive regulation, the empirical studies to date suggest that implementation has led to substantial gains.

E. Regulation of Networks 17. Introduction to the Issues As competition has been introduced into at least some areas of industries that have long been regulated, a new industry structure is arising. The new structure consists of a situation where a regulated firm controls an essential facility, generally a physical network, to which competitors must have access in order to compete with the regulated firm in at least some markets. For example, in the US much of the competition in local telephone service, at least initially, is expected to come from firms that lease access from the regulated local phone company on which the competitor can send calls. The question is how to appropriately price access to the essential facility. The first-best solution, marginal cost pricing, is generally not feasible because the regulated firm will not recover sufficient revenues to cover the fixed cost of providing the network. (Typically, provision of the network remains a regulated monopoly due to economics of scale.) Thus, the relevant question for economists and the regulator is how to efficiently structure prices subject to the constraint that the regulated firm cover its costs. Why is regulation necessary in this situation? The economic justification continues to be to reduce the deadweight loss that arises under monopoly. However, the issue is more complicated because the owner of the network competes with others in sectors that are potentially competitive. (When AT&T was broken up, the initial industry structure prohibited the regional operating companies (local service) from competing in these potentially competitive markets (long distance). With the Telecommunications Act of 1996 and deregulation of electricity in the US, the exclusion of network owners from the competitive sectors is declining.) A natural incentive arises for network owners to price access to the network in such a way to give itself an advantage in the

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competitive sectors. Another important issue regards the overall regulatory structure and how the competitive market/sector fits in. For example, if prices are high in some potentially competitive sectors in order to subsidize regulated sectors, as was done in the US with regard to long-distance and local service, respectively, then the effect of access/entry on the ability of the firm to maintain such price subsidies must be considered. Thus, the same sustainability issues discussed in Section 10 arise again. I now describe the work that has attempted to characterize the optimal access price.

18. Access Pricing Baumol and Sidak (1994a) describe the traditional (in the US until the early 1980s) approach for pricing access. Suppose that a regulated firm earns T from a particular service towards its overall revenue shortfall, defined as the difference between total incremental revenue less total incremental cost. Asuming that the price for the final product is fixed, the traditional approach assigns an access fee equal to the average incremental cost of providing access to the competitive firm plus a charge that would leave the regulated firm with its market share weighted share of T. That is, if upon granting access a firm is expected to keep two thirds of the market, then the total price for access will be such that the regulated firm earns in total two-thirds of T. However, in this situation the firm is not ade quately compensated for its common fixed costs. In addition, inefficient entry may occur. The entrant essentially does not have to cover as large a portion of fixed costs as does the regulated firm, and hence can still profitably enter even if its average incremental cost is higher than the regulated firms. To remedy the entry inefficiency induced by the traditional approach, Baumol, Sidak and Willig have proposed perhaps the most commonly known and used access pricing rule, the efficient component pricing rule (ECPR) or the Baumol-Willig rule. (The rule is generally attributed to Willig, 1979, and Baumol, 1983, and is extensively discussed by Baumol and Sidak, 1994a and 1994c. It has been used in the US by the Interstate Commerce Commission in the rail industry since the early 1980s, by the California Public Utilities Commission in local telephone service since 1989, and in New Zealand in the telecommunications industry since the early 1990s.) Essentially, the rule proposes that access to essential facilities should be priced at the direct cost of providing access plus the opportunity cost to the regulated firm of granting access to a competitor. The opportunity cost to the incumbent is the profit that would have been earned had the incumbent supplied the final product rather than the entering firms. One of the benefits of such a rule is that it leads to efficient entry. In other words, no firm will enter the competitive market unless its marginal cost is less than or equal to the marginal cost of the incumbent regulated firm. Kahn and Taylor (1994) point out an additional potential

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benefit. By including the regulated firm’s opportunity cost in the access charge, subsidies mandated by regulators can be maintained. (I call this a potential benefit since many of these cross-subsidies are not efficient. However, this is not always the case, as in Ramsey-Boiteux pricing.) For example, in the days of a common local and long-distance regulated firm, high prices in longdistance service were used to subsidize rates for local service. As discussed in Section 10, entry into the high-profit markets can make the regulatory regime unstable; access pricing under the ECPR can allow entry but sustain the regulatory regime by maintaining the contribution towards the fixed costs provided by that service. A number of critiques of the ECPR have arisen. In particular, several have questioned the generality of the rule, noting that its efficiency result is contingent on a number of rather strict assumptions. Baumol and Sidak (1994a) and Kahn and Taylor (1994) note that the ECPR gives the efficient solution to pricing access subject to the assumption that the price of the final product is subject to effective regulation or effective competition. Economides and White (1995) develop a rigorous model analyzing the efficiency of the ECPR in the case where the firm that controls the essential facility has market power in the potentially competitive market. They assume that the price for the final product is not regulated, and that the incumbent therefore is able to charge the full monopoly price. Their argument reduces to the point that entry of an inefficient firm, that is a firm with marginal costs above that of the regulated incumbent, can be socially beneficial if entry sufficiently reduces the deadweight loss that arises when the regulated monopolist prices above marginal cost for the final product, while the ECPR in this circumstance acts to protect the monopolist from any competitive challenge. Economides and White (1995) show that under Bertrand or Cournot competition in the final product market, the gain from increased competition can offset some degree of inefficiency on the part of the entrant. The criticisms of the ECPR highlight an important aspect of the debate: whether the ECPR is efficient depends crucially on the overall regulatory environment, technology, and demand. Is the price for the final product effectively regulated? Laffont and Tirole (1996) emphasize this point: ‘A discussion of an access rule without reference to the rest of the regulatory environment has limited interest. The quality of an access pricing rule depends on the determination of prices for the final products.’ Are products perfect substitutes? Is technology subject to constant returns to scale? It seems clear that the ECPR does not have the wide applicability first claimed. Indeed, many show that while the ECPR arises as a special case of the optimal access rule in certain circumstances, more often than not the optimal access rule may be higher or lower than the EPCR. Armstrong, Doyle and Vickers (1996) take the ECPR as their framework and analyze how the opportunity cost should be properly measured under

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different assumptions regarding demand and supply. They begin with the clear-cut case where the final product is homogeneous; inputs, including access, are used in fixed proportions; no bypass is possible, that is, access is a necessary input into production of the final product and cannot be obtained from any source except the incumbent; and the entrant is a price taker. They then relax some of these assumptions, allowing for product differentiation, variable proportions, and the possibility of bypass. They show that under these new assumptions, the optimal access charge is less than the access charge suggested by the ECPR, because under these assumptions the opportunity cost of access is reduced as the incumbent loses fewer final product sales given entry. However, they also point out that the optimal access charge can be interpreted as an extension of the ECPR, taking into account the ‘displacement ratio’, which is the change in the incumbent’s final product sales over the change in sales of access to competitors as the access price changes slightly. (They also show that, when incorporating the firm’s budget constraint, a positive RamseyBoiteux price must be added to the access charge, so that the optimal price subject to the budget constraint is higher than the ECPR access price.) They also show that, when the opportunity cost is analyzed properly, the informational demands of the ECPR are not as low as others have argued; in particular, proper calculation of the opportunity cost requires information regarding demand and supply elasticities. Armstrong, Doyle and Vickers (1998) consider access pricing in the situation where the price of the final product is not regulated, given that that is the direction in which many industries are headed. They find that, with linear demand and linear competitive supply, and no binding break-even constraint, the optimal price for access is set at marginal cost. More generally the relationship between the optimal access price and marginal cost is ambiguous. In essence the same trade-off identified in Economides and White (1995) is present: setting a high access price raises the price of the final product, resulting in the standard allocative inefficiency associated with monopoly pricing, but it reduces the margin available to competitors, reducing inefficient supply and increasing productive efficiency. Laffont and Tirole (1994) derive the optimal access price in a wide variety of situations and under pretty general conditions: degrees of effort exerted by the incumbent in operating the network, private information on the part of the incumbent regarding technology, various informational regimes, the presence and absence of government transfers, various degrees of market power on the part of the entrant, various regulatory regimes, and under the possibility of bypass. They also compare the optimal access price to that suggested by the ECPR. They identify the following assumptions as necessary to ensure the efficiency of the ECPR: (1) the regulated firm’s price for the final product is based on marginal-cost pricing; (2) the products produced by the regulated firm and the entrant are perfect substitutes; (3) production of the final product is

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characterized by constant returns to scale; (4) the entrant has no market power; and (5) the regulated firm’s marginal cost can be accurately observed. If any of these fail to hold, then the access price must be adjusted from the ECPR level to achieve efficiency. Larson and Lehman (1997) demonstrate that ECPR pricing can be derived as a special case of Ramsey-Boiteux pricing with interdependent demands, but also show that ECPR is not always efficient. In particular, in order for a Ramsey-Boiteux pricing structure to arise, the following assumptions must hold: (1) entrants must have a fixed proportions technology; (2) the essential facility must be strict, that is have a zero elasticity of substitutions for other inputs; (3) perfect competition must exist in the non essential inputs; (4) the regulated firm and entrants must face the same elasticity of demand for the final product; (5) the entrants set price at the level charged by the regulated firm; (6) Bertrand competition ensues in the downstream market, which in combination with assumption (5) results in equal market shares for the regulated firm and entrants; and (7) there is symmetry of weighted income effects. They then discuss the many reasons why these assumptions are likely to be violated. Finally, Laffont and Tirole (1996) consider a completely different approach to regulating interconnection. They suggest that access be regulated under a global price-cap. Under this approach, the price-cap would apply the weighted sum of price changes for final products and price changes for intermediate products sold to rivals, including access. They argue that one benefit is that it requires no more informational requirements than existing regulatory policies. The firm will adopt the optimal Ramsey-Boiteux price structure given its information about demand and cost; the regulator does not require information on marginal costs nor demand elasticities. (Ramsey-Boiteux prices obtain so long as all goods, including access, are included in the definition of the price cap and the weights are exogenously set at the level of output to be realized.) They also consider a global price-cap that also imposes the ECPR as a price ceiling on the access price, though the informational requirements of the ECPR are severe under more realistic assumptions, as shown by Armstrong, Doyle and Vickers (1998). The benefits identified by Laffont and Tirole (1996) from adding an ECPR price ceiling is to provide a better setting of the weights in the price-cap and to limit predatory behavior (the incumbent may increase the access price and reduce the final output price, squeezing out entrants) by tying the access and output prices. The theoretical work suggests that a general approach to pricing access at the direct marginal cost of access plus the opportunity cost is appropriate. However, it appears that calculating the opportunity cost is not as easy as originally proposed. In addition, the work illustrates the importance of taking into account the entire regulatory regime, including the regime covering the competitive sector. (I found no empirical work regarding access prices.)

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F. Conclusion 19. Regulation in Practice As regulation theory has advanced, especially in the last decade or two, regulation in practice has changed tremendously. The US saw immense deregulation occur beginning in the 1970s, mostly in industries that were never believed to be natural monopolies but had been regulated for other reasons. (For example, regulation of trucking in the US largely developed in order to protect regulation of railroads, which were thought to be natural monopolies.) In particular, deregulation occurred in railroad and trucking, air passenger transportation, natural gas, electricity, telecommunications, and cable television. (About the only move in the US in the opposite direction was the 1992 Cable Consumer Protection and Competition Act, which re regulated cable television in response to the increase in cable prices after deregulation in the Cable Communications Policy Act of 1984. It is not clear how regulation affected the quality adjusted price; Hazlett, 1993, for example, believes the quality-adjusted price declined under deregulation, while Otsuka, 1997, suggests that the quality- adjusted price was kept low under regulation. However, cable was rederegulated with the passage of the Telecommunications Act of 1996.) Other countries have seen an impressive move away from handling natural monopolies by nationalizing them to regulation of privatized firms. These countries, especially the United Kingdom, have led the way towards the use of incentive regulation. Not only has the US moved towards deregulation, but the form of regulation has been changing rapidly over the 1980s and 1990s. There is a general movement away from cost-based regulation towards incentive-based regulation, in an effort to achieve a better outcome. The United Kingdom led the way with adoption of price-cap regulation in 1984, after privatizing its telecommunications industry. Privatization of other industries spread the use of price-cap regulation to electricity, gas and water. Price-cap regulation in practice in the United Kingdom has included a bit of a mix of cost-based regulation. For example, gas, water and electricity utilities can pass on increases in costs of inputs outside their control. Nonetheless, this method of regulation has proved to be revolutionary, leading to changes in the approach to regulation in many countries.

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Acknowledgments I gratefully acknowledge the comments of Ken Boyer and of an anonymous referee. Their comments significantly improved the content and organization of the paper and extended the bibliography. Chris Haan, Vivian Lei and Aaron White provided valuable assistance in compiling the bibliography.

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Economics, 37-45. Richter, Wolfram F. and Weimann, Joachim (1985), ‘Ramsey Pricing the Telephone Services of the Deutsche Bundespost’, 141 Zeitschrift für die Gesamte Staatswissenschaft, 516-524. Riordan, Michael H. (1984), ‘On Delegating Price Authority to a Regulated Firm’, 15 Rand Journal of Economics, 108-115. Riordan, Michael H. and Sappington, David E.M. (1987), ‘Awarding Monopoly Franchises’, 77 American Economic Review, 305-332. Robichek, Alexander (1978), ‘Regulation and Modern Finance Theory’, 33 Journal of Finance, 693-705. Roeloffs, Matthew (1998), ‘Local Measured Service Revisited: A Southern Wisconsin Test Case’, 26 Atlantic Economic Journal. Rohlfs, Jeffrey (1974), ‘A Theory of Interdependent Demand for a Communications Service’, 5 Bell Journal of Economics, 16-37. Romer, Thomas and Rosenthal, Howard (1987), ‘Modern Political Economy and the Study of Regulation’, in Bailey, Elizabeth E. (ed.), Public Regulation: New Perspectives on Institutions and Policies. MIT Press Series on the Regulation of Economic Activity, no. 14, Cambridge, MA, MIT Press. Ros, Agustin J. and Harvill, Terry S. (1995), ‘Incentive Ratemaking in Illinois: The Transition to Competitive Market’, 133 Public Utilities Fortnightly, 22-25. Rose, Nancy L. (1985), ‘The Incidence of Regulatory Rents in the Motor Carrier Industry’, 16 Rand Journal of Economics, 299-318. Rose, Nancy L. (1987), ‘Labor Rent Sharing and Regulation: Evidence from the Trucking Industry’, 95 Journal of Political Economy, 1146-1178. Rubinovitz, Robert N. (1993), ‘Market Power and Price Increases for Basic Cable Service since Deregulation’, 224 Rand Journal of Economics, 1-18. Russo, Michael V. and Teece, David J. (1991), ‘Natural Gas Distribution in California’, in Gilbert, Richard J. (ed.), Regulatory Choices: A Perspective on Developments in Energy Policy, Berkeley, LA and Oxford, University of California Press, 120-186. Salant, David J. and Woroch, Glenn A. (1992), ‘Trigger Price Regulation’, 23 Rand Journal of Economics, 29-51. Samet, Dov and Tauman, Yair (1982), ‘A Characterization of Price Mechanisms and the Determination of Marginal Cost Prices under a Set of Axioms’, 50 Econometrica, 895-910. Samprone, Joseph C., Jr (1979), ‘Rate Regulation and Nonprice Competition in the Property and Liability Insurance Industry’, 46 Journal of Risk and Insurance, 683-696. Sappington, David E.M. (1980), ‘Strategic Firm Behavior under a Dynamic Regulatory Adjustment Process’, 11 Bell Journal of Economics, 360-372. Sappington, David E.M. (1983), ‘Optimal Regulation of a Multiproduct Monopoly with Unknown Technological Capabilities’, 14 Bell Journal of Economics, 453-463. Sappington, David E.M. (1994), ‘Designing Incentive Regulation’, 9 Review of Industrial Organization, 245-272. Sappington, David E.M. and Sibley, David S. (1988), ‘Regulating Without Cost Information: The Incremental Surplus Subsidy Scheme’, 29 International Economic Review, 297-306. Sappington, David E.M. and Sibley, David S. (1992), ‘Strategic Nonlinear Pricing under Price-Cap Regulation’, 23 Rand Journal of Economics, 1-19. Sappington, David E.M. and Sibley, David S. (1993), ‘Regulatory Incentive Policies and Abuse’, 5

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5300 ANTITRUST LAW Patrick Van Cayseele Professor of Economics Katholic University of Leuven and F.U.N.D.P. Namur

Roger Van den Bergh Professor of Law and Economics Erasmus University Rotterdam and Utrecht University © Copyright 1999 Patrick Van Cayseele and Roger Van den Bergh

Abstract The first part of this chapter surveys the interaction of the economics of competition and antitrust in a somewhat historical perspective. The evolution of economic theories on competition can be divided into four stages: (1) the origins of competition: the dynamic concept of competition in classical economic literature and the static concept of competition in price theory, followed by the development of models of imperfect competition and monopolistic competition; (2) the structure-conduct-performance paradigm (Harvard School of Industrial Organisation); (3) the ‘antitrust revolution’ of the Chicago School and the related theory of contestable markets, and (4) the new industrial economics, making use of game theory and transaction cost analysis. The second part of this chapter investigates how far economic theory and concepts of industrial economics have had an influence on antitrust law. In the USA economic views on competition theory have had a much clearer impact on antitrust law: legal rules tend to change when the underlying economic theory changes. In Europe, competition law seems to be influenced more by political objectives than by economic theory; economic considerations are often either absent or outdated. The discussion of some leading antitrust cases illustrates the differences between the American and the European approach. JEL classification: K21 Keywords: Cartels, Competition, Structure, Conduct, Performance, Chicago School, Bounds Approach

1. Introduction The economics of competition and antitrust law have a long-lasting tradition of fruitful interaction. Since the very beginning of antitrust legislation, 467

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microeconomics has influenced the context as well as the implementation of the law. And as one of the great economists of this century, Lord Keynes, pointed out, practitioners always adhere to the theories of a defunct economist, leading contemporary economists to write papers on the inadequate or outdated application of economics on antitrust legislation. Nowadays, not only the economics of competition, but also the economics of information and the theory of economic federalism have exercised their influence. The field of economics of competition is currently called industrial organisation or industrial economics. This has, however, a much broader scope by also focusing on the economics of regulation, innovation and advertising, among others. For a leading textbook, see Tirole (1988), for an introduction, see Scherer and Ross (1990) or Carlton and Perloff (1994). The economics of information was recently recognised in the economics profession by awarding the Nobel prize to Vickrey and Mirrlees. The economics of information only could advance due to major breakthroughs in the field of noncooperative game theory under incomplete information. Nash, Selten and especially Harsanyi pioneered contributions in this area, for which they got the 1994 Nobel prize in economics. Game theory also made its way to the law (see Baird, Gertner and Picker (1994) and Phlips (1988, 1995) for pioneering contributions regarding antitrust economics. Applications of information economics to the law can be found in Levine and Lippman (1995). For a combined effort of information economics with the economic theory of (fiscal) federalism within the context of antitrust, see Smets and Van Cayseele (1995). The present contribution will try to survey the abovementioned interaction in a somewhat historical perspective. This contribution therefore is organised along the following table of contents: the next section sketches the antecedents and the very beginning. Then the old paradigm in industrial economics, together with its application to antitrust in a carefree era, is discussed. More troublesome was the application of these old industrial organisation theories to a number of antitrust cases in the 1970s and 1980s. The criticisms advanced by the Chicago School will receive special attention. The response by the new industrial economics (NIE) as well as the new empirical industrial organisation (NEIO) is put under scrutiny in the following sections. Then follows a description of the current situation in terms of academic research with respect to concentrations. Last but not least, in the final section we investigate what can be retrieved from all this research in legal practice. This structure to some extent follows Van Cayseele (1996), who engages in a similar survey from a pure industrial economics point of view, rather than focusing on antitrust.

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2. The Origins of Competition The roots of the concept of ‘competition’ are as old as economic science if the latter starts with the famous book The Wealth of Nations (see Smith, 1776, 1937). Even before that time the merits of and problems with competition often submerged in economic writings. In an overview, McNulty (1967) referred to the seventeenth-century mercantilist Johann Joachim Becher, writings by Turgot and Hume and to Sir James Stuart, who provided the most complete pre-Smithian analysis of competition. Smith, by anticipating the welfare theorems with his ‘invisible hand’ theory, generalised competition to a force driving economies to the very best outcomes that are feasible. The most frequently quoted passage in the book is: He [specifically each individual] generally, indeed neither intends to promote the public interest, nor knows how much he is promoting it… [He] intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.

Subsequently economists have proved those theorems and showed their shortcomings (see the Nobel prize winners Arrow and Debreu). Parallel with those mathematical models of a general equilibrium nature - which sacrifice much of the institutional details of competition in real markets - economists have engaged in the mathematical modelling of market forces in much more institutional detail, including asymmetries in information, transaction costs and the concentration and use of power. As already argued in the introduction, these models were only recently recognised. What does classical economics then have as an implication for competition policy? According to classical economics, healthy competition signifies both reciprocal rivalry and the absence of government restrictions, such as the exclusive privileges which characterised the mercantilist period. The common law in relation to restraints of trade reflected the classical view of competition. Modes of conduct with limited individual freedom were condemned as restrictive to competition. Hence a widespread belief in the ‘laissez faire’ principle was held. Government intervention in general certainly would not improve upon the results of the competitive process although Smith himself was a believer of keeping entry into the market open. Competition was hailed as a process but limited government intervention sometimes would be necessary to allow for the process to work. Neoclassical economists continued to believe in the healthy effects of competition but somewhat shifted the interest from competition as a process to competition as a situation, as one later would say, a market structure. The necessary conditions to achieve a perfectly competitive outcome are: (i) the

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rivals must act independently or noncooperatively in today’s terminology; (ii) the number of rivals, potential as well as present, must be sufficient; (iii) the economic decision makers must possess knowledge of the market opportunities; (iv) there must be freedom to act on this knowledge; and (v) sufficient time must elapse for resources to flow in the directions desired by their owners with no restrictions on the magnitude of these flows. Although Stigler (1968) attributes these necessary conditions to Smith, the characterisation and implications of perfect competition and alternating market structure emerged most pronouncedly in this period. In particular, Edgeworth (1925) and Cournot ([1838], 1971) introduced pioneering contributions which until today remain at the heart of daily antitrust practice. A perfectly competitive market now was defined as a set of properties such as supply and demand exercised by a very large number of actors, free entry and exit, homogeneous products being traded on the market and zero search or transaction costs. The outcome of such a market is an efficient one in that no other outcome can achieve the same level of welfare for society. Yet it relies on many conditions which are unachievable, such as very large numbers of suppliers (in the presence of scale economies), no search costs (difficult to maintain in the few cases one has very many suppliers) and so on. The model of perfect competition therefore has to be seen as a yardstick against which other market structures are to be judged. In all instances in which this set of properties are not met, a case of market failure is seen to exist. For a long time, the mere existence of such market failures were seen to be sufficient reasons for government policies, such as antitrust laws or the creation of public utilities. Nowadays, this viewpoint has changed. A market failure is a necessary condition for government intervention, but not a sufficient one. The cost of government failures, for instance due to government officials and regulators being captured by private and social interest groups (as documented so well in the public choice literature and avocated by Stigler, 1971), has to fall short of the costs due to market failures. In general, antitrust policy, due to its distance vis-à-vis redistributive issues, and due to its permanent and ‘generic’ character is not an area of government intervention where one expects a lot of capture a priori (see De Bondt and Van Cayseele, 1985). Cournot and Edgeworth introduced models of imperfect competition. Cournot ([1838], 1971) explicitly took into account the possibility of only a few suppliers in the market. As shown by Novshek (1985), his model can replicate both the perfectly competitive outcome as well as the other extreme, that is, monopoly. While Cournot’s model still abstracts from the price formation process by assuming the existence of a Walrasian auctioneer, it substantially adds to realism due to the introduction of conjectures on behalf of the rivals. Recent research, for example by Kreps and Scheinkman (1983) sustains the Cournot model without the Walrasian assumption. But Davidson and

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Deneckere (1986) and Van Cayseele and Furth (1996a) demonstrate that the conclusion is very fragile. Edgeworth readily abandoned the abstractions of a price equilibrating process and allowed rivals to undercut each others’ price and engage in price warfare. While his conclusions as to cyclical behaviour of prices with periods of collusive pricing alternating with price wars could only be interpreted by means of game-theoretical models half a century later, another model of oligopoly had been conceived. Many textbooks in microeconomics deal with these models as the leading paradigm (see among others Pindyck and Rubinfeld, 1993, and Schotter, 1994). Meanwhile monopoly, as a market structure that occurs in reality and can be analysed, was also studied. Indeed, the quantitative contributions of economists such as Cournot and Edgeworth allowed for an estimation of the costs associated with monopoly. A clear definition of consumer and producer surplus by Marshall (1920) or Lerner (1934), as well as the recognition of deadweight losses associated with monopoly pricing, was an essential step into giving empirical content to the problem of monopoly. The estimates of the direct loss in welfare of course vary across nations and over time, but are in the range of 0.1 percent to as much as 9 percent. For the US, these estimates can be found in Harberger (1954) or Worcester (1973). Cowling and Mueller (1983) estimated the direct welfare effects in France. The indirect losses are due to rent-seeking phenomena, and can be in the order of magnitude of the direct effects. They, of course, have to be added and illustrate the need to work with models that capture the dynamic aspects of competition. These quite substantial amounts of losses certainly justify the operation of antitrust control, at least from an economic point of view. In addition to this concern with allocative efficiency, other reasons have been put forward to embrace antitrust enforcement. Each of these, however, is disputed. We therefore only mention them briefly. First, many believe that monopolies and cartels are less innovative than firms operating in competitive market structures. This is sort of the ‘opposite Schumpeterian assumption’. While this literature is vast, in particular the empirical studies trying to detect a link between concentration and innovation are highly inconclusive (for a survey see Van Cayseele, 1998). The abovementioned rent-seeking effects are particularly pronounced in the theoretical literature regarding the dynamics of innovation. This is quite natural as one realises that market structure will not only influence innovative activity, but that also the opposite is true. This begs the question whether incumbent monopolies will exploit innovative activities, for example by winning subsequent patents, to continue their position, or whether some kind of ‘leapfrogging’ will take place, where today’s market leaders are tomorrow’s followers, a paradigm nowadays acclaimed by Microsoft officials. A second belief which still is disputed is the following: monopolies and cartels, by being sheltered from competition, become lazy. This gives rise to

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organisational slack or X-efficiency (see Leibenstein, 1966, the critique by Stigler, 1976, and the reply by Leibenstein, 1978). Finally, many object to the transfer of wealth from consumers to firms with market power, or the shareholders beyond these firms. While the economic foundations for redistribution are seriously disputed, Lande (1982) believes that the principle reason behind the enactment of antitrust laws was to prevent these wealth transfers, implying political economy motivations for antitrust. Further relaxations of the perfectly competitive model occurred with the abandoning of the homogeneous goods assumption by, for example, Hotelling (1928), Chamberlin (1933) and Robinson (1964). By allowing for differences with respect to the products sold, each producer gets some monopoly power over those consumers who are addicted to his brand. Nonetheless, there may be many producers in the market, so that the focus here is not necessarily game-theoretic, that is, the recognition of mutual interdependency need not to be central, although contemporary contributions in the field of product differentiation all recognise this interdependency. In doing so, the economic models of product differentiation have provided the foundations to determine the relevant market, a concept used currently in antitrust legislation (see Van Cayseele, 1994). As reviewed by Friedman (1984), each and every of these departures from the competitive model proved to be path-breaking for the development of the field of oligopoly theory. A few decades and antitrust filibusters later, the socalled new industrial organisation would pick up from here. On the other hand, each of these departures also showed the tremendous richness in terms of modelling possibilities that exist for analysing competition in an industry, and hence the difficulties that will arise in constructing models of general relevance. As such it is difficult to formulate a legal approach that is theoretically correct, predictable and easy and inexpensive to administer for a majority of antitrust issues that can come up, although this has been tried, as the next section shows.

3. The Structure, Conduct, Performance Paradigm (S-C-P Paradigm) Each and every one of the original models of competition discussed in the previous section has a few items in common. First, the number of suppliers as those who have access to a certain technology is specified. Next, the consumers who have different tastes can make their choice over different brands. In general, the technology and tastes constitute market structure. Still this allows for many different outcomes unless a particular structure entails a certain type of conduct. This is what the S-C-P paradigm tried to achieve: a general theory that mapped common elements in the market structure of any industry into a performance indicator of that sector.

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The S-C-P paradigm was developed by Edward S. Mason (1949a) at Harvard University in the late 1930s and early 1940s. The original empirical applications of the new theory were by Mason’s colleagues and students, the most famous of whom was Joe S. Bain (1968). The paradigm implies that market results (the success of an industry in producing benefits for consumers, employment, stable prices, technological advancement and so on) in an industry are dependent on the conduct of sellers and buyers (as regards decision variables like advertising, R&D, and so on). Conduct, as mentioned, is determined by the structure of the relevant market. The structure of an industry depends on basic conditions, such as technology and preference structure. Government policy (antitrust policy, regulation, taxes, and so on) may affect the basic conditions, and hence the structure, conduct and performance of an industry. If true, research along this paradigm would allow any outsider to know profits and consumer surplus in any industry simply by plugging in the variables representing the market structure, at least if a significant and positive relationship was detected in the study. Hundreds of studies have attempted to link market structure to market performance. Concerning static performance (profits and consumer surplus), three major measures of market performance are used: (1) the rate of return, which is based upon profits earned per dollar of investment; (2) the price-cost margin, which should be based upon the difference between price and marginal cost, and is related to the Lerner index of monopoly power and (3) Tobin’s q, which is the ratio of the market value of a firm to its value based upon the replacement cost of its assets (for more details see Carlton and Perloff, 1994). The initial studies are by Bain (1951, 1956). In the latter publication Bain argues that profits are higher in industries with high concentration and high barriers to entry. Many studies followed, to name just a few: Schwartzman (1959), Levinson (1960), Fuchs (1961), Minhas (1963), Weiss (1963), Comanor and Wilson (1967), Collins and Preston (1969), Kamerschen (1969), and many others. Other performance criteria, such as the cyclical behaviour of price-cost margins or pricing behaviour as such have been carried out (see, respectively, Domowitz, Hubbard and Petersen, 1986, and Weiss, 1989). To examine how performance varies with structure, measures of market structure are needed. Industry concentration is typically measured as a function of the market shares of some or all of the firms in a market. The four-firm concentration ratio (CR4) is the sum of the market shares of the four largest firms. The eight-firm concentration ratio (CR8) focuses attention on the top eight firms in measuring concentration. Alternatively, market structure may be measured by using a function of all the individual firm’s market shares. The Herfindahl-Hirschman Index (HHI) is the sum of the squares of the market shares of every firm in the relevant market. Later, when the empirical Harvard tradition underlying the S-C-P paradigm was no longer tenable, the pioneering game-theoretic Cournot model was able to strike a link between the Lerner

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index and the HHI, which suddenly made it quite popular (see Scherer and Ross, 1990). The fact was already known to Stigler (1968). The concentration indices (CR4 or CR8 and the HHI) can be related to one another (see Weiss, 1969). Many studies indeed found a positive and significant relationship between market structure and performance, yet others casted doubt as to whether the relationship would hold for different sets of industries or in other eras. Nonetheless the paradigm condemns high degrees of concentration, especially if they are not the result of scale economies but of barriers to entry. Regarding market shares, some studies have made clear that substantial market shares are not evidence prima facie for the presence of market power. On the contrary, it seems to be the case that the resulting larger market shares are the result of superior efficiency, as predicted by a Cournot model with cost asymmetries. In the United States, the Harvard analysis became the cornerstone of competition policy in the 1960s and remained so until the neoclassical and neoinstitutional approaches began to win the upper hand in the mid 1970s. In the 1968 Merger Guidelines of the American Department of Justice it was stated that an analysis of market structure was fully adequate for showing that the effect of a merger, as spelled out in Section 7 of the Clayton Act, ‘may be substantially to lessen competition, or to tend to create a monopoly’. The Department announced that its merger policy would focus on market structure ‘because the conduct of the individual firms in a market tends to be controlled by the structure of that market’ (see also Section 7 below). An enforcement policy emphasizing a limited number of structural factors would not only produce adequate economic predictions for the showing of anticompetitive effects, but would also facilitate both enforcement decision making and business planning, and as such contribute to legal certainty. Such rudimentary decision making, however, also holds some dangers, for example in allowing firms to accomplish the target indirectly, by circumventing the limited number of structural factors. In some cases this will lead to the same outcome, at a higher cost, or at a counterproductive outcome, as claimed by Bittlingmayer (1985). Here the trade-off will need to strike a balance between the additional costs resulting from closing down all the loopholes vis-à-vis the advantage of a simple and transparant attack to antitrust. In many cases, the second order effects probably will not be important enough to tip the balance in favour of an extensive enlargement of the set of structural factors to be monitored, but we know industries can differ in many respects.

4. The Chicago School The antecedents of the new theories of competition have to be found in the original contributions discussed in Section 2 and, most importantly, to the

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presence and interaction of Director and Stigler at the University of Chicago in the 1950s. In 1942, Stigler had already written that ‘it is doubtful whether the monopoly question will ever receive much illumination from large scale statistical investigations’ (see Stigler, 1942). In the 1950s the economist Aaron Director, together with a lawyer, Edward Levi, taught anti-trust at the University of Chicago. According to Posner (1979), Director formulated his ideas mainly orally. Numerous authors since then have further elaborated on Aaron Director’s core ideas and published them in scholarly journals. Bork (1954) elaborated on the often misunderstood aspects of efficiency resulting from vertical integration and brought together many of the schools’ insights in The Antitrust Paradox: A Policy at War with Itself (1978). (This book gives a complete and orthodox overview of the doctrine of the Chicago School.) The problem of tie-in-sales was analysed by Bowman (1957). Predatory pricing was investigated by McGee (1958), while another hot issue overwhelmed with misconceptions, namely vertical price fixing, was the topic of a paper by one of Chicago’s leading scholars in microeconomics, industrial organisation and law and economics, Telser (1960). A good survey of the issues involved and the economic forces at work is Reder (1982). The Chicago School’s point of departure can be found in neoclassical price theory. The confrontation between the classical, dogmatic approach to anti-trust law and the microeconomic angle of attack gave rise to an extremely rich, new efficiency theory. The Chicago approach to competition policy is not merely the result of the rejection of government intervention in the economy, although the opposite view often occurs. On the contrary, Director reached his conclusions by analysing competition problems through price theory. Unlike the economists following the S-C-P paradigm (the Harvard School), who examine competition problems on the basis of observable phenomena (empirical research) and industry tales instead of having recourse to an economic theory, Director sought an explanation for practices observed in real markets which tallied with the maximisation of profits, utility and welfare. Of course, if firms can engage in actions which are anti-competitive and profitable, they will do so. But already in 1964, Stigler showed that it was often more profitable to stay out of cartels than to form them. This conclusion, however, has been both confirmed (see Salant, Switzer and Reynolds, 1983), and rejected (see Deneckere and Davidson, 1984), indicating that one has to carefully investigate the nature of the interactions that takes place in industry, as is done in the game-theoretic tradition, discussed below. In the Chicago tradition, concentration mostly will be the result of efficiency, hence if antitrust authorities interfere with an existing market structure, they are likely to cause inefficiencies, and reduce rather than enhance welfare.

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One of the most important attacks on the S-C-P doctrine of conducting antitrust policies was given again by Stigler when investigating the role of barriers to entry. Often the Harvard tradition argued that fixed costs were seen to lead to scale economies on the one hand, but also to barriers to entry on the other. Stigler defines a barrier to entry as ‘a cost of producing (at some or every rate of output) that must be borne by a firm which seeks to enter the industry but is not borne by firms already in the industry’. Barriers to entry are present only if the costs for firms entering the market turn out to be higher than the costs for the existing firms. If, for example, it costs $10,000,000 to build the smallest possible efficient factory having an economic life of ten years, then the annual costs for a new entrant will be only $1,000,000. The existing firms will be confronted with the same annual costs, at least if it is assumed that they also intend to replace their factories. Accordingly, there is no cost disadvantage for the new entrant (see Posner, 1979; Spence, 1980, or Schmalensee, 1983) for initial ideas regarding the importance of sunk rather than fixed costs. These ideas were the fundamentals of what later on became the contestable market defence for ATT, and the subsequent new theories of industry structure by Baumol, Panzar and Willig (1982) and Sutton (1991). In fact, what turns out to be important for understanding market structure are not fixed but sunk costs. The latter are defined as non-recoupable costs, or outlays one has to make in order to get in business, but which are without value if one exits. Entrants will not be stopped if the fixed cost - the factory in the example above - can get a new destination or can be sold on a second-hand market (see Section 5 below). In short, the Chicago tradition then is the bundling of several ingredients, which taken together tell us that the monopoly problem is not all that important. First of all, as a stylised fact, monopolies (or strong market concentration for that matter) do not occur all that often. Moreover, if they are present, they are either the result of scale economies in production and/or distribution - and hence efficient - or the result of barriers to entry. But in the latter case, they are transitory, for the freedom of entry will induce the presence of other players in the market, which compete and hence limit the market power of the initial monopolist. Persistency of market power therefore can only be the result of government itself, by the fact that many of its regulatory policies establish legal barriers to entry, hence creating public monopolies. In terms of conduct, the often alleged malpractices also are explained by efficiency. Vertical restraints may provide the appropriate incentives for dealers to invest in quality of service or to appropriately advertise the product in its region. Others if allowed to deal in this region would free-ride on these efforts, the final result being that the initial dealer would no longer undertake the necessary efforts to maintain an high quality of service for the product (see also Telser, 1960). Commodity bundling also may be the result of efficiency

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considerations rather than trying to exploit monopoly power (see Kenney and Klein, 1983). From 1970 on, the influence of Chicago economics on US antitrust policy gradually increased. This has led, together with the renewed role of the private sector in the economy, to a different implementation of the law, in the sense that mergers or particular types of conduct have caused less problems for the firms involved. Such an evolution was bound to trigger the comment that Chicago economics is ideologically biased. In addition there is the belief held sometimes in Europe that the majority of the economics profession agrees with the characterisation of the Chicago School as an ideology. This is of course wrong, since what matters is the methodology to study antitrust issues along the lines of price theory, which was pioneered by the Chicago School and has currently been embraced by all scholars in industrial organisation as the starting point of every sound antitrust case. As such, the Chicago learning is well established both within the economic discipline of modern industrial organisation and antitrust practice, at least in the US, although it would be premature to claim that all of the US antitrust action is in line with the Chicago tradition (see Van den Bergh, 1997, and Section 7 below for a relativisation. Nonetheless, the Chicago School influences antitrust policy. The Merger Guidelines were revised several times (in 1982, 1984 and 1992) to take account of developments in economic thinking concerning the competitive effects of mergers. In the 1992 Guidelines there is no longer an explicit reference to the S-C-P paradigm; there is also explicit scope for an ‘efficiency defense’, which clearly reflects the influence of the Chicago School (see also Section 7 below). In Europe the same acceptance holds for the academic profession which has been very active in the field of industrial organisation, not the least through the EARIE (European Association for Reseach in Industrial Economics) conferences which celebrate their 25th edition, and for which there is no American counterpart. In antitrust policy however, the gap is substantial. This has led often to inconsistent treatment of one and the same phenomenon over a variety of industries (see again Van den Bergh, 1997). A real danger of the Chicago price theory tradition comes from the exageration of some theoretical concepts that do not apply to the real world very often. To some, contestability theory is such an example. In the US, it has been mistakenly applied, for example, in the airline mergers (see Utton, 1995). The result has been that it has been somewhat discredited. While in general thrust and effects, it is very much in the Chigaco School tradition, the major difference with mainstream Chicago concepts seems to lie in the lack of a positive inclination: the contestable market model serves a normative purpose in that it merely shows that there exists a yardstick market structure in which antitrust policies are useless even in the presence of monopoly. As will become clear, the assumptions needed to obtain this conclusion are so restrictive that

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the contestable market model cannot make claims to be descriptive or positive theory. In the theory of contestable markets, the fact that the market structure is concentrated says nothing, of itself, about the degree of efficiency. Even with a high degree of concentration, allocative efficiency is not excluded because potential entrants exercise a controlling discipline. Perfect contestability produces a similar outcome to perfect competition: prices are equal to marginal costs, as required by the welfare theorems, but without having a substantial number of competitors in the industry. The players necessary to guarantee this result are found outside the industry. In a perfectly contestable market, entry is completely free and withdrawal costs absolutely nothing. (Free entry does not imply that entry costs absolutely nothing, or that it is easy, but rather that the entrant has no relative disadvantages compared with participants who are already active in the market.) Besides lacking empirical support, many contributions have pointed out that the contestable market model is very particular, and that nearly every change of the assumptions leads to dramatically different outcomes (see, for example, the very early critical review article by Brock, 1983, or the discussion in Schwarz and Reynolds, 1983). For example, if some costs are sunk the incumbent has already paid for them, and will have written them off instantaneously as they are worth nothing if the activity is stopped. Potential entrants find it appropriate to judge the profitability of market entry on the basis of the post entry competition (which will determine the profitability) and the costs they still have to sink. If competition is hard, profits will be too low to cover these costs, and potential entry will never discipline the incumbents for it will not occur. Implicitly, the contestable market model by assuming zero sunk costs therefore assumes that investments can be redeployed in another activity (complete lack of asset specificity), or resold on a second-hand market that is not prone to failures (see, however, Akerlof, 1970, and Van Cayseele, 1993). Another example of the vulnerability of the conclusions with respect to small changes in the assumptions has been investigated in game theoretic detail by Van Cayseele and Furth (1996a, 1996b). In these articles, it is shown that if merely one assumption, namely that consumers react faster to lower prices than producers, is changed by the reverse assumption, the outcome of the contestable market model completely changes. Instead of predicting the perfectly competitive outcome for an industry in which firms compete with one another in prices, the monopoly outcome results. Other examples which follow a strict game-theoretic methodology show that one change in the assumptions may be sufficient to get drastically different outcomes (see Ausubel and Deneckere, 1987). There, the assumption that non-durable goods are involved is changed into the production of durable goods. While Coase (1972) had

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argued that durable good monopolists had no market power, the contestable market model with a duopoly in durable goods yields monopoly outcomes. From an academic viewpoint, the Chicago price theory tradition has been surpassed in the last decade by the contributions game theory made to the field of industrial organization. In the next section, we enter in detail into the gametheoretic contributions which are important in the area of antitrust economics. For the moment, it is important to stress that these newer contributions have shown that it is quite possible to explain certain mergers and particular types of conduct not as the result of efficiency, but from a clear pursuit of gaining or keeping market power. However, it would be untrue to say that the newer game-theoretic contributions are at odds with the Chicago tradition. On the contrary, from a methodological viewpoint this new approach has pursued with the same rigor as price theory the analytical approach to understanding the operations of firms in an industry. However, by allowing for a richer set of strategies it has been shown that some of the conclusions reached by the Chicago tradition could indeed be the outcome, but at the same time that under slightly different assumptions (which some will argue more closely to reality), quite different conclusions result. What certainly is taken for granted is that both the advocates of laissez-faire (no antitrust) as well as those in favour follow mathematical modelling approaches which allow sharp inroads into the problem, just as price theory pioneered by Director, Stigler and others a few decades earlier.

5. The New Industrial Economics: Game Theory and Transaction Cost Analysis Game theory offers a rigorous analytical framework - like price theory - to analyse the competition of firms. Game theory requires being explicit on the set of players (firms), on their strategies, and on the advantages these strategies can bring to them (payoffs). It offers solution concepts that take into account firstmover advantages and credible commitments that firms can take. As such it is said to reflect much more real-world competition than any other body of theory. A general introduction of the achievements game theory was able to accomplish for competition policy is provided by Phlips (1988, 1995). Jacquemin (1997) provides examples of the links that game theory has regarding both the goals of competition policies and the anti-competitive practices that are unconceavable with such policies. In addition to the many valuable insights received from the Chicago tradition, game theory especially has contributed by explicating carefully the relevant strategies and considerations that need to be taken into account as well as by pointing out that perfect information is not always prevalent. This has serious implications for the working of a market. In some cases, including a

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more full description of the strategic possibilities has led to a reversal of the conclusion: an insight found within the Chicago tradition was turned upside down. In other cases, the conclusions of the Chicago School have been confirmed, in a richer and more realistic economic environment. An important example for antitrust is horizontal mergers. Stigler had already argued that mergers for a market power motive would not be formed as it is more profitable to stay out such a merger than to join it. Paradoxically, Salant, Switzer and Reynolds (1983) show that with a linear demand curve, constant marginal costs and firms competing in quantities, at least 80 percent of the firms in an industry have to be included in the merger in order for it to be profitable. Clearly, these are not the mergers that will show up, for antitrust authorities would quickly rule them out on the basis of the creation of dominant positions. This would imply that mergers are not likely to form, unless some important efficiency gains in terms of, for instance, production or distribution costs are made. But these are the mergers that need to be approved from a welfare point of view, hence antitrust authorities only have to bother with clearly dominant positions. But the result depends on one critical assumption: the competition is in quantities rather than in prices. It was shown by Deneckere and Davidson (1984) that all mergers are profitable even if they do not yield efficiency improvements in the latter case. Hence the conclusions are turned upside down by merely the change of one assumption. This has led those critical of game theory to claim that any conclusion or its reverse can be proved, while the defenders of game theory claim that the advantages definitely outweigh this disadvantage (see, for instance, the discussion between Fisher, 1989 and Shapiro, 1989). The latter includes the fact that game theory requires one to explicate all the assumptions made also on behalf of the rival players (which was not always done by price theory), as well as the richness in terms of institutional detail and hence the realism game theory has added to economic models. In Sleuwaegen and Van Cayseele (1997) still another reason is given, namely the fact that as more game theoretic analysis of industries become available, it becomes possible to operate along a decision tree approach and to guide antitrust authorities as to whether a detailed investigation of the proposed operation is necessary. Finally, and as shown in a seminal article by Kamien and Zang (1990), game theory allows one to do more. In the just mentioned controversy between Salant, Switzer and Reynolds, on the one hand, and Deneckere and Davidson, on the other, the mergers under consideration are all given exogenously. But it is possible to endogenise the formation of mergers by considering different coalitions that can be formed, and hence reduce the number of conceivable mergers to those that are feasible. Similar game-theoretic exercises endogenise the strategies in which the firms will compete with one another, or even the moves, hence explaining who leads and who follows (see Hamilton and Slutsky, 1990). Another development which seriously attenuates the critique on game-

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theoretic models is the bounds approach by Sutton (1991) (see also Section 6 below). A final advantage of game theory is that, by its analysis of bounded rationality, it opens the way to approaches which hitherto remained outside the mainstream of microeconomics, by the fact that pure price theory does not offer much room for search and transaction costs phenomena. Nonetheless, transaction cost theory has a longstanding tradition in the law and economics of antitrust (see Williamson, 1975, 1979). The central idea in transaction cost economics is that the market is not entirely free in the sense that certain operations (transactions) are not entirely costless. As such, the transaction cost approach superimposes frictions upon microeconomic price theory. Seen in this light, transaction cost analysis is more a complement to than a substitute for price theory. The point of departure in Williamson’s analysis is not the subject matter of the sale/purchase transaction (goods or services) but the transaction or transfer system itself. The transaction is an exchange between two or more individuals whereby they transfer ‘property rights’ (that is, rights to dispose of scarce resources, which may be limited not only by other individuals’ ownership rights but also by rules of legal liability and the provisions of competition law). Transactions differ perceptibly so far as costs are concerned and these differences in transaction costs influence the choice of the right organisational form or ‘governance structure’. The transaction cost approach is thus concerned with the costs which are necessary to maintain the economic system. To put it briefly: markets and firms are regarded as alternative instruments for implementing transactions (see Williamson, 1985, 1986). Colloquially, managers speak about the ‘make or buy’ decision. Indeed, whether a transaction to acquire a good or service is carried out over the market or within the firm depends on the relative efficiency of these two institutions. A hierarchical form of organisation may be superior to a market-based solution. The relative efficiency of the two forms is determined on the one hand by the costs of entering into and carrying out agreements in a market, and on the other hand by the characteristics of the individuals who are affected by the transaction. As such, the origins of transaction cost economics go back at least to Coase (1937), who in his classic essay laid the foundations for the new institutional economics. Markets and firms are indeed institutional forms, and their existence and survival are explained out of economic efficiency. The use of one mode or the other for a particular type of transaction directly follows from the relative costs of operating over one system or the other. As such, the laws which regulate and interfere with these institutions will also be judged in the long run by economic efficiency. If legal rules make it more difficult to operate over a particular institution (for instance competition policies which forbid vertically integrated firms), that institution will lose appeal and vanish, together with the law that regulated it.

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Transactions differ from each other in a number of respects: the uncertainty to which the transactions are exposed, the frequency with which the transactions are repeated (once, occasionally, regularly) and the extent to which transactions must be supported by transaction-specific investments (‘asset specificity’). By asset specificity Williamson means the extent to which suppliers and customers must make specific investments in order to be able to carry out the transactions. Transaction-specific investments bind the supplier and the customer closely together. If the supplier cannot readily exploit his specific investments elsewhere and the purchaser, because of his specific investments, cannot readily place his order elsewhere, the supplier and the purchaser are bound to each other for a substantial period of time. This leads to situations in which market participants are very much dependent upon each other (‘small numbers exchange’). The importance of transaction costs depends on human factors such as the limited possibility to solve complex problems and ‘opportunism’. Opportunism follows straightforwardly out of the pursuit of self-interest in environments characterised by incomplete information or the lack of repeated transactions, making it simply not worthwhile to care for reputation. As already argued above, game theory has allowed the investigation of such moral hazard problems. And more recently game theory also has allowed the analysis of bounded rationality phenomena (see Young and Foster, 1991). Transaction cost economics has important implications for antitrust policy. Certain market structures might be the result of transaction cost efficiencies, not the strive for market power. A welfare-maximising anti-trust law then must take into account these efficiency aspects. In the context of the control of concentrations it is necessary to consider what transaction cost savings will be prevented by a merger prohibition and whether these (possible substantial) costs are compensated by the anticipated advantages of more intensive competition. Vertical integration or vertical restraints can be the result of complex negotiations aiming at the reduction of transaction costs. As a conclusion for this section, it is clear that game theory has entered the field of industrial economics to remain as a dominant supplier of tools to analyse sectors and industries. For the moment, the problem is not that the new industrial organisation is not very accurate but, on the contrary, that for nearly each different sector studied the assumptions and solution concepts of the models have to be adapted. This is of course mainly a problem for the laymen who lack the game theoretical knowledge to analyse industries, or to judge the quality of studies done by others. The plethora of models around does not make it easy to pick a model and be sure that it is appropriate for the sector under investigation. But things are changing quickly as, from the empirical side, the new empirical industrial organisation and the bounds approach are providing a workable synthesis.

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6. The New Empirical Industrial Organisation and the Bounds Approach The new empirical industrial organisation has tried to resolve the problem of indeterminacy in the new industrial economics, by leaving it open as to what kind of conduct prevails in an industry. The general idea is that industry structural elements can be measured and modelled, hence one starts from theoretical models of a sector. As such, conduct which is much harder to know ex ante is left open to be determined empirically. The divergence of industries necessarily calls for sector-specific models. Usually the fundamental ingredients are specifications of supply and demand, modified and augmented with industry-specific features. Estimation based on time series analysis allows the identification of market power, that is to separate the effects of cost changes from mark ups. The new empirical industrial organisation is a great leap forward for antitrust practitioners, as it allows the simulation of the effects of mergers and the detection of collusive behaviour. Models for an increasing number of industries become available, as we have witnessed since the pioneering studies applications to the cigarette industry (see Sullivan, 1985), automobile industry (see Berry, Levinsohn and Pakes, 1995; and Verboven, 1996), steel industry (see Baker, 1989), soft drinks (see Gasmi, Laffont and Vuong, 1992), and many others. The problem with this approach is that models do not already exist for every sector. Hence, an open industry in terms of publishing and communicating data might face a study which is at the disadvantage of the sector, whereas in other sectors collusion is much more important, but remains unknown. Moreover, often these studies will have to rely on historical data, hence it might not be appropriate to study a merger today in view of conduct a few decades ago. On the other hand, the pioneering studies by Panzar and Rosse (1987) and Porter (1983) offer many perspectives in that they have been applied successfully to many sectors without too much re-modelling. A similar effort to find robust results, that is results that can be applied to every industry under consideration is Sutton (1991). This approach is even more generally applicable, at the expense however of having to incorporate some degrees of freedom as to what can happen. Typically, one will only be able to say within which boundaries a sector will move, without being precise as to where it will be. Or, only an upper and lower bound to concentration will result. As such, this approach tries to provide the foundations for the S-C-P paradigm, but immediately shows how shaky the traditional Harvard approach was when it claimed it could make exact predictions regarding the impact of market structural changes such as concentrations. While some claim that many factors that are identified to be important in explaining market structure and the evolution of concentration could have been written down without all the theoretical efforts by Sutton, the old Harvard

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approach simply never has done it. Moreover, the explicit game-theoretic foundations used by Sutton illustrate the importance of adequate modelling of product differentiation, commitment, sunk costs and so on. It also shows the exact relation in which those factors relate to one another. Indeed, the Harvard approach mostly has looked for causal relations between variables that all are endogenous if one truly understand the dynamics of competition. This is mainly due to feedback effects of market performance variables, a fact well known in the European tradition on industrial organisation (see Jacquemin and De Jong, 1977).

7. The Influence of Economics on Antitrust Law In the last part of this contribution it will be investigated how far economic theory and concepts of industrial economics have had an influence on antitrust law. It seems fair to say that American antitrust law has been influenced by a constantly increasing and ever more penetrating use of economic theory, whereas the influence of economics on European competition law has remained rather modest. At present there are remarkable differences between American and European law with respect to the treatment of some hot issues in antitrust, such as predatory pricing and merger control. These differences may be attributed to at least two reasons. The main goal of European competition law (Articles 85-86 EC Treaty and Regulation 4064/89) has always been the promotion of market integration. A similar goal is absent in American antitrust law, since the latter rules came into being when a common market was already established. It was mainly political necessity, rather than economic theory, that made an active competition policy necessary in the eyes of the authors of the EC Treaty. The elimination of market compartmentalisation caused by restrictions on competition was necessary in order to achieve the central objective of integrating national markets. This aim of market integration is essential for an understanding of the principal characteristics of European competition law. The emphasis put on market integration has enabled European policymakers to avoid a profound debate about the values or objectives underpinning the competition rules of the EC Treaty. Consequently, the view of the Chicago School that productive and allocative efficiency are the only objectives which may be taken into account in interpreting and applying antitrust law could not get a firm basis in Europe. To a large extent, European competition law is at the same stage of development as American antitrust law was in the 1960s (see Van den Bergh, 1996). However, there are some first signs of a greater willingness by the European Commission to make use of economic theory (for example, with respect to the analysis of vertical restraints (see European Commission, 1997, pp. 19-31). It would, however, be wrong to label the latest developments in Europe as a victory for economic efficiency. Compared to American antitrust law European competition law still is less

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consistent with an efficiency based approach. Neither the European Commission nor the Court of Justice are sufficiently receptive to economic arguments, so that decisions and judgements are often formalistic and based on reiteration or expansion of early case law. 7.1 United States of America Although there may be disagreement as to the origins of the oldest competition legislation - the American Sherman Act of 1890 - it is clear that the Act was based not only on political objectives but also on the dominant economic theory at the end of the nineteenth century (see Sullivan, 1991). The economic objectives of the Sherman Act can be traced back to classical economics, which define competition as a process of rivalry taking place between large and small competitors in open and accessible markets. Consequently, the Sherman Act prohibits all ‘contracts, combinations and conspiracies’ which hinder trade, together with business conduct aimed at achieving a monopoly position by excluding competitors. In neoclassical economic theory the concept of ‘perfect competition’ was developed. Perfect competition is a situation in which the possibility of competitive behaviour in the Smithian sense is ruled out by definition. To some European authors the concept became a blueprint for competition policy (see, for example, Eucken, 1949), but the model was not used as a policy guideline in the USA. The same is true for the early theories of imperfect competition (Robinson, 1933, 1964) and monopolistic competition (Chamberlin, 1933), which did not have a clear influence on American antitrust policy either. The influence of economics on antitrust law increased dramatically, once the Harvard School had articulated the basic perceptions of industrial organisation theory in the well-known SCP paradigm and claimed to be able to explain the relationships among these three variables. This, together with the emergence of the new competitive ideal of workable competition had a clear influence upon competition policy. The concept of workable competition came about as a result of the publication, in 1940, of John M. Clark’s classic article. Clark denied that the ideal of perfect competition could serve as a blueprint for competition policy. Furthermore, Clark emphasised that, in the long run, market imperfections were not bound to be injurious per se. Not all market imperfections should be eliminated by competition policy, for market imperfections can neutralise each other (the antidote theory). Clearly, antitrust authorities will enjoy broad discretionary powers if competition policy must not eliminate all persistent market imperfections but should instead judge only to what extent an industry is workably competitive. Discretionary powers of antitrust authorities are further increased when antitrust law is also supposed to include non-economic objectives, as was the case with the Harvard School’s view in the 1950s-1960s. A complete and orthodox description of the Harvard

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views at that time is provided in Kaysen and Turner (1959). Kaysen and Turner distinguished no less than four objectives of competition policy: to achieve favourable economic results; to create and maintain competitive processes; to prescribe norms of ‘fair conduct’ and to restrict the growth of large firms. These objectives are partly inconsistent with each other and thus provide for large discretionary powers to be exercised by antitrust authorities. The Harvard analysis became the cornerstone of competition policy in the 1960s and remained so until the neoclassical and neoinstitutional approaches began to win the upper hand in the mid 1970s. Nowadays very few antitrust scholars in the United States believe that non-economic factors should pay any role whatsoever in antitrust analysis. In the light of the relationship between market structure, market conduct and market results, competition law became an instrument for generating optimal outcomes by directly influencing market structure (merger control). If prices increase as a result of market concentration, then mergers must be closely scrutinized. In the 1968 Merger Guidelines of the American Department of Justice it was stated that an analysis of market structure was fully adequate for showing that the effect of a merger, as spelled out in Section 7 of the Clayton Act, ‘may be substantially to lessen competition, or to tend to create a monopoly’ (US Department of Justice, 1968). The Department announced that its merger policy would focus on market structure ‘because the conduct of the individual firms in a market tends to be controlled by the structure of that market’. Following the Harvard views, only in exceptional circumstances would structural factors not alone be conclusive (for example in the case of conglomerate mergers). With respect to horizontal mergers, the 1968 Merger Guidelines used the CR 4 ratio as market concentration measure: when the shares of the four largest firms amounted to approximately 75 percent or more, the market was regarded as highly concentrated. The Department announced that mergers should be challenged when the market shares of both the acquiring firms and the acquired firms exceeded a certain threshold: for example, in highly concentrated markets mergers between firms both accounting for approximately 4 percent of the market would be challenged; in less highly concentrated markets a 5 percent market share for both the acquiring and the acquired firm was used as the relevant threshold (US Department of Justice, 1968). The Chicago School acquired a strong influence on American antitrust policy from the 1970s onwards and reached the apogee of its influence in the 1980s. A number of examples appropriately illustrate the altered judgement on forms of market conduct which, until the Chicago School emerged, seemed to cause competition problems but which, through the renewed application of price theory, no longer give rise to problems. The Harvard School was very critical of vertical restraints; the orthodox view proposed a strict ‘per se illegality’ for vertical price-fixing and tying (Kaysen and Turner, 1959, pp. 148-160). The Chicago revolution began when, in 1960, Telser published an

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article on vertical restraints which has since become a classic. In this essay the free-rider problem played a central role in explaining vertical price-fixing (see Telser, 1960, and Marvel and McCafferty, 1984, who added a quality certification argument). The free-rider rationale is not only used in the analysis of vertical price-fixing but has been extended by the Chicago School authors to other intra-brand restraints such as the reservation of exclusive sales territories and exclusive sales channels (selective distribution, franchising). The most far-reaching proposal of Chicago scholars was to introduce ‘per se legality’ for restricted distribution (Posner, 1981). Protection against free-riding may also explain interbrand restraints, such as exclusive dealing. Exclusive territories address the free-riding of one dealer on the efforts of another, whereas exclusive dealing addresses the free-riding of one manufacturer on the efforts of another (see Marvel, 1982). In deciding about the lawfulness of vertical restraints the American Supreme Court has been influenced by the Chicago analysis. The assessment of vertical restraints has wavered back and forth between the rule of reason and per se unlawfulness. In 1963 a majority of the Supreme Court held that vertical restraints did not necessarily violate the antitrust laws and were therefore subject to a rule of reason test (White Motor Co. v. United States). Four years later, the Supreme Court enunciated a clear-cut, but formalistic, distinction between restraints imposed by a manufacturer who retained ownership of the goods in question, and those imposed by a manufacturer after parting with ownership. If a manufacturer parts with ownership over his product or transfers risk of loss to another, he may not reserve control over its destiny or the conditions of its resale (United States v. Arnold, Schwinn & Co.). Then in 1977 the Supreme Court made clear that ‘departure from the rule-of-reason standard must be based upon demonstrable economic effect rather than … upon formalistic line drawing’. In so holding the Court drew also on the academic writings of the Chicago School. It would be premature, however, to consider the case-law of the American Supreme Court as a victory for the Chicago School analysis. The readiness of the American judiciary to apply the rule of reason does not extend to minimum vertical price-fixing. With respect to maximum resale prices the rule only recently shifted from a per se prohibition to the reasonableness standard (State Oil v. Kahn, Slip op. at 5). In the United States the Chicago learning has clearly influenced the analysis of predatory pricing. In the Matsushita case (in which American manufacturers of consumer electronic products accused Matsushita of combining with other Japanese manufacturers to monopolize the American market through predatory pricing), the Supreme Court quoted a number of publications by disciples of the Chicago view in support of its rejection of price-undercutting as a rational (that is, profit-maximising) economic strategy. The Supreme Court emphasised that a campaign of predatory pricing can be rational only if, after the elimination of the target, there remains sufficient monopoly power to raise prices and thus

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generate additional income. Given that in the Matsushita case it was improbable that the purpose of the predatory pricing could be achieved, the majority concluded that the price-undercutters ‘competed for business rather than to implement an economically senseless conspiracy’ (Matsushita Elec. Indus. Co. v. Zenith Radio Co.). In recent American case-law economic arguments are playing an ever more important role, but the Supreme Court seems no longer willing to blindly follow the Chicago approach. Antitrust defences based on Chicago ideas may be rejected using counter-arguments which are similarly economic in nature and largely based on criticisms towards the assumptions underlying the Chicago analysis. The Kodak case provides an interesting example (Eastman Kodak Co. v. Image Technical Services, Inc. et al.). Independent service organisations complained that Kodak had limited the availability of its proprietary spare parts, thus monopolising the market for the servicing of Kodak equipment. Kodak’s defence was primarily based on the argument that if there was competition in the primary market, then aftermarket power should have little adverse effect on consumers. The argument was similar to the Chicago School’s view that it is not possible for a dominant firm to achieve monopoly profits twice: the so-called leverage hypothesis was rejected already in the early days of the Chicago School (see Bowman, 1957). If a manufacturer raises the price of maintenance services, it can only do this - so Kodak argued - at the expense of lowering the initial purchase price of the equipment. The Supreme Court rejected this Chicago-inspired argument and demonstrated that consumers were not able to calculate lifetime cost with any accuracy, either because necessary information was not available to them or because of ‘bounded rationality’. Thus the Supreme Court made clear that the Chicago analysis of tying arrangements only holds under conditions of perfect information. Chicago theorists also exerted a clear influence upon American merger policy. The current 1992 Merger Guidelines are evidence that many concepts that started out as Chicago School concepts are now embraced by almost all of the US antitrust community. Throughout the Guidelines the analysis is focused on whether consumers or producers ‘likely would’ take certain actions, that is whether the action is in the actor’s economic interest. This reflects the concern to explain, rather than to merely describe, behaviour in (concentrated) markets, in order to be able to avoid inappropriate regulatory interventions. Intervention by the antitrust authorities is also geared to the goals of allocative efficiency: merger control should prevent that prices are raised above competitive levels for a significant period of time. Market power is defined accordingly. To create or enhance market power or facilitate its exercise, the merger must significantly increase concentration. The concentrated market must be properly defined and measured; the Guidelines pay considerable attention to the difficult problem of market definition. As a measure of market concentration the HHI index is used,

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instead of the CR4. If concentration increases significantly, the American antitrust agency will assess whether the merger raises concern about potential adverse competitive effects. It is stressed that market share and concentration data provide only the starting point for analyzing the competitive impact of a merger. Hasty conclusions from market structure of performance are thus overcome. A merger may diminish competition by enabling the firms selling in the relevant market more likely, more successfully or more completely to engage in coordinated interaction that harms consumers (tacit or express collusion). Mergers may also harm consumers if they create conditions conducive to reaching terms of coordination or conditions conducive to detecting and punishing deviations. If the merger raises significant competitive concerns, the antitrust agency will examine whether market entry may counteract the competitive effects of concern. At this point of the analysis the Chicago influence is obvious: Chicagoans stress that the possibility of market entry may prevent the post-merger firm from earning above-normal profits. Following this view, the Guidelines state that mergers in markets where entry is easy raise no antitrust concern. Entry is considered as ‘easy’ when it passes the tests of timeliness (entry must take place within a timely period), likelihood (entry must be profitable) and sufficiency (entry must be sufficient to return market prices to their pre-merger levels). The analysis of entry conditions will not yet complete the analysis. Efficiency gains of the merger will next be assessed. The Guidelines explicitly state that the primary benefit of mergers to the economy is their efficiency-enhancing potential, which can increase the competitiveness of firms and result in lower prices to consumers: ‘As a consequence, in the majority of cases, the Guidelines will allow firms to achieve available efficiencies through mergers’. Finally, it will be examined whether, but for the merger, either party to the transaction would be likely to fail, causing its assets to exit the market (failing company defense). The ultimate question whether the merger is likely to cause prices above competitive levels for a significant period of time will thus only be answered after an assessment of market concentration, potential adverse competitive effects, entry, efficiency and failure (US Department of Justice, 1992). 7.2 Europe Notwithstanding the fact that it is unlikely that the authors of the Treaty of Rome were aware of the concept of workable competition, many of the distinguishing features of European competition policy seem to fit into this theoretical framework. It is noteworthy that the European Court of Justice, in its leading Metro judgement, referred to the concept of workable competition as being the type of competition that was necessary to achieve the economic objectives of the EC Treaty (Metro v. SABA and Commission). The judgement was concerned with the lawfulness of selective distribution agreements. Once

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technical and luxury products are sold - for resale - only to recognised distributors, there can no longer be any question of a market which accords with the model of perfect competition. On the other hand, it is indeed possible to speak of workable competition. The European Court of Justice emphasised that price competition is not the only form of competition for wholesalers and retailers. It considered that it was in consumers’ interests for prices to be set at a certain level in order to be able to support a network of specialised dealers alongside a parallel system of dealers who themselves provide services and undertake other actions to keep distribution costs down. This choice is open to certain sectors in which high-quality, technically advanced and durable goods are produced and distributed. The manner in which the concept of workable competition acquired specific content can, by way of example, be further examined by studying present-day law in relation to selective distribution systems (for an overview, see Goyder, 1993). Provided the only criteria for selecting a distributor are objective, qualitative ones relating to his technical qualifications, his staff and his firm, and these criteria are determined uniformly for all distributors; and provided, furthermore, that they are applied in a non-discriminatory manner, the agreement is not regarded as restricting competition within the meaning of Article 85(1) EC Treaty. In order to establish the precise nature of such qualitative criteria for the selection of distributors, it is necessary to consider whether the characteristics of the product require a selective distribution system in order to maintain the quality and the proper use of the product. It is also necessary to examine to what extent these aims can already be accomplished by national regulations concerning access to the distributor’s profession or the conditions under which the products in question may be sold. Finally, one must answer the question of the extent to which the criteria thus determined are necessary in order to achieve the objective of improved quality. The European Commission has approved selective distribution systems for, for example, cars, television sets, watches and personal computers. It is evident that selective distribution agreements make resale to non-recognised dealers in other EC countries impossible, but the European Commission has nothing against this so long as exports within the selective distribution channels continue unhindered. By contrast, with the strict prohibition against absolute territorial protection in exclusive distribution agreements, increasing interbrand competition is balanced against the restraints inherent in intra-brand competition. Inter-brand competition guarantees consumers’ freedom of choice so long as access to the relevant market, or the competition within it, is not restricted to a significant extent by the cumulative effects of parallel networks or by similar agreements between competing producers or distributors. It is therefore necessary, when judging selective distribution systems, to take account of competition between competing systems of distribution. When selective distribution goes hand in hand with a quantitative restriction on

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recognised resellers the Commission will, as a rule, give full effect to the prohibition against cartels. The fact that the economic doctrine of the Chicago School has not influenced European competition law is clearly apparent from the decisions in AKZO and Tetra Pak II. The Court of Justice accepted a price-cost comparison as the yardstick by which to establish predatory pricing. Abuse of dominant position must be deemed to be present once prices fall below the level of average variable costs. According to the Court of Justice, a firm with a dominant position will always suffer losses if it charges such prices and it will have an interest in doing so only if it is aiming to exclude competitors in order to profit thereafter, by means of price increases, from the monopoly it has achieved. Furthermore, the Court of Justice considered that prices which are higher than average variable costs but lower than average total costs must be considered as unlawful to the extent that the fixing of prices at that level forms part of a strategy of excluding competitors. According to the Court of Justice, such prices can exclude from the market firms which, while just as efficient as the dominant firm, do not possess sufficient financial resources to enter such a price war. One can detect in this last argument the ‘deep pocket’ reasoning which has been discredited in the Chicago-oriented economic literature. In the event that the prices of the defendant firm are lower than average variable costs, there exists an irrefutable presumption of prohibited price-undercutting (predatory pricing). The European Court therefore adopts a stricter attitude towards price wars than the American judges do. Once prices are higher than average variable costs but lower than average total costs, supplementary evidence must be adduced in order to establish incontrovertibly the existence of a strategy aimed at the exclusion of competitors. From the Court’s further reasoning it seems that making threats, asking ‘unreasonably low prices’, maintaining artificially low prices over long periods and granting fidelity rebates can, together, provide the necessary supplementary evidence. In the AKZO case the Court relied heavily on the subjective evidence of intention on AKZO’s part (AKZO v. Commission). According to the Court, AKZO’s intention was clearly aimed at annihilating ECS (the target of the price war) because AKZO’s prices were not fixed in order to respond to competition from ECS but turned out in fact to be significantly lower. The weakest point both in the Commission’s reasoning and in that of the Court of Justice’s is that in neither of them was it adequately demonstrated that AKZO’s so-called predatory pricing could have succeeded. In the Chicago view an essential condition for considering predatory pricing as a rational competitive strategy is that the price-undercutter can recoup his losses after driving the target from the market. The longer the price-undercutting lasts, the larger the accumulated losses will be. Also, it will be very difficult or impossible to recoup the losses if potential new entrants to the market have to

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be borne in mind. Neither the Commission nor the Court of Justice gave sufficient consideration to these factors. In 1994, the European Court of First Instance had an opportunity to reconsider the position in Tetra Pak II, for the Commission’s finding that Tetra Pak had practised predatory pricing was specifically challenged by reference to the economic theory accepted in the most recent American case-law. Tetra Pak argued that, even if it had priced its products under cost, it could not have been indulging in predatory pricing because it had no reasonable hope of recouping its losses in the long term. The Court, however, upheld the Commission’s finding without any serious examination of this argument, holding that, where a producer charged AKZO-type loss-making prices, a breach of Article 86 EC Treaty was established ipso facto, without any need to consider specifically whether the company concerned had any reasonable prospect of recouping the losses which it had incurred (Tetra Pak International SA v. Commission). Finally, in the field of merger control the emphasis of the inquiry is on whether the concentration ‘creates or strengthens a dominant position’ (Reg. 4064/89). This clearly reflects the Harvard ideas that the structure of the market has an impact on the ultimate performance of the market. There is no explicit efficiency defence. Efficiencies are often seen as evidence of market power, rather than as benefits which may outweigh the anti-competitive consequences of mergers (see Neven, Nuttall and Seabright, 1993).

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Sleuwaegen, Leo and Van Cayseele, Patrick (1997), ‘Belgian Competition Policy, Some Facts and an Economic Analysis’, in Martin, S. (ed), Competition Policy in Europe, Amsterdam, North Holland, 185-204. Smets, Hilde and Van Cayseele, Patrick (1995), ‘Competing Merger Policies in a Common Agency Framework’, 15 International Review of Law and Economics, 425-441. Smith, Adam ([1776] 1937), An Enquiry into the Nature and Causes of the Wealth of Nations, New York, Modern Library Edition. Spence, A. Michael (1980), ‘Notes on Advertising, Economics of Scale, and Entry Barriers’, 95 Quarterly Journal of Economics, 493-507. Stigler, George J. (1942), ‘The Extent and Bases of Monopoly’, 32(2) American Economic Review, 1-22. Stigler, George J. (1968), The Organisation of Industry, Homewood, Ill., Irwin.. Stigler, George J. (1964), ‘A Theory of Oligopoly’, 72 Journal of Political Economy, 44-61. Stigler, George J. (1971), ‘The Theory of Economic Regulation’, 2 Bell Journal of Economics and Management Science, 3-21 Stigler, George J. (1976), ‘The Xistence of X-Efficiency’, 66 American Economic Review, 213-216. Sullivan, Thomas E. (1991), The Political Economy of the Sherman Act. The First One Hundred Years, New York and Oxford, Oxford University Press. Sullivan, Daniel (1985), ‘Testing Hypotheses about Firm Behaviour in the Cigarette Industry’, 93 Journal of Political Economy, 586-598. Sutton, John (1990), ‘Explaining Everything, Explaining Nothing? Game Theoretic Models in Industrial Economics’, 34 European Economic Review, 505-512. Sutton, John (1991), Sunk Costs and Market Structure, Cambridge, MA, MIT Press. Telser, Lester G. (1960), ‘Why Should Manufacturers Want Fair Trade?’, 3 Journal of Law and Economics, 86-103. Tirole, Jean (1988), The Theory of Industrial Organisation, Cambridge, MA, MIT Press. US Department of Justice (1968), Merger Guidelines, Trade Regulation Reports, CCH, 13, 101ff. US Department of Justice (1985), Vertical Restraints Guidelines, Washington. US Department of Justice (1992), Merger Guidelines, Washington. Utton, Michael A. (1995), Market Dominance and Antitrust Policy, Aldershot, Edward Elgar, 342 p. Van Cayseele, Patrick (1993), ‘Lemons, Peaches and Creampuffs, or the Economics of Second-hand Markets’, 38 Tijdschrift voor Economie en Management, 73-85. Van Cayseele, Patrick (1994), De Belgische Wet op de Mededinging in een Industrieel Economisch en Internationaal Juridisch Perspectief (The Belgian Law on Competition in a Industrial, Economic and International Legal Perspective), Antwerpen, Maklu, p. 152. Van Cayseele, Patrick (1996), ‘Industriële Economie, Toen en Nu (Industrial Economics, Then and Now)’, Maandschrift Economie, 5-24. Van Cayseele, Patrick (1998), ‘Market Structure and Innovation: A Survey of the Last Twenty Years’, De Economist, forthcoming. Van Cayseele, Patrick and Furth, Dave (1996a), ‘Bertrand-Edgeworth Duopoly with Buyouts or First Refusal Contracts’, 16 Games and Economic Behavior, 153-180. Van Cayseele, Patrick and Furth, Dave (1996b), ‘Von Stackelberg’s Equilibria for Bertrand-Edgeworth Duopoly with Buyouts’, 23 Journal of Economic Studies, 96-109.

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Van den Bergh, Roger (1996), ‘Modern Industrial Organisation versus Old-Fashioned European Competition Law’, 17 European Competition Law Review, 75-87. Van den Bergh, Roger (1997), Economische Analyse van het Mededingingsrecht. Een Terreinverkenning, 2nd edn, Arnhem, Gouda Quint. Verboven, Frank (1996), ‘International Price Discrimination in the European Car Market’, 27 Rand Journal of Economics, 240-268. Viscusi, W. Kip, Vernon, John M. and Harrington, Joseph E. (1995), Economics of Regulation and Antitrust, Cambridge, MA, MIT Press, 757 p. Weiss, Leonard W. (1963), ‘Average Concentration Ratios and Industry Performance’, 11 Journal of Industrial Economics, 237-254. Weiss, Leonard W. (1969), ‘Quantitative Studies of Industrial Organisation’, in Intriligator (ed), Frontiers of Quantitative Economics, Amsterdam, North-Holland. Weiss, Leonard W. (1989), Concentration and Price, Cambridge, MA, MIT Press. Williamson, Oliver (1975), Markets and Hierarchics: Analysis and Antitrust Implications, New York, The Free Press. Williamson, Oliver (1979),’ Assessing Vertical Market Restrictions: Antitrust Ramifications of the Transaction Cost Approach’, 127 University of Pennsylvania Law Review, 953-993. Williamson, Oliver (1985), The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting, New York, The Free Press. Williamson, Oliver (1986), Economic Organisation, Firms, Markets and Policy Control, New York, New York University Press. Worcester, Dean A. (1973), ‘New Estimates of the Welfare Loss to Monopoly in the United States 1956-1969', 40 Southern Economic Journal, 234-245. Young, H. Peyton and Foster, Dean (1991), ‘Cooperation in the Short and in the Long Run’, 3 Games and Economic Behavior, 145-156.

Cases US Eastman Kodak Co. v. Image Technical Services, Inc. et al., 112 S.Ct. 2072 (1992)) Matsushita Elec. Indus. Co. v. Zenith Radio Co.,475, pp. 597-598 (1968) State Oil v. Kahn, US 1997 WL 679424 (U.S. Nov. 4, 1997) United States v. Arnold, Schwinn & Co., 388 U.S. 365 (1967) White Motor Co. v. United States, 372 U.S. 253 (1963) EU AKZO v. Commission (1991), Case 62/86, ECR 3359 Metro v. SABA and Commission (1977) , Case 26/76, ECR 1875 Tetra Pak International SA v. Commission (1994), Case T-83/91, ECR II

5400 REGULATION OF NATURAL MONOPOLY Ben W.F. Depoorter Researcher Center for Advanced Studies in Law and Economics University of Ghent, Faculty of Law © Copyright 1999 Ben W.F. Depoorter

Abstract The concept of natural monopoly presents a challenging public policy dilemma. On the one hand a natural monopoly implies that efficiency in production would be better served if a single firm supplies the entire market. On the other hand, in the absence of any competition the monopoly holder will be tempted to exploit his natural monopoly power in order to maximize its profits. This chapter will take a closer look at the model of natural monopoly. It will address those areas where an unregulated natural monopoly is generally considered to be the cause of concern, before offering a brief overview of the regulatory process and some of its specific regulatory tools. It should be noted that this chapter mainly aims to provide an introduction to the vast literature on this topic, which has fascinated many economic and legal scholars over the years. JEL classification: K23, L90 Keywords: Cream Skimming, Price Regulation, Incentive Regulation, Contestable Markets, Public Ownership

1. The Natural Monopoly Model A natural monopoly exists in an industry where a single firm can produce output such as to supply the market at a lower per unit-cost than can two or more firms. The telephone industry, electricity and water supply are often cited as examples of natural monopolies. These industries face relatively high fixed cost structures. The costs necessary to produce even a small amount are high. In turn, once the initial investment has been made, the average costs decline with every unit produced. Competition in these industries is deemed socially undesirable because the existence of a large number of firms would result in needless duplication of capital equipment. The classic example might be that of two separate companies providing local water supplies, each constructing underground pipelines. 498

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In undergraduate textbooks one finds the natural monopoly condition linked to the issue of economies of scale. Traditionally, natural monopoly is often described as a situation where one firm may realize such economies of scale that it can produce the market’s desired output at an average cost which is lower than two firms could with smaller scale processes. The modern approach to defining natural monopoly was initiated by William J. Baumol (1977). In an industry where a single firm can produce output to supply the entire market at a lower per-unit cost than can two or more firms (subadditivity of the cost functions) or in an industry to which entrants are not ‘naturally’ attracted and are incapable of survival, even in the absence of predatory measures by the incumbent monopolist (sustainability of monopoly) the single firm is called a natural monopoly. The concept of subadditivity is a precise mathematical representation of the natural monopoly concept (Baumol, 1977) . If all potential active firms in the industry have access to the same technology, represented by a cost function c, then at an aggregate output x, the industry is a natural monopoly if c (x) < c (x1) + ... + for any set of outputs of x1, ..., xt such that

A cost function c is globally subadditive if for any non-negative output vectors x and y, c (x1 + y1, ..., xn + yn) < c (x1, ..., xn) + c (y1, ..., yn )

Given the production of a set N' 71, ..., n? of indivisible objects, the cost function is subadditive if c (S cT) < c (S) + c (T) for any disjoint subsets S and R (on the concept of subadditivity, see Baumol, 1977; Sharkey, 1982). There is a close relation between economies of scale and subadditivity. In a single-product firm economies of scale are a sufficient but not necessary condition for a natural monopoly. Production processes, although subadditive at output levels which exhibit economies of scale (decreasing average costs), may also be subadditive when exhibiting increasing average costs. In a multiproduct firm, for instance, economies of scope may create a natural monopoly although there are no economies of scale with regard to the production of the goods separately.

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Herein lies the difference between a strong and a weak natural monopoly (Gegax and Nowotny, 1993, p. 67). While strong natural monopolies exhibit decreasing average costs, the weak natural monopoly firm exhibits increasing average costs even though its costs are subadditive. The latter finds itself in a situation where it may not be able to prevent entry by other firms, for example when its monopoly position is non-sustainable. Since costs are subadditive, society might prefer a market consisting of only one firm rather than a multiplicity of firms producing the same output. Therefore, in the case of a weak natural monopoly it is often considered desirable that regulatory authorities bar entry into the market of the weak natural monopoly and in turn regulate prices. Graphically, a strong natural monopoly exists when the long-run average cost curve of a single firm is still declining at the point where it intersects the total market demand curve for the product. The D line on Figure 1 represents the demand curve, which is also the market-demand curve. A monopolist will supply the market with output at a price Po. The optimal scale of the firm is reached at point A in the figure. The market conditions, illustrated in Figure 1, allow for one firm to provide the entire market cheaper than could two or more firms. Suppose the market consists of four firms, each producing at an optimal level, where marginal revenue equals marginal costs. Thus, each firm produces a quantity of 1000. The total market demand curve determines price, which adds up to Px. At scale B, where the market is restructured into 4 firms, instead of one monopoly firm, each firm produces at a smaller scale. The total amount produced is unchanged but the average unit costs are higher at scale B. The market allows for one producer to generate total market demand at cheaper costs than can two or more equal producers. Figure 1

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A. Why Regulate Natural Monopoly? Many supposed natural monopolies are the subject of various types of regulation. As described above, under conditions of natural monopoly the market is best served when one firm supplies total market demand. Public interest theory claims to provide an explanation for government intervention in what may be considered a market imperfection. The need to avoid duplication of facilities, particularly fixed costs, would serve as a justification for traditional entry regulation. Consider in this respect the restructuring of the telecom industry in the United States that broke up the Bell system to AT&T, while forbidding Regional Bell Operating Systems to enter the lines of business assigned to AT&T in order to prevent destructive competition (Crandall, 1988). In Part A we will try to provide a brief insight into some other motives behind the regulation of natural monopolies. We refer to Chapter 5940 in this volume for a detailed review of the specifics of regulation of utilities and to Chapter 5000 for a general discussion of the various theories of regulation.

2. Allocative Inefficiency Under perfect competition prices of goods equal marginal cost, as firms engage in a competitive bidding process. Under conditions of monopoly, the profitmaximizing behavior of the incumbent firm will lead to a higher price charged to consumers and a lower output. It enables the seller to capture much of the value that would otherwise be attained by consumers. Monopoly pricing thus results in a wealth transfer from consumers of a product to the seller. At the higher price, at which the monopolist tries to maximize profits, a group of potential consumers will be excluded as they will not be able to afford the product at the higher (artificially set) price. Thus, monopoly leads to the classic case of the occurrence of dead weight losses: the part of the consumer surplus that the monopolist cannot appropriate but consumers lose. Now as a result of the monopoly pricing scheme, these consumers may be forced to consume more costly substitutes or less useful products, although society’s resources would be better used producing more of the good provided by the monopoly firm. Furthermore, the argument goes that by limiting output the monopolist underutilizes productive resources. The argument of the negative consequences of monopoly on economic welfare has been the subject of heavy debate. This article will not venture into the broad discussion of welfare economics, monopoly and distributive justice (for an introduction, see Tullock, 1967; Rahl, 1967; for case studies on the consequences of monopoly pricing and welfare, Albon, 1988). We can,

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however, focus on a few of the arguments concerning the case of natural monopoly which challenge the relevance of the alleged allocative inefficiency. The classic opposition to monopoly rents as opposed to everyday rent-seeking by the common man is that monopoly rents are the result of an artificial scarcity rather than a natural scarcity (Schap, 1985). The question arises whether the same really can be said about an unregulated natural monopolist. Early on, Posner (1969) rightly noted that market power in the latter case stems from cost and demand characteristics of the market, not from unfair or restrictive practices.

3. X-Inefficiency The condition of natural monopoly raises the question whether internal efficiency, cost minimization by the firm, is achieved under natural monopoly. Does a monopoly firm put its resources to the best possible use within the existing state of technology? Modern antitrust economists have used the term ‘X-Inefficiency’ to indicate the internal wastes that occur when a firm acquires monopoly power and is no longer pressured by strong competitors to keep its costs at the competitive minimum. Often-cited legendary examples are US Steel, General Motors, Sears, IBM and American Airlines. These giant firms, which once dominated their industries, are accused of falling victim to their own inefficiencies (Mueller, 1996). Empirical data suggest that the amount to be gained by increasing X-efficiency is significant (for a review, see Leibenstein, 1966). Generally, in a competitive market firms have an incentive to reduce costs, in order to obtain higher profits by selling at the same price or a price between the old price and the new cost level. Although cost reduction might be shortlived in a competitive situation, as competitors reduce their production costs and adjust their prices to those of their direct competitors, the concern for survival provides a firm in such a market with a strong incentive to minimize costs (Dewey, 1959). If a firm fails to anticipate or match the cost reductions of its competitors, it might suddenly find itself in a market dominated by its competitors. Where there are no significant entry barriers the threat of potential competition will hold price down to cost. Otherwise other firms will enter the market at the same scale of production, sell at a slightly lower price and capture the whole market for as long as it is profitable (for more on contestability, see Section 8). Also, it could be argued a monopoly firm has an even stronger incentive to minimize costs in order to gain maximized profits. Since the threat of a counter

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reaction to its pricing schemes is absent, it does not face the risk that the consequential benefits will only be short-lived.

4. Technological Progress Technological developments have been the drive behind the transformation of certain natural monopoly markets to more competitive outcomes. Most notably, this is the case for the more recent changes in the telecommunications industry, where the enhancement and development of microwave and satellite technology has come to provide a strong substitute for the traditional cable networks. The value of technical development should not be underestimated. Technological progress often reduces production costs or creates new products and has been of enormous importance to economic welfare. The classic argument goes that monopoly firms lack an efficient incentive to promote technical change and invest in expensive R&D programs. Allegedly, a monopoly firm would discourage progress. By virtue of its protected position it would not fear that a rival will promote products and production methods and would therefore not be driven to pioneering himself. Real-life observations regarding the introduction of new technology in monopoly firms seem to validate this criticism - witness the long life of equipment in telephone industries. This is often the case, regardless of whether the monopoly firm is conducted as a public or private monopoly (Dewey, 1959). Some empirical data suggests that small, profit-seeking firms are responsible for most major innovations (Scherer, 1984). However, there are strong arguments that provide indications that contradict the traditional allegations concerning the case of under-innovation under monopoly. Even when assuming that a monopoly firm will not introduce new products unless the cost of the new product is less than the marginal cost of the old (as sunk costs are bygones), there is no reason the same could not be said about competitive firms (Fellner, 1951). Furthermore, an important point has to be made. The fact that an industry is a monopoly does not mean than only one firm is pursuing research and development in its technology. Through the presence of external forces it is likely that the incumbent monopoly firm will feel the pressure to spend time and money on innovation, in order to safeguard its position (Posner, 1969). Certainly in an unregulated market, with free entry, successful research in the field of production methods could seriously threaten the position of natural monopoly firms. Although a natural monopolist is less concerned about survival, the possible threat of the introduction of new technology in substitute

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markets should provide monopoly firms with a strong incentive to anticipate such developments through R&D expenditure (this relates to the theory of contestable markets, see Section 8). At the other end of the spectrum Schumpeter (1950) holds that there is a positive relation between innovation and market power. A monopoly firm would be a strong instead of a poor innovator. Superior access to capital, the ability to pool risks and economies of scale in the maintenance of R&D laboratories are likely to advance industrial technology.

5. Cream-Skinning and Cross-Subsidization Because of social considerations, government may often feel the need to ensure the provision of certain products or services at a lower-than-cost price to some consumers. For instance, it is quite common that governments demand the provision of ‘universal services’ to consumers by telephone companies, the availability of minimum services at reasonable prices, even to small and distant communities where the small scale of operation may lead to very high costs, which often results in the occurrence of losses. The delivery of such services is often financed by obtaining higher profits on the sale of other products and services. This is termed cross-subsidization, referring to the practice where the difference between the price charged to the targeted consumers and the cost of supply might be funded by crosssubsidization from the prices paid by other consumers or, in a multiproduct firm by the purchases made for other products or services. When a firm, burdened with ‘universal service’ obligations of some sort, is not protected from price competition and free entry of competitors, it might not be able to maintain its position in the market as potential competitors will enter these market segments that are provided at prices well above cost. Creamskimming occurs when a supplier concentrates only on those areas of the market where the costs of supply are lowest, for instance because of geographical reasons (on cream-skimming in a natural monopoly market, see Zupan, 1990). Regulated firms on such a market, with universal services obligations, might find themselves in a possibly fatally detrimental situation, when competitors capture these low-cost/high-profit parts of the market which are crucial to recover losses made in the high cost market parts. Take the example of the US Postal Service. Without legislative protection, its uniform pricing scheme, according to which it charges the same price to deliver a letter anywhere in the United States regardless of distance and specific difficulties, would soon deprive it of its most profitable routes.

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Yet, the practice of cross-subsidization, when a company that supplies more than one product and uses the revenues from product A to recover a portion of the costs of product B, generates economic inefficiencies. Although benefits from economics of joint production might have to be sacrificed, in most cases the consumers of product A would be better off if the products were produced and priced separately, while the customers of good B are given incorrect price signals about the incremental costs of producing product B (Spulber, 1995). The cross-subsidization of loss-making services by taxing remunerative services has been demonstrated to lead to significant allocative inefficiencies (Brennan, 1991).

B. The Regulatory Process 6. Price Regulation Price control, although driven to the background in the years of deregulation, has been of increased importance in the recent trend of privatization in Europe. From a public interest perspective, price control should allow regulators to set prices at a level which induces allocative and productive efficiency. This part provides a brief, non-technical introduction to some of the tools governments have at their disposal to assure that firms meet consumer demand at efficient cost levels. For a more in-depth look at the different forms of price regulation and its analysis, reference is made to Chapter 5200, Price Regulation, which also deals with natural monopoly. Figure 2

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Marginal and Average Cost Pricing and Rate of Return Policy Without regulation, Qm in Figure 2 represents the profit-maximizing output of the monopolist and the demand, in turn, determines the market price Pm. The monopoly earns a positive economic profit represented by the area of the rectangle PmFGH. Welfare maximization to society as a whole is achieved at the quantity-price of P1 , Q1 . In other words, regulating authorities should set a price P1 (marginal cost pricing) in order to maximize economic welfare. However, at price P1 consumers will buy a quantity of Q1, whereas AC is NQ1, which is greater than the price P3. This will result in a total negative economic profit, shown by the area of the rectangle P1P2AM. In the long run, the monopoly firm will not stay in business. If the commodity or service provided is desirable, the only way to keep the monopoly firm in business is to provide a public subsidy to the amount of P1 P2 AM. The political problems associated with subsidization, its implementation and financing and the difficulties of calculating demand and MC have led to the application in the public utility field of average cost pricing. In Figure 2 such a price is P2, determined by the intersection of the demand and long-run AC curve. The output under average-cost pricing, Q2, is greater than the unregulated monopoly output of Qm. Also, part of the welfare costs arising from restricted output by an unregulated monopoly is eliminated. Expansion of output, from Qm to Q2 provides benefits to consumers that are greater than the additional costs. On the other hand, average cost pricing can hardly be deemed entirely satisfactory either. Under average cost pricing, when Q2 is produced, welfare losses are caused because at this point average costs (the AC curve) exceed marginal costs (MC). Graphically, the AMO triangle in Figure 2 represents this consequential welfare loss. When applying a rate-of-return policy, regulating agencies focus on the rate of return on invested capital (accounting profit) earned by a monopoly (fair rate of return) (Moorehouse, 1995). Allowing regulated firms to acquire a total sum that consist of annual expenditure plus a reasonable profit on capital investment, the so-called ‘fair’ rate of return, was constructed by American courts and the regulating bodies in order to meet constitutional demands of utilities to set prices on a ‘just and reasonable’ level. This can be formulated as E + ( r ·RB) where E represents the firms annual expenditure, r is the multiplier, representing the fair rate of return, and RB the rate (attributed value of the capital investment). If the realized rate of return is higher than what is considered to be a normal return, then the price must be above average cost. In a trial-and-error fashion regulators try to locate the price where profit is normal, for example, where price equals average cost.

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Allowing the regulated monopolist a fair rate of return creates various economic problems that have to be taken into account. Auditing costs involved in determining the firms capital base are considerable. Especially the determination of r, which should reflect a level of return that is satisfactory to attract investment, is problematic. Looking at other ‘comparable’ industries or applying the capital asset pricing model, where one looks at the returns obtained by investors from a portfolio of investments, as modified by the difference between the returns from shares in utilities and those from more general market shares, it is clear that these are imperfect methods for determining a rate of return that potential investors will demand from the regulated industry. Also, the perverse effects on incentives that occur when applying the standard rate of return policy are perhaps even more troublesome (Train, 1991). The regulated firm has an incentive to inflate its capital cost figures, since higher costs imply higher absolute returns (Baron and Taggart, 1977, on profitmaximizing behavior under rate of return regulation, see Hughes, 1990). If the regulator sets the fair rate of return above the cost of capital, the regulated firm is likely to utilize more capital than if it were unregulated. Thus, it might use inefficient high capital/labor ratios for its output. Also, average cost pricing diminishes the monopolist’s incentive to minimize costs. Figure 2 illustrates some of the consequences of this behavior. Inflation of costs shift the actual AC curve to AC'. At a price of P2 losses occur, therefore, regulators grant a price increase to cover the higher costs (point C). When implementing rate-of-return regulation the complexity accompanied with instituting and enforcing regulation schemes may often lead to delays in the regulatory response to changes in costs and other market conditions. When costs are fallingduring a certain period of time firms will benefit from these socalled regulatory lags, as they will be able to enjoy rates of return greater than those deemed ‘fair’ in the outcome of the regulatory proceedings. Several authors have argued in favor of regulatory lags:they would, at least temporarily, provide a way to allow regulated firms to profit from achieving lower costs (Baumol, 1967; Williamson, 1971; Bailey, 1973). However, if costs shift upwards, for instance due to factors external to the regulated firm, the opposite effect will occur and, the firm will incur costs that were not foreseen by the regulator. Also, because profit rates are restricted, the firm’s managers face the option of providing themselves with amenities in their salaries or the firm’s profits. Whether they do take advantage of this option in practice is largely dependent on whether they are externally controlled by reliable public officials, which in turn involves considerable monitoring costs.

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Price Discrimination Charging consumers different prices relative to what they are willing to pay, even though the costs of producing and supplying the goods or services are the same, has been demonstrated to enable allocative efficiency. With this technique, often referred to as Ramsey pricing, information on the priceelasticity of the different goods should allow for efficient price setting (the higher the price-elasticity, the closer the price needs to be set to marginal cost) (Ramsey, 1927). The objection often heard is that such a pricing scheme involves a wealth transfer from the consumer (consumer surplus) to the producer. Also, severe price discrimination, often termed predatory discrimination, is an effective method by which competition may be crushed out (see however for a detailed and comprehensive account McGee’s case study of the Oil of Indiana case, 1958). The classical analysis of price discrimination was set out by Pigou (1920). A distinction between three degrees of discrimination was made. The first degree involves a different price set for every unit purchased by every consumer, in such a way that virtually all the possible consumer surplus is obtained by the producer. Although this pricing mechanism can be efficient, as marginal decisions are made as marginal cost, it is often opposed on income distributional grounds: the transfer from consumer to producer. Second-degree price discrimination consists of pricing groups according to their willingness to pay, where all those with a demand price above a certain level are charged one price, while those with a lower demand price are charged a lower price. Third-degree price discrimination comes into effect when consumers are divided into separate groups, each group is charged a different monopoly price. This technique is of course strongly dependent on the possibility for the seller to identify groups in each specific case, which will vary according to market circumstances. In the telephone and electricity industries, for instance, the distinction is made between residential and commercial customers, who pay different prices (Hollas and Friedland, 1980; Primeaux and Nelson, 1980; Naughton, 1986; Eckel, 1987). Sometimes, sorting consumers by their willingness to pay can be achieved by requiring customers to tie (Cummings and Ruhter, 1979) or bundle (Adams and Yellen, 1976). In circumstances of uncertainty of demand, where prices must be established before demand is known, special distinctions, such as ‘saver-airfares’ requiring early bookings may be enforced on separate consumers (Leland and Meyer, 1976; Sherman and Visscher, 1982). Peak-Load Pricing When demand follows a periodic cycle, during which demand might be high at certain times and low at others, peak-load pricing might offer a way to achieve marginal cost pricing. As marginal cost generally rises with output,

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price variations will allow it to reflect the higher costs. This allows for the moderation of the demand cycle while establishing a more effective use of capacity (Crew, Fernando and Kleindorfer, 1995). Higher pricing during periods of peak demand might discourage use and save costly capacity, whilst lower prices when demand is low might encourage use of capacity that otherwise would have been left idle.

7. Incentive Regulation Many of the problems arising from the pricing models, such as the AverechJohnson model find their origin in the absence of incentives to operate at minimum cost levels. The motivation behind incentive regulation is to provide the firm with the motivation to behave more consistently with regard to the social optimum. Price-Cap Regulation or RPI-X Requiring the firm to increase its prices for each year within a given period by no more than the retail price index (RPI) minus a variable factor (X) which is the agency’s assessment of the firm’s cost-efficiency potential, price-cap regulation was found to be superior to the fair rate of return method both in terms of efficiency and administrative costs (Littlechild and Beesley, 1992). The system, as described above, would require less information from the firms to the regulating bodies, which would not only make this model less costly but also diminish the capture problems associated with rate of return regulation (for an overview, see Chapter 5200, Price Regulation).

C. Alternatives for Regulation The inefficiencies (Coase, 1959, Posner, 1969, 1975) and costs (Gerwig, 1962; Hahn and Hird, 1991) of the regulatory processes have been well documented over the years. Many scholars became dissatisfied with the public interest approach to regulation and looked for an alternative that would explain data that did not correspond with the normative approach to regulation. Capture theory, which holds that producers are the winners under most, began to shape (Jordan, 1972). A considerable body of literature, the economic theory of regulation, grew from this (Peltzman, 1976; Stigler, 1971, 1976; for an overview, see Viscusi, Vernon and Harrington, 1995).

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This in turn, has given rise to new, appealing theories where the approach is to have optimality induced without regulation, even in markets with one producer. Competition amongst numerous firms can be used to achieve optimality under natural monopoly conditions, where competition is held amongst firms that could produce. The argument goes that the pressure from potential producers will induce efficient pricing decisions by the natural monopolist.

8. Contestable Markets Building upon Demsetz’s ideas (1968) on the threat of potential competition as a disciplinary mechanism, the theory of contestable markets was further developed by Willig (1980) and Baumol, Panzar and Willig (1982) and applied to natural monopoly (Coursey, Issac and Smith, 1984). In a market where entry and exit are completely free and unconstrained, the threat of potential competition may hold price down to cost. When potential entrants exercise strong constraints on the behavior of the incumbent monopoly firm, the latter will be moved to pricing schemes closer to cost. Firms in a contestable market will not be able to gain pricing profits that exceed normal profits under competitive circumstances, as otherwise other firms will enter the market at the same scale of production, sell at a slightly lower price and capture the whole market for as long as it may be profitable, a practice often referred to as hitand-run entry and exit (Baumol, 1982). When entry is allowed, new firms will be able to enter the market of a Ramsey-pricing natural monopolist at a lower price (Faulhaber, 1975; Sharkey, 1982). Thus, when the nature of the market allows for only one firm to provide total demand, competition can assert itself by deciding which firm will obtain market domination. Contestability of a market would render regulation pure waste, as without regulation the monopoly would yield price efficiency. Instead, given this theory, when determining the proper form of regulation, governments should restrain from measures that obstruct potential entry and create an environment that promotes contestability. In other words, regulators should encourage rather than prevent entry into the natural monopoly market. However, in order for a market to be qualified as contestable various conditions, most notably the absence of any significant entry barriers, are demanded. Perfectly contestable markets are based on free entry - the firm does not have to incur any cost that is not also incurred by the incumbent natural monopolist - by entrepreneurs who do not face any disadvantages in relation to the incumbent monopolist. It assumes the possibility for the firms to freely exit, that is, potential recoupal of all costs incurred upon entering - minus

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depreciation. Also, the potential entrants must have access to equally efficient production technology as employed by the incumbent firm. Finally, the incumbent firm must not be able to adjust prices instantaneously when faced with the threat of entry. As a theoretical construction the theory of contestable market certainly has its merits. Indeed, a natural monopoly firm may not be immune to profitseeking hit and run entry (Faulhaber, 1975; Baumol, Bailey and Willig, 1977; Baumol, Panzar and Willig, 1982; Sharkey, 1982). However, it remains uncertain whether perfectly contestable markets do actually exist. The assumption which holds that an entrant can leave a market without costs when its presence is no longer profitable is rarely encountered in real-life economics (Waterson, 1988). Also, sunk costs, the difference between the ex ante opportunity cost of the funds and the value that could be recovered ex ante, have early on been demonstrated to deter entry (Eaton and Lipsey, 1978; Spence, 1977, 1980; Dixit, 1980). Cost curves reflecting large sunk fixed costs, already borne by the incumbent firm, place potential entrants in a disadvantaged situation. (Bailey and Panzar, 1981).

9. Entry Regulation and Auction Until 1968, the inevitability of regulation of natural monopoly was broadly accepted. It was Demsetz (1968) who argued that formal regulation, as described above, is uncalled-for where government can allow ‘rivalrous competitors’ to bid for the exclusive right to supply a good or service over the given ‘franchise period’. Monopoly pricing is prevented, as competition has asserted itself at the bidding stage. In other words, competition at the franchise stage will be sufficient to reduce the price below that of the monopoly profit maximizer. Therefore, a monopoly structure does not necessarily lead to monopoly behavior. Along the same lines we may situate Chadwick’s (see Crain and Eklund, 1976) historical reasoning in his investigation of water supply in London in the 1850s, where he advocates competition for the market rather than the costly and that time prevalent competition within the market. Successful and competitive bidding, in terms of prices and services offered, could initially eliminate the need for a principal-agent relationship (Chadwick, 1859). In certain cases, government might find it appropriate, most notably in the case of a natural monopoly, to limit the number of firms operating in a certain market. Bidding refers to a free and open right to supply the market, where the regulator announces that it will accept bids from all firms that are willing to provide the goods. Each bid could consist of the price that the firm would agree to charge consumers when awarded the franchise. In such a bidding process,

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price will eventually be bid down to a price at which the winning firm earns zero-profits. This will be the result of a repeated process where firms given the choice between zero profits from not winning the auction, and earning a small but positive profit by bidding below the lowest bid, will choose the latter. Even in the case where the bidding would be held at once, each firm would realize it could only win if it bids at a price that provides zero economic profit with least-cost production. (Coursey, Isaac and Smith, 1984; for a survey on the bidding process in the electricity industry, see Rozek, 1989; in cable television franchise allocation, see Zupan, 1989). This form of bidding, often referred to as Chadwick bidding, should be distinguished from auctions where the state is acting as a monopolist attempting to attain high prices, for instance when auctioning oil exploitation rights, instead of acting as a consumer agent (Posner, 1972; Waterson, 1988). At this point, reference should be made to recent proposals to have the auctions centered around an incentive contract, where the winner is consequentially bound to a desirable incentive arrangement (McAffee and McMillan, 1987; also Riordan and Sappington, 1987). However, the effective pursuit of economic welfare through the competitive awarding of monopoly franchises has its difficulties. Auction theory suggest that the quality of the winning bid only increases as the number of bidders increases (for a different view, see Bishop and Bishop, 1996). As has been demonstrated early on (see Williamson, 1976) in the cable television industry, the winner of a monopoly franchising procedure does not always fulfill the service contract as promised. Here, monitoring costs and the principle-agent problems should be taken into account. Government contracts are often won by bidding in terms that cannot be met (Sherman, 1989), the main reason being that the services are complicated and all eventualities cannot be anticipated fully when contracts are drawn up (see also the debate on the winner’s curse, Thaler, 1992). Also, once a firm has obtained the franchise for a certain period of time with exclusive information on costs, production processes and control over resources, future franchise biddings will be among unequals. Furthermore, it should be noted that costs and demand change over time in such a way that the price fixed in the franchise contract might not be optimal at a later point of time (Williamson, 1976). Contingency clauses, anticipating future events might offer a remedy, but are merely second best solutions, as they are bound to bring about considerable imperfections. Contractual stipulations, which specify the price movement in the event of price changes, demand information from a government which it simply does not have. Another type of contingency clause, the implementation of procedures by which to revise prices periodically, faces the same problem of asymmetry of information, as it provides the regulated firm with incentives to report smaller than real cost changes, for instance from

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technological progress (Train, 1991, p. 301). Reference can be made to the suggestion (Posner, 1992) to have repeated auctions held with short-term contracts for the winning firm. These short-time contracts will allow a better reflection of changes in cost and demand. However, it should be reminded that these auctions will only result in efficient price offerings if the incumbent firm has no other advantages with respect to the other firms involved in the franchise bid. Loeb and Magat (1979) propose an institutional arrangement consisting of a mixing of regulation and franchising, while supposedly eliminating the problems associated with both. As an alternative to rate-of-return regulation, they set forth a decentralized system of regulation in which the utility chooses its own price and where the regulatory agency subsidizes the utility on a per unit basis equal to the consumer surplus at the selected price. The classic opposition to subsidies, that revenues to provide a subsidy have to be collected elsewhere and that any subsidy policy as such brings along allocative inefficiencies, are countered by the introduction of a sale of the franchise which should reduce the net subsidy or, alternatively, the imposition on the utility of a lump-sum tax by the regulatory agency in order to recover part of the subsidy. Sharkey (1979), commenting on the Loeb-Magat (L-M) scheme, argues that such a policy might hold if conditions exist that the net subsidy paid to the utility is sufficiently small. Aside from imperfections of the regulatory bodies and the costs resulting from political manipulation, the L-M scheme is less convincing where one attaches more importance to the quality of service as opposed to the price. Nevertheless, as an alternative to rate of return regulation the L-M model has the advantage that the regulatory body does not need to obtain or verify information about the cost function of the utility and as such it has considerable merit (Sharkey, 1979). Moreover, experimental research on the behavioral robustness of the contestable market hypothesis has shown it to be promising (Coursey, et al., 1984; Harrison and McKee, 1985) especially in environments where the Bertrand-Nash assumption is satisfied (Harrison, 1987).

10. Public Ownership Another possible alternative to regulation is government ownership of enterprises that provide services under conditions of natural monopoly. Although one could argue that regulation occurs in its most severe and complete form under public ownership, its unique characteristics distinguish it from the broad range of traditional regulatory processes (Ogus, 1994). Instead of having a privately owned monopoly with profit-seeking shareholders one could institute a publicly owned enterprise with less concern about profits. This

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lack of profit-maximizing incentives in a public enterprise is sometimes thought to be beneficial, as it allows publicly responsible attention to nonfinancial goals and/or distributional goals (on the various possible reasons for state ownership, Ahoroni, 1986). The institutional framework of public ownership would provide a way to impose public interest prices and standards. This would allow the equation of prices to marginal cost, to have monopoly profits avoided, and so on. Half a century ago, government ownership of firms was thought of as the key solution to market imperfections, such as monopoly. Due to the failures of competition, the regulation during the Great Depression, the apparent success of Soviet industrialization and a misunderstanding of the consequences of political control over firms, the state took control of significant parts of production in the economy of many countries. In the last 29 years, a renewed faith in the market process induced governments in market economies throughout the world to privatize most of their sectors, including strategic ones such as steel, energy and telecommunications. The absence of a profit incentive under the institutional framework of public ownership had proven to be a high price to pay. In a public enterprise which lacks a group of residual profit-claiming shareholders, who emphasize fiscal goals and enforce efficient performance through management, economic efficiency is no longer guaranteed (Spann, 1977; Williamson, 1987; for a survey of economic performance under public ownership in the British fuel and power industry see Shepard, 1965). When assets are publicly owned, the public manager has relatively weak incentives to reduce costs or to improve quality or innovate, because he only gets a fraction of the return as a non-owner (Hart, Shleifer and Vishny, 1997; more on public managers, De Alessi, 1974, 1980). In private corporations, the shareholders’ ability to sell their vote or to vote out management creates incentives for management to serve the interests of the owner. The diffuse, non-transferable shareholding that characterizes government ownership reduces these incentives. Those in control of the enterprise pay less attention to the taxpaying shareholders and are more likely to succumb to more concentrated interest groups, such as suppliers, consumers, employees, and so on (Zeckhauser and Horer, 1989). The statutory monopoly will become the primary source of information about industry possibilities. The monopoly will not suffer as a competitive firm would when it is wrong, because regulators either cannot appreciate its errors completely or will forgive them. Regulatory agencies, distanced from the industry, might have a hard time to reflect the complexity of the industry. As regulators cannot evaluate all decisions, inefficient technologies may be chosen for years (Sherman, 1989).

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Also, the question remains what goals replace the profit incentive? Imposition of vague goals often results in diminished accountability which imposes the risk of inefficient results. Moreover, it should be noted that the absence of a profit incentive does not guarantee the absence of monopoly prices; these remain a possibility, for instance to make the life of managers easier, and so on. A public enterprise is often constrained by its budget. As it is required only to have a certain difference between total revenue and total costs, it may, especially when no stronger restrictions have been set out, seek to maximize its total expenditures or its revenue. In order to do this it may well follow a monopoly pricing rule. The US Postal Service can serve as an example of a public enterprise (since its 1970 charter) exhibiting such behavior, empirical evidence shows it has behaved as a cost or revenue maximizer for many years (Sherman, 1989, pp. 265-268). A publicly-owned firm with limited restrictions such as budget constraint has considerable managerial discretion, which often leads to the pursuit of various goals such as budget maximization (Niskanen, 1971; Crew and Kleindorfer, 1979), revenue maximization (Baumol, 1976) and the maximization of total output. The importance of innovation in market economies should not be disregarded. Voices as early as Marshall (1907), have argued that government is generally a poor innovator. The development and adoption of new technologies in telecommunications, that occurred shortly after the privatization of phone companies in the US, may serve as an example of the benefits of private ownership (Winston, 1998). In industries where innovation is crucial, the case for government provision is strained (Shleifer, 1998). Technology changes often have enormous impact on cost structures and may cause a natural monopoly market to move to a more competitive setting.

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the Electricity Sector Regulation)’, 3-4 Ekonomist, 197-204. Armstrong, Christopher and Nellis, Henry Vivian (1986),Monopoly’s Moment: The Organization and Regulation, Toronto, University of Toronto Press, 393 p. Atkinson, Scott E. and Halvorsen, Robert (1990), ‘Tests of Allocative Efficiency in Regulated Multi-product Firms’, 12(1) Resources and Energy, 65-77. Atkinson, Scott E. and Kerkvliet, Joe (1989), ‘Dual Measures of Monopoly and Monopsony Power: An Application to Regulated Electric Utilities’, 71 Review of Economics and Statistics, 250-257. Babilot, George, Frantz, Roger and Green, Louis (1987), ‘Natural Monopolies and Rent: A Georgist Remedy for X Inefficiency among Publicly Regulated Firms’, 46 American Journal of Economics and Sociology, 205-217. Baca, Alvin (1987), ‘FERC $50 ERA: Issues in Natural Gas Regulation’, 27 Natural Resources Journal, 815-822. Bailey, Elisabeth E. (1973),Economic Theory of Regulatory Constraint, Lexington, MA, D.C. Health. Bailey, Elisabeth E. and Panzar John C. (1981), ‘The Contestabilty of Airline Markets, during the Transition to Deregulation’, 44 Law and Contemporary Problems, 125 ff. Baish, Richard O. (1987), ‘The Role of the California Public Utilities Commission in Western Gas’, 27 Natural Resources Journal, 805-810. Baldwin, John R. (1989), Regulatory Failure and Renewal: The Evolution of the Natural Monopoly Contract , Ottawa, Supply and Services Canada, 122 p. Barnes, David W. and Stout, Lynn A. (1992), Economic Foundations of Regulation and Antitrust Law, St Paul, MN, West Publishing. Baron, David P. and Besanko, David A. (1984a), ‘Regulation and Information in a Continuing Relationship’, 1(3) Information Economics and Policy, 267-302. Baron, David P. and Besanko, David A. (1984b), ‘Regulation, Asymmetric Information, and Auditing’, 15 Rand Journal of Economics, 447-470. Baumol, William J. (1967), ‘Reasonable Rules for Rate Regulation: Plausible Policies for an Imperfect World’, in Phillips A. and Williamsen O.E. (eds), Prices: Issues in Theory, Practice, and Public Policy, Philadelphia, University of Pennysylvania Press. Baumol, William J. (1976), Business Behaviour, Value and Growth, NY, Harcourt, Brace and World. Baumol, William J. (1977), ‘On the Proper Cost Tests for Natural Monopoly in a Multiproduct Industry’, 809 American Economic Review. Baumol, William J. (1982),’Contestable Markets: An Uprising in the Theory of Industry Structure’, 72 American Economic Review, 1982, 1-15. Baumol, W.J., Bailey, Elisabeth E. and Willig, R.D. (1977), ‘Weak Invisable Hand Theorems on Pricing and Entry in a Multiproduct Natural Monopoly’, 67 American Economic Review, 350365. Baumol, William J., Panzar, J. and Willig Robert (1982), Contestable Markets and the Theory of Industry Structure, New York, Harcourt Brace. Beesley, Michael E. (1997), Privatization, Regulation and Deregulation, London, New York, Routledge. Beesley, Michael E. and Littlechild, Stephen C. (1989), ‘The Regulation of Privatized Monopolies in the United Kingdom’, 20 Rand Journal of Economics, 454-472.

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Berg, Sanford V. and Tschirhart, John (1988), Natural Monopoly Regulation: Principles and Practice, Cambridge, Cambridge University Press, 564 p. Bernard, Jean Thomas and Cairns, Robert D. (1987), ‘On Public Utility Pricing and Forgone Economic Benefits’, 20 Canadian Journal of Economics, 152-163. Berry, S. Keith (1987a), ‘The Ratepayer and the Stockholder under Alternative Regulatory Policies: Comment’, 63 Land Economics, 201-205. Berry, S. Keith (1987b), ‘Rate of Return Regulation and Demand Uncertainty with a Symmetric Regulatory Constraint’, 31(2) American Economist, 8-12. Berry, S. Keith (1988), ‘The Allocation of Risk between Stockholders and Ratepayers in Regulated Utilities’, 64 Land Economics, 114-124. Besen, Stanley M. (1974), ‘The Economics of the Cable Television “Consensus”’, 17 Journal of Law and Economics, 39-51. Bishop, B. and Bishop, S. (1996), ‘When Two is Enough: Competition in Bidding Markets’, 1 European Competition Law Review, 3-6. Blackstone, Erwin A. and Fuhr, Joseph P., Jr (1989), ‘The Economics of Public Utility Regulation: Review Article’, 17(2) Atlantic Economic Journal, 68-73. Bold, Frederick C. (1987), ‘Responses to Energy Efficiency Regulations’, 8 Energy Journal, 111-123. Bowman, Ward S. (1966), ‘The New Haven, A Passenger Railroad for Nonriders’, 9 Journal of Law and Economics, 49-59. Boyes, William J. and McDowell, John M. (1989), ‘The Selection of Public Utility Commissioners: A Reexamination of the Importance of Institutional Setting’, 61 Public Choice, 1-13. Bradley, J.F. (1981), ‘Antitrust Policy under Regulation: Airline Mergers and the Theory of Contestable Markets’, 61 Boston University Law Review, 823 ff. Bradley, Ian and Price, Catherine Waddams (1991), ‘Partial and Mixed Regulations of Newly Privatized U.K. Monopolies’, in Weigel, Wolfgang (ed), Economic Analysis of Law - A Collection of Applications, Vienna, Österreichischer Wirtschaftsverlag, 212-220. Braeutigam, Ronald R. (1990), ‘Regulatory Reform: Lessons for Natural Gas Pipelines’, 8 Contemporary Policy Issues, 122-141. Braeutigam, Ronald R. and Hubbard, R. Glenn (1986), ‘Natural Gas: The Regulatory Transition’, in Weiss, Leonard W. and Klass, Michael W. (ed), Regulatory Reform: What Actually Happened, Boston, Little Brown, 137-168. Braeutigam, Ronald R. and Panzar, John C. (1989), ‘Diversification Incentives Under “Price-Based” and “Cost-Based” Regulation’, 20 Rand Journal of Economics, 373-391. Brennan, Timothy J. (1991), ‘Cross-Subsidization and Cost Misallocation by Regulated Monopolists’, 2 Journal of Regulatory Economics, 37-51. Broadman, Harry G. (1986), ‘Natural Gas Deregulation: The Need for Further Reform’, 5 Journal of Policy Analysis and Management, 496-516. Broadman, Harry G. and Kalt, Joseph P. (1989), ‘How Natural is Monopoly? The Case of Bypass in Natural Gas Distribution Markets’, 6 Yale Journal on Regulation, 181-208. Brown, Donald J. and Heal, Geoffrey M. (1987), ‘Ramsey Pricing in Telecommunications Markets with Free Entry’, in Crew, Michael A. (ed), Regulating Utilities in an Era of Deregulation, New York, St. Martin’s Press, 77-83. Brown, Lorenzo (1988), ‘Modelling Diversified Utilities and Cross Subsidization’, 10 Resources and

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5500 LABOR LAW AND EMPLOYMENT REGULATION: GENERAL © Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest

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Kruse, Douglas L. (1990), ‘The Economic Implications of Employment Rights and Practices in the United States’, 14 Journal of Comparative Economics, 221-253. Kübler, Friedrich, Mendelson, Morris and Mundheim, Robert H. (1990), ‘Die Kosten des Bezugsrechts - Eine rechtsökonomische Analyse des Amerikanischen Erfahrungsmaterials (The Costs of the Subscription Right - A Legal Economic Analysis of the American Experience)’, Die Aktiengesellschaft, 461-475. Kuhn, Peter J. (1990), ‘Reply’, 80 American Economic Review, 290-297. Lande, Robert H. and Zerbe, Richard O., Jr (1985), ‘Reducing Unions’ Monopoly Power: Costs and Benefits’, 28 Journal of Law and Economics, 297-310. Reprinted in 29 Corporate Practice Commentator, 1987, 107-122. Lande, Robert H. and Zerbe, Richard O., Jr (1990), ‘More Lessons From Japan: End Industrywide Collective Bargaining ?’, 28 Asian Economic Journal. Landes, William M. (1968), ‘The Economics of Fair Employment Laws’, 76 Journal of Political Economy, 507-559. Lemley, Mark A. and Durie, Daralyn J. (1992), ‘The Antitrust Liability of Labor Unions for Anticompetitive Litigation’, 80 California Law Review, 757 ff. Linder, Mark (1987), ‘Employees Not-so-Independent Contractors and the Case of Migrant Farmworkers: a Challenge to the ‘Law and Economics’ Agency Doctrine’, 15 New York University Review of Law and Social Change, 435-475. Mendeloff, John M. (1986), ‘Regulatory Reform and OSHA Policy’, 5 Journal of Policy Analysis and Management, 440-468. Meyer, Dirk (1989), ‘Rent Seeking durch Rationalisierungsschutz oder die Wohlfahrtsverluste einer Kostensenkungssteuer (Rent Seeking through Regulations Protecting Human Capital from Devaluation Due to Technological Innovation)’, 35 Konjunkturpolitik, 188-1200. Miller, James C., III and Yandle, Bruce (eds) (1979), Benefit-Cost Analysis of Social Regulation, Washington, American Enterprise Institute for Public Policy Research. Miyazaki, Hajime (1977), ‘The Rat Race and Internal Labor Markets’, 8 Bell Journal of Economics, 394-418. Moore, William J., Newman, Robert J. and Thomas, R. William (1974), ‘Determinants of the Passage of Right-To-Work Laws: An Alternative Interpretation’, 17 Journal of Law and Economics, 197-211. Myhrman, Johan (1981), ‘Kontraktsrätt och löntagarfonder (Contractual Rights and Labour Funds)’, 6 Ekonomisk Debatt. Nagel, Bernhard (1979), ‘Die Verlagerung der Probleme um die Unternehmensmitbestimmung auf das Informationsproblem (Transferring the Problems of Worker Participation to the Information Problem)’, BB, 1799-1804. Nagel, Bernhard (1982a), ‘Der Schutz von Arbeitsplätzen im Kartell- und Wettbewerbsrecht (Protection of Jobs in Anti-Trust and Competition Law)’, in Kittner (ed.), Arbeitsmarkt Ökonomische, Soziale und Rechtliche Grundlagen, Heidelberg, Müller Juristischer Verlag. Nagel, Bernhard (1982b), ‘Fusionskontrolle und Schutz von Arbeitsplätzen (Merger Control and Job Protection)’, Arbeit und Recht, 207-215. Nagel, Bernhard (1992), ‘Von der Lex Mercatoria zur Lex Laboris, zur Rechtlichen Bewältigung der Internationalen Arbeitsbeziehungen (Lex Mercatoria and Lex Laboris. On the Legal Analysis of International Work Relations)’, in Däubler, Wolfgang, Bobke, Manfred and Kehrmann, Karl (ed.), Festschrift für Albert Gnade, Köln, Bund-Verlag.

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5510 LABOR CONTRACTS Ann-Sophie Vandenberghe Netherlands School for Social and Economic Policy Research Utrecht University © Copyright 1999 Ann-Sophie Vandenberghe

Abstract This chapter contains an overview of the literature on labor contracts. Four important aspects of the employment relationship will be discussed: matching of employer and employee, acquisition and retention of firmspecific human capital, earnings stability as insurance and the effort intensity of employees. These four important areas of the employment relationship are encountered by imperfections, mainly information problems and opportunistic behavior. Some labor market institutions, such as the design of a certain wage policy, can be explained as devices to overcome these imperfections. The employment contract can be viewed as a combination of explicit and implicit agreements. An explicit contract is legally enforceable. An implicit contract is an informal understanding which is too vague to be legally enforceable. In order to be of any value, the implicit contract must be selfenforcing. JEL classification: J41, K31 Keywords: Adverse Selection, Asymmetric Information, Efficiency Wage, Effort, Firm Specific Human Capital, Implicit Contracts, Opportunistic Behavior, Signaling

1. Introduction Job matching constitutes the process whereby heterogeneous workers are matched to heterogeneous jobs. This matching process consists of two steps: discovering appropriate individuals and providing the workers with specific skills (see Elliott, 1991, p. 292). The first step is to discover appropriate individuals and will be discussed in Section 2. The employer wants to find the ‘right’ kind of employee and the employee wants to find the ‘right’ kind of job. Information asymmetry and opportunistic behavior of one or both parties at the precontractual stage might result in a suboptimal match and in adverse selection. Some devices help parties to overcome those inefficiencies. In Section 3, the second step of the matching process or the investments in specific human capital by both employer and employee are considered. 541

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These investments are specific to the unique match between a firm and the worker and will be lost if the match is broken (see Becker, 1975; Parsons, 1986, p. 819). Therefore, compensation schemes might be adopted to prevent the employee from quitting soon after investments are made. Parties might also behave opportunistically as regards the division of the surplus resulting from investments in firm-specific training. Parties who anticipate the opportunistic behavior might refrain from investing in specific capital; this is the hold up problem. One role of the employment contract is to overcome the hold up problem by introducing wage rigidity. Another role of the employment contract, as will be shown in Section 4, is to enable firms to share the risks for uncertain income streams. This is at the heart of the implicit contract theory which also provides arguments for wage rigidity. In Section 5 an overview is given of the employment arrangements, mainly compensation plans, used to induce an employee to provide the optimal level of effort. Finally, some characteristics of the form of the employment contract will be explained; the employment contract is in general a long-term, incomplete and self-enforcing implicit contract.

2. Matching of Employer and Employee For markets to successfully promote mutually beneficial transactions, both buyers and sellers must have access to accurate information about the quality and price of the goods (Ehrenberg and Smith, 1997, p. 378). Translated to the labor market the employer wants to have information about the productivity level of the potential employee and his attachment to the job; the employee wants to have information about the pecuniary and non pecuniary job characteristics. Schäfer and Ott (1993) and De Geest (1994, pp. 167-189) summarize the law and economics literature on information production in the precontractual stage in general. De Geest, et al. (1999) apply the insights of the general analysis of information production to labor contract negotiations. In many cases the information is ‘asymmetric’ - that is, when one party knows more than the other about its intentions or performance under the contract. When information is asymmetric, opportunities for malpractice are enhanced. Applicants have incentives to overstate their productive capacities and employers have incentives to represent jobs as less demanding than they may actually be. As a result, mutually beneficial transactions may be ‘blocked’ and disallocation of the resource labour may be the result.

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It is interesting to look at some labor market institutions that remove the information asymmetry or reduce the inefficient consequences of it, on the employer’s side as well as on the employee’s side. Employer’s Side It is profitable for an employer to distinguish between high-productivity workers and low-productivity workers. How can the employer find out about a potential employee’s productivity? A mechanism by which employers and employees deal with the problem of asymmetric information is ‘signaling’. The concept of job market signaling was first developed by Spence (1973). He uses the term signals for those observable characteristics attached to the individual that are subject to manipulation by him. The costs of making the adjustments by manipulation are signaling costs. A signal is strong when the signaling costs are negatively correlated with the individual’s unknown productivity so that high-productivity persons are more likely to give the signal than low-productivity persons. Education might be a strong signal in labor markets. Prior to hiring, the employer not only wants to know the potential productivity but also whether the employee is likely to stay for a long term with the employer, especially when firm-specific investments will be made. Salop and Salop (1976) offer a sorting model of quit behavior. The rationale is that offered pay plans may induce signaling. Employees who choose to work under compensation plans with deterred payments, signal that they intend to stay for a longer time with the employer. ‘The essence of signaling ... is the voluntary revelation of truth about oneself in one’s behavior, not just one’s statements’ (Ehrenberg and Smith, 1997, p. 379). In many cases complete information revelation about the potential employee’s productivity is not possible at a reasonable cost; the information will remain partly asymmetric which may have inefficient consequences. An important consequence of the asymmetry of information at the precontractual stage is known as adverse selection. The adverse selection problem was discussed by Akerlof (1970) in the used car market. In the employment relationship the adverse selection problem arises when employers cannot devise a way to distinguish between groups of employee candidates with different levels of productivity at a reasonable cost. In that case, firms would be forced to assume that all applicants are ‘average’ and would pay them an average wage. Low-quality workers would profit as they are paid a wage above the value of their marginal productivity, where goodquality workers are underpaid. According to Weiss (1980) this will result in good-quality workers refraining from applying for the job; employees (as opposed to employers) know their productivity and will only accept wages that correspond with their productive endowments. Only the low-quality

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workers find it profitable to apply for the job. However, the employer can attract more high-quality employees by offering a higher wage. ‘Because reservation wages are positively correlated with labor endowments, if a firm were to cut the wage it offered, the workers that would be discouraged from applying to work for the firm would be the workers that the firm finds most desirable’Weiss, 1991, p. 15). This model is an efficiency-wage model, and the reason for paying above market wages is to avoid adverse selection; this will be done by enlarging the pool of applicants with good-quality workers. Discrimination might be another consequence of asymmetric information when screening and signaling are not perfect. Statistical discrimination might occur when the employer assigns group characteristics to people who may not be typical of the group. Employers who rely on false stereotypes will face adverse selection because they are not hiring the most productive workers. Chapter 5530 gives an overview of Employment Discrimination. Employee’s Side We now turn to the information shortage on the side of employees with respect to the job characteristics. The employer normally possesses more information about the job characteristics, but he will have the incentive to present the job as less demanding than it actually is. Economic theory, however, predicts that compensating wage differentials will be associated with various job characteristics. Positive differentials (higher wages) will accompany ‘bad’ characteristics, while negative differentials (lower wages) will be associated with ‘good’ ones (Ehrenberg and Smith, 1997, p. 251). A company offering a job with ‘bad’ characteristics with no compensating wage differentials would have trouble recruiting or retaining workers; the company would eventually be forced to raise its wages, even above the wage level offered by the company offering good characteristics. The prediction that there are compensating wage differentials was already proposed by Adam Smith in his The Wealth of Nations (1776). The prediction is only true under the assumption that workers want to maximize their utility, are informed of the job characteristics and perfect worker mobility (see, for example, Ehrenberg and Smith, 1997, chapter 8). When the assumptions are not fulfilled, regulation might discipline the employer. For an overview of Occupational Safety and Health Regulation see Chapter 5540.

3. Firm Specific Investments Many workers increase their productivity by learning new skills and perfecting old ones while on-the-job. Gary Becker (1975) was the first to formalize the distinction between two types of on the job training: general

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training that increases an individual’s productivity to many employers equally, and specific training that increases an individual’s productivity only at the firm in which he or she is currently employed. Future productivity can be improved only at a cost. These investment costs will only be incurred when there is a possibility to recoup the returns of investments. This necessitates that the employment relationship should endure for a sufficiently long period of time. Some arrangements of the employment relationship can be seen as incentives for the continuance of the relationship. The original theoretical literature in the area of human capital theory (Becker, 1975; Mincer, 1962; Oi, 1962; Parsons, 1972; Pencavel, 1972; and Salop, 1973) focused on the effect of firm specific human capital on firm compensation policies and the consequences for firm lay-off and quit experiences. General Training Because general training increases workers’ productivity in the firm providing it, as well as in many other firms, the prediction holds true that firms will not offer general training, or only if the employees bear the full cost of their training. However, general training is widely provided and paid for by employers in the actual labour market. A possible explanation is that the mobility of workers to work for another firm is sufficiently limited by the mobility costs, that is by the various costs employees must naturally bear in finding other offers and switching employer. In that way employers can obtain the returns of the training if they have paid for it. Specific Training Becker (1975) defines ‘completely specific’ training as training that has no effect on the productivity of trainees that would be useful in other firms. If training were completely specific, the wage that an employee could get elsewhere would be independent of the amount of training he had received. When a firm offers specific training, it has to decide how to structure wages during and after training so that it can recoup its investment. This will be explained with the two period example (this is essentially the model developed in Becker, 1975). Suppose the firm’s workers come to it with a marginal product of MP*, and they can obtain a wage of W* (=MP*) elsewhere. If they receive specific training in the first period of employment, their marginal product with the firm is reduced to MP0 (< MP*) during the training period but rises to MP1 (>MP*) in the post-training period. The difference between MP1 and MP* in the post-training period is called the post-training surplus. What is the optimal pay policy to be adopted by the firm? First, a firm is hurt by the departure of a trained employee because an equally profitable new employee could not be obtained and the firm’s

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training investments would be lost. Therefore the firm must offer a posttraining wage that is high enough to discourage its trained workers from quitting immediately after training (W1 > W*). But the firm incurred costs in the training period, which it wants to recoup. Therefore the post-training wage must be below MP1 (W1 < MP1) so that the firm is allowed to recoup investment costs. Where exactly within this range W1 will be depends on the mobility costs (job search costs, change of residence) of the trained employee. If these costs are high, then W1 need not be much above W* to induce those workers to stay with the firm in the post-training period. When employees are offered some of the return from training, the higher wage would make the supply of trainees greater than the demand, and rationing would be required. The final step is then to shift some training costs as well as returns to employees. This will be done by offering a wage below W* in the training period. Some of the training costs will be borne by the employer. Therefore the wage will be higher than MP0. If employees bore all the costs of specific training, then employers would have no investment to protect and would not be inhibited from firing employees after training. The optimal pay policy is one in which firms do not pay all training costs nor do they collect all the return, but they rather share both with the employees. In the efficiency-wage theory it is shown that high wages have a quitdeterring effect (Salop, 1973, 1979; Stiglitz, 1974). So employers pay an above market wage in order to prevent their specifically trained employees from quitting. But an element that also plays an important role in efficiency wage theories is unemployment. The basic idea is that employees are less likely to quit when their current wage is higher than what they can earn elsewhere and when the level of unemployment is higher. Hold-Up Problem Becker focused on the possibility of the employee to threaten in an opportunistic way to quit after the firm makes the specific investment unless the wage rate is adjusted upwards. Becker’s solution is a sharing of the costs and benefits of the specific investment via an initial lump-sum payment by the employee and a later higher-than-market wage. But as Klein, Crawford and Alchian (1978) show, this solution does not eliminate the bilateral opportunistic bargaining problem; the employer may later decrease the wage back to the competitive level or the employee may demand a higher wage to appropriate the partial specific investment by the employer. Williamson (1985) has termed this problem ‘hold-up’. By threatening to quit, an employee might bargain for a large share of the surplus in a way that the employer can only partly reap the returns of his specific investment. The employer will have to concede because if the employee quits, the employer cannot reap any returns at all. The same is true for the employee who has

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invested in specific training when the employer acts strategically by threatening to dismiss the employee. Parties might anticipate this opportunistic behavior and refrain from firm-specific investments. The investments in specific training will then be less than what is socially optimal. A solution put forward in the literature is a formal fixed-wage contract specifying a wage at the start of employment (Klein, Crawford and Alchian, 1978; Macleod and Malcomson, 1993; and Malcomson, 1997). When renegotiations are avoided through wage rigidity, the scope for opportunistic behavior will be smaller: ‘a contract that ensures a wage independent of the amount the firm invests insures those investments are efficient’ (Malcomson, 1997, p. 1933). However, a wage contract will not completely avoid the hold-up problem, especially when alternative market opportunities for one or both parties are considered. Due to macro shocks in product demand and firm-specific shocks, the alternative opportunities for one or both parties might be better than the existing wage contract. In order to avoid an inefficient separation, the wage must be adjusted. Those adjustments are normally not foreseen in the employment contract because the employment relationship is too complex and uncertain. Renegotiation is necessary and again the hold-up problem occurs. Renegotiation to prevent an inefficient separation when an outside option constraint binds may allow one party to capture part of the returns to specific investments made by the other. Anticipation of that means that the original investments may not be efficient. (Malcomson, 1997, p. 1943)

According to Teulings (1996) the solution is to delegate the power to renegotiate to centralized labour unions and employer organisations. Negotiations are then independent of the problems of the workplace and specific investments do not influence the decisions. In general the fear of opportunistic behavior leads to wage rigidity in long term explicit contracts where specific human capital is present. This argument is distinct from the argument for the existence of rigid long-term implicit labor contracts as a means of bearing risk. The use of the employment contract as an insurance contract will be discussed in the next section.

4. Insurance Contract Azariadis (1975) considers the risk-neutral firms to act both as employers and as insurers of homogenous, risk-averse laborers. The use of the employment contract as an insurance contract has been discussed in the implicit contract theory. The origins of implicit-contract theory lie in the belief that observed movements in wages and employment cannot be

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adequately explained by a competitive spot labor market in which wages are always equal to the marginal product of labor and the labor market is always in equilibrium. Instead, the observation in the labor market is that over the cycle wages are ‘rigid’ while employment varies. Basic ideas about implicitcontract models were originally proposed by Baily (1974), Gordon (1974) and Azariadis (1975). But the ideas spawned an enormous amount of literature. For surveys see Azariadis and Stiglitz (1983), Hart and Holmstrom (1986) and Rosen (1994). The earliest literature on implicit contracts exploits the insight by Knight (1921), who argued that inherently confident and venturesome entrepreneurs will offer to relieve their employees of some market risks in return for the right to make allocative decisions. The basic idea of implicit-contract theory is that in their dealings employers are less risk-averse than workers. One reason is that owners of capital who represent the employers can divide their capital among many different firms through the stock market, and by this diversification they obtain insurance against the risks faced by individual firms. On the other hand, for workers it is generally difficult to diversify assets which take the form of human capital because workers generally work for only one employer at the time. Risk-averse workers do not like fluctuations in their wages. But in a competitive labor market, fluctuations in the marginal product of labor would lead to fluctuations in the wage. However, the risk-averse employee is willing to pay for income certainty because it increases his utility. Due to the imperfect nature of insurance markets, workers who desire such an insurance coverage cannot get it on the insurance market. The employing firm, having more information than a separate insurer, is much better placed to undertake the insurance function, if compensated for it. The crucial feature of implicit-contract models is how risk is shared between workers and firms. Both parties to the employment relationship can be made better off by replacing a fluctuating wage with a fixed wage contract which has a slightly lower average value. So it appears that the implicit contract theory can explain wage stickiness, one of the stylized facts of the labor market. In the optimal contract, the wage is rigid and does not vary with the marginal revenue product of labor. The marginal revenue product is supposed to be high in good times and low in bad times. In that way the employment contract will include an insurance element, insuring workers against bad times by collecting premiums from them in good times. According to Azariadis (1987) an implicit contract is a complete description, made before the state of nature (good or bad) becomes known, of the labour services to be rendered unto the firm in each state of nature, and of the corresponding payments to be delivered to the worker. These types of risk sharing agreements are termed ‘implicit-contracts’ in the implicit contract theory. By ‘implicit’ we normally mean that something is

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understood to be the case. In the case of a contract, an implicit contract has connotations of an informal arrangement which is not written down. The converse of an implicit contract would then be an explicit contract in which everything that matters is clearly specified and written down. The use of the term ‘implicit contracts’ to denote risk-sharing contracts is rather confusing according to Bosworth, Dawkins and Stromback (1996, p. 280). It is not the implicit nature of the insurance contract that is the crucial feature of implicit contract theory, but it is the question how risk is shared between employer and employee. For that reason, ‘risk-sharing agreements’ would be a better term. It is, however, true that the risk-sharing agreement considered by the implicit contract literature is implicit. Indeed, we do not observe such risksharing contracts in the real world, so if they exist they must be implicit (see Manning, 1990, p. 65). The problem with contracts that are implicit (understood) compared to explicit (written) contracts, is that they are not enforceable by a third party, such as a court. One of the parties might breach the implicit risk sharing agreement; the employer can increase his profits by dismissing the worker whose marginal revenue product is below the fixed wage in the bad state of nature and replace him by a cheaper worker, and the employee has an incentive to quit when his marginal revenue product is higher than the fixed wage in the good state of nature. These implications can be avoided when the implicit contract is self enforcing through labor market institutions such as mobility costs (for example Baily, 1974) and reputation (for example Holmstrom, 1981; and Bull, 1987). The mechanism of self-enforcing implicit contracts will be further discussed in this contribution.

5. Employee’s Effort Level and Compensation Scheme The employment relationship can be thought of as a contract between a principal (the employer) and an agent (the employee). The employee is hired to help advance the employer’s objectives in return for receiving wages and other benefits. But workers are considered to be utility maximizers. They are primarily motivated by self interest and they seek to avoid unpleasant or otherwise costly activities. Which policies can employers devise in order to ensure the alignment of the agent’s interests with those of the principal and more specifically to induce a high level of effort from their employees? One way to motivate high levels of effort is to closely supervise employees. According to Alchian and Demsetz (1972), the essence of the firm is ‘the centralized contractual agent in a team productive process’. And one method of reducing shirking is for someone to specialize as a monitor to check the input performance of team members.

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While virtually all employees work under some form of supervision, close and detailed supervision or monitoring is costly. With imperfect monitoring and full employment, workers will choose to shirk, that is to provide a low level of effort. If supervision or monitoring is too costly, the employer can use various compensation plans to motivate the employee to work hard. A possible incentive-based pay scheme to motivate the employees is linking one’s pay to one’s output. Possible systems under which workers are paid for their output are piece-rate pay, payment by commission, gainsharing, profit-sharing, and bonus plans. Although such pay systems reduce the monitoring costs for the employer, in reality in most employment relationships employees are paid (at least partly) for their time. Output-based pay encounters difficulties of measurement of output. Such incentive contracts that are legally enforceable are limited by the practical difficulty of finding measures of employee performance that can be verified in court. Without such verifiability, contracts that make the wage conditional on output will not be legally enforceable (Macleod and Malcomson, 1987, 1989). Another problem is that a system of pay for performance places employees at a risk of having earnings that are variable over time. Such a system does not satisfy the desire of a risk averse employee (see Section 4 above contract) and the employee is only willing to accept the risk if this is offset by a higher expected income. At the heart of the principal-agent problem lies the inevitable trade-off between the provision of incentives to work hard and the sharing of risks. The challenge is to design an employment contract so that there are incentives to perform well, but without burdening the workers with too much risk (see for example Douma and Schreuder, 1998, 7.6). Given the difficulties with output-based pay plans, another method to increase the chances that the workers will not shirk their duties is to pay them a wage above the market wage. This method has been the object of the efficiency-wage theories. The reasons why higher wages are thought to generate greater productivity from given workers all relate to the commitment to the firm they build. Wages affect the productivity of individual workers by affecting whether workers are supportive or antagonistic to their employer. The main contributor to this line of investigation has been Akerlof (1984) in the context of ‘gift-exchange’ relationships. He argues that when firms pay ‘high’ wages they are in effect making a gift to the workers, which is reciprocated by the workers. They act in ways that benefit the firm even if they are not rewarded for those actions. However, the aspect of behavior that has been widely discussed as being affected by wages is the quality and intensity of work (effort level or productivity level). Employees realize that even though supervision may not be detailed enough to detect shirking with certainty, if they are caught

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cheating on their promises to work hard and are fired as a result, the loss of a job paying above market wages is costly. If an employee’s work is not diligent and he is fired, he faces the risk of earning a lower wage. The cost of earning less provides the incentive to work hard. Raising compensation above the level that workers can earn elsewhere has both benefits (less monitoring costs) and costs (higher wages) to the employer. While initial increases in pay may well serve to increase productivity and therefore the profits of the firm, after a point the costs to the employer of further increases will exceed the benefits. The above-market level at which the marginal revenues to the employer from a further pay increase equal the marginal costs is the level that will maximize profits. This has become known as the efficiency wage (Ehrenberg and Smith, 1997, p. 396). The wage premium that efficiency-wage employers must pay to discourage shirking depends upon the alternatives open to their employees. The prediction holds that there should be a negative association between average wage rates and unemployment rates across areas (see Ehrenberg and Smith, 1997, p. 582). Shapiro and Stigliz (1984) state in their shirking model that if all employers were to follow the strategy of raising wages, then the incentive not to shirk again disappears; the worst that can happen to a worker who shirks on the job is that he is fired, since he can be rehired (assuming there is no unemployment) at the same high wage. But as all firms raise their wages, supply of labor would exceed demand and unemployment would result. With unemployment, even if all firms pay the same wages, a worker has an incentive not to shirk. For, if he is fired, an individual will not immediately obtain another job. Lazear (1979) shows that it is beneficial to both employer and employee to arrange workers’ pay over time so that employees are ‘underpaid’ (less than their marginal productivity) early in their careers and ‘overpaid’ later on. Holding out payments until late in the individual’s lifetime alters the worker’s incentives to reduce his effort on the job. Workers are less likely to shirk their responsibilities because the penalties for being caught and fired are forfeiture of a late future award. Another form of worker motivation is the promotion tournament. Workers with high effort levels will be awarded with promotion. Promotion tournament models are given by Malcomson (1984, 1986) and Bhattacharya (1986). A contract to induce the employee to provide a certain effort level is often an understanding that cannot be enforced by third parties, such as courts. Such contracts are labelled ‘implicit contracts’. It is, for example, usually understood, but seldom explicitly expressed, that workers who provide a high effort level will be rewarded with a bonus. Implicit contracts are distinguished from explicit contracts which can be enforced by third parties. There is no use for parties explicitly to write down the required

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effort level of the employee in the employment contract because courts generally cannot verify information about the effort level of the employee. The worker’s effort and thus his output are modeled as nonverifiable (Carmichael, 1989).

6. Long-Term, Incomplete and Self-Enforcing Implicit Contract When the motivation for an employment contract is to regulate and divide the surplus of relation-specific investments, to ensure a certain income stream, and to provide incentives to the workers to work hard through deferred forms of pay, long-term employment relationships are in many instances conducive to economic efficiency (see Büchtemann and Walwei, 1996). Normally, long-term employment contracts are incomplete. A contract is incomplete when it does not specify each party’s obligations in every conceivable eventuality (Hart, 1987). The employment contract might be incomplete if parties are not able to foresee all future contingencies. If they envisage contingencies, it may just be too costly to write all those details into the contract. And even if they want to specify all those details in a contract, they may be unable to do so in such a way that a court can enforce their intentions because the necessary information cannot be verified by third parties, such as courts (see Malcomson, 1997, p. 1917). Even when legal enforcement is possible, it may be too costly. If parties do not write all their agreements explicitly down for the reasons just mentioned, they can still rely on an implicit type of long-term contract. For a review of long-term and incomplete contracts see Chapters 4100, Contractual Choice and 4200, Long-Term Contracts and Relational Contracts. It is fruitful to look at the employment contract as a combination of explicit and implicit agreements. An implicit agreement is an understanding that is not legally enforceable. We could think, for example, of the informal understanding between employer and employee that the employee will be rewarded when his effort level is high or when his attachment to the job is strong. Implicit contracts are not legally enforceable. This does not render the implicit agreement valueless. Implicit agreements will be made when parties can rely on self enforcement of the agreement. The basic idea of selfenforcing implicit contracts is that if both parties benefit from the continuance of the employment relationship, they will not cheat on their promises implicitly made. Self enforcing implicit contracts will exist only if upholding the agreement will generate a surplus for the two parties (MacLeod and Malcomson, 1987, 1989). The way in which the surplus is divided between the two parties is important, because this is what determines the form of the contract. Among others, Carmichael (1989) has summarized the potential sources for a surplus of self enforcing implicit contracts in the labor market.

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A first source for a surplus in the relationship is savings of direct mobility costs for each party. One of the earliest approaches (for example Baily, 1974) was to assume the existence of mobility costs for workers and costs for the employer of replacing workers. If employers profit more from the continued employment of their existing workforce than they could from hiring replacements, they will suffer losses, for example by failing to promote ‘good’ workers as promised and thereby inducing them to quit. Investment in specific human capital is a second source for a surplus. Terminating the contract is unattractive when it makes the investments disappear. Reputation is a third source for a surplus, as illustrated by Holmstrom (1981) and Carmichael (1984). If either employer or workers gain a reputation for breaking contracts when it is in their short term interest to do so, we might expect them to have difficulty in finding employers or workers to sign contracts with them in the future, that is they will acquire a bad reputation which is costly to them in the future. According to Bull (1987) strong reputation effects require that accurate information about breach of the agreement flows rapidly to a large portion of the labor market. It is unlikely that market-based or external reputation will, in many labor markets, be strong enough to support implicit agreements. While the market will not have timely, accurate information on the outcomes of trades within the firm, the information flows within the firms will be fast and accurate. It is these strong intrafirm reputations that will support implicit agreements. An unfair breach of a promise on the part of the employer could result in an unprofitable drop in the morale of the workforce. Efficiency wages can also do the trick. The employee will not quit when he will earn less elsewhere. If workers are receiving more from the existing relationship than they expect to receive elsewhere, they will automatically lose if they shirk on their duties and are fired as a consequence.

7. Conclusion It has been shown how parties to the employment contract cope with imperfections such as asymmetric information, uncertainty and opportunistic behavior with respect to different areas of the employment relationship. The employment contract has several roles or functions: to match employer and employee, to regulate and divide the surplus from relation-specific investments, to share risks and smooth the income stream and to induce a high effort level (Ehrenberg and Smith, 1997, p. 394). For many employees, setting a compensation policy consists of more than just ‘finding out’ the market wage for given jobs. Paying above-market wages might attract high-

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productivity workers, reduce the incentive of the employee to quit after receiving specific training and reduce the incentive to shirk. Risk-averse employees prefer certain income streams which leads to the rigid wage result of implicit contract theory; wages do not fluctuate in response to fluctuations in the firm’s output price. Rigid wages have also been proposed as a solution for the hold up problem. Besides explicit agreements, employers and employees exchange a set of informal, implicit promises regarding their current and future behavior. To make these implicit contacts self-enforcing there must be a surplus of the relationship and the challenge for employer and employee is to make arrangements concerning the division of the surplus.

Acknowledgements I would like to thank Gerrit De Geest and Jacques Siegers for helpful comments on the first draft. They are naturally not accountable for any remaining errors and shortcomings.

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Dana, James D., Jr and Spier, Kathryn E. (1993), ‘Expertise and Contingent Fees: The Role of Asymmetric Information in Attorney Compensation’, 9 Journal of Law, Economics, and Organization, 349-367. Dau-Schmidt, Kenneth G. (1992), ‘A Bargaining Analysis of American Labor Law and the Search for Bargaining Equity and Industrial Peace’, 91 Michigan Law Review, 419 ff. Dau-Schmidt, Kenneth G. (1993a), ‘Bargaining Theory and Canadian Labour Law’, in Kuttner, T. (ed.), The Industrial Relations System: Proceedings of the XXIXth Conference of the Canadian Industrial Relations Association, 753 ff. Dau-Schmidt, Kenneth G. (1993b), ‘Meeting the Demands of Workers Into the Twenty-First Century: The Future of Labor and Employment Law’, 68 Indiana Law Journal, 685 ff. Dau-Schmidt, Kenneth G. (1995), ‘The Labor Market Transformed: Adapting Labor and Employment Law to the Rise of the Contingent Workforce’, 52 Washington and Lee Law Review, 879 ff. Dau-Schmidt, Kenneth G. (1996), ‘Employment Security: A Comparative Institutional Debate’, Texas Law Review. Dudley, Leonard (1986), ‘Implicit Labor Contracts and Public Choice: A General Equilibrium Approach’, 29 Journal of Law and Economics, 61-82. Dye, Ronald A. (1985), ‘Optimal Length of Labor Contracts’, 26 International Economic Review, 251-270. Flanagan, Robert J. (1984), ‘Implicit Contracts, Explicit Contracts, and Wages’, 74 American Economic Review. Papers and Proceedings, 345-349. Frech, H. Edward III (1985), ‘The Property Rights Theory of the Firm: Some Evidence from the U.S. Nursing Home Industry’, 141 Journal of Institutional and Theoretical Economics, 146-166. Frech, H. Edward III, Borjas, George J. and Ginsburg, Paul B. (1983), ‘Property Rights and Wages: The Case of Nursing Homes’, 18(2) Journal of Human Resources, 231-246. Freeman, Smith (1977), ‘Wage Trends as Performance Displays Productive Potential: a Model and Application to Academic Early Retirement’, 8 Bell Journal of Economics, 419-443. Goldberg, Victor P. (1980), ‘Bridges Over Contested Terrain: Exploring the Radical Account of the Employment Relationship’, 1 Journal of Economic Behavior and Organization, 249-274. Goldberg, Victor P. (1984), ‘A Relational Exchange Perspective on the Employment Relationship’, in Stephen, Frank H. (ed.), Firms, Organization and Labour: Approaches to the Economics of Work Organization, London, Macmillan, 127-145. Greene, Kenneth V. and Moulton, George D. (1986), ‘Municipal Employee Residency Requirement Statutes: An Economic Analysis’, 9 Research in Law and Economics, 185-204. Hall, Robert E. (1982), ‘The Importance of Lifetime Jobs in the U.S. Economy’, 72 American Economic Review, 716-724. Harris, Milton and Holmström, Bengt (1987), ‘On the Duration of Agreements’, 28 International Economic Review, 389-406.

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Harris, Milton and Raviv, Artur (1978), ‘Some Results on Incentive Contracts with Applications to Education and Employment, Health Insurance, and Law Enforcement’, 68 American Economic Review, 20-30. Hashimoto, Masanori and Yu, Ben T. (1980), ‘Specific Capital, Employment Contracts, and Wage Rigidity’, 11 Bell Journal of Economics, 536-549. Hertog, Johan A. and Kraamwinkel, Margriet M. (1991), ‘Pensioennadelen in Het Licht Van De Contracttheorie (Pension Disadvantages in the Light of Contract Theory)’, Economisch-Statistische Berichten, 908-912. Hirsch, Werner Z. (1989), ‘The Economics of Contracting Out: The Labor Cost Fallacy’, 40 Labor Law Journal, 536-542. Ichino, Pietro (1998), ‘Il Diritto del Lavoro e i Modelli Economici (Labour Law and Economic Models)’, Lavoro e Diritto, 309-322. Ickes, B.W. and Samuelson, Larry (1987), ‘Job Transfers and Incentives in Complex Organizations: Thwarting in the Ratchet Effect’, 18 Rand Journal of Economics, 275-286. Ioannides, Y.M. and Pissarides, C.A. (1983), ‘Wages and Employment with Firm-Specific Seniority’, 14 Bell Journal of Economics, 573-580. Klein, Benjamin (1984), ‘Contract Costs and Administered Prices: An Economic Theory of Rigid Wages’, 74 American Economic Review. Papers and Proceedings, 332-338. Kübler, Dorothea (1997), ‘Auctioning Off Labor Contracts: Legal Restrictions Reconsidered’, 17 International Review of Law and Economics, 63-74. Lazear, Edward P. (1984), ‘Incentives and Wage Rigidity’, 74 American Economic Review. Papers and Proceedings, 339-344. Lazear, Edward P. (1987), ‘Incentive Contracts’, in Eatwell, John, Milgate, Murray and Newman, Peter (eds), The New Palgrave: A Dictionary of Economics, London, MacMillan, 744-748. Lemley, Mark A. and Durie, Daralyn J. (1992), ‘The Antitrust Liability of Labor Unions for Anticompetitive Litigation’, 80 California Law Review, 757 ff. Lewis, Tracy R. (1980), ‘Bonuses and Penalties in Incentive Contracting’, 11 Bell Journal of Economics, 292-301. MacDonald, Glenn M. (1982), ‘Specific Investments and Nonlabor Income’, 13 Bell Journal of Economics, 225 ff. Magee, R.P. (1978), ‘Accounting Measurement and Employment Contracts: Current Value Reporting’, 9 Bell Journal of Economics, 145-158. Martin, Donald L. (1977), ‘The Economics of Employment Termination Rights’, 20 Journal of Law and Economics, 187-204. McCall, John, J. (1970), ‘The Simple Economics of Incentive Contracting’, 60 American Economic Review, 837-846. Murphy, Kevin J. (1986), ‘Incentives, Learning, and Compensation: A Theoretical and Empirical Investigation of Managerial Labor Contracts’, 17 Rand Journal of Economics, 59-76. Nogler, Luca (1992), ‘Una Ventata di Analisi Economica del Diritto in Tema di Contratto di Lavoro a Termine (Nota a Cass., sez. lav., 21 febbraio 1992, n. 2153, Matteucci c. Cassa risp. Città di Castello) (A Wave of Economic Analysis of Law on Forward Employment Contract)’, I Giustizia Civile, 2104-2105.

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Peltzman, Sam (1987), ‘Comment (on R. B. Freeman, ‘How Do Public Sector Wages and Employment Respond To Economic Conditions’)’, in Wise, D. (ed.), Public Sector Payrolls, Chicago, IL, University of Chicago Press. Petersen, Trond (1991), ‘Reward Systems and the Distribution of Wages’, 7(S) Journal of Law, Economics, and Organization, 130-158. Plaut, Steven E. (1986), ‘Implicit Contracts in the Absence of Enforcement: Note’, 76 American Economic Review, 257-258. Rasmusen, Eric and Zenger, Todd (1990), ‘Diseconomies of Scale in Employment Contracts’, 6 Journal of Law, Economics, and Organization, 65-92. Roemer, J. (1979), ‘Divide and Conquer Microfoundations of a Marxian Theory of Wage Discrimination’, 10 Bell Journal of Economics, 695-705. Rosen, Sherwin (1982), ‘Authority, Control, and the Distribution of Earnings’, 13 Bell Journal of Economics, 311-323. Rubin, Paul H. and Shedd, Peter (1981), ‘Human Capital and Covenants Not to Compete’, 10 Journal of Legal Studies, 93-110. Schwab, Stewart J. (1987), ‘Collective Bargaining and the Coase Theorem’, 72 Cornell Law Review, 245-287. Schwab, Stewart J. (1992), ‘Union Raids, Union Democracy, and the Market for Union Control’, 22 University of Illinois Law Review, 367-416. Schwab, Stewart J. (1994), ‘Employment Life Cycles and the Employment-At-Will Doctrine’, 20 Cornell Law Forum, 7-11. Schwab, Stewart J. (1995), ‘The Diversity of Contingent Workers and the Need for Nuanced Policy’, 52 Washington and Lee Law Review, 915-933. Schwab, Stewart J. (1996), ‘Wrongful Discharge Law and the Search for Third-Party Effects’, Texas Law Review, 74 ff. Shadowen, Steve D. and Voytek, Kenneth (1984), ‘Note: Economic and Critical Analyses of the Law of Covenants Not To Compete’, 72 Georgetown Law Journal, 1425-1450. Simon, Herbert A. (1951), ‘A Formal Theory of the Employment Relationship’, 19 Econometrica, 293-305. Sklivas, S.D. (1987), ‘The Strategic Choice of Managerial Incentives’, 18 Rand Journal of Economics, 452-460. Spier, Kathryn E. and Dana, James D., Jr (1993), ‘Expertise and Contingent Fees: The Role of Asymmetric Information in Attorney Compensation’, 9 Journal of Law, Economics, and Organization, 349-367. Taylor, John B. (1980), ‘Aggregate Dynamics and Staggered Contracts’, 88 Journal of Political Economy, 1-23. Topel, Robert H. and Welch, Finis (1986), ‘Efficient Labor Contracts with Employement Risk’, 17 Rand Journal of Economics, 490-507. Verkerke, J. Hoult (1995), ‘An Empirical Perspective on Indefinite Term Employment Contracts: Resolving the Just Cause Debate’, 61 Wisconsin Law Review, 837-918. Vogel, Kenneth R. (1983), ‘Analysis of Labour Contracts and their Administration Using Transaction Costs Economics’, 5 Law and Policy Quarterly, 129-152. Waldman, Michael (1984), ‘Job Assignments, Signalling, and Efficiency’, 15 Rand Journal of Economics, 255-267. Weitzman, Martin L. (1980), ‘Efficient Incentive Contracts’, 94 Quarterly Journal of Economics, 719-730.

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Weitzman, Martin L. (1984), The Share Economy. Conquering Stagflation, Cambridge, MA, Harvard University Press, 167 p. Williamson, Oliver E., Wachter, Michael L. and Harris, Jeffrey F. (1975), ‘Understanding the Employment Relation: The Analysis of Idiosyncratic Exchange’, 6 Bell Journal of Economics, 250-278. Willman, Paul (1982), ‘Opportunism in Labor Contracting: An Application of the Organizational Failures’ Framework’, 3 Journal of Economic Behavior and Organization, 83-98.

Other References Akerlof, George A. (1970), ‘The Market for ‘Lemons’: Qualitative Uncertainty and the Market Mechanism’, 84 Quarterly Journal of Economics, 488-500. Alchian, Armen A. and Demsetz, Harold (1972), ‘Production, Information Costs, and Economic Organization’, 62 The American Economic Review, 777-795. Azariadis, Costas (1975), ‘Implicit Contracts and Underemployment Equilibria’, 83 Journal of Political Economy, 1183-1202. Azariadis, Costas and Stiglitz, Joseph E. (1983), ‘Implicit Contracts and Fixed-Price Equilibria’, 98 Quarterly Journal of Economics Supplement, 1-22. Baily, Martin N. (1974), ‘Wages and Employment under Uncertain Demand’, 41 Review of Economic Studies, 37-50. Becker, Gary S. (1962), ‘Investment in Human Capital: A Theoretical Analysis’, 70 Journal of Political Economy, S9-49. Becker, Gary S. (1975), Human Capital, 2nd edn, New York, National Bureau of Economic Research. Bhattacharya, Sudipto (1986), ‘Tournaments, Termination Schemes and Forcing contracts’, Bell Communications Research, Working Paper, December. Bosworth, Derek L., Dawkins, Peter J. and Stromback, Thorsten (1996), The Economics of the Labour Market, Harlow, Longman, 460 p. Büchtemann, Christoph F. and Walwei, Ulrich (1996), ‘Employment Security and Dismissal Protection’, in Schmid, Günther, O’Reilly, Jacqueline and Schönmann, Klaus (eds), International Handbook of Labour Market Policy and Evaluation, Cheltenham, Edward Elgar, 652-693. Bull, Clive (1987), ‘The Existence of Self Enforcing Implicit Contracts’, 102 Quarterly Journal of Economics, 147-159. Carmichael, H. Lorne (1984), ‘Reputations in the Labor Market’, 74 American Economic Review, 713-725. Carmichael, H. Lorne (1989), ‘Self Enforcing Contracts, Shirking, and Life Cycle Incentives’, 3 (4) Journal of Economic Perspectives, 65-83. De Geest, Gerrit (1994), Economische Analyse van het Contracten- en Quasi-Contractenrecht. Een Onderzoek naar de Wetenschappelijke Waarde van de Rechtseconomie (Economic Analysis of Contract Law and Quasi Contract Law. Research of the Scientific Value of Law and Economics), Antwerpen, Maklu, 568p. De Geest, Gerrit, Siegers, Jacques, Jaspers, Teun and Vandenberghe, Ann-Sophie (1999), ‘The Right to Lie: New Law and Economics versus Dutch Labour Law?’, in De Geest, Gerrit,

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Siegers, Jacques and Van den Bergh, Roger (eds), Law and Economics in the Labour Market, Cheltenham, Edward Elgar, forthcoming. Douma, Sytse W. and Schreuder, Hein (1998), Economic Approaches to Organizations, London, Prentice Hall, 238 p. Ehrenberg, Ronald G. and Smith, Robert S. (1997), Modern Labor Economics. Theory and Public Policy, Reading, MA, Addison-Wesley, 652 p. Elliott, Robert F. (1991), Labor Economics: A Comparative Text, London, McGraw-Hill, 536 p. Gordon, Donald F. (1974), ‘A Neo Classical Theory of Keynesian Unemployment’, 12(4) Economic Inquiry, 431-459. Hart, Oliver D. (1987), ‘Incomplete Contracts’, in Eatwell, John, Milgate, Murray and Newman, Peter (eds), The New Palgrave: A Dictionary of Economics, London, Macmillan, Volume 2, 752-759. Hart, Oliver D. and Holmstrom, Bengt (1986), ‘The Theory of Contracts’, in Bewley, Truman (ed.), Advances in Economic Theory, Cambridge, Cambridge University Press. Holstrom, Bengt (1981), ‘Contractual Models of the Labor Market’, 71 American Economic Review. Papers and Proceedings, 308-313. Klein, Benjamin, Crawford, Robert G. and Alchian, Armen A. (1978), ‘Vertical Integration, Appropriable Rents, and the Competitive Contracting Process’, 21 The Journal of Law and Economics, 297-326. Knight, Frank (1921) Risk, Uncertainty and Profit, Boston, Houghton Miffin. Lazear, Edward P. (1979), ‘Why is there Mandatory Retirement?’, 87 Journal of Political Economy, 1261-1284. Macleod, W. Bentley and Malcomson, James M. (1987), ‘Involuntary Unemployment in Dynamic Contract Equilibria’, 31 European Economic Review, 427-435. Macleod, W. Bentley and Malcomson, James M. (1989), ‘Implicit Contracts, Incentive Compatibility, and Involuntary Unemployment’, 57 Econometrica, 447-480. MacLeod, W. Bentley and Malcomson, James M. (1993), ‘Investments, Holdups, and the Form of Market Contracts’, 84 American Economic Review, 811-837. Malcomson, James M. (1984), ‘Work Incentives, Hierarchy, and Internal Labor Markets’, 92 Journal of Political Economy, 486-507. Malcomson, James M. (1986), ‘Rank Order Contracts for a Principal with Many Agents’, 53 Review of Economic Studies, 807-817. Malcomson, James M. (1997), ‘Contracts, Hold up, and Labor markets’, 35 Journal of Economic Literature, 1917-1957. Manning, A. (1990), ‘Implicit Contract Theory’, in Sapsford, David and Tzannatos, Zafiris (eds), Current Issues in Labour Economics, Basingstoke, Macmillan, 63-85. Mincer, Jacob (1962), ‘On-The-Job Training: Costs, Returns, and Some Implications’, 70 The Journal of Political Economy, 50-79. Oi, Walter Y. (1962), ‘Labor as a Quasi Fixed Factor’, 70 Journal of Political Economy, 538-555. Parsons, Donald O. (1972), ‘Specific Human Capital: An Application to Quit Rates and Layoff Rates’, 80 Journal of Political Economy, 1120-1143. Parsons, Donald O. (1986), ‘The Employment Relationship: Job Attachment, Work Effort, and the Nature of Contracts’, in Ashenfelter, Orley C. and Layard, Richard G., Handbook of Labor Economics, Amsterdam, North-Holland, Volume 2, 789-848.

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Pencavel, John H. (1972), ‘Wages, Specific Training, and Labor Turnover in U.S. Manufacturing Industries’, 13 International Economic Review, 53-64. Rosen, Sherwin (1994), Implicit Contract Theory, Aldershot, Edward Elgar, 467p. Salop, J. and Salop Steven C. (1976), ‘Self Selection and Turnover in the Labor Market’, 90 Quarterly Journal of Economics, 619-627. Salop, Steven C. (1973), ‘Wage Differentials in a Dynamic Theory of the Firm’, 6 Journal of Economic Theory, 321-344. Salop, Steven C. (1979), ‘A Model of the Natural Rate of Unemployment’, 69 The American Economic Review, 117-125. Schäfer, Hans-Bernd and Ott, Claus (1993), Lehrbuch der Ökonomischen Analyse des Zivilrechts (Handbook of the Economic Analysis of Civil Law), Berlin, Springer-Verlag, 2nd edn. Shapiro, Carl and Stiglitz, Joseph E. (1984), ‘Equilibrium Unemployment as a Worker Discipline Device’, 75 American Economic Review, 433-444. Smith, Adam (1776), The Wealth of Nations, Oxford, Clarendon. Spence, Michael (1973), ‘Job Market Signaling’, 87 Quarterly Journal of Economics, 355-374. Stiglitz, Joseph E. (1974), ‘Alternative Theories of Wage Determination and Unemployment in LDC’s: The Labor Turnover Model’, 88 Quarterly Journal of Economics, 194-227. Teulings, Coenraad N (1996), De Plaats van de Vakbeweging in de Toekomst (The Future Position of Labour Unions), Amsterdam, Welboom, 96p. Weiss, Andrew (1980), ‘Job Queues and Layoffs in Labor Markets with Flexible Wages’, 88 Journal of Political Economy, 526-538. Weiss, Andrew (1991), Efficiency Wages: Models of Unemployment, Layoffs, and Wage Dispersion, Oxford, Clarendon Press, 118 p. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism: Firms, Markets, Relational Contracts, New York, Free Press.

5520 MINIMUM WAGE LEGISLATION Simon Deakin Reader in Economic Law and Assistant Director, ESRC Centre for Business Research, University of Cambridge

Frank Wilkinson Senior Research Officer, Department of Applied Economics and ESRC Centre for Business Research, University of Cambridge © Copyright 1999 Simon Deakin and Frank Wilkinson

Abstract Economists have traditionally been hostile to minimum wage legislation, seeing it as an unwarranted interference with the operation of the market and a cause of unemployment among the less skilled. Recent evidence from the USA and the UK claims to show, however, that employment rises when minimum wage laws are introduced and falls when such laws are repealed. A number of explanations have been offered for these findings, ranging from monopsony effects to labour market segmentation. There are trade-offs between short-run adjustment costs and long-run improvements to productivity and performance which are, however, difficult to assess. From the point of view of the economics of law, the minimum wage studies show how important empirical work is in testing and reshaping economic theory. JEL classification: K31, J38 Keywords: Unemployment, Household Poverty

1. Introduction Most developed economies (and many developing ones) set a legal minimum level to wages, either through statute or by giving legal force to the terms of collective agreements negotiated between employers and trade unions. Economists, however, have traditionally been hostile to minimum wage legislation and to labour standards more generally, seeing them as an unwarranted interference with the operation of the market and a cause of unemployment among the less skilled. Recent evidence from the USA and the UK claims to show, however, that employment rises when minimum wage laws are introduced (Card and Krueger, 1995) and falls when such laws are repealed (Dickens et al., 1993). The story of how these findings 561

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have been evaluated by the economics profession is of considerable interest in itself for what it tells us about the present state of economic theory and the way in which it intersects with the law.

2. The Traditional Neoclassical Account In the traditional neoclassical account of the labour market, competition between firms for labour, and between workers for jobs, ensures that wage rates for labour of comparable productivity are more or less equal throughout the market and beyond the power of any individual economic actor to affect. The movement of the market towards equilibrium acts as an implicit regulator of individual decisions on whether to trade and at what price. Firms which attempt to pay below the market rate risk losing their workers to competitors, in the same way that workers who attempt to force up wages above the competitive level risk losing their jobs as firms at the margin substitute labour for capital or cease to trade. Repeated empirical studies - surveys and case-studies of firms dating back to the first large-scale studies of low pay in Britain and the USA - have shown that, in reality, labour markets do not display these characteristics (see Nolan, 1983). Firms do not automatically adjust wages to changes in demand for labour, and there is considerable divergence in the pay and conditions offered by different employers to workers doing similar jobs. Neoclassical theory tries to explain away these findings by the argument that freely competitive markets tend towards equilibrium. Limitations upon the flow of information and upon the mobility and substitutability of factors of production are overcome in time by the unravelling of competitive market forces. The market itself is seen as a powerful force for equality: under conditions of perfect competition, equal pay for work of equal value would follow from the operation of supply and demand. Where apparent inequalities in pay persist, they are viewed as the result of pre-market factors: differences between individuals in terms of endowment and ability, differences in individuals’ ‘tastes’ for work, training or leisure, or differences in employers’ ‘tastes’ for discrimination (Becker, 1957). Regulation is also seen as an exogenous cause of inequality, preventing market clearing. Public choice theory regards labour legislation as the outcome of organised pressure-group activity (Heldman, Bennett and Johnson, 1981; Rowley, 1985). Trade unions, according to this point of view, are labour monopolists seeking to cartelise the labour market. By driving wages above the market or equilibrium rate, they depress demand for employment and divert resources into wasteful rent-seeking. The costs of trade union activity are borne by consumers, in the form of artificially high

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prices, and the unemployed, who are ‘priced out’ of work. Trade union legislation, by supporting collective bargaining and the right to strike, ensures that these inefficient monopoly practices are protected against the market forces which would otherwise drive them out (Posner, 1984). On similar grounds, it is predicted that minimum wage laws would have a disproportionately adverse impact on the young, those without formal training or qualifications, and those re-entering the labour market after a long absence (such as the long-term unemployed) (Minford, 1985).

3. Empirical Evidence The minimum wage has given rise to a vast empirical literature. Until recently, the consensus was that the introduction of a minimum wage and subsequent rises in its level would both almost certainly lead to increases in youth unemployment, and sometimes to increases in adult unemployment (Brown, Gilroy and Kohen, 1982). However, this conclusion rested mainly upon time-series studies using long-term aggregate data of teenage unemployment derived from a single source, the US Current Population Survey. Critics suggested that these studies could not be regarded as definitive since the estimated employment effects are small and also highly sensitive to the choice of sample period (Card, 1991). Case studies by Card, Katz and Krueger examining the implementation of minimum wage reforms in various US states in the late 1980s and early 1990s presented a different picture (see Card, 1991; Card, Katz and Krueger, 1993; Card and Krueger, 1995). The research took advantage of the opportunity for comparative study which arose from the variations in rates of increase between states, and by the decision of the US Congress in the late 1980s to raise the federal minimum wage after a period of several years when its nominal value remained constant and its real value declined. One study examined the effects of raising the minimum wage in California in 1987, comparing teenage employment rates with those in states which did not increase their minima at the same time. It was found that both the earnings and the employment of teenagers in California increased after the minimum wage was raised, despite over half the teenage employees in the state being affected, a very high compliance rate, and few exemptions being allowed in the legislation. Similarly, a study comparing New Jersey, which increased its minimum wage, with Pennsylvania, which did not, found evidence of increasing employment in the former state. An analysis of the implementation of changes in the federal law in the fast food industry in Texas, a sector employing mostly part-time workers and with labour turnover rates in excess of 300 percent per annum, found that most

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employers observed the new adult rates for the minimum wage but that few took advantage of the possibility of paying a teenage sub-minimum. Over 70 percent of the firms interviewed did not report responding to the new rates by either dismissing workers or cutting fringe benefits. In Britain during the same period, minimum wage regulation was being weakened as a consequence of legislation which cut back the powers of the Wages Councils (wage-setting bodies operating at industry level in certain sectors). After 1986 they were prevented from setting rates for younger workers and in 1993 their powers to set wages and conditions were completely removed. Prior to the 1986 Act it was ‘confidently postulated’ that the abolition of the Wages Councils would ‘serve to expand employment [and] offer competitive wages for the socially disadvantaged’ (Minford, 1985, p. 122). However, econometric studies found that employment in low-paying service sectors declined as a result of the decreasing effectiveness of the Wages Councils (Machin and Manning, 1994; Dickens et al., 1993). In a similar vein, studies of the UK Equal Pay Act 1970 found that while the legislation was responsible for a considerable narrowing of the male-female gap, this was accompanied without a fall in female employment levels (Zabalza and Tzannatos, 1985).

4. Alternative Theoretical Perspectives The US findings on the positive impact upon employment of minimum wage increases produced a stormy debate. Some critics argued against the use of a comparative case study methodology, while others sought to provide different explanations for the observed employment effects (see Keenan, 1995; Neumark and Wascher, 1995). However, when the findings are taken together with the British research which demonstrates the converse effect the negative consequences of weakening minimum wage enforcement - they can be seen to have far-reaching implications for the conventional understanding of how labour market regulation works. Under these circumstances, it is not surprising that attention has focused on alternative theoretical perspectives. One possibility which is compatible with orthodox neoclassical theory is that employers in low-wage sectors are monopsonists holding a degree of market power over their employees. This enables them to keep their wages below the equilibrium or external market rate. It would be in the interests of such employers to avoid taking on new employees at the market rate if they then felt obliged, on the grounds of equity, to raise the wages of their existing employees. Under such conditions, a limited rise in the minimum wage would necessarily lead to a rise in employment, as the higher wages

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attracted new recruits into the industry concerned. Too large a rise, on the other hand, would lead to unemployment, particularly where there were wide variations in the degree of monopsony power which individual firms possessed (Stigler, 1946). A more radical departure from the orthodox account is provided by theories of labour market segmentation. These focus on the link between low pay and industrial structure, and take a historical and institutional perspective which is to some degree compatible with theories of path dependence or institutional lock-in. It is argued that since low pay is concentrated in particular occupations and industries, pay inequality cannot be wholly explained by differences in the skill and quality of individual workers (Craig et al., 1982). Rather, low pay comes to be associated with jobs which are socially undervalued or which are performed by workers who are accorded a low labour market status. ‘Undervaluation’ is a consequence of a number of factors including employer strategies, differences in the effectiveness of worker organisation, and the division of labour within the household. For example, one effect of the sexual division of labour is that skills traditionally associated with women’s non-waged labour in the home, such as caring and cleaning, command lower pay in the labour market than other comparable ‘male’ skills. Linking women’s pay to skill levels is, in practice, highly problematic. Studies comparing male and female earnings across a range of occupations have suggested that as much as three quarters of the wage gap between men and women in comparable jobs could not be put down to skill-related factors (Horrell, Burchell and Rubery, 1989). A labour market segmentation perspective leads to a very different view of minimum wage legislation (Deakin and Wilkinson, 1992). Rather than it being an ‘artificial’ interference in the free market, it becomes just one form of regulation which, together with other conventions, norms and customary practices, governs the way in which labour is contracted. The case for legislation is that as a consequence of segmentation, certain groups in the labour market will not have access to voluntary means of labour organisation, such as collective bargaining or the protection of professional rules governing entry and access to jobs. Hence the industries in which low pay is endemic are those in which there are structural factors, such as ease of entry by both firms (the result of low capital requirements) and workers (the result of the failure to develop and enforce formal skills and qualification requirements), which impede the effective organisation of labour and hence the application of common terms and conditions. Although these sectors appear more than any other to resemble the neoclassical ‘norm’ of free competition, in fact they are the exception. The persistence of these conditions creates the basis for a fundamental disequilibrium: low pay is in effect a subsidy, enabling otherwise uncompetitive firms and industries to

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survive. Minimum wage regulation is therefore necessary in order to help create an environment in which firms compete not on the basis of low pay but instead through high labour quality and product and process innovation (Deakin and Wilkinson, 1999). Equally, placing a floor under wages can augment the purchasing power of workers and so underpin effective demand (Michie, 1987; Prasch, 1996). These macroeconomic effects have indeed been prominent among the justifications offered for the introduction of minimum wage regulation in most of the systems adopting it.

5. Dynamic Effects of Introducing and Raising the Minimum Wage The general case for retaining a minimum wage, if one is in place, is distinct from more specific arguments for and against introducing or reintroducing minimum wage regulation. A fundamental change of this kind in the regulatory framework may well have far-reaching effects which cannot be precisely predicted. Moreover, it is unlikely that the effects will all be in one direction. Although an argument can be made, as we have just seen, for long-term efficiencies arising from the presence of a statutory wage floor, these may have to be traded off against short-run adjustment costs as some enterprises go out of businesses and workers retrain. Other matters to be decided include the level at which the minimum wage is set, and the mechanism through which it is subsequently varied. Many of these issues have been the focus of intense debate in Britain since the election of a Labour government in 1997 which was committed to reintroducing minimum wage regulation after an interval of four years during which no minimum wages of any kind were in operation. The government-appointed Low Pay Commission (LPC), which reported in June 1998, recommended the introduction of a national minimum wage (previously minimum rates only had the force of law in certain industries) (LPC, 1998). The proposed rate was towards the lower end of the range put forward by advocates of the minimum wage, namely £3.60 per hour from April 1999, rising to £3.70 in June 2000. The £3.60 figure represented about 45 percent of median earnings and was expected to affect about 11 percent of the working population over the age of 20. Sixteen and 17 year olds were to be exempt and 18-20 year olds were to receive a lower rate of £3.20 per hour from April 1999, rising to £3.30 in June 2000. The Commission estimated that the effect of introducing these reforms would be to add 0.6 percent to the total national wage bill; the sectors most heavily affected would be cleaning, catering and security, while the groups to benefit most included women workers and homeworkers. The government accepted the

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Commission’s recommendations for adult workers but set the starting rate for 18-20 year olds at £3.00 per hour, rising to £3.20 by June 2000. The work of the UK Low Pay Commission represents an interesting example of the use of economic evidence to aid public policy. The Commission was sympathetic to the monopsony model, noting its implication that ‘moderate minima can be introduced without destroying jobs’ (LPC, 1998, p. 114), while at the same time noting the broader ‘undervaluation’ argument in particular as it applied to female labour (LPC, 1998, p. 115). It also considered that the introduction of a minimum wage could have an impact on industrial structure: Whatever the nature of the labour market, it is likely that a National Minimum Wage will have a greater effect on the structure of employment than on its level. Businesses which are inefficient or which produce low value-added goods may need to reorganise working practices. If the National Minimum Wage is properly enforced, business and employment are likely to transfer to more efficient firms or to those offering higher value-added products and services … minimum wages may cause a transfer of jobs between groups such as the substitution of more skilled for less skilled workers … . (LPC, 1998, 115)

It is debatable whether the level set by the Low Pay Commission is sufficiently high to realise these potentially beneficial effects of reintroducing a minimum wage. A minimum wage set at about 45 percent of median earnings is low by international standards (the minimum wage in France, for example, is 57 percent of the median), although it is higher than the US federal minimum. In setting the rate at a low level, the Commission may have minimised the short-run adjustment costs of low-paying employers, at the expense of forfeiting a longer run improvement in productivity and economic performance from this source. A significant feature of the new UK legislation is that no provision is made for automatic increases of the minimum wage in future years. In the USA, a similar lack of automatic uprating has led to stagnation and decline in the level of the federal minimum, and has turned the level of the minimum wage into a hotly debated political issue, so arguably increasing the scope for wasteful pressure group activity (Sachdev and Wilkinson, 1999). In France, by contrast, legislation embodies a formula whereby the ‘minimum growth wage’, the salaire minimum interprofessionel de croissance or SMIC, rises automatically with prices and with at least half the increase in the purchasing power of the average wage. This has ensured that, alone of minimum wage systems in western Europe, the SMIC has retained its real value since the mid-1980s (OECD, 1998, chapter 2).

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6. The Minimum Wage, Household Poverty and Work Incentives The minimum wage, it is sometimes said, disproportionately benefits households with more than one person in employment, some of whom are so-called ‘secondary’ earners (typically wives and children of a male ‘breadwinner’). In practice, the employment of ‘secondary’ earners is often essential to improving the living standards of multiple earner households. A more important objection is that minimum wage appears at first sight to offer no means of relieving poverty in households with no member in employment. In practice, however, the minimum wage may assist the unemployed by improving work incentives. This depends upon how the minimum wage interacts with the benefits system. The contribution of the minimum wage to alleviating poverty and inequality needs to be set in the context of other, complementary measures, in particular those operating through the social security system. The institutional choice here is whether to have a system based on wage-substitutes, such as an extended negative income tax, or whether to use the minimum wage in conjunction with social security benefits to provide incentives for the non-employed to re-enter the labour market at a wage level which makes it worth their while to work. In Britain, the former system was in operation between 1986 and 1997. Social security benefits were targeted on low-paid earners with families at the same time as the minimum wage was abolished. Because these benefits were (unavoidably) means tested, they were progressively withdrawn as earnings from wages increased, so extending the ‘poverty trap’ which reduces the incentive for workers to take better paid jobs or jobs involving longer hours (Deakin and Wilkinson, 1991). Moreover, since employers could reduce wage levels or at least avoid increasing them in the knowledge that the difference would be met by social security, the state was in a position of subsidising low-paying firms which were often among the least efficient in terms of productivity. This reinvention of the Speenhamland system (see Polanyi, 1944) soon led to huge increases in state expenditure on benefits for the low paid. After 1997, the election of a new government led to a change in emphasis. Benefits to the low paid were retained but restructured with the intention of building on the level set by the minimum wage rather than directly substituting for it. As part of these reforms, taxes and social security contributions for the lower paid were substantially reduced. The aim of the reforms was to ‘demonstrate the rewards of work over welfare’ (Treasury, 1998).

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7. Conclusion The recent debate over the minimum wage demonstrates the remarkably tenacious hold which orthodox neoclassical theory has over the economics profession, even when confronted with evidence which, to say the least, puts in doubt the predictive capacity of that theory. From the point of view of the economics of law, the minimum wage studies show how important empirical work is in testing and reshaping economic theory. The hostility of mainstream law and economics towards labour regulation, as exemplified by the symposium on labour market published in the University of Chicago Law Review in 1984, is just one of many instances in which apparently clear-cut normative conclusions were drawn from models which had only a weak link to real-world conditions. From an institutional perspective such as that which can be drawn from the theory of labour market segmentation, the effects of the minimum wage - in particular, the consequences of introducing or raising the minimum - can be seen to be highly complex. There are trade-offs between short-run adjustment costs and long-run improvements to productivity and performance which are, however, difficult to assess. This may lead us to conclude that while the economic analysis of labour standards may help improve our understanding of how such laws operate, in and of itself it does not provide clear normative guidance to policy makers. At the end of the day, the case for social policy interventions will continue to be made on broader, ethical grounds.

Bibliography on Minimum Wage Legislation (5520) Becker, G. (1957), The Economics of Discrimination, Chicago, University of Chicago Press. Brown, C., Gilroy, G. and Kohen, A. (1982), 'The Effect of the Minimum Wage on Employment and Unemployment', 20 Journal of Economic Literature, 487-528. Brozen, Yale (1962), 'Minimum Wage Rates and Household Workers', 5 Journal of Law and Economics, 103-109. Brozen, Yale (1969), 'The Effect of Statutory Minimum Wage Increases on Teen-Age Employment', 12 Journal of Law and Economics, 109-122. Card, D. (1991), Do Minimum Wages Reduce Employment? A Case Study of California 1987-1989, NBER Working Paper, 3710. Card, D. and Krueger, A. (1995), Myth and Measurement - the New Economics of the Minimum Wage, Princeton, Princeton University Press. Card, D., Katz, L. and Krueger, A. (1993), An Evaluation of Recent Evidence on the Employment Effects of Minimum and Subminimum Wages, NBER Working Paper, 4528. Colberg, Marshall R. (1960), 'Minimum Wage Effects on Florida's Economic Development', 3 Journal of Law and Economics, 106-117.

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Cousineau, Jean-Michel (1991), 'L'Effet du Salaire Minimum sur le Chômage des Jeunes et des Femmes au Québec: une Réestimation et un Réexamen de la Question (The Impact of a Minimum Wage on Unemployment of Young People and Women in Quebec: A New Look at the Question)', 67 Actualité Economique, 144-165. Craig, C., Rubery, J., Tarling, R. and Wilkinson, F. (1982), Labour Market Structure, Industrial Organisation, and Low Pay, Cambridge, Cambridge University Press. De Bruyne, G. (1987), 'Inkomensvorming en Deregulering van de Arbeidsmarkt: 2. Indexering (Income Formation and Deregulation in the Labour Market: Indexation)', in X (ed.), 18de Vlaams Wetenschappelijk Economisch Congres, Brussel 8 en 9 mei 1987, Sociaal-economische Deregulering, Brussel, V.E.H.U.B., 249-263. Deakin, Simon and Wilkinson, Frank (1991), 'Labour Law, Social Security and Economic Inequality', 15 Cambridge Journal of Economics, 125-148. Deakin, Simon and Wilkinson, Frank (1992), 'The Law and Economics of the Minimum Wage', 19 Journal of Law and Society, 379-392. Deakin, Simon and Wilkinson, Frank (1999), 'Labour Law and Economic Theory - a Reappraisal', in De Geest, Gerrit, Van den Bergh, R. and Siegers, Jacques J. (eds), Law and Economics and the Labour Market, Aldershot, Edward Elgar. Dickens, R., Gregg, P., Machin, S., Manning, A. and Wadsworth, J. (1993), 'Wages Councils - Was there a Case for Abolition?', 31 British Journal of Industrial Relations, 515-529. Fortin, Pierre (1980), Les Conditions Minimales de Travail: leurs Conséquences Économiques (The Fixation of Minimum Working Conditions: Their Economic Consequences), 35e Congrès des Relations Industrielles, La Détermination des Conditions Minimales de Travail par l'État: une Loi: son Économie et sa Portée. Hashimoto, Masanori (1987), 'The Minimum Wage Law and Youth Crimes: Time-Series Evidence', 30 Journal of Law and Economics, 443-464. Heldman, D., Bennett, J. and Johnson, M. (1981), Deregulating Labor Relations, Dallas, Fisher Institute. Horrell, S., Burchell, B. and Rubery, J. (1989), 'Unequal Jobs or Unequal Pay?', 20 Industrial Relations Journal, 176-191. Keenan, J. (1995), 'The Elusive Effects of the Minimum Wage', 33 Journal of Economic Literature, 1950-1965. Leffler, Keith B. (1978), 'Minimum Wages, Welfare, and Wealth Transfers to the Poor', 21 Journal of Law and Economics, 345-358. Low Pay Commission (1998), The National Minimum Wage. First Report of the Low Pay Commission, Cm 3976. Machin, S. and Manning, A. (1994), 'Minimum Wages, Wage Dispersion, and Employment: Evidence from UK Wages Councils', 47 Industrial and Labor Relations Review, 319-329. Michie, Jonathan (1987), Wages in the Business Cycle: An Empirical and Methodological Analysis, Oxford, Basil Blackwell. Minford, P. (1985), Unemployment: Cause and Cure (2nd edn), Oxford, Basil Blackwell. Miyagiwa, Kaz (1989), 'Human Capital and Economic Growth in a Minimum Wage Economy', 30 International Economic Review, 187-202. Neumark, D. and Wascher, W. (1995), The Effect of New Jersey's Minimum Wage on Fast Food Employment: a Re-Evaluation Using Payroll Data, NBER Working Paper, 5224.

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Nolan, P. (1983), 'Labour Market Behaviour and the Firm', in Bain, G. (ed.), Industrial Relations in Britain, Oxford, Basil Blackwell. OECD (1998), Employment Outlook, Paris, OECD. Polanyi, K. (1944), The Great Transformation, New York, Rinehart & Winston. Posner Richard A. (1984), 'Some Economics of Labor Law', 51 University of Chicago Law Review, 988-1004. Prasch, R. (1996), 'In Defense of the Minimum Wage', 30 Journal of Economic Issues, 391-398. Rottenberg, Simon (ed.) (1981), The Economics of Legal Minimum Wages, Washington, American Enterprise Institute for Public Policy Research. Rowley, Charles K. (1985), 'The Relationship between Economics, Politics and Law in the Formation of Public Policy', in Matthews, R.C.O. (ed.), Economy and Democracy, New York, St. Martin's Press. Rubin, Paul H. and Kau, James B. (1978), 'Voting on Minimum Wages: A Time Series Analysis', Journal of Political Economy, 337-342. Sachdev, Sanjiv and Wilkinson, Frank (1999), The Labour Market, the Minimum Wage, and the Low Pay Commission Report, CBR Working Paper, 110. Shaviro, Daniel N. (1997), 'The Minimum Wage, the Earned Income Tax Credit, and Optimal Subsidy Policy', 64 University of Chicago Law Review. Stigler, George J. (1946), 'The Economics of Minimum Wage Legislation', 36 American Economic Review, 358-365. Treasury (1998), The Modernisation of Britain's Tax and Benefit System. Number Three: The Working Families Tax Credit and Work Incentives, London, Her Majesty's Treasury. Trejo, Stephen J. (1991), 'The Effects of Overtime Pay Regulation on Worker Compensation', 81 American Economic Review, 719-740. Uri, Noel D. and Mixon, J. Wilson, Jr (1980), 'An Economic Analysis of the Determinants of Minimum Wage Voting Behavior', 23 Journal of Law and Economics, 167-177. Yaniv, Gideon (1994), 'Complaining about Noncompliance with the Minimum Wage Law', 14 International Review of Law and Economics, 351-362. Zabalza, A. and Tzannatos, T. (1985), Women and Equal Pay. The Effects of Legislation on Female Employment and Wages in Britain, Oxford, Basil Blackwell.

5530 EMPLOYMENT DISCRIMINATION Stewart J. Schwab Professor of Law Cornell University School of Law © Copyright 1999 Stewart J. Schwab

Abstract This chapter first discusses the multiple overlapping definitions of discrimination, including distinctions between group and individual discrimination and between segregation and discrimination in pay. It then summarizes the major economic models of discrimination, particularly Becker’s taste-for-discrimination model and statistical-discrimination models, as well as sorting and status-production models. The discussion focuses on the conditions under which markets will tend to eliminate discrimination, noting that this occurs in a more limited range of situations than commonly recognized. The chapter next surveys the economic role of anti-discrimination laws, evaluating arguments that the law speeds the journey to a non-discriminatory equilibrium and that the law breaks social norms perpetuating inefficient discrimination. Finally, it examines empirical studies of employment discrimination laws, including analyses of litigation trends and of the laws’ effects on labor markets. JEL classification: J15, J16, J70, J71, J78 Keywords: Discrimination; Statistical Discrimination; Status-Production Model

1. Scope of Law and Economics Analysis of Employment Discrimination The law and economics scholarship on employment discrimination examines the welfare consequences of the legal rules regulating employment discrimination. While substantial overlap exists, the inquiry is distinct from the efforts of labor economists to determine the extent of discrimination in labor markets. For recent surveys in this vein, see Darity and Mason (1998); Blau (1998). It is also distinct from the efforts of academic lawyers to describe and criticize employment discrimination laws. The major task of law and economics work surveyed here is to link the two inquiries by studying the effects of law on the labor market. This review limits itself to the literature on race and sex discrimination, ignoring the important areas of

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age discrimination (see Posner, 1995, for an excellent overview of the issues), and disability discrimination.

2. Definitions of Discrimination The term ‘discrimination’ is elusive. A wine expert is admired for his discriminating taste, but an employer with a taste for racial discrimination is despised (see Cooter, 1994, p. 137). For an extensive discussion of various definitions of discrimination, see Kelman (1991). An overly broad definition would say that an employer discriminates whenever it distinguishes between two workers because they belong to different groups. To see that the definition is too broad, consider an employer who pays ‘highly productive’ workers more than ‘less productive’ workers. Although distinctions based on productivity (or, more broadly, merit) violate a policy of egalitarianism, they do not implicate traditional concerns of discrimination. One must be careful with the meaning of ‘productivity’ as well. Aigner and Cain (1977) define productivity in terms of physical output or actual job performance. They recognize that discrimination against, say, blacks, can always be explained away if their productivity includes antipathy they create in others unrelated to their output or performance. As a second attempt at definition, perhaps discrimination occurs whenever an employer treats equally productive workers differently because of any group characteristic other than, but perhaps related to, productivity. As Cooter (1994, p. 137) suggests, ‘discrimination in economic life usually consists in sorting people according to traits rather than productivity’. This definition, at least for law, is both too broad and too narrow. The definition is over broad because every distinction can be said to be based on a group characteristic, but only some group distinctions are discriminatory. The problem comes in separating invidious discrimination from appropriate (or benign, or merit-based, or non-problematic) distinctions. For example, an employer might distinguish between equally productive college and high school graduates, or between equally productive workers scoring 95 and 85 on a test, or between equally productive black and white workers. Only the last distinction is generally labeled discrimination, because it is based on a suspect or protected group. Anti-discrimination laws have prohibited employers from making distinctions on a number of characteristics, including race, color, sex, age, religion, national origin, age, sexual orientation, marital status and disability. In general, but not invariably, these are immutable characteristics over which the person has no control. Often they are irrelevant characteristics for proper or profit-maximizing employment decisions, but models of statistical discrimination wrestle with situations when these characteristics are correlated with productivity. Epstein (1992, p. 413) has

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attacked as inherently arbitrary the labeling of certain distinctions as invidious discrimination. As he puts it, a ‘central part of [my] argument against Title VII was that there is no independent conception of which characteristics count as “merit” characteristics and which are invidious’. While difficult lines must be drawn (do distinctions based on beauty, obesity, or veteran’s status count as discriminatory?), the law has singled out a few distinctions as legally discriminatory, the most important being distinctions based on race and sex. Still, it is too narrow to define discrimination as occurring only when an employer treats two equally productive workers differently because of a protected characteristic. This definition matches the legal concept of ‘disparate treatment’ fairly closely. But the definition is narrower than one that focuses on effects. A worker in a protected group could be said to be discriminated against whenever he or she is treated differently than someone in another group on grounds other than productivity. This definition includes the legal concept of ‘disparate impact’. For example, employers often distinguish between workers on the basis of non-protected characteristics, such as education, test scores, or criminal convictions. While the anti-discrimination laws do not protect criminals or those with low education or test scores, the laws do forbid employers from distinguishing on such a trait if it has a disparate impact on racial or gender lines and the employer cannot demonstrate that the practice is job related and a business necessity. Some scholars, including Aigner and Cain (1977), have separated individual from group discrimination. They argue that individual or within-group discrimination is inevitable. As an example, they note that when college graduates are paid their average productivity and high school graduates paid their (lower) average productivity, some high-school graduates will be paid less than their individual productivity (and others paid more, although rarely will an individual complain about being overpaid). But no group discrimination exists. Similarly, they note that racial group discrimination might not occur even when black and white individuals of the same underlying ability are not paid equally, because the overpayment of some might cancel the underpayment of others. In their definition, then, discrimination only occurs when groups with the same average productivity receive different average pay. Anti-discrimination law, however, does not separate individual and group discrimination. An individual black who is treated worse than a white with the same productivity has a claim under the anti-discrimination laws, regardless of whether other blacks might be treated better than whites of corresponding ability. A final definitional complication is that some writers separate discrimination from segregation. For example, Becker (1971, p. 57) declared

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that ‘[m]any serious errors have been committed because of a failure to recognize that market segregation and market discrimination are separate concepts’. Racial discrimination occurs when blacks earn less than whites of comparable productivity; racial segregation occurs when race affects job assignments by particular firms. Segregation without discrimination can occur when all-black firms pay workers the same as all-white firms of equal productivity. Discrimination without segregation occurs when blacks and whites of equal productivity work in the same firms but blacks are paid less. Segregation and discrimination can go together. Strauss (1991, p. 1635) has warned of the long-term dangers of ‘separate but equal’ segregation. Anti-discrimination laws prohibit employers both from discriminating in wages and from segregating their workforces.

3. Economic Models of Discrimination Economists have developed two prominent models of why employers discriminate - a taste model and a statistical discrimination model. Two other models - a sorting model and a status-production model - have appeared more recently. 3.1 Becker’s Taste for Discrimination Model In the 1950s, Becker ([1957] 1971) introduced the ‘taste for discrimination’ model that captures the intuitive notion of invidious discrimination. An employer has a taste for discrimination, according to Becker, when he acts ‘as if he were willing to pay something ... to be associated with some persons instead of others’ (Becker, 1971, p. 14). This definition is general enough to finesse the issue discussed above of which group distinctions are discriminatory, but Becker focused on race discrimination. Assume that group-W and group-B workers (to update Becker’s original notation of W and N) are equally productive, and that employers are willing to pay ‘d’ not to associate with B workers. In equilibrium, the market wage for W workers is w, equal to the marginal revenue product of W workers. The wage of B workers, however, is w - d. Under this model, in the short run black workers will receive a lower wage than white workers of equal productivity, and discriminatory firms will earn lower monetary profits than non-discriminatory firms. Becker also introduced variants of his model in which customers or employees had a taste for discrimination, meaning that they would demand lower prices or higher wages when associating with black employees. Profit-maximizing firms will respond by segregating their workforces. If enough non-discriminatory customers or employees exist, all-black or integrated firms can pay the same wages as all-white firms. If the taste for

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discrimination is pervasive, however, black workers will be segregated and paid less. Many scholars have asserted that, under Becker’s model, in the long run competitive markets will eliminate firms with a taste for discrimination. Posner (1987), for example, has said that discrimination can persist only with some kind of market failure. The issue is more complex, however. The basic point, not fully realized in the literature, is that markets cater to tastes rather than drive them out. People willing to pay for the costs of apples, or safety, or discrimination, will have it provided to them. True, well-functioning markets confront actors with the full costs of their actions, and so only actors who value their taste more than it costs to produce will indulge. In this sense, markets discipline tastes. One cannot indulge the taste for discrimination or apples on a whim, but will have to pay for it. Further, the taste for discrimination in labor markets is tied to another product - profits for employers, wages and other working conditions for workers, and the physical product or service for customers. Markets will confront actors with the costs of tying. Discrimination will be tied to the product only for actors willing to pay for the joint good. But it seems wrong to say, in general, that competitive markets will drive out a taste. Rather, markets drive out tastes that people are not willing to pay for, and markets sustain tastes where value exceeds cost. The taste for discrimination differs from the taste for apples in one respect, in that it directly affects other market actors. A customer’s preference for red over green apples lowers the relative price of green apples, but the green apples do not care. A customer’s preference for white over black workers lowers the wage of black workers, and the black workers suffer lower utility. It may seem that a discriminatory taste imposes an externality on black workers. But this is not so. Externalities occur when the full costs of a market transaction are not borne by the decision makers. Here, however, the discriminatory customer faces higher prices passed on by the employer who hires a more expensive white workforce. Becker himself was more cautious, and claimed only that ‘under certain conditions’ would competitive markets eliminate discriminatory employers (1971, p. 45). A number of points - some pointing to market failure but others not - can be made that suggest that a taste for discrimination is consistent with competitive markets in the long run. First, production technology matters. If constant-returns-to-scale technology exists, so that one firm can expand indefinitely without increasing its average costs, then a single non-discriminating firm can undersell all others and produce the entire industry output (Becker, 1971, p. 44). But if costs rise with output, more than one firm is required to eliminate discrimination. If employer discrimination is pervasive, there may not be

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enough non-discriminating firms to hire all the minority workers and eliminate the wage differential. Becker (1968, p. 210) has suggested that a shortage of entrepreneurial skill may prevent firms from fully eliminating discrimination, and thereby declared that ‘discrimination exists, and at times even flourishes, in competitive economies’. Donohue (1997, p. 180) is unconvinced by the shortage-of-entrepreneurs explanation. It did not take special skill to know that hiring low-wage black workers in the textile industry would be profitable - unless, as Donohue puts it, ‘the scarce skill was knowing how to do this without having one’s mill burned down by the Ku Klux Klan’. Second, a firm with a taste for nepotism, as Becker called it, will thrive in a competitive market. A nepotistic employer gains utility from hiring whites, as distinct from a discriminatory firm that loses utility from hiring blacks. An all-white nepotistic employer, then, has a (subjective) cost advantage over both non-discriminatory and discriminatory employers and thus could produce the entire output, assuming constant returns to scale (see Becker, 1971, p. 44 n.4; Goldberg, 1982). Donohue (1986, p. 1422) finds the nepotism theory unimportant, arguing that the basic assumption that favoritism rather than animus drives discrimination is ‘arbitrary and unrealistic’. Third, as mentioned above, employers willing to pay for their taste in discrimination with lower profits can remain competitive indefinitely. Two scenarios are imaginable here, the closely-held firm and the joint-stock company. An entrepreneur who works alongside his employees may dislike working with blacks, and thus prefer an 8 percent monetary return with an all-white workforce to a 10 percent monetary return with an integrated or all-black workforce. He will stay in business if he is willing to reject offers from non-discriminatory entrepreneurs willing to pay the full monetary value (10 percent return) for the firm. If only a few entrepreneurs with his discriminatory tastes exist, these few firms will be segregated with no market discrimination. If enough discriminatory entrepreneurs exist, discrimination against blacks as well as segregation will occur. The capital market will pressure discriminatory entrepreneurs to sell out, thereby capturing the high monetary return, and retire or go into another business that does not require association with blacks to make high profits. But this repeats the point that if entrepreneurs are willing to pay for their taste in discrimination, the market allows them to do so. The alternate scenario involves dispersed shareholders who do not physically associate with the firm. Some investors might willingly accept lower monetary returns in order to indulge in their taste for investing in discriminatory firms, increasing their overall return as they see it. This is the flip side to the South Africa divestiture movement of the 1980s, where investors willingly accepted lower returns by refusing to invest in firms involved in South African apartheid. If only a small number of investors act this way, segregation may occur without discrimination. If enough discriminatory investors are willing to accept lower monetary returns, they can permanently lower black wages.

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Perhaps a more important explanation for long-run discrimination is that profit-maximizing employers in competitive markets will cater to the discriminatory tastes of employees or customers. If some customers will pay less for a product or service from a black employee, or some employees demand hire wages to work with blacks, black employees become less valuable. As Strauss (1991) has ably recounted, the result could be segregation or discrimination. The issue is analogous to the debate whether domestic labor standards are ineffective in the face of foreign competition. There, the assertion is that workers in developing countries willing to work in unsafe conditions or forego other benefits will undercut domestic workers with a taste for safety. While it is far from clear that cheap foreign labor even sets overall levels of compensation domestically (see Freeman, 1995), profit-maximizing domestic employers will provide benefits that workers are willing to pay for with reduced wages, even in the face of foreign workers with no taste for benefits. Analogously, workers with no taste for discrimination will not undercut workers willing to pay for their taste for discrimination. Other scholars point to market imperfections to explain the persistence of discrimination. Epstein (1992) blames governmental Jim Crow laws for maintaining discrimination. Like other governmental regulation that interferes with labor markets, these laws mandating segregation perpetuated discrimination. Critics of Epstein have noted that Jim Crow laws, while mandating segregated schools, busses, and marriages, almost never regulated labor markets (see Verkerke, 1992). Labor market impediments were far broader than mere governmental restrictions. Indeed, a debate in the literature is the degree to which discriminatory social norms can persist without government involvement. Becker (1971, pp. 46-47) pointed to monopolies as a market imperfection. He emphasized that one of the fruits of a product monopoly is the ability to indulge in a taste for discrimination in the labor market without suffering competitive harm. The firm will earn lower profits than if it hired the cheapest possible labor of a given quality, but can still earn above-average profits. Still, if the monopoly is transferable, a discriminating monopolist has pressure to sell out to those without a taste for discrimination. In other words, competitive capital markets as well as competitive product markets put pressure on discriminatory employers. In a somewhat different vein, Akerlof (1985) shows that discrimination can persist in competitive markets with transaction costs. Suppose some traders have a taste for discrimination against blacks while others do not, and that it takes time or money to distinguish discriminators from others.

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Firms with black employees will miss out on some trades and be under a perpetual cost disadvantage. 3.2 Statistical Discrimination In Becker’s employer-taste-for-discrimination model, employers lose profits by discriminating, even if they gain in utility. The deviation from the profit-maximizing assumption was troubling. This deviation meant that competitive pressures might reduce or eliminate discrimination, although as discussed above, more or less ad hoc or secondary assumptions can explain the persistence of discrimination within the taste-for-discrimination model. As an empirical fact, the seeming persistence of discrimination cast doubt on Becker’s model. As Arrow (1972, p. 192) observed, only a poor model ‘predicts the absence of the phenomenon it was designed to explain’. Still, as Samuelson (1951, p. 323) put it in discussing labor market models, ‘In economics it takes a theory to kill a theory; facts can only dent the theorist’s hide’. In response to the shortcomings of the taste model, economists developed models of statistical discrimination as an application of the growing insights from limited-information theories (see Phelps, 1972; Arrow, 1973; Aigner and Cain, 1977). These models assume no prejudice or invidious motive by employers. Rather, employers use group characteristics as a cost-effective way of predicting individual worker attributes in a world of limited information. A profit-maximizing employer wants to hire the worker with the highest expected productivity for the going wage. But gathering information to predict individual productivity is costly. Rather than undertake an expensive inquiry into the quality of the high schools attended by job applicants, the employer might assume that on average blacks attend lower-quality high schools than do whites. Or, rather than undertake a lengthy interview, the employer might assume that a woman job applicant is more likely to quit than an otherwise similar man, or is likely to put a greater drain on the pension fund by living longer in retirement. These stereotypes are merely statistical correlations, hence the term statistical discrimination. Employers that rely on false stereotypes will face a competitive disadvantage similar to employers acting on a taste for discrimination, because they are not hiring the most productive workers. But some stereotypes are true, in the sense that the average differs by group even though the generalization does not apply to many members of the group. Profit-maximizing employers will statistically discriminate whenever the net gains from using the cheap but often-inaccurate proxy outweighs the net gains of more accurate but more costly individualized information. Statistical discrimination models, while differing in their precise formulations, show how individuals from disfavored groups can receive less

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pay than individuals with identical ability but from favored groups. The stereotypes can arise from ‘innate’ differences between the groups (differences in longevity being one of the less controversial examples here, although even here some argue that women live longer than men because they have been excluded from high-stress jobs), stereotypes can also arise from invidious discrimination outside labor markets (for example, in education), or from the effects of prior labor market discrimination. In Aigner and Cain’s prominent early model, the group differences arose because an individual productivity test predicted white performance more accurately than black performance. Statistical discrimination can persist over time, for it is engaged in by profit-maximizing employers. Nevertheless, pressures exist to reduce statistical discrimination. Money can be made through developing low-cost tests and other methods of predicting individual worker ability that reduce the gains from blunt stereotyping. It might seem that statistical discrimination increases overall efficiency by allowing individual employers to maximize their individual profits. In a world of imperfect information, statistical discrimination indeed helps place workers in jobs where their expected productivity is most valued. But statistical discrimination, by tying individuals to group averages beyond their control, creates an externality that can thwart overall efficiency. Statistical discrimination uses average valuations, rather than marginal valuations which are necessary for efficient resource allocation. Individual incentives can be dulled. For example, in the Aigner-Cain model workers are paid a weighted average of their individual predicted productivity and their group average productivity. Workers in such a model invest too little in training, because they are not completely compensated for individual increases in productivity. As Lundberg and Startz (1983) show, statistical discrimination can exacerbate the distortions. While white workers with statistical discrimination will be encouraged to receive more training, this can be more than offset by the discouragement of blacks to receive training. One empirical problem with the Lundberg-Startz model is that the returns to education are higher for blacks than white, at least in recent years (see Donohue and Heckman, 1991b; Sunstein, 1991, pp. 29-30), contrary to the prediction that statistical discrimination will discourage blacks to acquire human capital. Statistical discrimination might also exacerbate labor-supply distortions, as shown by Schwab (1986). In his model, workers can work in an individualized market that recognizes individual productivity (self-employment being an obvious example) or in a ‘factory’ that recognizes only average worker ability. Suppose the more-productive workers in the individualized market are also more productive in the factory market. If so, some workers will inefficiently choose the individualized market even though they would produce more in the factory market, because they would

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receive only the average factory wage. Now suppose factory employers learn one more thing about their workers, which is their group status, and productivity varies by group. Favored-group workers are encouraged to work more in the productive factory market, but disfavored-group workers are discouraged. Under plausible scenarios, the discouraged workers can outweigh the encouraged workers, reducing overall efficiency. For example, suppose employers statistically discriminate against women because of their greater average quit rate. This may inefficiently divert women toward selfor home-employment. If men are likely to remain employees in the outside labor market regardless of statistical discrimination (that is, men have a more inelastic labor supply), the discouragement of women will outweigh the encouragement of men. 3.3 Sorting Model In his important book advocating a repeal of employment discrimination laws, Epstein (1992) introduces a sorting and searching model that blends aspects of the statistical and taste models. For a sympathetic review, see Crespi (1992). Epstein argues that decentralized markets provide substantial protection against discrimination. Epstein contrasts the victims of violence and the victims of discrimination. Without strong laws against violence, people have to be on guard against violent people. That is why we lock our house even when 99 percent of our neighbors are friendly. Even if one pays off one violent person, others will arise. Once laws against violence are enforced, people can concentrate on finding people who make good offers. Even if 90 percent of the people refuse to deal with someone because of his race, he can concentrate on doing business with the remaining 10 percent. The bigots are powerless to block their mutually beneficial deals. Epstein recognizes, however, that competitive forces will not totally eliminate discrimination. Much of the remaining discrimination is an efficient response by firms to sorting problems. To have smooth workplace arrangements, firms must solve many collective goods problems. What type of firm atmosphere will exist, from type of piped-in-music to work intensity to degree of office talk? When workers have very different tastes, a firm has difficulty making a decision that will not anger many. ‘To the extent that individual tastes are grouped by sex, by age, by national origin - and to some extent they are’ says Epstein, smooth operation of the firm may call for sorting on these groups. Epstein recognizes that diversity, say in a sales staff, has benefits as well. Some profit-maximizing firms will opt for diversity, but others for homogeneity. For a related argument, see Cooter (1994, pp. 141-44).

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3.4 Status-Production Model of Discrimination Becker’s taste model assumed rather simplistically that individual discriminators wanted to avoid associating with people with certain characteristics, and were willing to pay to indulge in this taste. The model ignored the fact that discriminatory whites were often willing to closely associate with blacks, so long as the relationship maintained hierarchy. A prime example was the common practice of whites employing black domestic workers in their homes. More importantly, the taste model gives no importance to group status. McAdams (1995) has developed a quite different model, which he labels a status-production model. The key element is that whites form a socially connected group that invests in elevating its self-esteem by subordinating blacks. The importance of group solidarity explains why whites will not deviate from the social norm by hiring blacks into important positions. Building on Akerlof’s (1985) model, McAdams posits that the deviator loses intra-group status, and that the group develops a secondary norm of shunning or otherwise punishing the deviator. Thus, the profit-maximizing entrepreneur calculates that he loses more than he gains by hiring the shunned but cheap blacks. The status-production model captures the virulent aspects of racism. Its vision of discrimination is more brutal than the prissier taste model, which seems to apply more ‘to a kind of tea party discrimination than to the blood and steel of the southern racial scene’ (Higgs, 1977, p. 9). As McAdams (1995, p. 1063) emphasizes, the model predicts that discrimination ‘will persist in the face of market competition’. It also explains why lower-class whites are most likely to discriminate, because they are least able to produce status in other ways. The status-discrimination model may well explain the Jim Crow South. More open to question is whether it captures the central features of discrimination today, particularly discrimination based on sex, age, or disability. Epstein (1995) has termed the status-production model a sideshow, applicable to government-sponsored discrimination of the Jim Crow South but little else. He suggests that the enforcement of discriminatory norms is impossible without violence. As he puts it, ‘[c]oercion is always the main event; status production is the side show’.

4. The Economic Role of Anti-Discrimination Laws One’s views on the need for and effectiveness of law depends greatly on one’s model of discrimination. The taste-for-discrimination model sees little need for law. Starting with the premise that markets would root out taste-based discrimination, early law and economics writers urged civil

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rights advocates to rely on markets rather than laws (see Friedman, 1962; Demsetz, 1965). An exception to this early writing is Landes (1968). He posits that fair employment laws raise the cost of discrimination and thus, at the margin, will discourage employers from discriminating and will raise the black-white wage ratio. Posner (1987) complains that the anti-discrimination laws are often counter-productive. Profit-maximizing employers break down discriminatory barriers by hiring qualified blacks at their lower market wage rate, thereby obtaining a cost advantage over discriminatory employers. But the anti-discrimination laws prohibit an employer from paying unequal wages for equal work (indeed, a separate Equal Pay Act prohibits wage discrimination against women, in addition to the general anti-discrimination prohibition of Title VII). Anti-discrimination laws are less effective at finding employers liable when they refuse to hire minority workers at all. Thus, the laws penalize profit-maximizing employers who pay low wages to blacks, but in practice condone employers who refuse to hire blacks. Posner’s argument assumes that wage discrimination occurs within a firm, but this rarely happens. As Wright (1986) has shown, throughout this century employers rarely paid blacks less than whites for identical work within a firm, even when it was legal to do so. Rather, blacks were excluded from many high-paying jobs and industries. Even law and economics scholars more sympathetic to the basic thrust of anti-discrimination laws have worried about some of its perverse incentives. For example, Ayres and Siegelman (1996) warn that disparate impact litigation might induce employers to discriminate against minorities in hiring. Their conclusion runs counter to the usual assertion that disparate impact litigation (which focuses on the relative numbers of minority and majority workers) leads to hiring quotas by employers. But Ayres and Siegelman show that, in recent years, most disparate impact opinions involve firing cases rather than hiring cases. A firing disparate impact case is easier to show because the relevant pools exist within the firm (a greater fraction of black than white employees were terminated), whereas in a hiring case great debate concerns the appropriate pool to compare racial hiring patterns with (all workers? all skilled workers? all suburban workers?). The danger to employers, then, is that hiring large numbers of minorities opens them up to a disparate impact firing suit. For a related argument that anti-discrimination laws do not lead to quota hiring, see Issacharoff (1992, pp. 1238-1239). Other scholars looked with more sympathy on the efficiency justifications for anti-discrimination laws, even within the taste-based model. Donohue (1986) has argued that the laws speed up the market’s push towards non-discrimination. Employers with a taste for discrimination have higher costs than non-discriminatory employers. Anti-discrimination laws, to the

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extent they are effective, impose additional costs on employers who discriminate and thus drive them from the market more rapidly. Posner (1987) criticized Donohue for ignoring the costs of government enforcement, arguing that government intervention could make the transition to non-discriminatory markets inefficiently quickly, just as a government mandate that shippers adopt a new, fuel-efficient technology would wastefully cause old ships to be scrapped too quickly. The market is best, asserted Posner, at both eradicating discrimination and determining the optimal timing in which to eradicate discriminate. Posner’s basic objection to Donohue’s argument was that Donohue argued that government intervention was efficient without pointing to some market failure, such as externalities, monopoly, or high information costs, that casts doubt on the market solution. Donohue, in response, rejected Posner’s analogy to shippers, because it implicitly assumed that shipping was in equilibrium when a new technology was discovered, while the existence of discriminatory employers shows that labor markets were not in equilibrium under the Becker model. Companies with outmoded machines cannot be suddenly made efficient by changing ownership, but companies with a taste for discrimination can be suddenly made more efficient by switching ownership, because the psychic costs of discrimination immediately disappear. Later, taking up more directly Posner’s challenge to point to the market failure, Donohue (1992) pointed to third-party moralists who abhor discrimination directed against others. Their preferences are not considered in the contracts between employers and black and white employees. Even if discriminating employers are willing to pay for their taste for discrimination in reduced profits, the outcome is not efficient because employers are ignoring the external harm their discrimination causes these moralists. Conducting a ‘thought experiment’, Donohue argued that if the average adult American were willing to pay $100 per year to keep Title VII, the resulting $17.5 billion benefits would outweigh a ‘middle-case’ estimate of its administrative and incentive costs. Donohue (1997, p. 28) has acknowledged that economists generally try not to rely on altruism or the preferences of moralists in making efficiency arguments. The status-discrimination model makes the sharpest efficiency justification for the anti-discrimination laws. In that model, employers are trapped by the fear of white stigma from integrating their workforces. As Lessig (1995) has put it, hiring blacks would mark an employer as having either a special greed for money or affection for blacks. The anti-discrimination laws put an important ambiguity in the decision; perhaps the employer hiring a black merely wants to obey the law. By altering the social meaning of discrimination, the anti-discrimination laws can break the

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cartel-like solidarity among whites, just as anti-dueling laws ended an inefficient social practice in the previous century (see also McAdams, 1995). Even Epstein has recognized the usefulness of the anti-discrimination laws in ending rigidities in southern labor markets. As he puts it, ‘Title VII was heaven-sent’ (Epstein, 1992, p. 251). Epstein emphasizes that Title VII destroyed the web of indirect legal sanctions against firms trying to exploit the profit potential in discrimination, rather than merely alter private behavior. As he explains, in the pre-Title VII south it was all to easy for an all-white town board to lose a building application, or postpone a meeting to approve the sewage connection, of a firm that violated the segregation norms of the era. Epstein’s major point, however, is that much contemporary discrimination is efficient, as indicated in his sorting model and in some statistical discrimination models. He therefore concludes that continuance of the anti-discrimination laws imposes heavy costs that are no longer worth the gains. Other law and economics scholars have questioned the means rather than ends of anti-discrimination law. Cooter (1994), for example, has argued that the absolute regulatory prohibition against discrimination is an inefficient method of controlling discrimination. Cooter’s premise is that some discrimination is efficient and thus should not be prohibited, but that market imperfections may allow too much discrimination and perhaps justify intervention. Analogizing to the use of taxes or tradeable permits to control pollution, Cooter suggests that anti-discrimination laws should tax employers who employ too few blacks or women, or give employers tradeable rights, rather than prohibit discrimination altogether. A tax or tradeable rights regime can reach equivalent levels of discrimination, differing only in whether government officials adjust prices or quantities. Either method can enforce discrimination laws at lower cost than a flat prohibition, in part by allowing firms with especially high costs of complying (for example, few qualified minorities are in their particular pool) to hire fewer minorities. Strauss (1991) makes a similar argument, phrasing it as a preference for disparate impact analysis than disparate treatment analysis. Current disparate-treatment law prohibits firms from ever considering race in a decision. Strauss argues that this is costly to enforce because it requires extensive case-specific findings. Many cases of invidious discrimination go unchecked, while some cases of efficient discrimination (particularly efficient statistical discrimination) are banned. Far better, Strauss says, would be to require employers to pay a fine if they do not hire proportionately to the nationwide labor force. If a firm has correct bottom-line numbers, it can then make individual decisions to hire or fire without scrutiny by the anti-discrimination laws. In making this argument, Strauss uses an unconventional conception of disparate impact, because he would not require the government to point to a specific employment

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practice, such as a test, that caused the firm to hire fewer blacks. In a similar vein, Mashaw (1991) has argued for racial quotas, with firms with a small percentage of blacks in their workforce being allowed to buy permits from firms with large black workforces. One problem with such tax, fine, or tradeable rights schemes is that the government needs detailed information to set the optimal tax rate. Enormous wasteful lobbying would occur by rent-seeking advocates seeking higher or lower rates or special exemptions. A greater problem is the symbolism of allowing trade in rights to discriminate, although this symbolism has been overcome in allowing tradeable pollution rights. Bell (1992, pp. 47-64) has savagely satirized the concept of tradeable rights. Bell calls his hypothetical Racial Preferencing Licensing Act a ‘legalized reincarnation of Jim Crow’. McCaffery (1993) has likewise advocated tax reform as a solution to sex discrimination. McCaffery sees extensive market failures that create disparities between men and women, including search costs and incomplete markets, but he emphasizes the failures from tax policy. The result of these market failures, he suggests, is that women have been given a stark choice: act like men and become highly committed to the paid labor force, or get out. The market has been dictating choices rather than accommodating them, as Epstein would see it. McCaffery advocates higher taxes on primary workers, typically married men, and lower taxes on secondary workers, typically married women. These changes could unravel the dynamic that leads to polarized options for women.

5. Empirical Studies of Employment Discrimination Law Unlike law and economics scholarship in many other areas, the scholarship in employment discrimination has gone beyond model building and has taken a serious empirical look at discrimination litigation and the effects of anti-discrimination law. The amount of employment discrimination litigation has exploded in the last quarter century. Between 1970 and 1989, employment discrimination case filings rose by 2,166 percent, compared to a rise of only 125 percent in the overall civil docket (Donohue and Siegelman, 1991). By 1995, employment cases (about 80 percent of which are discrimination cases) comprised 6.8 percent of the federal civil docket (Eisenberg and Clermont, 1995). Employment cases are less likely than other cases to privately settle out of court. Employees win only 26 percent of cases going to trial, significantly less than the 45 percent overall win rate by plaintiffs in federal civil litigation (Eisenberg and Clermont, 1995). Most employment-discrimination cases protest firings, not refusals to hire. The common image of discrimination is that employers reject black or

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women job applicants or pay black or women workers less for the same work. Indeed, in the early years of Title VII litigation, most cases were hiring cases. By the 1980s, however, firing cases were six times more common than firing cases. Donohue and Siegelman (1991, p. 1015). An employer is thus far more likely to be sued when it terminates a minority worker than when it refuses to hire minority job applicants. This makes employers more reluctant to hire minorities in the first place. Paradoxically, societal success in overcoming discriminatory barriers may explain much of the rise in discrimination litigation (see Donohue and Siegelman, 1991, pp. 1006-1015). A worker is more likely to sue when rejected from a high-paying job than a low-paying job, because the payoff of a successful lawsuit increases while the costs of litigation vary little with pay. Further, lawsuits protesting discrimination are more likely as the workforce becomes more integrated, because it becomes easier to show that the rejected black or woman was treated less favorably than a white male. Thus, as women and blacks enter high-paying, integrated jobs, the number of discrimination lawsuits rises. In addition to long-term trends, discrimination lawsuits respond to business cycles. The number of lawsuits increases during recessions, damages for successful suits rise, but win rates fall (Donohue and Siegelman, 1993). The key link is that victims of discrimination receive higher damages the longer they are out of work. Moving beyond empirical studies of the litigation process, several studies have examined whether the anti-discrimination laws have improved black earnings. Such studies are notoriously tricky. Essentially, the researcher is trying to examine changes after a nationwide law goes into effect, when many other changes in society occur as well. In the case of the anti-discrimination laws, Title VII became effective in 1965, coinciding with important executive orders requiring affirmation action by government contractors, a new Voting Rights Act, continuation of the civil rights movement, and general social unrest. Smith and Welch (1989) have argued that federal anti-discrimination laws had little effect on black economic progress, because black/white earnings ratios had been steadily increasing since the 1940s. Better black education and migration from the south to higher-paying jobs in the north are the most important explanations for black economic progress, they suggest, neither of which is directly attributable to law. Donohue and Heckman (1991a) have contested this conclusion. As the title of their review article indicates, they find black economic progress to be episodic rather than continuous. The first period of progress occurred around World War II. The second critical episode was the period from 1964 to 1975, when the black/white earnings ratio increased from 0.62 to 0.72, with most of the progress coming in the South (Donohue and Heckman, 1991a, p.

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1607). Black outflow from the south had slowed dramatically by 1965, and improvements in amount and quality of black schooling explain only part of the post-1965 jump in black earnings. Donohue and Heckman conclude that Title VII, along with other civil rights legislation of the period, had a positive impact on black/white earnings by shaking the economic and social taboos of the south that had prevented employers from hiring black workers. A particularly important example comes from the textile industry in South Carolina, as examined by Heckman and Payner (1989). Prior to 1965, few blacks were employed in the South Carolina textile industry, when black employment levels and wages suddenly rose. Shifts from agriculture and improved black education cannot explain the timing. The mid-1960s saw a tight labor market, making the underemployment of blacks particularly costly to employers. Heckman and Payner find quite plausible the story that in 1965 entrepreneurs ‘seized on the new federal legislation and decrees’ and began hiring black workers as they had wanted to do. Epstein (1992, p. 245) attributes the surge of black employment to the federal government’s attack on Jim Crow regulation, pointing out that South Carolina had a 1915 statute, not formally repealed until 1972, mandating segregation in textile factories. Verkerke (1992, p. 2091) responds that nearby southern states also had highly segregated textile factories but no express segregation law. Some intriguing studies have exploited changes in coverage of Title VII to measure its effectiveness. In 1972 Congress expanded the coverage of Title VII from employers with 25 employees to employers with 15. Chay (1998) has found that relative black employment and earnings rose in industries in the South with a high percentage of small employers, suggesting that the statute increased the relative demand for blacks. Bloch (1994) has also emphasized differences in coverage, noting that the most intensive enforcement of anti-discrimination policy is for federal contractors, followed by employers with 100 or more employees required to file detailed EEO-1 reports on their hiring practices, followed by employers with 15 or more employees who are subject to Title VII. While significant data problems exist, he shows that minorities appear to have greater representation in more-regulated firms. Welch (1989), as reported in Donohue (1989), likewise has found that employment of blacks and women has increased between 1966 and 1980 for EEO-1 reporting firms. Bloch warns, however, that this pattern does not necessarily show any aggregate increase in black employment or wages, and may represent only a shift in black employment from the uncovered to the covered sector. Most analysts agree that, after the 1965-75 surge, blacks have made far less economic progress since then, and that black earnings remain substantially less than for whites, even after adjusting for education and other productivity factors. The anti-discrimination laws seem to have had

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little effect in the last twenty years (although it is always hard to disprove the negative assertion that the laws prevented a decline). Whether more vigorous enforcement of the anti-discriminations would help, or whether they have run their course and further progress must come in other directions, is unclear.

6. Special Issues in Sex Discrimination Laws Much of the general law and economics approach to employment discrimination applies equally to sex and age discrimination as well as race discrimination. Sex discrimination raises a number of special issues, however, and as Epstein (1992) has emphasized, the parallels between race and sex discrimination are imperfect at best. As Wasserstrom (1977) has ably explained, color-blindness is the eventual goal of the anti-discrimination laws, but sex-blindness is not. No employer could provide separate but equal bathrooms for blacks, but all large employers provide separate bathrooms for women. In addition, pregnancy and childbirth uniquely affect women workers. The economic models fit differently for race and sex discrimination. Becker’s taste for discrimination model is formulated generally enough to accommodate a preference against associating with women or blacks. It seems to fit well enough the fact that many bosses, co-workers, or customers prefer dealing with men (and, in other situations, dealing with women). Perhaps men gain status by maintaining group solidarity against women, but McAdams’s status-production model seems somewhat hollow when applied to sex discrimination. Statistical discrimination models, by contrast, often apply well to sex stereotypes. Epstein (1992, p. 65) has applied his sorting model to sex discrimination, emphasizing the divisions within the firm that can arise when women want part-time status. In Posner’s (1989) view, the economics of sex discrimination is distinctive because of the interdependence in utilities of men and women. Married couples have joint consumption and often act altruistically towards each other. Thus, for example, married women indirectly benefit if labor market discrimination increases husbands’ pay. Because racial intermarriage remains rare, blacks do not indirectly benefit when whites are favored. Anti-discrimination law has recognized differences between race and sex discrimination. Most important is the bona fide occupational qualification (bfoq) under Title VII, which applies to sex but not race distinctions. Title VII prohibits employers in any context from using race to sort workers, but allows employers to sort by sex if sex is a bona fide occupational qualification (bfoq). Thus, employers can have separate but equal bathrooms or grooming standards for men and women, but not for race.

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Women tend to live longer than men. Many employers acted on this ‘true stereotype’ in constructing pension plans, using sex-based annuity tables that required women to make higher contributions for equivalent monthly pensions, or receive lower monthly pensions for equivalent contributions. The practice is a paradigmatic example of statistical discrimination. No malicious discrimination was intended, but employers were explicitly using sex as a proxy to predict longevity. Nevertheless, it is illegal. In two cases, Los Angeles Department of Water and Power v. Manhart and Arizona Governing Committee v. Norris, the Supreme Court prohibited employers from using sex-based tables in calculating individual contributions or benefits (although the Court allowed employers to consider the overall percentage of women in calculating whether overall contributions match benefits). The Court reasoned that the anti-discrimination laws demand fairness toward individuals before fairness to groups, and the sex-based classification involved group generalizations rather than ‘thoughtful scrutiny of individuals’. In short, the Court prohibited statistical discrimination even when ‘true’. An extensive law and economics commentary has criticized the pension decisions, arguing that employers should be allowed to consider sex in calculating pension contributions or benefits (see Kimball, 1979; Freed and Polsby, 1981; Benston, 1982; Epstein, 1992). They see employers or their insurance companies using sex classifications to solve an adverse selection problem. With unisex tables, women covered by a pension plan will receive six to twelve percent more than they contribute to the plan (Epstein, 1992, p. 323, citing Benston, 1982, p. 515). These distributional consequences reduce overall welfare, as plan participants begin ‘gaming’ the system. As Epstein points out, strategic considerations become largest when a husband and wife are each entitled to pension benefits. With unisex tables, the couple has an incentive to shift their benefits towards the wife by having the husband take a self-and-survivor annuity and the wife take an annuity for her life alone. Employers have an incentive against hiring women or toward dropping life-time pension benefits. Similar controversy arose over the issue of whether employers violated anti-discrimination laws by excluding pregnancy from health-insurance benefits or pregnancy leave from disability benefits. Epstein (1992, p. 32) emphasizes that pregnancy is a poor candidate for insurance, because it is largely a controlled event and thus a moral hazard problem is created by insuring its costs - women are more likely to become pregnant. Many European countries, concerned with low birth rates, regard this as a favorable aspect of insurance, and provide for pregnancy health costs (generally as part of national health insurance) and paid maternity leave with government programs. Indeed, whether childbirth benefits should be

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provided through government programs or employer mandates is a good example of the tradeoffs articulated by Summers (1989). In a thoughtful article, Issacharoff and Rosenblum (1994) contrast the extensive European government benefits toward pregnancy with the limited employer mandates in the United States - essentially a non-discrimination command and an employee’s right to twelve weeks’ unpaid leave for childbirth. They propose a more extensive set of benefits modeled after unemployment insurance. In the early US pregnancy cases, the Supreme Court upheld employer benefit plans that excluded pregnancy. The Court reasoned that a classification between pregnant persons and other persons was not explicitly sex-based and therefore was not disparate treatment; and because the costs of providing health insurance was as great for women (even without pregnancy coverage) as for men, no disparate impact claim was made. Congress promptly reversed this holding with the Pregnancy Discrimination Act amending Title VII. Employers must treat pregnancy like any other disability. Posner (1989) notes that this compels employers to ignore the higher average cost of employing women, who are more likely to leave the workforce to have children. The consequence of ignoring these differences, Posner argues, is inefficient and may not benefit women as a whole. Women directly lose because employers have an incentive not to hire them. Applying his interdependence analysis, Posner argues that women as wives indirectly lose. The biggest losers are married but childless working women, because the wife and husband have lower wages than if employers could consider pregnancy and she will not gain from the higher fringe benefits. Donohue (1989) challenges Posner’s argument that statistical discrimination against women is socially efficient. Following the approach of Lundberg and Startz (1983) and Schwab (1986) discussed above, Donohue reiterates that while acting on statistical averages may maximize firm profits, it creates dynamic distortions. For example, if employers are reluctant to train women for top corporate positions because they tend to quit to have children, even women who plan to stay in the labor market have reduced incentives to invest in human capital. Donohue also more broadly challenges Posner’s interdependency thesis. Even if consumption is joint and women are altruistic, Donohue says, women may have different preferences and may want altruistically to spend more on their children than their husbands would wish. If sex discrimination lowers the economic power of women, their bargaining within a marriage is probably weakened. Sexual harassment continues to be a major issue in employment discrimination law, and the law and economics literature helps frame the issues. Hadfield (1995) has used an avowedly economic approach to define sexual harassment. Harassment occurs, under her test, whenever a woman is subjected to actions that a man is not that would cause the woman to alter

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her behavior to avoid the actions if she could do so without cost. Hadfield emphasizes that many women are trapped (not at the margin) and thus must endure the harassment, but otherwise might refuse night shifts, overtime or travel assignments where harassment is likely. Whatever the definition, Posner (1989) notes that sexual harassment is not in the employer’s self interest, but often the costs of prevention are high. Just as other antisocial workplace behavior, such as embezzlement, is subject to public enforcement, so too should sexual harassment be - depending on the relative costs of public and private enforcement. Epstein (1992) agrees that prohibitions on sexual harassment are perhaps the easiest anti-discrimination prohibitions to justify, at least if the claims stay close to their tort roots. Verkerke (1995) has explored the standards upon which employers should be liable for sexual harassment by its employees. He argues first that employer liability for creating a sexually hostile environment should not differ from employer liability for other forms of discrimination, but rather should depend on creating the proper incentives for employers to acquire information about harassment. Conditional notice liability, whereby employers are not liable if they have ‘experimented’ in creating notice procedures and have not been notified of the harassment, may be most appropriate. But Verkerke emphasizes that the choices of liability standard require data currently not available.

Bibliography on Employment Discrimination (5530) Aigner, Dennis J. and Cain, Glen G. (1977), ‘Statistical Theories of Discrimination in Labor Markets’, 30 Industrial and Labor Relations Review, 175-187. Akerlof, George (1985), ‘Discriminatory, Status-Based Wages Among Tradition-Oriented, Stochastically Trading Coconut Producers’, 93 Journal of Political Economy, 265-276. Arrow, Kenneth (1972), ‘Some Mathematical Models of Race Discrimination in the Labor Market’, in Pascal, Anthony (ed.), Racial Discrimination in Economic Life, Lexington, Lexington Books, 187-203. Arrow, Kenneth (1973), ‘The Theory of Discrimination’, in Ashenfelter, Orley and Rees, Albert (eds), Discrimination in Labor Markets, Princeton, Princeton University Press, 3-33. Ayres, Ian and Siegelman, Peter (1996), ‘The Q-Word as Red Herring: Why Disparate Impact Liability does not Induce Hiring Quotas’, 74 Texas Law Review, 1487-1526. Becker, Gary S. (1968), ‘Discrimination, Economic’, in Sills, David L. (ed.), International Encyclopedia of the Social Sciences, vol. 4, New York, Macmillan and Free Press, 208-210. Becker, Gary S. (1971), The Economics of Discrimination, 2nd edn (1st edition 1957), Chicago, University of Chicago Press. Bell, Derrick (1992), Faces at the Bottom of the Well: The Permanence of Racism, New York, Basic Books.

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Benston, George (1982), ‘The Economics of Gender Discrimination in Employee Fringe Benefits: Manhart Revisited’, 49 University of Chicago Law Review, 489-542. Blau, Francine D. (1998), ‘Trends in the Well-Being of American Women, 1970-1995', 36 Journal of Economic Literature, 112-165. Bloch, Farrell (1994), Antidiscrimination Law and Minority Employment: Recruitment Practices and Regulatory Constraints, Chicago, University of Chicago Press. Chay, Kenneth Y. (1998), ‘The Impact of Federal Civil Rights Policy on Black Economic Progress: Evidence From The Equal Employment Opportunity Act of 1972', 51 Industrial and Labor Relations Review, 608-632. Cooter, Robert (1994), ‘Market Affirmative Action’, 31 San Diego Law Review, 133-168. Crespi, Gregory S. (1992), ‘Market Magic: Can the Invisible Hand Strangle Bigotry?’, 72 Boston University Law Review, 991-1011. Darity, William A., Jr and Mason, Patrick L. (1998), ‘Evidence on Discrimination in Employment: Codes of Color, Codes of Gender’, 12 Journal of Economic Perspectives, 63-90. Demsetz, Harold (1965), ‘Minorities in the Marketplace’, 43 North Carolina Law Review, 271-297. Donohue, John J., III (1986), ‘Is Title VII Efficient?’, 134 University of Pennsylvania Law Review, 1411-1431. Donohue, John J., III (1989), ‘Prohibiting Sex Discrimination in the Workplace: An Economic Perspective’, 56 University of Chicago Law Review, 1337-1368. Donohue, John J., III (1992), ‘Advocacy versus Analysis in Assessing Employment Discrimination Law’, 44 Stanford Law Review, 1583-1614. Donohue, John J., III (1997), Foundations of Employment Discrimination Law, New York, Oxford University Press. Donohue, John J., III and Heckman, James J. (1991a), ‘Continuous versus Episodic Change: The Impact of Civil Rights Policy on the Economic Status of Blacks’, 29 Journal of Economic Literature, 1603-1643. Donohue, John J., III and Heckman, James J. (1991b), ‘Reevaluating Federal Civil Rights Policy’, 79 Georgetown Law Journal, 1713-1735. Donohue, John J., III and Siegelman, Peter (1991), ‘The Changing Nature of Employment Discrimination Litigation’, 43 Stanford Law Review, 983-1033. Donohue, John J., III and Siegelman, Peter (1993), ‘Law and Macroeconomics: Employment Discrimination Over the Business Cycle’, 66 Southern California Law Review, 709-765. Eisenberg, Theodore and Clermont, Kevin M. (1995), Judicial Statistical Inquiry Form, http://teddy.law.cornell.edu:8090/questata.htm. Epstein, Richard A. (1992), Forbidden Grounds: The Case Against Employment Discrimination Laws, Cambridge, MA, Harvard University Press. Epstein, Richard A. (1995), ‘The Status-Production Sideshow: Why the Antidiscrimination Laws Are Still a Mistake’, 108 Harvard Law Review, 1085-1109. Freed, Mayer G. and Polsby, Daniel D. (1981), ‘Privacy, Efficiency, and the Equality of Men and Women: A Revisionist View of Sex Discrimination in Employment’, 1981 American Bar Foundation Research Journal, 583-636. Freeman, Richard B. (1995), ‘Are Your Wages Set in Beijing?’, 9 Journal of Economic Perspectives, 15-32.

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Friedman, Milton (1962), Capitalism and Freedom, Chicago, University of Chicago Press. Goldberg, Matthew (1982), ‘Discrimination, Nepotism, and Long-Run Wage Differentials’, 97 Quarterly Journal of Economics, 307-319. Hadfield, Gillian K. (1995), ‘Rational Women: A Test for Sex-Based Harassment’, 83 California Law Review, 1151-1189. Heckman, James J. and Payner, Brook S. (1989), ‘Determining the Impact of Federal Antidiscrimination Policy on the Economic Status of Blacks: A Study of South Carolina’, 79 American Economic Review, 138-177. Higgs, Robert (1977), Competition and Coercion: Blacks in the American Economic, 1865-1917, New York, Cambridge University Press. Issacharoff, Samuel (1992), ‘Contractual Liberties in Discriminatory Markets’, 70 Texas Law Review, 1219-1259. Issacharoff, Samuel and Rosenblum, Elyse (1994), ‘Women and the Workplace: Accommodating the Demands of Pregnancy’, 94 Columbia Law Review, 2154-2221. Kelman, Mark (1991), ‘Concepts of Discrimination in “General Ability” Job Testing’, 104 Harvard Law Review, 1157-1247. Kimball, Spencer (1979), ‘Reverse Sex Discrimination: Manhart’, 1979 American Bar Foundation Research Journal, 85-139. Landes, William M. (1968), ‘The Economics of Fair Employment Laws’, 76 Journal of Political Economy, 507-552. Lessig, Lawrence (1995), ‘The Regulation of Social Meaning’, 62 University of Chicago Law Review, 943-1045. Lundberg, Shelly and Startz, Richard (1983), ‘Private Discrimination and Social Intervention in Competitive Labor Markets’, 73 American Economic Review, 340-347. Mashaw, Jerry L. (1991), ‘Implementing Quotas’, 79 Georgetown Law Journal, 1769-1775. McAdams, Richard H. (1995), ‘Cooperation and Conflict: The Economics of Group Status Production and Race Discrimination’, 108 Harvard Law Review, 1005-1084. McCaffery, Edward J. (1993), ‘Slouching Towards Equality: Gender Discrimination, Market Efficiency, and Social Change’, 103 Yale Law Journal, 595-675. Phelps, Edmund (1972), ‘The Statistical Theory of Racism and Sexism’, 62 American Economic Review, 659-661. Posner, Richard A. (1987), ‘The Efficiency and the Efficacy of Title VII’, 136 University of Pennsylvania Law Review, 513-521. Posner, Richard A. (1989), ‘An Economic Analysis of Sex Discrimination Laws’, 56 University of Chicago Law Review, 1311-1335. Posner, Richard A. (1995), Aging and Old Age, Chicago, University of Chicago Press. Schwab, Stewart (1986), ‘Is Statistical Discrimination Efficient?’, 76 American Economic Review, 228-234. Smith, James P. and Welch, Finis R. (1989), ‘Black Economic Progress After Myrdal’, 27 Journal of Economic Literature, 519-564. Samuelson, Paul A. (1951), ‘Economic Theory and Wages’, in Wright, David M. (ed.), The Impact of the Union, New York, Harcourt, Brace & Co., 312-342.

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Strauss, David A. (1991), ‘The Law and Economics of Racial Discrimination in Employment: The Case for Numerical Standards’, 79 Georgetown Law Journal, 1619-1657. Summers, Lawrence H. (1989), ‘Some Simple Economics of Mandated Benefits’, 79 American Economic Review. Papers and Proceedings, 177-183. Sunstein, Cass R. (1991), ‘Why Markets Don’t Stop Discrimination’, 8 Social Philosophy and Policy, 22-37. Verkerke, J. Hoult (1992), ‘Free to Search’, 105 Harvard Law Review, 2080-2097. Verkerke, J. Hoult (1995), ‘Notice Liability in Employment Discrimination Law’, 81 Virginia Law Review, 273-385. Wasserstrom, Richard A. (1997), ‘Racism, Sexism, and Preferential Treatment: An Approach to the Topic’, 24 UCLA Law Review, 581-621. Welch, Finis (1989), ‘Affirmative Action and Discrimination’, in Shulman, Steven and Darity, William, Jr (eds), The Question of Discrimination, Middleton, CT, Wesleyan University Press. Wright, Gavin (1986), Old South, New South: Revolutions in the Southern Economy Since the Civil War, Baton Rouge, Louisiana State University Press.

5540 OCCUPATIONAL SAFETY AND HEALTH REGULATION Sidney A. Shapiro John M. Rounds Professor of Law University of Kansas © Copyright 1999 Sidney A. Shapiro

Abstract An employer will invest in safety and health precautions until the cost is more than the expense of paying higher wages, workers’ compensation, and other accident and illness costs. Employees receive additional protection because governments have chosen to augment these financial incentives with regulation. Studies indicate that all three approaches cause employers to invest in health and safety precautions, but the extent to which injuries and illnesses are reduced is difficult to verify and may be limited in numerous work situations. The literature has identified potential reforms, but the viability of key reforms is uncertain. Thus, labor markets, compensation and regulation are highly imperfect alternatives concerning the reduction of occupational accidents and illnesses. As a result, continued reliance on all three approaches is indicated. JEL classification: K31, K32 Keywords: Occupational Safety, Occupational Health, Occupational Risk, Workers’ Compensation

A. Introduction 1. Imperfect Alternatives Economic theory predicts that workers will demand additional wages, or a ‘wage premium’, to compensate them for workplace safety and health risks. Employers will respond by reducing such risks until it is less expensive to pay workers additional compensation than it is to invest in additional health or safety precautions. In this manner, labor markets should produce the abatement of some safety and health hazards, and workers should be compensated for the risks that remain. Since the early 1900s, governments have intervened to augment these labor market incentives. According to Darling-Hammon and Kniesner (1980), virtually every state in the United States enacted some quasi-administrative 596

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scheme to award compensation for workplace accidents between 1911 and 1920. Today all 50 states and the federal government administer such programs. In 1970, Congress enacted the Occupational Safety and Health Act (OSH Act) which established the Occupational Safety and Health Administration (OSHA) in the Department of Labor to regulate workplace conditions. States have the option to accept federal regulation of employers or to administer their own safety and health regulations subject to OSHA’s approval and supervision. Other countries have also implemented administrative regulation. These governmental efforts indicate a political judgment that labor markets produce insufficient protection for workers. This essay describes how economic theory explains the role of labor markets, compensation, and regulation in addressing occupational injuries and illnesses. I also report on studies that have tested the effectiveness of each of these methods, and I discuss reforms to improve the effectiveness of each approach. Readers seeking an overview of these issues can consult several books and articles. Chelius (1974), Oi (1974), Rea (1983), Viscusi (1983, 1992), Dickens (1984), Schroeder and Shapiro (1984) and Robinson (1991) offer general comparisons of the impact of labor markets, compensation and regulation on workplace safety and health. This chapter confirms Komesar’s (1994) insight about options for making society safer and healthier. When governments choose between market, compensation, and regulatory approaches, Komesar contends that ‘[t]he choice is always a choice among highly imperfect alternatives’. Labor markets, compensation, and regulation are ‘imperfect’ alternatives concerning the reduction of occupational accidents and illnesses because none of these alternatives is reliable. Instead, each is limited by significant constraints, which are explained below. Reformers seek to address these constraints, but the constraints are intractable in many instances. Thus, it appears to be necessary to rely on all three approaches, because no one (or even two) approaches is likely to produce an appropriate level of occupational safety and health. Together, however, labor markets, compensation and regulation can come closer to this elusive goal.

B. Labor Markets 2. Introduction Economic theory establishes that labor markets create several incentives for employers to reduce occupational safety and health risks. Economic studies confirm the existence of one such incentive: the demand by workers for additional compensation, or a ‘wage premium’, for exposure to safety risks.

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The adequacy of such wage premiums, however, is in dispute. Moreover, analysts generally concede that workers are unlikely to be compensated for most health risks. Governments have attempted to aid workers in obtaining additional compensation by promoting the distribution of information about workplace risks and by addressing workers’ lack of bargaining power.

3. Economic Theory An employer will determine whether to prevent workplace accidents or illnesses by comparing the cost of prevention with the cost of not taking such action. Employers that fail to reduce workplace hazards can expect to pay increased labor costs because workers will demand additional compensation for enduring occupational safety and health risks. For a given level of workers’ compensation, workers will demand a wage premium that compensates for any inadequacies in ex post compensation. In other words, assuming workers are fully informed about job risks, they will seek compensation equal to the expected cost of an injury or illness not covered by workers’ compensation. In addition, the employer may have to pay for the cost of recruitment and training of additional workers to replace those persons who are injured or killed and other related costs. To avoid these expenses, an employer will make safety and health improvements until the cost of additional precautions is more than paying wage premiums and other related costs. In this manner, labor markets should produce the abatement of some safety and health hazards and workers should be compensated (ex ante and ex post) for the risks that remain. The employer’s assumption of these costs will make the market for the employer’s product or service more efficient. Because the employer assumes these costs, the price of the product or service will reflect the cost to society of the production of the good or service, including the cost of occupational illnesses and injuries.

4. Empirical Evidence Studies by Viscusi (1983) and other analysts (listed and described by Viscusi) find that workers in risky jobs receive higher wages after controlling for education, experience, and other market characteristics. Viscusi estimates that average annual compensation for all job risks in the United States totals about $400. Similarly, Robinson (1991) estimates that workers exposed to significant risks of occupational injuries received annual wage premiums of about $300$500. This amounts to about a 5-8 percent increase above the earnings of unexposed blue-collar workers. Fishback (1986) cites empirical evidence that

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miners in the United States in the 1900s received risk compensation. Weiss, Maier and Gerking (1986) discovered risk compensation in Austrian labor markets. By comparison, Leigh (1991), who reviewed several prior studies, found that only variables which reflected job hazards resulting in death were associated with compensating wages, and that among studies using death rates, only some studies found evidence of wage premiums. Further, among studies finding evidence of such wages, the amount of compensation paid for the risk of death varied widely. Leigh’s own study found evidence of compensating wages based on Bureau of Labor Statistics fatality data, but he found no correlation based on workers’ compensation fatality data. A review by Dorman (1996) of the literature on compensating wages, including Leigh’s study, characterizes the evidence for wage premiums as ‘weak at best’.

5. Evaluation of Empirical Data The empirical evidence is mixed concerning the extent to which workers obtain wage premiums for dangerous work. Moreover, even when workers obtain compensating wages, there is an issue of the adequacy of the compensation. As the last section revealed, studies finding compensating wages indicate that workers receive only modest wage premiums. Even a small wage premium, however, is significant if workplace risks are not very large. For example, Viscusi (1983) concludes that once analysts take into account the nature of a risk and the population exposed to it, it is evident that workers are well paid for the risks that they face. According to Viscusi, ‘most’ of the ‘reasonable’ estimates indicate that workers demand between $3 and $7 million compensation for exposure to potentially fatal accidents. Workers, however, may receive less compensation than Viscusi estimates. First, if the risk of a fatal accident is greater than the data on which Viscusi relies, workers receive less compensation than he estimates. McGarity and Shapiro (1993, 1996) found that experts believe existing statistics understate the extent of workplace fatalities (and injuries) in the United States by an unknown and perhaps significant extent. Second, the amount of additional compensation that a worker will seek for hazardous work is a function of the worker’s knowledge and understanding of existing risks. Robinson (1991) cites survey data which reveal that workers’ knowledge is incomplete. He found, for example, that 33 to 50 percent of workers in occupations with high rates of disabling injuries and illnesses reported that they faced no significant safety or health hazards. Carmichael (1986) adds that because the dissemination of safety information in labor markets takes time, workers may lack adequate information when they seek a job. Oi (1974) notes, however, that full information by all workers is not

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necessary to obtain adequate compensating wages. What is important is that the marginal worker possess full information. Third, workers must be able to discern marginal differences in risks to bargain effectively for hazard pay. Yet, as Lave (1983), Dickens (1984) and McGarity and Shapiro (1993) discuss, such distinctions are especially difficult to make in the context of occupational illness, where huge uncertainties befuddle attempts to predict the precise effects of health risks on longevity and the quality of life once a disease has manifested itself. Further, as Dorman (1996) discusses, a worker’s evaluation of risk may be distorted by psychological effects in the way individuals process risk information. Studies in the psychological literature suggest that people do not process risk information in the rationale manner that economic theory assumes. For example, people engage in several forms of ‘bounded rationality’ which simplify and filter risk perceptions. Risk perceptions are also impacted by attitudes towards risk, such as the fact that persons tend to fear more acutely those risks they cannot control. Cognitive dissonance is another factor, because it induces people to ignore or alter their perceptions of risk in order to avoid unpleasant conflicts with established beliefs. Fourth, the additional compensation that a worker can obtain for hazardous work is a function of the worker’s bargaining power. Boden and Jones (1987) point out that estimates of wage differentials are substantially higher for unionized employees than for nonunionized employees. Moreover, Robinson (1991) cites data indicating that only poorly educated and low-skilled employees are likely to take dangerous jobs. His calculations reveal that hazardous jobs pay 20-30 percent less than safe employment after taking into account education and skill levels. He concludes that persons with training and education avoid such jobs because safer employment pays more, and that hazardous jobs are more likely to go to minority workers. Robinson found that Hispanic males were 80 percent more likely to suffer a disabling injury or illness than whites in California, and that black men were 40 percent more likely. McGarity and Shapiro (1993) argue that even educated and skilled workers may hesitate to leave dangerous jobs because the hazardous pay is inadequate. Such workers may be hesitant to change jobs because of the loss of health benefits, pension rights, and seniority, the expense and disruption of relocation, and the difficulty of becoming familiar with a new employer. Boden and Jones (1987) hypothesize that these reasons explain the relatively low wage premium received by asbestos installation workers who were familiar with the significant risks that they faced. A study by Kahn (1987) finds that occupational safety levels in nonunionized firms reflect only the preferences of workers with three or less years of job tenure, who are, he presumes, the most mobile workers in the firm.

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Dorman (1996) proposes that game theory be used to study the relationship of workers and employers concerning issues such as risk compensation. He argues that because game theory accounts for strategic behavior, it can clarify how cooperation and conflict inside a corporation impacts issues of public policy such as the protection of workers.

6. Reform Workers may be inhibited in obtaining wage premiums for workplace safety and health risks because of the lack of information or inadequate bargaining power. Analysts have discussed what steps governments can take to address these problems. Regulatory policies that increase workers’ access to risk information should improve market performance. Government action is likely to be necessary because, as Viscusi (1983) points out, the ‘aberrant characteristics of information as an economic good’ inhibit the creation of market arrangements to produce such information. OSHA’s hazardous communication standard is a good example of this type of government mandate. The regulation requires chemical manufacturers to provide a material safety data sheet, based on the available literature, for each hazardous product that they produce or use. The information is then made available to workers who are exposed to these products. Carle (1988) proposes improvements in OSHA’s regulation, while Viscusi (1983) supports additional regulation. He recommends that employers be required to apprise workers of the nature of the risks that they face, the risk level of the firm (death, injury and illness rates), its relative risk as compared to other firms in the industry, and other relevant risk information. The impact of additional information will depend on the ability of workers to use risk information. As noted in the last section, workers may have limited cognitive capacities or psychological defense mechanisms that impede rational use of risk information. Government can address these limitations by requiring that employers train workers to evaluate the information that they receive. A worker’s ability to obtain a wage premium is also dependent on the person’s bargaining power. Workers would have more bargaining power if they could not be fired for their refusal to undertake hazardous work. Rea (1983) reports that some Canadian provinces have given workers the right to refuse unsafe work. McGarity and Shapiro (1993) support similar reforms for the United States.

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C. Compensation 7. Introduction The wage premiums received by workers constitute ex ante compensation for occupational accidents and diseases. Workers also receive ex post compensation through workers’ compensation and tort law. Spieler (1994) provides a detailed description of the role of workers’ compensation in the United States. Prior to the early 1900s, workers could sue their employers for negligence if they were injured at work, but these tort suits were frustrated by a number of legal doctrines that prevented workers from recovering. According to Chelius (1976), many state legislatures had abolished some of these defenses prior to 1911. Recovery under the tort system remained inadequate, however, which prompted the passage of workers’ compensation laws. These laws discarded most of the remaining legal obstacles to recovery and, as a tradeoff, established two important limitations on workers. States prohibited workers from suing their employers under tort law, and they limited the types and amount of damages that workers could recover. Morgenstern (1982) has a general description of the role of compensation in other countries. Employers should respond to higher compensation costs by investing in safety and health improvements. Yet, analysts have been unable to establish a clear correlation between such higher costs and a reduction in workplace injuries and fatalities. Despite the lack of evidence, some analysts argue that workers’ compensation provides a significant incentive to make safety and health improvements, but other analysts dispute this conclusion. What is clear is that workers’ compensation fails to reimburse employees for accident and illness costs that are not paid by wage premiums. Government may improve the function of workers’ compensation by requiring employers to pay higher compensation, mandating that insurance rates more accurately reflect an employer’s safety experiences, or imposing a tax-based system of compensation.

8. Economic Theory An employer will determine whether to prevent workplace accidents or illnesses by comparing the cost of prevention with the cost of not taking such action. For risks that are not prevented, the employer will be responsible for paying workers’ compensation to injured or ill employers. A firm will invest in safety and health precautions until the cost is more than the cost of paying higher wages, workers’ compensation, and other accident and illness costs. If workers are fully compensated (ex post and ex ante) for the accidents and illnesses which are not prevented, the market for an employer’s product or

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services will be more efficient. The market is more efficient because the price of the product or service will include the cost of occupational accidents and illnesses associated with its production. In this manner, the price will reflect the actual cost to society of the production of the good or service. The actual cost to the firm of paying compensation, however, will depend on the nature of its insurance arrangements. Insurance arrangements can reduce a firm’s incentive to prevent future accidents and illnesses as explained below.

9. Empirical Evidence Although employers pay billions of dollars for workers’ compensation, analysts have been unable to verify that higher costs are associated with a reduction in workplace injuries. Some studies even find that higher costs are associated with an increase in injuries. The cost of workers’ compensation in the United States was about $62 billion in 1992 according to Boden (1995). Viscusi (1992) points to this cost as evidence that workers’ compensation is more influential than OSHA in promoting workplace safety because employers paid only about $10 million in OSHA fines in the same year. The empirical evidence, however, is equivocal concerning whether workers’ compensation induces employers to take safety precautions. Boden (1995) reviewed sixteen studies (which he lists and describes) which tested the relationship between an increase in workers’ compensation costs and workplace injuries, as measured by injury statistics or workers’ compensation claim rates. Most of the studies concluded that injuries increased or remained unchanged when benefit levels rose. A study by Moore and Viscusi (1989), however, concludes that the average fatality rate would have been 22 percent higher if there had been no workers’ compensation. By comparison, Butler and Worrall (1991) report that ‘virtually’ all studies of claim usage in workers’ compensation find that an increase in indemnity benefits increases workers’ compensation claim frequency.

10. Evaluation of Empirical Data Some analysts interpret the previous data as supporting the conclusion that workers’ compensation provides a significant incentive to make safety and health improvements. They argue that the data do not reveal this correlation because various actions by employees offset the reduction in compensation claims attributable to employer safety improvements. Other analysts argue that workers’ compensation does not create significant incentives for employers to

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invest in safety and health improvements because of the impact of insurance and other factors. The impact of workers’ compensation on occupational safety and health also depends on the extent to which workers are compensated for their injuries and illnesses. Despite the large cost of workers’ compensation, employers pay for only a portion of the cost of workplace accidents and for almost none of the cost of occupational illness.

11. Employee Behavior Employee behavior may explain why increases in workers’ compensation costs may not have produced lower injury rates. According to Butler and Worrall (1991), an increase in benefits will increase the propensity of workers to file claims for two reasons. When benefits are increased, workers are willing to undertake greater risk than previously and more injuries will occur. Also, workers have a greater incentive to file a claim for any given level of risk. Butler and Worrall characterize the former response as a ‘risk-bearing moral hazard’ and the latter behavior as a ‘claims-reporting moral hazard’. In addition, claims may increase because higher benefits induce additional fraud. The additional claims which result from these three types of behavior, if large enough, could offset any reduction in compensation claims attributable to employer safety or health improvements undertaken in response to increased compensation costs. According to the ‘risk-bearing moral hazard’ theory, workers are less vigilant and therefore suffer more (and more serious) injuries because higher benefits diminish the personal economic risks associated with such injuries. If such behavior offsets the impact of safety improvements by employers, as Fishback (1986, 1987), Lyttkens (1988), Moore and Viscusi (1990) and Butler and Worrall (1991) suggest, this theory would explain the positive relationship between increased workers’ compensation costs and injury rates. McGarity and Shapiro (1996) are skeptical of this explanation, however, because workers have strong economic and other incentives to avoid injuries. As discussed below, workers receive less, sometimes far less, than the actual costs of their injuries and illnesses. McGarity and Shapiro also doubt the idea that the prospect of money in the future will persuade a significant number of people to risk severe pain, hospitalization, dismemberment, and even death in the present. The second explanation of employee behavior focuses on the ‘claims reporting moral hazard’, which is also characterized as a ‘reporting’ effect. According to this explanation, higher workers’ compensation only increases the number of accident reports and not the absolute number of injuries. Since workers lose less income if they miss work, they may report more injuries and stay off work longer.

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Researchers have evaluated this second type of moral hazard by focussing on the link between workers’ compensation rates and events that should not be subject to a reporting effect. Some studies have focussed on the relationship between higher compensation rates and fatalities. Because fatalities are clearcut events, there should be no overreporting. Moore and Viscusi (1990) and Ruser (1993) found that increased benefits levels were associated with reduced fatality rates, but Butler (1983) discovered that benefit increases were associated with higher fatality rates. A study by Robertson and Keeve (1983) compared the impact of benefits levels on sprains and strains as compared to more ‘objective’ injuries, such as lacerations and fractures. This comparison revealed that reported injuries of both types increased with benefit levels, although the effect was stronger for sprains and strains. Kniesner and Leeth (1989) claim to establish the validity of the reporting theory based on a computer simulation. A study by Butler, Durbin and Helvacian (1996) attributed most of the significant increase in workers’ compensation claims for soft tissue injuries in the 1980s to moral hazard responses by employees and also by physicians. A physician in a health maintenance organization (HMO) may earn more by misclassifying a soft tissue injury as compensable in the workers’ compensation system, because this permits the physician to avoid a payment cap imposed by the employee’s health insurance company. Higher benefits might also induce more cases of fraud. For example, Staten and Umbeck (1986) propose that the practical need for administrators to screen compensation applicants on the basis of observable characteristics creates the potential that workers can manipulate the evidence at critical margins. They found evidence to support such a ‘signaling effect’ among air traffic controllers who sought compensation for stress-induced impairment. Burton (1992), however, concludes there is a ‘lack of supporting quantitative evidence’ and a ‘paucity of compelling qualitative analysis’ that significant fraud occurs.

12. Employer Behavior Moral hazard behavior may explain why analysts have had difficulty finding a correlation between higher compensation costs and a reduction in accidents and illnesses. Another explanation is that workers’ compensation does not create significant incentives for employers to invest in safety and health improvements. Employers may fail to take safety precautions in response to higher compensation costs for two reasons. First, workers’ compensation insurance accurately reflects an employer’s safety experience only for the largest firms. Second, there may be less expensive ways for employers to decrease compensation costs than to make safety and health improvements.

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Spieler (1994) explains that the price of workers’ compensation insurance does not reflect, or only partially reflects, the claims experience of most employers. The sensitivity of premiums to claims experience varies inversely with the size of the firm. The smallest firms, which constitute the majority of purchasers of all insurance, pay premiums that have no relationship to their actual claims experience. Because small firms have so few employees, insurance companies view their individual claims experience as too random to have any predictive value. Insurance companies therefore base the cost of insurance for small employers on the claims experience of a class of similar employers. Thus, small employers have only a weak economic incentive to take safety precautions because their actual claims experience will have little effect on their future premiums. Larger firms, which pay premiums based in part on claim losses, have a greater incentive to engage in injury prevention. The extent to which these firms are rated according to their claims experience depends on the credibility or predictive value of that experience. Only the largest employers are self-rated, which means they pay rates that are based entirely on their claims experience. These firms, and firms that selfinsure, therefore have the greatest economic incentive to reduce workplace risks. According to Victor (1982), however, the incentives for prevention are greater for self-rated firms in hazardous industries than for firms that selfinsure in the same industries. Analysts have compared the reduction in injuries at large and small firms to determine if there is an ‘experience-rating effect’. Some studies have found that higher compensation costs are associated with a decrease in injuries at large firms as compared to small firms, but other analysts have been unable to confirm this result. A study by Worrall and Butler (1988) revealed that reported injuries declined more at large firms than small ones when compensation costs increased. By comparison, Ruser (1985, 1991, found that higher benefits led to higher rates of nonfatal injuries at large and small firms, but that these effects were smaller for larger firms. Ruser considers this result as evidence that experience rating does matter, and that it counteracts other incentives for increased injuries. Another study by Ruser (1993) found an experience rating impact for injuries, but not for fatalities. Chelius and Smith (1983, 1993) were unable to verify an experience rating effect. Employers will not invest in safety or health improvements if there are lower cost methods to avoid compensation payments. The literature suggests that employers may have two such options. First, Spieler (1994) and Ison (1986) specify a number methods by which employers can discourage employees from filing claims or if claims are filed, from prevailing. Employers can pressure employees not to file claims, delay the

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completion of necessary paperwork, aggressively contest claims, and persuade employees who file claims to return to work prematurely. Second, as Spieler (1994) documents, employers have reacted to higher compensation costs by engaging in political activity to reduce future payments to workers. In response, states have reduced the level of benefits for some types of injuries, made other types of injuries noncompensable, limited allowable medical costs, capped physician fees, adopted administrative changes to make it easier to discontinue benefits to workers, and reduced lawyers’ fees. At the same time, however, states have also adopted various types of injury prevention and safety incentives or requirements. The literature does not indicate whether the net effect of these two types of actions has been to reduce or increase the incentive of employers to take safety precautions. The impact may vary from state to state depending, among other factors, on the relative political strength of employers and organized labor. Spieler also hypothesizes that employers may seek to reduce workers’ compensation payments by methods other than safety improvements because they ‘often perceive themselves as having less influence over the occurrence of injuries than they in fact have’. More generally, Veljanovski (1982) demonstrates that compensation systems will not produce optimal results under conditions when employers, as well as workers, have imperfect and asymmetrical information.

13. Adequacy of Compensation Analysts debate whether the cost of workers’ compensation creates an incentive for employers to reduce workplace accidents and illnesses. Even if it is assumed that such an incentive exists, spending on accident and illness prevention will not be optimal unless employers compensate employees for inadequacies in ex ante compensation. The evidence suggests however, that workers’ compensation does not reimburse workers for the costs of an injury or illness not covered by wage premiums. Schroeder and Shapiro (1984), Spieler (1994) and Boden (1995) establish that the states have established damage caps and other limitations that significantly restrict workers’ compensation for accidents. In most states, the level of compensation varies inversely with the seriousness of an injury. Compensation for temporary disabilities is controlled by statutory prescribed formulas that limit compensation to less than the direct wage losses of better paid employees. Compensation for permanent partial disability payments often does not equal the total wage loss of any employee. Compensation for fatalities is often less than for temporary and permanent disabilities. Furthermore,

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workers’ compensation does not include in damage calculations the loss of fringe benefits or nonpecuniary losses to workers and their families. Moreover, employers pay very little compensation for workplace-induced illness. Statistics cited by Weiler (1986) indicate that states compensate only 250 cancer cases per year as compared to the thousands of cancer fatalities that may be work related. Government studies cited in Schroeder and Shapiro (1984) indicate that only 2-3 percent of all workers’ compensation payments are for occupational disease. Schroeder and Shapiro and Barth (1984) hypothesize that several factors explain this low compensation rate. Workers and their physicians often fail to recognize that many illness are work-related. Moreover, employers are often successful in contesting those claims which are filed because of the difficulty of proving causation and because many states have restrictive standards for recovery. The few disease victims that do prevail face the same statutory limitations on compensation amounts that apply to injury victims. Even if more workers were compensated at higher rates, employers may still lack a strong economic incentive to invest in health precautions. A manager’s decision to invest in disease prevention is not based on current compensation expenses, which result from past actions, but on the likelihood that the investment will prevent future illness. Since occupational diseases are frequently characterized by long latency periods between exposure and disease onset, the manager can discount heavily the consequences and spend little or nothing on prevention. The manager’s decision to discount the costs of future illnesses may accurately reflect the current costs to the employer of future illnesses. A manager, however, may be tempted to discount the cost of future illnesses for another reason: any consequences for the employer will occur long after the manager has retired. Moreover, managers know that many workers will change jobs during the long latency period which frees the employer from paying compensation when the worker becomes ill.

14. Tort Compensation Few workers can seek additional compensation in a tort suit. Workers’ compensation laws in the United States almost always prohibit an employee from suing an employer for a tort remedy. As a result, a worker can seek a tort remedy only if some third party is responsible for an accident or illness. Viscusi (1989, 1991) reports that product liability claims for work-related injuries constitute about 13 percent of all product liability claims. After a detailed analysis of such law suits, he concludes that both workers’ compensation and tort liability have ‘important’ roles to play and that further research is necessary to understand the relationships of the two

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remedies. Boden and Jones (1987) found that the product liability compensation in asbestos cases ‘may’ provide substantial incentives for manufacturers to warn of future hazards, but that workers’ compensation provided ‘extremely’ low incentives for the control of asbestos. Schroeder and Shapiro (1984) believe few workers are likely to receive tort compensation for occupational illnesses. They list the array of legal hurdles that such workers must overcome. Moreover, Wiggins and Ringleb (1992) demonstrate that bankruptcy can be a viable shield from compensation payments in cases involving long-term hazards.

15. Workers’ Compensation Reform The government, as Phillips (1976) discusses, has three options to increase the financial incentive of employers to make safety and health improvements. First, it can require employers to pay higher amounts of workers’ compensation. Second, it can require insurance companies to base rates to a greater extent on the actual accident experience of employers. Finally, the government can impose a tax on employers that would reflect the costs associated with workplace accidents and illnesses. This last option is discussed in the next section. An increase in workers’ compensation payments should stimulate greater investment by employers in safety and health precautions, but an earlier discussion indicated that employers may not react in this manner. Moreover, there are significant practical and legal hurdles to adopting this reform in the United States. An increase in compensation would require action by 50 states and overcoming the opposition of employers who could expect to pay higher insurance costs. Greater reliance on experience rating should encourage employers to improve workplace safety and health because an employer’s insurance costs would be more closely tied to the firm’s actual safety and health record. Phillips (1976) discusses Ontario’s experience with a ‘penalty’ rating system that is intended to increase experience rating by insurance companies. Spieler (1994) explains that insurance companies in the United States have fought attempts to increase experience rating because it increases their costs. Governmental attempts to impose experience rating will therefore draw the political opposition of both insurance companies and high injury rate employers. Low injury rate employers, however, may support such changes. The previous reforms would improve how workers’ compensation functions to reduce workplace accidents. Most analysts agree with Lave (1983), however, that it ‘seems inconceivable’ that workers’ compensation can be reformed to handle occupational disease. Dewees and Daniels (1988) discuss the difficulties

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of designing a system that addresses the constraints, discussed earlier, which impair disease compensation.

16. Injury and Illness Taxes Instead of reforming workers’ compensation, many analysts have expressed interest in imposing injury and illness taxes. Analysts recommending imposition of an injury tax include Smith (1974, 1976), Nichols and Zeckhauser (1977), Mendeloff (1980), Rubin (1984), Sider (1984) and Sunstein (1990). Employers can be expected to oppose vigorously a new tax. This may explain why so few governments have tried this approach despite its theoretical attractiveness. An injury tax would have several advantages. It would create an additional incentive for employers to reduce workplace accidents and illnesses. Further, the amount that an employer would pay would be a function of its safety record. Thus, unlike workers’ compensation, an employer’s incentive to take safety precautions is not diluted because of the impact of insurance. As explained earlier, the cost of workers’ compensation insurance for many firms does not reflect, or does not fully reflect, their safety record. Finally, as compared to OSHA regulation, a tax is a more efficient method by which to reduce workplace risks. Under OSHA regulation, all employers must comply with the level of safety that OSHA specifies regardless of the cost of compliance. Under a tax approach, an employer would have the option of paying the tax if it was less expensive that the cost of abatement of a hazard. Shapiro and McGarity (1991) dispute that a tax would necessarily be more efficient than regulation. First, they contend that OSHA regulation is not as inefficient as the agency’s critics believe. They note that OSHA relies on performance standards, which permit an employer to choose the method of compliance, and on variances, which give employers with high costs additional time for compliance. Second, they predict that employers are likely to engage in the same types of tax avoidance as they now practice concerning other taxes. A tax approach can also be used for occupational disease, but calculation of an appropriate tax rate might not be possible. Dewees and Daniels (1988) caution that the determination of an appropriate exposure charge would be difficult because it would require information that is not readily available. An exposure charge based on health effects requires knowledge of a quantifiable dose-response function, which measures the number of workers likely to become ill at different levels of exposure. Dose-response estimates, however, are not available for most chemicals, and the estimates that are available often vary by several orders of magnitude. Barth (1984) and Viscusi (1984) would avoid this problem by financing compensation for employees with a broadbased tax levied on their employers. This approach, however, would not

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generate appropriate incentives for illness avoidance, because the tax would not be based on extent to which individual firms exposed workers to dangerous chemicals.

D. Regulation 17. Introduction Labor markets and compensation of injured and ill workers create financial incentives for employers to take safety and health precautions. Regulation offers a more direct means to accomplish the same result. Most of the literature on regulation addresses OSHA regulation in the United States. OSHA’s mandate is to ‘assure so far as possible every working man and woman in the Nation safe and healthful working conditions’. The OSH Act requires employers to comply with safety and health regulations, or ‘standards’, promulgated by OSHA. OSHA is authorized to inspect employers for potential violations and to assess civil penalties if violations are found. OSHA may also seek criminal penalties in limited circumstances if an employee has been killed. McGarity and Shapiro (1993) and Mendeloff (1980, 1988) generally summarize and evaluate OSHA’s role in promoting workplace safety and health. Wilson (1985) and Kelman (1981) compare OSHA regulation to regulation in Great Britain and Sweden respectively. Lanoie (1992a, 1992b) has analyzed the impact of occupational safety and health regulation in Canada.

18. Economic Theory An employer will make safety and health improvements until the cost of these precautions is more than the cost of paying additional wages, workers’ compensation premiums (if experience rated), and other related costs. If, however, such financial incentives fail, employers will underinvest in safety and health improvements. Such incentives can fail for the reasons discussed earlier, including the inability of workers to obtain full compensation for their injuries and illnesses from wage premiums and workers’ compensation. Regulators can address this shortfall by ordering employers to undertake safety and health precautions improvements up to the point where the costs of such improvements exceed their benefits. If benefits are measured as the value of the improvements to workers, administrative regulation will produce about the same level of investment in safety and health precautions as fully effective financial incentives. In other words, the government would order the same level of protection as would be produced if employers fully compensated workers for their injuries and illnesses.

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Although economic theory favors the use of such a cost-benefit approach, Congress has chosen another standard to control health and safety regulation in the United States. This standard requires OSHA to seek the level of protection for workers which is available from the ‘best-available technology’ (BAT). Once OSHA establishes that a workplace hazard is a ‘significant risk’, it must order an employer to reduce that risk to the extent that is ‘feasible’. A standard is feasible when it is technologically achievable and when employers can afford the cost of implementing it. A standard is not economically infeasible because it is financial burdensome or even because it threatens the survival of some firms in an industry. As discussed below, many analysts favor replacing this technology-based approach with a cost-benefit standard.

19. Empirical Evidence Analysts have attempted to confirm that OSHA’s activities have led to an improvement in workplace safety. They have isolated OSHA’s impact on fatality and injury rates in three types of studies. All three efforts have produced inconsistent results. Some studies have projected the trend of pre-OSHA injury rates and compared the projected results with the actual results. Smith (1976) compared the actual injury rates in several high-hazard industries that OSHA had targeted for enforcement with projected injury rates. The comparison revealed that actual rates were not significantly lower than projected rates. Mendeloff (1980), by comparison, found that the actual rates were significantly lower than the projected rates for several individual types of injuries in California. His study, however, found that OSHA had no impact on the aggregate injury rate for California and the nation. Curington (1986) likewise had mixed results. The frequency rate for all injuries in manufacturing industries in New York was no lower than the projected rate for such injuries, but there were reductions in injuries resulting from being struck by a machine (43.6 percent) and in the severity of all injuries (13.2 percent). Other studies have tested the correlation between aggregate industry level injury rates and OSHA inspection activity. For example, when Viscusi (1992) tested whether injury rates were affected by the frequency of OSHA inspections and penalties, he found that OSHA caused a 1.5-3.6 percent decrease in the lost workday rate. The ‘lost workday rate’ measures the number of days of work that an employee misses after an injury. Viscusi indicates that earlier studies by himself and others found no measurable correlation between the number of OSHA inspections and injury rates. Finally, some studies have sought a correlation between individual plant level injury data and an employer’s inspection experience. Gray and Scholz

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(1993) found that an inspection imposing a penalty reduced injuries by 22 percent and lost workdays by 20 percent in the following three years. Using the same methodology, Cooke and Gautschi (1981), Robertson and Keeve (1983), and Scholz and Gray (1990) found similar impacts, but Smith (1979), McCaffrey (1983), and Ruser and Smith (1991) found no association using a different testing technique. Other analysts have measured the relationship between OSHA inspection activity and compliance with OSHA safety regulations. Gray and Jones (1991a), for example, found a significant relationship between OSHA enforcement and compliance at individual plants. Bartel and Thomas (1985) also found that OSHA enforcement significantly increased compliance (by a total of 26 percent relative to no enforcement), but they found only a weak link between compliance and injury rates. Only a few analysts have attempted to confirm that OSHA’s activities have led to an improvement in workplace health. Gray and Jones (1991b) found that OSHA inspections reduced the exposure of workers to hazardous substances and increased compliance with health regulations.

20. Evaluation of Empirical Evidence Bartel and Thomas (1985) explain there are two conflicting explanations for the lack of empirical evidence that OSHA activity results in fewer workplace accidents and injuries. The ‘inefficacy’ explanation proposes that administrative regulation is unable to address many of the causes of workplace accidents. The ‘noncompliance’ explanation proposes that the OSHA lacks the resources to undertake effective enforcement. In addition, Mendeloff (1988) offers a theory for the lack of effective regulation of health risks, which is considered in the next section. The ‘inefficacy’ theory posits that administrative regulation does not increase workplace safety because there is a tenuous link between regulation and the causes of accidents. Administrative regulation focusses on making workplace equipment safer to use. Analysts argue, however, that the cause of most accidents is a complex interaction of labor, equipment and workplace environment. In light of this mismatch, Barcow (1980) predicts that OSHA may be incapable of preventing more than 25 percent of all workplace accidents. Moreover, Rea (1981) hypothesizes that moral hazard may reduce the level of safety because workers will attempt to substitute wages for safer jobs. Bartel and Thomas (1985) ask why Congress has failed to reform, or even eliminate, OSHA in light of its apparent inefficacy. They observe that OSHA regulations may give large firms a competitive advantage over their smaller rivals because the smaller firms are less able to afford expensive regulations.

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They hypothesize that larger firms support OSHA because the gains from this competitive advantage exceeds the costs of complying with OSHA regulations. Bartel and Thomas (1987) offer empirical evidence that larger firms have such a competitive advantage concerning OSHA regulations. Fuess and Loewenstein (1990) have similar evidence for coal mine regulation. Their study finds the imposition of expensive engineering controls shifted production to large mines by driving smaller, less safe mines out of business. Hughes, Magat and Ricks (1986), however, were unable to establish that OSHA’s cotton dust standards permitted large firms to gain in profitability at the expense of smaller producers. Similarly, Miller (1984) asks whether organized labor is rational in support of OSHA. He offers some empirical support for the proposition that engineering controls may increase the demand for labor. The ‘noncompliance theory’ proposes that OSHA lacks the statutory and budgetary authority to enforce its standards effectively. McGarity and Shapiro (1996) point out that OSHA inspections have had a greater impact on the injury rates of inspected firms than on aggregate injury rates. They also point out that the industries with the most significant decline in injuries and fatalities are the industries with the highest levels of enforcement. They attribute OSHA’s limited impact on aggregate injury rates to the fact that the agency’s limited resources do not permit it to inspect the vast majority of employers that it regulates.

21. Overregulation Causes Underregulation The previous theories address OSHA’s impact on workplace accidents. Mendeloff (1988) attempts to explain OSHA’s limited impact on occupational disease. He identifies OSHA’s mandate as the cause because it requires the strict regulation of toxic substances. The problem is that such ‘overregulation’ causes ‘underregulation’. Overregulation occurs when the costs of a regulation exceed its benefits. Underregulation occurs when the costs of additional regulation are less than the benefits. Mendeloff argues that strict regulation of toxic substances causes less protection of workers than the promulgation of more lenient regulations. Strict regulation protects workers less then more lenient regulations because of how employers react to each type of regulation. OSHA has been able to promulgate very few health regulations because employers vigorously resist overregulation. As a result, OSHA spends inordinate time and resources defending strict standards. Mendeloff proposes that OSHA could successfully promulgate more standards if it balanced costs and benefits. OSHA would be more successful because industry would be less likely to challenge more lenient regulations in court, and, if such regulations were challenged, OSHA would be more likely to prevail. In this manner, workers ultimately would receive more

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protection from a more lenient approach. Although each OSHA regulation would be less protective of workers, the sum total of protection for workers would be greater because the agency could promulgate more standards overall. McGarity and Shapiro (1993) and Shapiro and McGarity (1991) object that employers will oppose even lenient regulations. They offer evidence that employers gain financial benefits from delaying even modest health and safety regulations. If the problem is employer intransigence, McGarity and Shapiro propose that Congress changes OSHA’s statutory mandate to make it easier for OSHA to prevail when it is sued. McGarity and Shapiro (1993) and Shapiro and McGarity (1989) also propose rulemaking reforms that OSHA can undertake to speed up rulemaking and make it more rational. These include improving how OSHA sets its regulatory priorities and focussing on types of regulations that yield the greatest protection for workers.

22. Reform of OSHA’s Regulatory Standard Mendeloff proposes that OSHA should balance costs and benefits in health regulation because employers would be less likely to challenge more lenient regulation in court. Other analysts favor adoption of a cost-benefit standard for OSHA safety and health regulation because this approach is more consistent with economic theory. Economic theory favors a cost-benefit approach for regulation because it equates the marginal benefits of safety and health improvements with the marginal cost of such precautions. Besides Mendeloff, supporters of a cost-benefit approach include Viscusi (1983, 1992) and Sunstein (1990, 1996). More generally, Litan and Nordhaus (1986) propose that Congress establish a regulatory budget for OSHA and similar agencies which would establish caps for the regulatory costs that the agency could impose. Arguments that OSHA should be subject to a cost-benefit approach follow the arguments made in general for using cost-benefit analysis to specify the extent of safety, health and other social regulation. Sunstein (1990, 1996) and Breyer (1993) contain a useful statement of the general arguments. The primary benefit of the cost-benefit analysis is that it addresses safety and health risks in light of the fact that society will always have limited resources to spend on safety and health. Cost-benefit balancing promotes rationality by helping to ensure that those resources are spent in the most efficient manner possible. By comparison, critics find that OSHA regulations often impose costs that exceed benefits sometimes by hundreds of millions of dollars. For example, Morrall (1979) objects to OSHA’s noise regulation because it mandated the use of expensive engineering controls rather than much less expensive personal protection equipment such as ear plugs. Analysts have made similar criticisms of other workplace safety regulation. French

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(1988), for example, suggests that railroad safety regulation in the United States is inefficient because excessive burdens are imposed on firms. A second benefit of the cost-benefit approach is that it makes agencies more accountable to the public. Safety and health regulation will inevitably require tradeoffs among regulatory goals because of society’s limited resources. Without a cost-benefit approach, the public has difficulty learning about such tradeoffs. By comparison, a cost-benefit approach requires agencies to make these tradeoffs more explicit. A third advantage is that the cost-benefit approach responds to the problem of regulatory ‘perversity’. Critics of regulation, such as Sunstein (1997), warn that an attempt to reduce one safety or health risk can increase other safety or health risks. This would occur, for example, when the regulation of one chemical leads manufacturers to use more dangerous substitutes. More generally, Sunstein cites to an incipient literature that considers whether costly regulation increases risks because such regulations reduce wealth. This possibility is suggested by the fact that persons who are unemployed or poor tend to be more unhealthy and to live shorter lives. Cost-benefit analysis addresses this problem by requiring agencies to examine the ‘substitution risks’ that might result from a proposed regulatory action.

23. Support of OSHA’s Standard McGarity and Shapiro (1993, 1996) and Shapiro and McGarity (1991) defend the current technology-based approach to regulation. Their arguments, summarized below, follow the arguments made in general by Cranor (1993), McGarity (1991), Sagoff (1988) and others against using cost-benefit analysis to specify the extent of safety, health, environmental, and other social regulation. One criticism is that cost-benefit analysis is too unreliable to constitute an effective method to implement regulations. Critics point out that current risk assessment techniques do not have the power to permit precise calculations of the number of lives saved or injuries avoided, and that methods used to reduce these benefits to dollars amounts are highly contestable. As a result, the costbenefit approach ordinarily raises difficult methodological issues that are exceedingly expensive and time-consuming for agencies to resolve and defend in court. In comparison, a technology-based approach more simply sets industry-wide limitations on the basis of the level of precaution that the best performers in the industry are capable of achieving. Supporters of a technology-based approach also deny that it leads to the type of regulatory excesses identified by the supporters of the cost-benefit approach. As just noted, estimates of costs and benefits are highly imprecise. In light of this imprecision, critics of a cost-benefit approach are skeptical regarding

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claims that the cost of OSHA regulation greatly exceeds the benefits. A second criticism is that the cost-benefit approach is at its core ‘incoherent’ because it cannot yield a single numerical value. According to this argument, the general tendency of individuals to buy and sell goods for roughly the same price (the market price) does not apply when credible risks to health and safety are being traded. Instead, individuals are normally willing to sell the right to be free from increased mortality risks for considerable more money than they are willing to pay to reduce such risks. The reason is that most persons can demand more in a bargain in which they are asked to sacrifice something of great value, to which they have a right, than they can afford to pay for that same thing, if someone else has the right to take it from them. Thus, use of a ‘willingness to sell’ measure of the benefits of a safety or health regulation yields a different, and higher, value than use of a ‘willingness to buy’ measure of such benefits. Despite this incoherence, regulators must rely on a ‘willingness to buy’ measurement because it is the only one for which there are data. Estimates of wage premiums indicate how much workers are willing to pay for a safer workplace. When workers seek safer jobs, they will forfeit the wage premiums paid for riskier work. Critics also argue that reliance on a ‘willingness to buy’ measurement of the value of human life is ethically objectionable. This argument contends that poor people are not likely to sell the right to be safe for any less than a rich person would. By comparison, a person’s wealth will affect the amount that he or she can pay to purchase the right to be safe. A fourth criticism is that discounting future benefits to present value biases the cost-benefit approach against the prevention of occupational disease. Although employers must immediate pay for prevention, the benefits of such actions will not show up for years. The latency period for occupational disease is usually 20 or 30 years. As a result, the benefits of a regulation that would prevent such losses can be outweighed by even modest present costs. Supporters of a cost-benefit standard defend the use of a discount rate. They argue that if workers had the opportunity to spend money on prevention today, which would result in lower wages, in return for a lower probability of cancer 30 years later, the workers themselves could likely discount the future costs of the disease. In other words, individuals put different values on dying 30 years from now and dying today. Defenders also dispute that the use of discounting results in a lack of appropriate regulation. They assert that an investment in abatement should earn a sufficiently large return over 30 years to justify the protection of workers. When this is not true, evaluators should verify that they are using an appropriate discount rate. Finally, critics charge that use of a cost-benefit standard as the primary decision criterion effectively elevates economic efficiency to a ‘meta-value’ that trumps all other conflicting values. OSHA’s mandate, which reflects both

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economic and noneconomic considerations, rejects the idea that the maximization of material wealth is the only goal of a good society. Instead, it seeks to balance ‘efficiency’, ‘fairness’, and other important social values.

24. Reform of Enforcement An earlier discussion explained that empirical studies suggest OSHA inspection activity has not lead to a reduction in aggregate injury rates. One explanation is that many causes of workplace accidents cannot be addressed by safety regulations. Another explanation is that OSHA has insufficient resources to expand its successful enforcement efforts at some plants to most employers. The literature on enforcement focusses on how OSHA can promote greater compliance in light of its limited resources. Viscusi (1986a, 1986b) analyzes this issue in terms of an employer’s economic incentives to comply with OSHA regulations. Employers will comply when it cost less to make safety improvements than to risk an adverse OSHA inspection. The risk to an employer of an inspection is a function of the likelihood that the firm will be inspected and the penalties that the firm will suffer if violations are detected. These penalties include OSHA fines as well as any adverse effect on the employer’s reputation. If the employer’s reputation is adversely affected, there may be worker turnover, increased demands for wage premiums, or other adverse consequences. In light of these incentives, Viscusi proposes that OSHA can improve compliance by increasing the likelihood that the most dangerous workplaces are inspected and that large fines are assessed for serious violations. McGarity and Shapiro (1993) support these recommendations and amplify how they might be implemented. OSHA can increase the likelihood that it will find the most dangerous work conditions by focussing its inspection activity on the most dangerous employers and its individual inspections on identifying the most serious violations. Analysts, such as Bardach and Kagan (1982) and Howard (1994), have criticized OSHA for zealously enforcing detailed rules in circumstances where enforcement is counterproductive, unfair, or even nonsensical. OSHA, however, has a potential problem in using injury records to target inspections. Ruser and Smith (1988) show that using injury records to target inspections creates an incentive for employers to underreport injuries in high-hazard industries. If OSHA uses such records for purposes of targeting, it must audit employers to reduce underreporting. Fry and Lee (1989) propose that the ‘real teeth’ of OSHA citations may be the impact on the stock market value of a firm. They found that the announcement of fines produce an immediate and pronounced decline in the

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value of the firm subject to the penalties. They hypothesize the decline may reflect the additional costs a firm can expect such as the need to make safety improvements. Regulators might also enhance compliance with regulations by mandating that employers establish joint employer-employee health and safety committees to monitor workplace conditions. Such committees may improve safety by focussing the attention of employers and employees on workplace hazards, and by providing a forum for the exchange of information. These committees might be especially effective in the absence of a union to give workers a voice concerning safety issues. Spieler (1994) documents that a number of states have instituted such a requirement. Rea (1983) discusses Canadian laws which require such committees. He notes that because joint safety committees were already in existence in larger unionized establishments, the main impact of the legislation is to extend the practice to small firms and nonunionized work places. Walters and Haines (1988) found, however, that workers in Ontario had only weak links with their health and safety representatives, and few workers made use of this resource.

E. Conclusions 25. Market, Compensation and Regulatory Alternatives An employer will invest in safety and health precautions until the cost is more than the expense of paying higher wages, workers’ compensation, and other accident and illness costs. Employees receive additional protection because governments have chosen to augment these financial incentives with regulation. Economic theory would have governments order the same level of protection as would be produced if employers fully compensated workers for their injuries and illnesses and paid any additional accident and illness costs. In the United States, however, Congress has established a technology-based goal for OSHA, which requires the agency to seek the highest level of protection which is technologically feasible. Analysts have studied the impact of compensatory wages, workers’ compensation, and regulation on safety and health. These studies indicate that all three approaches promote investments in safety and health protection, but the extent of such improvement is difficult to verify and may be limited in numerous situations. There are various explanations for this lack of efficacy, some of which conflict, but all of which suggest that labor markets, compensation and regulation are impeded by significant constraints. Various reforms have been proposed to address these constraints, but the literature has not reached a consensus concerning some key proposals. In particular, there is a considerable debate concerning whether OSHA should be

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subject to a cost-benefit test. There is also a question of political viability concerning some reforms. In the United States, for example, reform of workers’ compensation requires action by all 50 states. This analysis confirms that labor markets, compensation, and regulation are highly imperfect alternatives concerning the reduction of occupational accidents and illnesses. It also suggests that it is necessary to rely on all three approaches. Each approach alone, even if reformed, is unlikely to produce an appropriate level of occupational safety and health. The combination of the three, by comparison, is more likely to move countries closer to this elusive goal.

Acknowledgments Professor Shapiro gratefully acknowledges the highly useful comments of two anonymous reviewers.

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Spieler, Emily (1994), ‘Perpetuating Risk? Workers Compensation and the Persistence of Occupational Injuries’, 31 Houston Law Review, 119-264. Staten, Michael and Umbeck, John (1986), ‘A Study of Signaling Behavior in Occupational Disease Claims’, 29 Journal of Law and Economics, 263-286. Veljanovski, Cento G. (1982), ‘The Employment and Safety Effects of Employers’ Liability’, 29 Scottish Journal of Political Economy. Victor, Richard B. (1982), Workers’ Compensation and Workplace Safety: The Nature of Employer Incentives, Santa Monica, CA, Institute for Civil Justice, Rand Corporation, 68 p. Viscusi, W. Kip (1983), Risk By Choice: Regulatory Health and Safety in the Workplace, Cambridge, MA, Harvard University Press, 200 p. Viscusi, W. Kip (1984), ‘Structuring an Effective Occupational Disease Policy: Victim Compensation and Risk Regulation’, 2 Yale Journal on Regulation, 53-81. Viscusi, W. Kip (1986a), ‘Reforming OSHA Regulation of Workplace Risks’, in Weiss, Leonard W. and Klass, Michael W. (ed), Regulatory Reform: What Actually Happened, Boston, Little Brown, 234-268. Viscusi, W. Kip (1986b), ‘The Structure and Enforcement of Job Safety Regulation’, 49(4) Law and Contemporary Problems, 127-150. Viscusi, W. Kip (1989), ‘The Interaction between Product Liability and Workers’ Compensation as Ex Post Remedies for Workplace Injuries’, 5 Journal of Law, Economics, and Organization, 185-210. Viscusi, W. Kip (1991), ‘Product and Occupational Liability’,5(3) Journal of Economic Perspectives, 71-91. Viscusi, W. Kip (1992), Fatal Tradeoffs: Public and Private Responsibilities for Risk, New York, Oxford Press, 306 p. Walters, Vivienne and Haines, Ted (1988), ‘Workers’ Use and Knowledge of the “Internal Responsibility System”: Limits to Participation in Occupational Health and Safety’, 14 Canadian Public Policy, 411-423. Weiler, Paul (1986), Legal Policy for Workplace Injuries, Philadelphia, American Law Institute Project on Compensation and Liability for Product and Process Injuries, 141p. Weiss, Peter, Maier, Gunther and Gerking, Shelby (1986), ‘The Economic Evaluation of Job Safety: A Methodological Survey and Some Estimates for Austria’, 13 Empirica, 53-67. Wiggins, Steven N. and Ringleb, Al H. (1992), ‘Adverse Selection and Long Term Hazards: The Choice between Contract and Mandatory Liability Rules’, 21 Journal of Legal Studies, 189-215. Wilson, Graham, K. (1985), The Politics of Safety and Health: Occupational Safety and Health in the United States and Britain, New York, Oxford Press, 179 p. Worrall, John D. and Butler, Richard J. (1988), ‘Experience Rating Matters’, in Borba, Philip S. and Appel, David (eds), Workers’ Compensation Insurance Pricing: Current Programs and Proposed Reforms, Boston, Kluwer Academic Publishers, 81-94.

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Other References Bardach, Eugene and Kagan, Robert A. (1982), Going By The Book: The Problem of Regulatory Unreasonableness, Philadelphia, Temple University Press, 375 p. Breyer, Stephen (1993), Breaking The Vicious Circle: Toward Effective Risk Regulation, Cambridge, MA, Harvard University Press, 127 p. Cranor, Carl F. (1993), Regulating Toxic Substances: A Philosophy of Science and The Law, New York, Oxford Press, 252 p. Howard, Philip K. (1994), The Death of Common Sense: How Law is Suffocating America, New York, Random House, 202 p. Komesar, Neil K. (1994), Imperfect Alternatives: Choosing Institutions in Law, Economics, and Public Policy, Chicago, University of Chicago press, 287 p. McGarity, Thomas O. (1991), Reinventing Rationality: The Role of Regulatory Analysis in the Federal Bureaucracy, New York, Cambridge University Press, 384 p. Sagoff (1988), The Economy of the Earth: Philosophy, Law, and the Environment, New York, Cambridge University Press, 271 p. Sunstein, Cass R. (1990), After the Rights Revolution: Reconceiving the Regulatory State, Cambridge, MA, Harvard University Press, 284 p. Sunstein, Cass R. ( 1991), ‘Administrative Substance’, Duke Law Journal, 607-646. Sunstein, Cass R. (1996), ‘Legislative Forward: Congress, Constitutional Moments, and the Cost-Benefit State’, 48 Stanford Law Review, 247-309. Sunstein, Cass R. (1997), Free Markets and Social Justice, New York, Oxford Press, 407 p.

5550 COLLECTIVE BARGAINING AND WORKER PARTICIPATION © Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest

Bibliography Collected by the Editors Adams, G.W. (1978), ‘Collective Bargaining by Salaried Professionals’, in Slayton, Philip and Trebilcock, Michael J. (eds), The Professions and Public Policy, Toronto, University of Toronto Faculty of Law. Albert, Michael and Hahnel, Robin (1991), The Political Economy of Participatory Economics, Princeton, Princeton University Press, 132 p. Backhaus, Jürgen G. (1980), ‘Wirtschaftliche Analyse der Entwicklungsmöglichkeiten mitbestimmter Wirtschaftssysteme (Economic Analysis of Co-Determination)’, in Kappler, Ekkehard (ed), Unternehmensstruktur und Unternehmensentwicklung, Freiburg, Rombach, 266-289. Backhaus, Jürgen G. (1987a), Mitbestimmung im Unternehmen, Göttingen, Vandenhoeck & Ruprecht, 306 p. Reprinted in Co-Determination: A Legal and Economic Analysis. Backhaus, Jürgen G. (1987b), ‘The Emergence of Worker Participation: Evolution and Legislation Compared’, 21 Journal of Economic Issues, 895-910. Bainbridge, Stephen M. (1996), ‘Participatory Management Within a Theory of the Firm’, 21 Journal of Corporation Law, 657 ff. Buxbaum, Hertig and Hirsch, Hopt (eds), European Economic and Business Law, Legal and Economic Analyses on Integration and Harmonization, Berlin, Walter De Gruyter, 401 p. Cohen, George M. and Wachter, Michael L. (1988), ‘An International Labor Market Approach to Labor Law: Does Labor Law Promote Efficient Contracting?’, Industrial Relations Research Association 41st Annual Proceedings, 243-250. Cohen, George M. and Wachter, Michael L. (1988), ‘The Law and Economics of Collective Bargaining: An Introduction and Application to the Problems of Subcontracting, Partial Closure, and Relocation’, 136 University of Pennsylvania Law Review, 1349 ff. Cohen, George M. and Wachter, Michael L. (1990), ‘Replacing Striking Workers: The Law and Economics Approach’, in X (ed), New York University Conference on Labor, 43rd Annual Proceedings, 109-125. Coljee, P.D. (1991), ‘Het Economisch Adviesrecht van de Ondernemingsraad, Quo Vadis? Artikel 25 WOR nader beschouwd (The Workers Council Economic Right of Advice, Quo Vadis?)’, in Coljee, P.D., Franken, H., Heertje, A. and Kanning, W. (eds), Law and Welfare Economics, Amsterdam, VU Amsterdam, 77-99. Crouch, Colin (1982), Trade Unions: The Logic of Collective Action, Glasgow, Fontana Paperbacks, 251 p. Currie, Janet and McConnell, Sheena (1994), ‘The Impact of Collective Bargaining Legislation on Disputes in the U.S. Public Sector: No Legislation May Be the Worst Legislation’, 37 Journal of Law and Economics, 519-547.

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Klemm, Günter (1983), Ökonomische Analyse von Streik und Ausperrung im Rahmen einer marktwirtschaftlichen Ordnung (Economic Analysis of Strike and Lock-out in the Context of a Market Economy), 214 p. Knight, Thomas R. (1988), ‘The Propensity to Sue and the Duty of Fair Representation: Reply’, 41 Industrial and Labor Relations Review, 461-464. Lande, Robert H. (1996), ‘Anticonsumer Effects of Union Mergers: An Antitrust Solution’, 46 Duke Law Journal, 197 ff. Lande, Robert H. and Zerbe, Richard O., Jr (1985), ‘Reducing Unions’ Monopoly Power: Costs and Benefits’, 28 Journal of Law and Economics, 297-310. Reprinted in 29 Corporate Practice Commentator, 1987, 107-122. Lande, Robert H. and Zerbe, Richard O., Jr (1990), ‘More Lessons From Japan: End Industrywide Collective Bargaining?’, 28 Asian Economic Journal. Leef, G.C. (1990), ‘Legal Obstacles to a Market for Employee Representation Services’, 9 Cato Journal, 663-687. Leslie, Douglas L. (1989), ‘Multiemployer Bargaining Rules’, 75 Virginia Law Review, 241-278. Levin, William R. (1985), ‘The False Promise of Worker Capitalism: Congress and the Leveraged Employee Stock Ownership Plan’, 95 Yale Law Journal, 148-173. Livernash, E.R. (1963), ‘The Relation of Power to the Structure and Process of Collective Bargaining’, 6 Journal of Law and Economics, 10-40. Lurie, Melvin (1960), ‘Government Regulation and Union Power: A Case Study of the Boston Transit Industry’, 3 Journal of Law and Economics, 118-135. Meltzer, Bernard D. (1963), ‘Labor Unions, Collective Bargaining, and the Antitrust Laws’, 6 Journal of Law and Economics, 152-223. Möschel, Wernhard (1996), ‘Ist die Tarifautonomie noch Zeitgemäß? (Is the German System of Autonomous Wage Bargaining Still up to Date?)’, 45 Zeitschrift für Wirtschaftspolitik, 39-48. Nagel, Bernhard (1980), ‘Beschaffung und Weitergabe von Informationen durch Mitbestimmungsträger im Aufsichtsrat (Collection and Transmission of Information by Workers’ Representatives in the Board of Directors)’, in Diefenbacher and Nutzinger (eds), Frankfurt/M., Bern, Cirencester, 249-269. Nagel, Bernhard (1981), ‘Rechtsauslegung und Rechtssetzung zur Mitbestimmung (Interpretation of Law and Law Making Concerning Worker Participation)’, Blätter für Steuer-, Sozialversicherungs- und Arbeitsrecht, 344-350. Nagel, Bernhard (1982), ‘Zusammensetzung mitbestimmter Aufsichtsratsausschüsse und Unternehmensinteresse (Composition of the Board of Directors under Worker Participation and the Goals of the Firm)’, DB, 2677-2681. Nagel, Bernhard (1984a), ‘Informationsrechte und Mitbestimmungsträger nach dem Mitbestimmungsgesetz 1976 und dem Betriebsverfassungsgesetz (Rights on Information and Worker Participation according to the German Law of 1976)’, in Koubek and Schredelseker (eds), Information, Mitbestimmung und Unternehmenspolitik, Frankfurt/M., Cirencester. Nagel, Bernhard (1984b), ‘Informationsrechte und Informationspolitik in Mitbestimmten Unternehmen (Rights on Information and Information Policy in Firms under Worker Participation)’, in Diefenbacher and Nutzinger (eds), Mitbestimmung, Theorie, Geschichte, Praxis, Heidelberg, Müller Juristischer Verlag.

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Nagel, Bernhard (1988), Mitbestimmung und Grundgesetz (Worker Participation and the German Basic Law), Baden-Baden, Nomos. Nagel, Bernhard (1990), ‘Erosion der Mitbestimmung und EG- Kommissionsentwürfe zur Europa-AG (Erosion of Worker Participation)’, Arbeit und Recht, 205-213. Nagel, Bernhard (1991), ‘Der EG-Richtlinienentwurf zum Europäischen Betriebsrat (The EG-Guideline on the European Workers Committee)’, Arbeit und Recht, 161-172. Nagel, Bernhard (1996), ‘Wie effizient sind Tarifvertrag und Mitbestimmung? (How Efficient are Wage Agreements and Worker Participation?)’, 2 Gewerkschaftliche Monatshefte, 97-111. Nutzinger, Hans G. and Backhaus, Jürgen G. (eds) (1989), Codetermination: A Discussion of Different Approaches, Berlin, Springer, 309 p. Peltzman, Sam (1961), ‘The Relative Importance of Unionization and Productivity in Increasing Wages’, 12 Labor Law Journal. Rees, Albert (1959), ‘Do Unions Cause Inflation?’, 2 Journal of Law and Economics, 84-93. Rees, Albert (1963), ‘The Effects of Unions on Resource Allocation’, 6 Journal of Law and Economics, 69-78. Roe, Mark J. (1994), ‘German "Populism" and the Large Public Corporation’, 14 International Review of Law and Economics, 187-202. Sadowski, Dieter and Frick, Bernd (1990), ‘Betriebsräte und Gesetzesvollzug (Labor Representatives and Execution of Laws)’, 4 Zeitschrift für Personalforschung, 165-178. Sadowski, Dieter, Backes-Gellner, Uschi and Frick, Bernd (1995), ‘Betriebsräte in Deutschland, Gespaltene Rationalitäten? (Labor Representatives in Germany)’, 14 Jahrbuch für Neue Politische Ökonomie, 157-182. Schmidtchen, Dieter (1981), ‘Leitungspartizipation, Wettbewerb und Funktionsfähigkeit des Marktsystems (Management Participation)’, in Issing, D. (ed), Zukunftsprobleme der Sozialen Marktwirtschaft, Schriften des Vereins für Socialpolitik, N.F. Bd. 116, Berlin, Springer, 191 ff. Schwab, Stewart J. (1992), ‘Union Raids, Union Democracy, and the Market for Union Control’, 25 University of Illinois Law Review, 367-416. St. Antoine, Theodore J. (1989), ‘Commentary on "Multiemployer Bargaining Rules": The Limitations of a Strictly Economic Analysis’, 75 Virginia Law Review, 279-283. Steinherr, A. (1977), ‘On the Efficiency of Profit Sharing and Labor Participation in Management’, 8 Bell Journal of Economics, 545-555. Turnbull, Shann (1990), ‘Re-Inventing Corporations’, 2(4) Journal of Employee Ownership Law and Finance, 109-136. Translated into Czech and republished 1991, Podnikov Organizace, Prague. Turnbull, Shann (1991a), ‘Equitable Capitalism: Promoting Economic Opportunity Through Broader Capital Ownership’, in Stuart M. Speiser, Socialising Capitalism, New York, New Horizons Press, 97-113. Turnbull, Shann (1991b), ‘Re-Inventing Corporations’, 10(3) Human Systems Management, 169-186. Turnbull, Shann (1993a), ‘Flaws and Remedies in Corporatisation and Privatisation’, 12(3) Human Systems Management, 227-252. Turnbull, Shann (1993b), ‘Democratic Capitalism; Self-Financing Local Ownership and Control’, 12(4) Human Systems Management, 333-348.

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5610 THE THEORY OF THE FIRM Nicolai J. Foss Department of Industrial Economics and Strategy Copenhagen Business School

Henrik Lando Department of Finance Copenhagen Business School

Steen Thomsen Institute of International Business Aarhus Business School © Copyright 1999 Nicolai J. Foss, Henrik Lando, and Steen Thomsen

Abstract This chapter is a survey of modern theories of the firm. We categorize these as belonging either to the principal-agent or the incomplete contracting approach. In the former category fall, for example, the Alchian and Demsetz moral hazard in teams theory as well as Holmstrøm and Milgrom’s theory of the firm as an incentive system. Belonging to the incomplete contracting branch are theories that stress the importance of the employment relationship (for example, Coase and Simon) as an adaptation mechanism, theories that stress the importance of ownership of assets for affecting incentives when contracts must be renegotiated (Williamson, Grossman and Hart, Hart and Moore), and some recent work on implicit contracts (Baker, Gibbons and Murphy). We argue that these different perspectives on the firm should be viewed as complementary rather than as mutually exclusive and that a synthesis seems to be emerging. JEL classification: K22, L22 Keywords: Principal-Agent Problems, Incomplete Contracts, Moral Hazard, Employment Relationship, Firm Ownership, Renegotiation

1. Introduction: The Emergence of the Theory of the Firm Along with households, firms have for a long time been a crucial part of the explanatory set-up of economics. For example, in basic price theory, firms are part of the apparatus that helps us trace out the effect on endogenous variables of changes in exogenous variables. But the explanatory atoms, firms and 631

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households, are not themselves treated in any detail. Thus, we have for a long time had an economics with firms, as it were; what was missing until the 1970s was an economics of firms. It is only relatively recently, in other words, that economists have felt the need for an economic theory addressing the reasons for the existence of the institution known as the (multi-person) business firm, its boundaries relative to the market, and its internal organization - to mention the issues that are generally seen as the main ones in the modern economics of organization (for example, Milgrom and Roberts, 1988; Hart, 1989; Holmström and Tirole, 1989). Although pioneering early work was done already by Frank Knight (1921) and Ronald Coase (1937), it was not until the mid 1970s that work really blossomed within the field, stimulated by advances in the economics of market failures, property rights, information and uncertainty which made possible a more rigorous understanding of the sources and nature of transaction costs and of the incentive properties of alternative types of economic organization. The work of Coase did not belong to this formal stream of work, and as late as in 1972, Coase lamented that his 1937 paper had been ‘much cited and little used’. However, at the time of Coase’s lamentation, serious work on the theory of the firm had begun to take off, notably with Williamson (1971) and Alchian and Demsetz (1972), two seminal contributions that helped found distinct perspectives within the modern economics of organization. It is fair to say that today organizational economics is one of the richest and most rapidly expanding fields in modern economics. It may seen as part of broader attempt (sometimes called ‘new institutional economics’) to move beyond the confines of the market institution and also inquire into the rationales and functioning of alternative institutions for resource allocation, generalizing standard neoclassical economics in the process (Arrow, 1987). The pure analysis of the market institution leaves almost no room for the firm (Debreu, 1959). Under the assumption of a perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce efficient outcomes. The question how organizations should be structured does not arise, because market-contracting perfectly solves all incentive and coordination issues. By assumption, firm behaviour (profit maximization) is invariant to institutional form (for example, ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal structure, contracts, and so on disappear from the picture, there are many other issues that the theory cannot address. For example, the theory does not tell us why firms exist. As already indicated this is not a new recognition, but rather a basic point in Coase (1937). What Coase observed was indeed that, in the world of

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neoclassical price theory, firms have no reason to exist. According to the textbook, the decentralized price system is the ideal structure for carrying out economic coordination. Why then do we observe some transactions to be removed from the price system to the interior of organizations called firms? The answer, Coase reasoned, must be that there is a ‘cost to using the price mechanism’ (Coase, 1937, p. 390). Thus was born the idea of transaction costs: costs that stand separate from and in addition to ordinary production costs. Firm organization may avoid these costs, and exists for this reason. However, as is well-known, Coase’s insights were neglected for more than three decades. During the 1960s, standard neoclassical theory was criticized for ignoring conflicts of interest between owners and managers, a point reaching back to Berle and Means (1932) (Marris, 1964; Williamson, 1964). Thus, the standard theory assumed that profit maximization was the main objective of managers. At the same time, critics from behavioral studies attacked the assumption of perfect rationality. In their view, the existence of organizations such as firms was primarily a matter of economizing with bounded rationality (Simon and March, 1958; Cyert and March, 1963). A little later, Williamson (1971, 1975) following Coase (1937) questioned the view (which he called ‘technological determinism’) that technologies are determinative of economic organization. This did not, according to Williamson, explain why the services of production factors are coordinated in a firm rather than offered to the market by self-sufficient factor-owners. More or less simultaneously, Kenneth Arrow’s work on welfare economics and information (Arrow, 1969, 1974) emphasized various limitations of the market mechanism and argued that firms can be understood in terms of market failures which arise under conditions of externality, economies of scale and information asymmetries. All these influences and insights set up a rich agenda for research. Work on the theory of the firm (as it has been defined here) began to take off during the 1970s, notably with seminal contributions by Williamson (1971, 1975), Alchian and Demsetz (1972), Ross (1973), Arrow (1974), Jensen and Meckling (1976), and, from a rather different perspective, Nelson and Winter (1982), summarizing their work in the 1970s. It is fair to say that the emerging economics of organization is now one of the richest and most rapidly expanding fields in modern economics. It may be seen as part of broader attempt (sometimes called ‘new institutional economics’) to move beyond the confines of the market institution and also inquire into the rationales and functioning of alternative institutions for resource allocation, generalizing standard neoclassical economics in the process (Arrow, 1987). (In this connection, it should be mentioned that what we here call ‘the theory of the firm’ really is a general theory of economic organization that also include, for example, ‘intermediate forms’, such as franchising arrangements or joint ventures.)

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While there exist various streams of research, they share the basic principle that economic organization, including paradigmatically the choice between firm or market, will turn on the maximization of joint surplus from cooperation in production (Coase, 1960). Although modern theories of organization are partial equilibrium theories, and although they emphasize bilateral aspects of transactions, many of them have a foundation in general equilibrium theory, both historically and conceptually (Hart and Holmström, 1987; Guesnerie, 1994). While this may not be historically true of the contributions of, for example, Coase and Alchian and Demsetz, nevertheless the various approaches to the theory of the firm can be rationalized as different departures from the Arrow-Debreu model. This is the interpretation we adopt in the following. Since firms would not exist in a full and perfect information setting (implying perfect and costless contracting), one can understand the existence of firms as a consequence of one or more of the Arrow-Debreu assumptions not holding true. We focus on two basic Arrow-Debreu assumptions which we use to structure our account of the different theories of the firm. 1. The assumption of complete contracting: Agents can foresee all future contingencies and can costlessly write contracts which cover all contingencies. Thus, there are no incomplete contracts. 2. The assumption of symmetry information concerning ‘states of nature’. Thus, there are no principal-agent incentive problems. Accordingly, theories of the firm may roughly be classified in a rough way into two categories: (a) Incomplete contracting models which are founded on the assumption that it is costly to write elaborate contracts, and that there is therefore a need for ex post governance. The work of Williamson; Grossman, Hart and Moore; Coase; and Simon, as well as implicit contract-theories, and the theory of communication in hierarchies, belong to this category. (b) Principal-agent models which allow agents to write elaborate contracts characterized by ex ante incentive alignment under the constraints imposed by the presence of asymmetric information. The work of, for example, Alchian and Demsetz; Holmström; and Milgrom belong in this category. One way of interpreting this division of the literature is to say that they have concentrated on different kinds of the transaction costs that Coase (1937) identified but did not elaborate on. Clearly, these perspectives are complementary, and should be integrated. There are signs that this integration process is slowly beginning (for example, Holmström and Milgrom, 1994). However, in this paper we stick to the above dichotomization, and after

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surveying theories in each category we end up discussing prospects and criticisms. (For more on the disagreement between the two modeling strategies, see Tirole, 1994.)

2. Complete Contracting and Economic Organization: Principal-Agent Theories 2.1 General Aspects of Principal-Agent Theories Historically, principal-agent theories (or simply, agency theory) reach back to early debates on the shareholders-managers relation. Following the observation by Berle and Means (1932) that ownership of US firms had become separated from management and control, managerialist theories have modeled firm behavior as the maximization of managerial objectives (firm size, growth) under a profit constraint (Marris and Mueller, 1980; Williamson, 1964). Managerial objectives are believed to be variables like firm size or growth, partly because they are positively correlated with managerial compensation and power. The conflict of interest between owners and managers is but one example of an incentive or principal-agent conflict which arises in the context of firms and which may explain important aspects of their organization. During the 1970s formal agency theory blossomed (Ross, 1973 is an early contribution). In its paradigmatic version, the theory deals with a relationship between a principal (for example, the owner) and an agent (for example, the manager) who works on a well-defined task, although the model can be generalized to encompass, for example, many agents, hierarchical layers (for example, a middle-manager who is both agent and principal), and multiple tasks. Indeed, much of the formal agency work in the 1970s consisted in such extensions of the basic model (see Hart and Holmström, 1987). A basic assumption is that some information asymmetry exists between the two, so that the principal cannot directly observe the activities of the agent or that the agent knows some other aspect of the situation which is unknown to the principal. The literature makes a distinction between ‘hidden action’ and ‘hidden information’ models (Arrow, 1985a). The principal may, of course, infer something by observing output (for example, profits), but under uncertainty output is an imperfect signal of the agent’s actions. Under these conditions the first-best (output maximizing) contract would be to let the agent compensate the principal with a fixed lump-sum payment and to be awarded the residual; however, risk aversion on behalf of the agent may rule out this solution. Other solutions are possible but all entail cost. In practice it has been suggested that managers are disciplined (that is, induced to behave efficiently) by takeover threats (Manne, 1965; Jensen, 1986), product market competition

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(Hart, 1983), debt pressure (Jensen, 1986) and competitive managerial labor markets (Fama, 1980). 2.2 The Nexus of Contracts View Alchian and Demsetz (1972), Jensen and Meckling (1976),Barzel (1997) and, most forcefully, Fama (1980) and Cheung (1983) argue that from the perspective of economics, it is essentially misguided to draw a hard line between firms and markets. Although firms are surely legal entities, and although this of course has important economic consequences (for example, limited liability, the right to deduct input purchases from tax statements, infinite lifetime, and so on), that firms are nevertheless merely special kinds of market contracting. What may distinguish them relative to other market contracts lies primarily in the continuity of association among input owners. In Alchian and Demsetz’ formulation, the authority relation associated with the employment relationship is, for example, in no way the defining characteristic of the firm. An employer has no more authority over an employee than a customer over a grocer. Both the employer and the customer rely on their ability to punish ‘disobedience’ by firing, that is, by no longer dealing with their counterpart. A customer ‘firing’ a grocer is not in economic terms any different from an employer firing an employee, it is asserted. In short, the firm is nothing but a nexus of contracts, backed up by special legal status and characterized by continuity of association among input owners. We may talk about a nexus of contracts being more ‘firm-like’ when, for example, residual claimancy becomes more concentrated, but it is not in general productive to talk about ‘firms’ as distinctive entities. While there is much truth in the view that defining the exact firmenvironment boundary is theoretically problematic, it would seem that this view ‘underdetermines’ real world firms: authority does seem to have a real existence and firms seem to be characterized by more than their legal status, for example, some argue, by specific technologies. While we treat the first of these two issues later, we briefly consider the second one in the following section. 2.3 The Firm as a Solution to Moral Hazard in Teams (Alchian-Demsetz and Holmström) Alchian and Demsetz (1972) emphasize that the firm is indeed characterized by something more than legal status, namely the technology of team production, by which they mean production with inseparable individual production functions. This implies, they argue, that marginal products are costly to measure. This may create a free-rider problem since team production can be a cover for shirking. The solution to this problem is to appoint a monitor who is given the right to fire and hire members of the team, based on his observation of employees’ marginal products. Giving him rights to the residual

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income of the team furthermore means that he is given incentives to perform the efficient amount of monitoring. This arrangement results in the distribution of rights known as ‘the classical capitalist firm’ (Alchian and Demsetz, 1972). In a formal contribution, Holmström (1982) discusses the incentive problems of monitoring and possible solutions (abstracting from team synergies by assuming an additive production function). Under the assumption that the monitor is uninformed about individual effort levels under team production, Holmström demonstrates that only under restrictive assumptions will the monitor be able to induce efficient effort levels. He can do this by devising clever incentive mechanisms. Specifically, Holmström proves that in a team production situation with unobservable effort levels, the triple requirement of the incentive system of Nash equilibrium, budget balancing (that is, the revenues should be distributed among the team members by the incentive system) and Pareto optimality cannot be met. A budget-balancing incentive system cannot reconcile Nash equilibrium and Pareto optimality. This is simply because every team member equalizes marginal costs and benefits of additional effort: if one team member’s effort generates some extra revenue for the team, he should be given that revenue in order to be properly motivated - but this cannot be done for all team members under budget balancing. In this perspective, the central advantage of the firm is that third parties can inject capital whereby the employees as a group do not have to balance their budget. However, neither the theory of Alchian and Demsetz nor that of Holmström provides us with a theory of the boundary of the firm. The basic question why the incentive problems cannot be just as well solved in the market through contracting as within firms cannot be answered by their theory. Thus, in Alchian and Demsetz’s theory it is not clear why the monitor must be the employer of the firm where he performs his monitoring services. He could be the employee of a firm specialized in monitoring services. Moreover, why don’t the employees monitor each other? Is it really meaningless to speak of authority if the employer/monitor has the right to deprive the employee of the right to work with his tools and equipment to which the employee may be strongly specialized? Still, as will become clear, unmeasurability of individual effort and contribution can be made part of a theory which explains the boundary of the firm (this is done in the Holmström-Milgrom model). 2.4 The Firm as an Incentive System (Holmström and Milgrom) The connection between ownership and employment is examined by Holmström and Milgrom (1994) who stress the importance of viewing the firm as ‘a system’, specifically as a coherent set of complementary contractual arrangements which mitigate incentive conflicts. In their opinion, it is misleading to focus on a single aspect of the coherent whole: the firm is characterized by the employee not owning the assets, by the employee being

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subject to a ‘low-powered incentive scheme’ (Holmström and Milgrom, 1991) and by the employee being subject to the authority of the employer. These ‘incentive instruments’ are complementary: for example, in the presence of measurement costs (Barzel, 1997), it is important that a person who does not own the assets, which he uses, is not subject to high-powered incentives, since he is then likely to care too little for the assets. Likewise, low-powered incentives make it important for the employer to be able to exercise authority over the use of the employee’s time, since the employee will lack the proper incentive to be productive. Due to this complementarity it is logical that independent contracting has the exact opposite constellation of instruments from the employment relationship. The choice between the two different incentive systems depends importantly on the extent to which every dimension of a person’s contribution can be measured. When an important dimension is unmeasurable, it might be counterproductive to remunerate the person through a high-powered incentive scheme since the person is likely to allocate too little attention on the unmeasurable activity. Thus, according to Holmström and Milgrom lack of measurability is an important variable determining the size of the firm (see also Barzel, 1997). They cite empirical evidence that sales agents (the sum of whose productive contributions can be measured with relatively high accuracy) are independent and vice versa. It should be mentioned that the Holmström and Milgrom model also incorporates the importance of the allocation of property rights to physical assets in determining bargaining powers and hence incentives, as in the class of models we consider later, those associated with the work of Williamson and the Grossman-Hart-Moore model. Hence, it is not only a principal-agent but also an incomplete contracting theory, and perhaps a sign of an increasing awareness of the need to join ideas from the complete contracting tradition with ideas from the incomplete contracting tradition. We consider the latter next.

3. Incomplete Contracting Theories 3.1 General Aspects This section reviews theories that may be reconstructed as departing from the assumption of complete contracting. Thus, for different reasons, not all contingencies can be contractually covered. This makes it possible to theorize about authority and asset-ownership. The view of Coase (1937) and Simon (1951) that the essence of the firm is the employment contract and the associated authority relation also belongs to the incomplete contracting category. This is because it emphasizes the costs of entering into a comprehensive contract and the consequent need of adaptation to changing

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circumstances that are not covered by the contract. The work of Williamson and Grossman and Hart also belongs here, although their focus is somewhat different: they focus on the bargaining power that asset-ownership may provide in those situations in which contingencies arise that are not covered by the contract. 3.2 The Authority View: The Firm as an Employment Relation The view that the employment contract is the characteristic feature which defines the firm is generally associated with Coase (1937) and Simon (1951). From this point of view, the size of the firm (the boundaries of the firm) is determined by the number of employees of the firm. An employee is distinguished from an independent contractor by the nature of his contract: while the employee is subject to the authority of the manager of the firm, an independent contractor acts autonomously. Coase sees the advantage of establishing an employment contract, that is a semi-authoritarian (hierarchical) relationship, in the saving of transaction costs, not least the costs of haggling over the terms of the contract. The disadvantage that is also part of the hierarchical relationship is seen as ‘information overload’: as a company expands, the manager will find it difficult to direct the actions of all employees subject to his authority, because he will be incapable of gathering all relevant information. This helps establishing the location of the boundaries of the firm. Simon defines the employment relationship more closely and compares its efficiency with the efficiency of a contract written between two autonomous actors. The latter contract specifies the action to be performed in the future and its price while the employment contract specifies a range of acceptable orders and establishes the right of the employer and the duty of the employee to accept orders within this range. The advantage of the employment relationship lies in its flexibility. The action of the employee can be adapted to whatever state of nature will occur. Intuitively, the benefit of flexibility is greater the greater the uncertainty. On the other hand, Simon stresses that the employment relationship is to some extent reliant upon the employer’s reputation for not abusing his authority. The need for trusting the employer is less if the employee is nearly indifferent between different tasks. Simon’s theory was criticized by Williamson (1975) for favorably comparing the flexibility of a short-term (spot market) employment contract to the rigidity of a (long-term) non-contingent output contract . But conceivably the flexibility of an output contract could also be achieved by a series of spot market contracts. A modern formulation by Wernerfelt (1997) overcomes some of the objections that can be raised against a theory of the firm that builds on Simon’s theory. Wernerfelt thinks of governance mechanisms as institutional mechanisms (game forms) according to which players adapt to changes in the environment and communicate about these changes. His conjecture here is that

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different game forms will be systematically characterized by different levels of costs of making adaptations. For example, in the case of the hierarchy, the employer and the employee avoid the costs of negotiating either a very complex agreement or a series of short-term contracts. Instead, the parties negotiate a once-and-for-all wage contract. In this context, authority is simply an implicit contract which states that one of the parties should have the authority to tell the other what to do (as in Coase, 1937). This game form requires less bargaining over prices than the market game form. The employment relationship is hence a game form which parties decide to adhere to in order to save on communication (adaptation) costs. The agreement to play by the least costly adaptation mechanism is upheld by the parties’ concern for reputation in a repeated game. As in Coase (1937), the size of the firm is limited by administrative information overload. 3.3 The Firm as a Governance Mechanism (Williamson) In spite of the contributions mentioned above, Coase’s idea that transaction costs can sometimes be diminished by interacting within firms rather than across markets, has been difficult to develop theoretically. In the terms of Oliver Williamson, Coase’s basic story for long awaited its ‘operationalization’. In particular, the nature and determinants of transaction costs were not, according to Williamson, adequately identified in Coase’s work. In a string of contributions, Williamson (for example, 1971, 1975, 1985, 1996) has erected an impressive edifice on Coasian foundations. Thus, Williamson’s work incorporates ideas from the so-called behavioral theory of the firm (Cyert and March, 1963), the emphasis on operating with a broad notion of self-interested behavior (a broad utility function) in the managerialist school (Williamson, 1964), ideas on contract law, and elements of information economics (Arrow, 1969).The behavioral starting points in Williamson’s theorizing are, first, Herbert Simon’s concept of bounded rationality, which produces contractual incompleteness and a need for adaptive, sequential decision making, and, secondly, opportunism, defined as ‘self-interest seeking with guile’, which has the implication that contractual agreements need various types of safeguards, such as ‘hostages’ (for example, the posting of a bond with the other party). Williamson calls contractual arrangements and the safeguards they embody ‘governance structures’, and the basic idea is to assign transactions to alternative governance structures on the basis of their transaction properties. Given bounded rationality and uncertainty, these are determined by what has increasingly become the central character in Williamson’s analysis, namely asset-specificity. Assets are highly specific when they have value within the context of a particular transaction but have relatively little value outside the transaction. This opens the door to opportunism. If contracts are incomplete

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due to bounded rationality, they must be renegotiated as uncertainty unfolds, and if a party to the contract (say, a supplier firm) has incurred sunk costs in developing specific assets (including human capital), that other party can opportunistically appropriate an undue part of the investment’s pay-off (‘quasi-rents’) by threatening to withdraw from the relationship. According to Williamson, vertical integration, that is, concentration of ownership of the (alienable) assets involved in the relation rather than having them separately owned, does away with these problems, because it removes the incentive to opportunism. Williamson’s arguments for the relative benefits of vertical integration for some classes of transactions - those that are characterized by a high degree of asset-specificity - rely on organizational theory and law. Thus, he argues that internal organization is characterized by its own implicit contract law, what he calls ‘forbearance’. Whereas divisions will not normally be granted standing for a court, corporate headquarters and headquarters function as the firm’s ‘ultimate court of appeal’. For example, Williamson points out that disputes which arise within the firm, for example, between different divisions, may be easier to resolve than disputes arising between firms which sometimes require the use of the court- system (Williamson, 1996). 3.4 The Firm as an Ownership Unit (Grossman, Hart and Moore) Over the last decade Oliver Hart, John Moore and others have developed an ‘incomplete contracts’ or ‘property rights’ theory of the firm (Grossman and Hart, 1986; Hart and Moore, 1990; Hart, 1995) which draws on elements in Williamson’s work. As in Williamson’s work, a central assumption is that because of transaction costs/bounded rationality, contracts must necessarily be incomplete in the sense that the allocation of control rights cannot be specified for all future states of the world. The theory defines ownership as the possession of residual rights of control, that is, rights to control the uses of assets under contingencies that are not specified in the contract. As a result, the allocation of formal ownership rights will affect behavior and resource allocation. For example, agents will be less inclined to invest in specific assets if they do not own these and relevant complementary assets. In the Grossman-Hart-Moore theory a firm is defined as a collection of jointly-owned assets. The basic distinction between an independent contractor and an employee, that is to say, between an inter-firm and an intra-firm transaction, turns on who owns the physical assets which the person utilizes in his work. An independent contractor owns his tools, and so on, while an employee does not. Owning an asset is important if one undertakes a non-contractible investment which is specific to the asset; if one does not own the asset, one is subject to the hold-up threat by the owner. Hence, according to this theory, the person who is to make the most important (non-contractible) asset-specific investment should own the asset. Hiring an employee (making the

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product within the firm) means hiring someone who stands the risk of being held up by the firm since the manager can threaten to ‘fire him’ (that is, exclude him from the use of the assets of the firm). Hiring an independent contractor (buying in the market) means granting him some power to hold up the firm by quitting with his assets. The optimal size of the firm balances these two opposing forces. The Grossman-Hart-Moore theory was the first to provide a formal model that could explain both the advantages and the disadvantages of firm-organization, that is, a theory that could convincingly establish the boundaries of the firm. 3.5 Implicit Contracts When it is difficult to write complete state-contingent contracts, for example, when certain variables are either ex-ante unspecifiable or ex-post unverifiable, people often rely on ‘unwritten codes of conduct’, that is, on implicit contracts. These may be self-enforcing, in the sense that each party lives up to the other party’s (reasonable) expectations from a fear of retaliation and breakdown of cooperation. The basic idea in the implicit-contract theory of the firm is that implicit contracts may function differently within firms than between firms; a person is hired as an employee rather than as an independent contractor when coordinating with him requires an implicit contract that is easier to implement within the firm than in the market place. In a recent paper, Baker, Gibbons and Murphy (1997) emphasize that implicit contracts occur both within firms (in the employment relationship) and between firms (‘relational contracting’). The difference lies in the options which are open to the parties if the implicit contract breaks down. Contrary to an independent contractor, an employee cannot leave the relationship with the assets belonging to it. Specifically, in their model, independent contracting is defined by the feature that the supplier has the possibility to sell the finished product elsewhere, while firm-contracting is defined by the supplier (the employee) not owning the finished product and hence not having the option of leaving with the asset or the product. The strength of the threat to leave the relationship determines the implementability of implicit contracts. For example, if the market for the good is volatile, relational contracts are vulnerable since the supplier is tempted to break out from the implicit contract when the market price is high. If the supplier is a division within the firm, this option does not exist and the implicit contract which holds the (internal transfer) price constant may therefore be self-enforcing. The implicit-contract theory is linked with Williamson’s idea that dispute resolution is easier to carry out within a firm than between firms: Mechanisms for dispute resolution can be seen as part of the system of self-enforcing implicit contracting within a firm.

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3.6 The Firm as a Communication-Hierarchy Recent work on the ‘theory of communication in hierarchies’ is based on the idea, well-known from organization theory (for example, Simon and March, 1958), that one important function of the firm is to adapt to and process new information. In most versions, it builds rather directly on the early work by Marschak and Radner (1972), a classic contribution on team-theory that was published at about the same time that work on incentive alignment began to take off. This book pointed to a completely different approach to economic organization, one in which incentive conflicts were disregarded, or at least assumed to have been solved, and where coordination and communication were highlighted instead. For some time enthusiasm over the new theories of the firm that all centered on incentive conflicts swamped interest in team theory issues, but recently interesting work that focuses on coordination in a team theory framework has emerged (Arrow, 1985b; Aoki, 1986; Crémer, 1990; Radner, 1992, 1996; Bolton and Dewatripont, 1994; Casson, 1997). These writers view the firm as a communication network that is designed to minimize both the cost of processing new information and the costs of communicating this information among agents. Communication is costly because it takes time for agents to absorb new information sent by others, but time consumption may be reduced by specializing in the processing of particular types of information. In Bolton and Dewatripont’s (1994) model, for example, each agent handles a particular type of information, and the different types of information are aggregated through the communication network. When the benefits to specializing outweigh the costs of communication, teams (firmlike organizations) arise. It was mentioned earlier that team- theory has difficulty explaining the boundary of the firm. This applies also to the theory of the firm as a communication hierarchy. It does not explain why communication hierarchies cannot exist between firms. However, if this can be given an explanation, that explanation together with the theory of the firm as a communication hierarchy may constitute a theory of the firm.

4. Some Criticisms of the Modern Theory of the Firm It is hard to deny that the modern theory of the firm represents one of the important instances of scientific advance in economics during the last two decades. However, criticisms of the modern theory of the firm have been raised. For example, Milgrom and Roberts (1988, p. 450), two of the most important representatives of modern formal work on the theory of the firm, made the following prediction ten years ago:

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The incentive-based transaction costs theory has been made to carry too much of the weight of explanation in the theory of organizations. We expect competing and complementary theories to emerge - theories that are founded on economizing on bounded rationality and that pay more attention to changing technology and to evolutionary considerations.

In the following, we organize our brief discussion around Milgrom and Roberts’ points of critique. To put it in admittedly simplistic terms, almost all of the focus in the modern economics of organization has been on interaction characterized by incentive conflicts. Very much attention has been given to the hold-up problem and its ex-ante consequences. Coordination problems not involving incentive conflicts have been much less treated, although they are surely important in most firms. However, as already mentioned, one attempt to study the non-incentive aspects of economic organization is represented by team theory. This sort of work adds a sophisticated, formal treatment of some hitherto ill-treated phenomena to the modern economics of organization. The theory’s focus on communication channels, on delays in information transmission, on costs of communicating, etc. makes some sense out of, for example, the economic function of corporate culture (see also Crémer, 1990) (Kreps, 1990, makes an attempt to conceptualize corporate culture in an incomplete contract setting, where corporate culture has the function of signaling trustworthy behavior under unforeseen - and therefore non-contractible - contingencies). With respect to the challenge from such allegedly ‘softer’ issues, it is also worth noting that work on implicit contracts meets this challenge to some extent (see Baker, Murphy and Gibbons, 1997; Segal, 1996). Bounded rationality still awaits its formalization, which may prove important in the development of the theory of the firm. The relevance of ideas on bounded rationality is illustrated by a fundamental problem in much of the modern economics of organization: how are efficient types of organization selected in reality? It is a basic postulate of the modern economics of organization that real-world agents will indeed structure their dealings in accordance with the theory’s predictions (for example, Williamson, 1985). But how can this be justified? One idea has been to rely on (untheorized) selection forces that weed out ill-adapted types of economic organization. We now know that social selection forces cannot in general be relied upon to produce efficient results. The other main approach is to simply assert that agents can rationally calculate pay-offs associated with alternative types of economic organization (for example, firms v. markets) and choose the efficient one (technically, agents can perform dynamic programming) (Kreps, 1992). Now, this assertion may perhaps be hard to square with the basic assumption of incomplete contracts,

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which typically (but not necessarily) involves some notion of unforeseen contingencies. Such problems await the development of precise models of bounded rationality. A primary source of unforeseen contingencies in real world economies is changing technology. It has been a persistent critique that the modern economics of organization ‘neglects technology’. Moreover, a number of critics (for example, Demsetz, 1991; Winter, 1988) have argued that the differences in different firms’ productive capabilities have been suppressed in the modern economics of organization in favor of an overriding concern with incentives. While the firm cannot generally be described by a production function, neither should technology be ignored altogether. The critics emphasize that knowledge may be imperfect in the realm of production - that firms have ‘differential productive capabilities’ - and that this may influence economic organization.

5. Concluding Comments In this chapter, we have surveyed a number of streams of research that together constitute the modern theory of the firm, or, the economics of organization. The tenor of the discussion has been optimistic, and although we have acknowledged the existence of rather deep problems (Section 4), we believe that we are on the way to a coherent theory of the firm. Thus, an argument may be made that at least some of the streams of research that we have discussed are strongly complementary. Together they provide a coherent picture of the advantages and disadvantages of firm (or firm-like) organization. The perhaps dominant basic perspective on the firm in today’s economics is that of an ownership unit under incomplete contracts, as it has emerged from the work of Williamson and Hart. The complementary nature of different attributes of firm-organization of the firm has been pointed out by Holmström and Milgrom (1994). And given incomplete contracts, Baker, Gibbons and Murphy (1997) have explained how implicit contracting under certain conditions is more likely to emerge within than between firms. Moreover, these contributions blend ideas from both the principal-agent and the incomplete contracting modeling approaches. Therefore, one may argue that a synthesis is gradually emerging. However, as we indicated, even this synthesis is not complete: critics argue that the field still needs to provide more room for issues relating to bounded rationality, coordination that is not related to incentive conflicts, cognition, embeddedness and differential capabilities. As it stands, the formal theory of the firm still differs from the casual observation of real business firm as well as from the richness of Williamson’s comparative institutional analysis (Williamson, 1975,

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1985, 1996). This present lack of realism should be seen in a positive way, namely as an invitation to further research.

Acknowledgements We are grateful for helpful comments by two anonymous reviewers.

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Tirole, Jean (1986), ‘Hierarchies and Bureaucracies: On the Role of Collusion in Organizations’, 2 Journal of Law, Economics, and Organization, 181-214. Tirole, Jean (1994), Incomplete Contracts: Where Do We Stand?, unpublished manuscript. Triantis, Alexander J. and George G. (1994), ‘Conversion Rights and the Design of Financial Contracts’, 72 Washington University Law Quarterly, 1231-1255. Triantis, George G. (1995), ‘Debt Financing, Corporate Decision Making and Security Design’, 26 Canadian Business Journal, 93-105. Triantis, George G. and Daniels, Ronald J. (1995), ‘The Role of Debt in Interactive Corporate Governance’, 83 California Law Review, 1073-1113. Turnbull, Shann (1994), ‘Stakeholder Democracy: Redesigning the Governance of Firms and Bureaucracies’, 23(3) Journal of Socio-Economics, 321-360. Turnbull, Shann (1995), ‘Innovations in Corporate Governance: The Mondragon Experience’, 3(3) Corporate Governance: An International Review, 167-180. Turnbull, Shann (1997), ‘Stakeholder Governance: A Cybernetic and Property Rights Analysis’, 5(1) Corporate Governance: An International Review, 11-23. Ulen, Thomas S. (1993), ‘The Coasean Firm in Law and Economics’, 18 Journal of Corporate Law, 301 ff. Vanberg, Viktor J. (1982), ‘Das Unternehmen als Sozialverband. Zur Sozialtheorie der Unternehmung und zur juristsichen Diskussion um ein neues Unternehmensrecht (The Firm as a Social Organization. The Social Theory of the Firm and the Legal Discussion on a New Law of Business Corporations)’, 1 Jahrbuch für Neue Politische Ökonomie, 276-307. Weisman, Dennis L. (1989), ‘Optimal Re-Contracting, Market Risk and the Regulated Firm in Competitive Transition’, 12 Research in Law and Economics, 153-172. Weiss, Elliott J. (1984), ‘Economic Analysis, Corporate Law, and the ALI Corporate Governance Project’, 70 Cornell Law Review, 1 ff. Wernerfelt, Birger (1997), ‘On the Nature and Scope of the Firm: An Adjustment-Cost Story’, 70 Journal of Business, 489-514. West, Richard R. (1984), ‘An Economist Looks at the ALI Propo sals’, 8 Delaware Journal of Corporate Law. Wiggins, Steven N. (1990), ‘The Comparative Advantage of Long-Term Contracts and Firms’, 6 Journal of Law, Economics, and Organization, 155-170. Williams, Philip L. (1993), ‘Corporate Groups: the Management Dilemma’, in Gillooly, Michael (ed), The Law Relating to Corporate Groups, Sydney, The Federation Press. Williamson, Oliver E. (1964), The Economics of Discretionary Behavior, Englewood Cliffs, NJ, Prentice-Hall. Williamson, Oliver E. (1971), ‘The Vertical Integration of Production: Market Failure Considerations’, 61 American Economic Review, 112-123. Williamson, Oliver E. (1975), Markets and Hierarchies: Analysis and Antitrust Implication: A Study in the Economics of Internal Organization, New York, Free Press, 286 p. Williamson, Oliver E. (1981), ‘The Modern Corporation: Origins, Evolution, Attributes’, 19 Journal of Economic Literature, 1537-1568. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism., New York, NY, Free Press. Williamson, Oliver E. (1988), ‘The Logic of Economic Organization’, 4 Journal of Law, Economics, and Organization, 65-93.

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Williamson, Oliver E. (1996), The Mechanisms of Governance, Oxford, Oxford University Press. Winter, Ralph K., Jr (1977), ‘State Law, Shareholder Protection, and the Theory of the Corporation’, 6 Journal of Legal Studies, 251-292. Winter, Sidney G. (1988), ‘On Coase, Competence, and the Corporation’, 4 Journal of Law, Economics, and Organization, 163-180. Wolff, Birgitta (1996), ‘Public-Private Partnerships (Public-Private Partnerships)’, in Schenk, Karl-Ernst, Schmidtchen, Dieter and Streit, Manfred E. (eds), Vom Hoheitsstaat zum Konsensualstaat, Neue Formen der Kooperation zwischen Staat und Privaten Jahrbuch für Neue Politische Ökonomie 15, Tübingen, Mohr.

5620 LIMITED LIABILITY William J. Carney James Howard Candler, Professor, Emory University, School of Law © Copyright 1999 William J. Carney

Abstract Limited liability has been known in Europe since at least the twelfth century, and developed later in England and throughout the developed world. Limited liability can be achieved by private contractual arrangements, by the use of limited liability forms of enterprise, by other statutory limits on liability, and by bankruptcy. The principal advantage of limited liability is in encouraging investment by passive investors in risky enterprises, particularly where these investors are poor monitors of managers. Joint and several liability is a particular deterrent to investment by wealthy investors, who are likely to bear all of the costs of judgment. Pro rata liability shifts collection costs from wealth investors who must seek contribution from other investors to judgment creditors, who must collect from all investors if they are to recover the entire judgment. It is generally agreed that in the context of contractual liability, the costs of limited liability on contract creditors will be fully internalized, as the cost of credit rises to reflect increased risk of firm bankruptcy shifted to these creditors. Determining the efficient rule in the context of tort liability is much more complex. While it is generally true that limited liability allows firms to become judgment proof and frustrate tort creditor recovery, this is only the beginning of the inquiry. First, tort creditors may benefit from efforts of contract creditors to minimize firm risk. Second, it is not clear that unlimited liability would deter risky firm activities if widely dispersed shareholders are poor monitors of risky firm activities, or if many tort liabilities are uncertain in their incidence and extent of harm. Third, it is not clear that shareholders are necessarily the superior risk-bearers where mass torts involve class actions where each claim is relatively small, if some shareholders would bear a large amount of liability. JEL classification: K22 Keywords: Limited Liability, Piercing the Veil, Bankruptcy, Shareholder Liability

1. Introduction This chapter reviews the literature on limited liability. This literature began in the eighteenth and nineteenth centuries with a concern for agency costs rather than for the liability system. After a long hiatus, when it reemerged in the 659

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1960s and 1970s it was concerned primarily with contract liability and with the role of limited liability in facilitating capital markets. It was only after the theoretical literature on limited liability on these topics was relatively well developed that attention turned to tort liability. This literature developed in tandem with the growth of tort actions in the United States for catastrophic liability - generally involving class actions on behalf of large classes of plaintiffs. It became clear with the development of such actions that actors had developed liability-limiting strategies that had the ultimate effect of frustrating the liability system (Dent, 1991; LoPucki, 1996; Roe, 1986; Ringleb and Wiggins, 1990). Because liability systems within societies tend to be unitary, empirical work has generally been difficult to undertake. There are a few examples of parallel systems of limited and unlimited liability, but the evidence on the effects of limited liability remains extremely limited.

2. The History of the Law of Limited Liability 2.1 Ancient Rome In ancient Rome many corporate entities were de facto rather than de jure, and liability remained unlimited (Gillman and Eade, 1995). This is attributed at least in part to the fact that most firms were not highly specialized, because pressure toward limited liability occurs with a separation of ownership and control (Gillman and Eade, 1995). While vicarious liability existed in Rome, it was strictly interpreted by limiting the agents’ authority, thus creating some de facto limited liability (Johnston, 1995). Further, the pater familias, the head of the principal economic unit in Rome, was liable for the debts of a slave or son only to the extent of the extent of the peculium, or sum entrusted to him (Johnston, 1995; Perrott, 1982). While Rome had well-developed notions of both corporate personality and limited liability, they were not related to each other (Perrott, 1982). 2.2 Medieval Italian and Continental Versions of Limited Liability Joint and several unlimited liability became the rule in Italian city-states as early as the twelfth and thirteenth centuries (Medici, 1982). As commerce expanded outside capital was required and outside investors who participated, either for interest or a share of profits, were liable only to the extent of their investment (Medici, 1982; Holdsworth, 1925). This form was widely adopted throughout the Mediterranean as the commenda for the maritime trade, and soon crossed over to inland undertakings (Medici, 1982; Perrott, 1982). The en commandite partnership was legalized in France in 1671, in Ireland in 1782, elsewhere on the Continent and in a few states in the USA in the early nineteenth century (Shannon, 1931), and in England in 1907 (Holdsworth,

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1925). Limited liability also developed for limited liability companies, which in most instances lack transferable shares but have other corporate characteristics (Carney, 1995). Limited liability did not make its appearance in chartered companies until the 1780s when clauses were inserted in charters limiting the liability of shareholders to the amount represented by their shares. Previously shareholders’ liability had been unlimited, though the directors of the French East India Company appear to have had limited liability (Minchinton, 1982). In 1807 France provided limited liability for joint stock companies known as sociétés anonymes. Napoleonic conquests spread this form to a number of German provinces, Prussia, Italy, the Low Countries and Switzerland. Limited liability survived the fall of Napoleon with the adoption by various German states of local statutes modeled after the Code de Commerce; the French Code also constituted the basis of the provincial Italian legislation during the first half of the nineteenth century and of the Spanish Code of 1829 (Blumberg, 1986; Macharzina, 1982). 2.3 English Limited Liability: Seventeenth and Eighteenth Centuries Those forms of corporation that required no royal grant from the English Crown were treated as having limited liability for their members without an express grant (Anderson and Tollison, 1983). The limited partnership or commenda form never took hold in England (Perrott, 1982; Gillman and Eade, 1995). While Coke made claims for the crown that corporate status could only come from a royal grant, the facts were otherwise, and Chancellor Coke was forced to argue that corporations created without royal permission must have had a ‘lost grant’. Charters could be obtained by common law or Parliamentary Act as well as from the Crown (Minchinton, 1982). At one point, the default rule for chartered companies seemed to be limited liability (Holdsworth, 1925). Indeed, if members of these corporations were to be held personally liable, it required an act of Parliament (Anderson and Tollison, 1983; Blumberg, 1986; Holdsworth, 1925). On the other hand, shareholders were liable to pay any assessments levied against them by the corporation, and some creditors were able to obtain court orders requiring the corporation to make such assessments (Holdsworth, 1925). Some corporations solved this problem by contracts that prohibited such assessments (Holdsworth, 1925). Some of the initial companies grew from guilds where members began to do business as joint stock companies, with charters in the sixteenth century that recognized this, sometimes with limited liability (Perrott, 1982; Shannon, 1931; Holdsworth, 1925). There is a statist tradition that treats limited liability as a privilege granted by government to encourage certain forms of economic activity (Bainbridge, 1993). In one version, government wished to encourage private undertaking of projects that were too large for individuals (Sundow, 1982). Much of the focus of English legal history on this subject takes this view, and assumes that the basic rule is (should be?) unlimited shareholder liability. Much of this attitude

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probably stems from the Bubble Act’s 1720 prohibition of trading in shares of unincorporated joint stock companies. But this did not end the use of unincorporated joint-stock associations; half of the companies formed in the eighteenth century after 1720 were unincorporated, and achieved de facto limited liability through the use of trusts and contract terms limiting creditors to corporate assets (Anderson and Tollison, 1983). Their charters also prohibited assessments in excess of the nominal value of the stock (Blumberg, 1986). Not only is the ‘privilege’ argument rejected by the historical evidence, but also by the economic evidence. The value that shareholders attach to limited liability will be a function of the probability of firm insolvency, which in the case of torts, will be a partial function of firm size. Thus, all other things being equal, limited liability with respect to torts will be of less value to shareholders of large firms than small firms (Horvath and Woywode, 1996). Since the likelihood that a firm will elect corporate status is positively related to its size, it appears that limited liability with respect to tort liability is an incomplete explanation for the use of the limited liability corporation (Forbes, 1986). 2.4 Nineteenth Century English Reforms The origins of a law and economics discussion of limited liability lie in England, but they center not on discussions of the efficiency of externalizing the costs of firm activities, but rather on the increasing agency costs of firms with passive investors and management separated from ownership. Adam Smith believed that the separation of ownership and control found in limited liability companies would only lead to managerial shirking, and that in general limited liability companies could only survive where they were granted monopolies, while noting their potential usefulness in businesses with largescale economies requiring large capital (an issue related less to limited liability than to transaction costs) (Smith, 1776). This debate continued among British economists throughout the late eighteenth and nineteenth centuries. Some writers were concerned that limited liability would reduce shareholder monitoring and lead to riskier choices by managers (Amsler, Bartlett and Bolton, 1981). John Stuart Mill expressed concern for the protection of small investors from fraud, while encouraging their investment of their savings in enterprise (Amsler, Bartlett and Bolton, 1981). Others report that the debate included discussions of the effects of externalizing the cost of failure on creditors, which would reduce capital available to business (Halpern, Trebilcock and Turnbull, 1980). Repeal of the Bubble Act in 1825 and adoption of a general incorporation law in 1844 were not responses to the need to limit liability, but to the growth in the number of unincorporated joint stock companies, suggesting that general incorporation laws occurred in England not primarily because of a felt need to limit liability, but to respond to the development of large companies that operated under the disabilities of not being recognized as entities in the courts

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(Anderson and Tollison, 1983). The 1844 Act emphasized unlimited liability by requiring registered companies to publicize their members (Shannon, 1931). In the years following 1844, the debate about limited liability was carried on almost entirely in terms of partnership, rather than company law (Saville, 1956); those who opposed limited liability did so on the grounds that it would create excessive speculation, create difficulties in securing credit, and promote fraudulent investment schemes (Shannon, 1931). In the early 1850s pressure for limited liability came in part from philanthropists seeking a safe investment for the savings of working people (Saville, 1956). The main argument for adopting limited liability was that the 1844 Act had not succeeded in attracting investors to new businesses (Diamond, 1982). In particular, wealthy investors were discouraged from participation (Perrott, 1982). Yet some joint stock companies had thousands of investors (Blumberg, 1986; Hansmann and Kraakman, 1991). It was not until 1855 and 1856 that Parliament granted limited liability to members of registered joint stock companies. This led to an increase in the number of companies seeking registration (Shannon, 1931; Blumberg, 1986; Gillman and Eade, 1995). The 1855 legislation attempted to protect creditors with both publicity (filings and inclusion of ‘Ltd.’ in the company name) and minimum capital (Diamond, 1982). This pattern was followed throughout Europe. After the 1855 Act it was common for industrial companies to create shares with large amounts of uncalled capital in the event of liquidation until the 1890s, and this trend continued in some cases in British banking until the 1960s (Evans and Quigley, 1995). While England was more highly industrialized than the United States in the early nineteenth century, it lagged behind the United States in the development of limited liability. In 1885, 30 years after introducing limited liability, only 10 percent of the number of ‘important’ firms were incorporated in England. Forbes suggests English entrepreneurs found limited liability less useful than Americans, although he offers no explanation for why this should be so (Forbes, 1986). Another explanation for the late arrival of limited liability in England compared to the United States is the lack of jurisdictional competition of the kind that existed in the United States (Forbes, 1986). But by 1855 English firms were registering under both French and American laws, giving credence to the competition among jurisdictions explanation (Saville, 1956). 2.5 American Limited Liability The American colonies inherited the Bubble Act early in their history, but the Colonial legislatures were more willing to issue charters than Parliament, so the corporation, rather than the joint stock company, became the dominant American form of business entity (Blumberg, 1986). The earliest treatise stated that the fundamental rule of corporate law was limited liability (Hovenkamp, 1991). The New England states provided for unlimited liability until increased demand for corporate charters for manufacturing, coupled with competitive

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pressure from other states, caused them to adopt limited liability between 1816 (New Hampshire) and 1847 (Rhode Island). While Massachusetts, the dominant industrial state, had granted eighteenth century charters providing for both limited and unlimited liability, in 1808 its first general statute provided for unlimited liability, which was not repealed until 1830 (Blumberg, 1986; Dodd, 1948; Forbes, 1986; Hovenkamp, 1991; Livermore, 1935). Massachusetts courts were hostile to this law, construing it narrowly as in derogation of the common law (Livermore, 1935). Massachusetts continued to grant limited liability only by special charter until 1839, when competitive pressures from other states forced the adoption of a general corporation law with limited liability (Livermore, 1935). While limited liability was the general rule in the United States after 1830, and in most cases before that date, there were a few exceptions. California’s constitutions of 1849 and 1879 imposed pro rata shareholder liability until 1931, and at one time six states imposed shareholder liability for unpaid wages, a law that survives in New York (Blumberg, 1986; Manne, 1967) and in Wisconsin (Wis. Stat. §180.0622(2)(b)). Both federal and state law imposed double liability for shareholders of banks from 1865 to 1932 (Blumberg, 1986; Macey and Miller, 1992). The rapid adoption of limited liability in the US for law and accounting firms when catastrophic liabilities appeared after the collapse of thrift institutions suggests that limited liability may be more directly caused by the prospect of catastrophic tort or regulatory liability than contract liability. On the other hand, limited liability for banking shareholders was introduced after the collapse of the U.S. banking industry in the early 1930s, although it was replaced with Federal deposit insurance and comprehensive monitoring of bank solvency by regulators. 2.6 Other Nations Virtually all nations seem to have developed the notion of limited liability for shareholders in stock corporations. This doctrine has extended to Asian nations that have adopted western legal forms. For example, Korea is a civil code country that provides for limited liability of shareholders (Kim, 1995). 2.7 Managers and Creditors Generally the subject of limited liability is addressed only in the context of shareholders, but it is important to recall that both managers and creditors of companies also benefit from limited liability. Generally managers will not be personally liable for the acts of their subordinates unless they actively participate in them, or sign corporate obligations in their personal capacity (Kraakman, 1984; Thompson, 1994). More recently, however, various regulatory statutes in the US have provided liability for managers for failure to supervise (Thompson, 1994). Creditors are generally not held liable for the obligations of their debtors (Easterbrook and Fischel, 1985). Some exceptions

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have developed where creditors hold pledged shares as collateral (Evans and Quigley, 1995), foreclose on pledged property that is the source of liability (Dent, 1991), exercise such control over the debtor that the relationship can be more properly characterized as one of principal and agent, or of co-partners, or where it can be said that third parties have been deceived into believing one of these relationships existed (Lawrence, 1989).

3. The Role of Liability Rules Liability is generally viewed as a device for minimizing the social cost of private activities, and for forcing actors to internalize the full cost of their actions. An efficient liability system causes actors to consider the full cost of their actions. Limiting liability can thus be seen as subsidizing risky behavior and allowing some actors to externalize part of the costs of their actions. While corporations generate positive as well as negative externalities (Leebron, 1991) there is no way to measure the balance of these externalities under a regime of limited liability. Posner argues that the social losses of employees from injuries are too small to warrant inclusion in a calculation, and makes only a passing reference to other tort liabilities (Posner, 1992). While others have discussed the issue of other tort liabilities (see Section 15, below), only one author has discussed the efficiency issues connected to mass tort liabilities, which have raised the question of the efficacy of limited liability in the tort context. That article suggests that in many cases mass tort liability, which commonly occurs in the context of unforeseeable harms, is inefficient, because such actions cannot be deterred by liability rules (except perhaps at the expense of over deterrence) (Schwartz, 1985). If this is correct, then discussions of unlimited shareholder liability in the context of large, well-capitalized publicly-held corporations are moot, and the discussion should focus on closely-held firms, where the justifications for limited liability, in terms of capital markets, are much less persuasive.

4. Means of Achieving Limited Liability While most discussion of limited liability centers around use of the corporate form to produce limited liability for shareholders, other means are available. Lending rather than investing in equity in a firm also provides limited liability (Easterbrook and Fischel, 1985). Indeed, part of the English debate over limited liability centered on whether creditors could accept variable interest under usury laws and retain limited liability (Gillman and Eade, 1995). Creditors can, however, be held liable for firm debts under circumstances discussed in Section 2, above.

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4.1 Express Contracts The oldest liability-limiting device is an express contract by which a creditor agrees to look only to the assets of a business firm. This was well known at common law in the joint stock association (Anderson and Tollison, 1983; Hessen, 1979). 4.2 Becoming Judgment Proof Securing assets with a friendly creditor can immunize them from seizure by other creditors. Debtors can sell assets to unrelated entities, which finance the purchase with issuance of their own securities, thus financing the debtor’s enterprise. Individuals can hold property in tenancies by the entirety that immunize them from seizure by creditors of individual owners, and some jurisdictions offer large exemptions from seizure by creditors (LoPucki, 1996). Owners can remove either themselves or their assets to foreign jurisdictions where enforcement is costly or impossible (Alexander, 1992; LoPucki, 1996; Grundfest, 1992). If shareholders were subject to unlimited liability, shares might only be owned by risk-preferrers (high rollers - Hansmann and Kraakman, 1992) or by foreign investors not readily subject to enforcement by local creditors (Grundfest, 1992). Recent developments in capital markets have permitted the securitizing of assets - that is, the separation of productive assets from an integrated firm into a separate entity that cannot be attacked as part of the bankruptcy of the risk-taking firm. This has the effect of making firms engaged in high-risk activities virtually judgment-proof (LoPucki, 1996). It is, of course, just a new variation on the use of corporate subsidiaries to achieve insulation of some assets from the risky activities of an integrated firm (Blumberg, 1986; Dent, 1991; Hansmann and Kraakman, 1991; Landers, 1975; Leebron, 1991; LoPucki, 1996; Presser, 1992; Ringleb and Wiggins, 1990; Roe, 1986). 4.3 Incorporation and the Use of Other Limited Liability Entities While limited liability for passive investors in partnerships (societas), recognized in Europe at an early date (Medici, 1982; Perrott, 1982; Shannon, 1931), was not generally recognized in common-law jurisdictions, New York adopted a limited partnership act in 1822 (Livermore, 1935). Most other US states did not follow this pattern until the promulgation of the Uniform Limited Partnership Act in the twentieth century. More recently, all American states have adopted limited liability company legislation (as European nations had done much earlier, Carney, 1995), and most have provided for limited liability for electing general partnerships (‘limited liability partnerships’). Some of these states have conditioned such limited liability on maintenance of liability insurance in specified minimum amounts. With these developments the partnership default rule of unlimited liability will occupy a very small niche in

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the United States (Ribstein, 1992). The mixed form - the limited partnership, with investors having both unlimited personal and limited liability, may be explained by the ability of management to entrench itself from control changes, coupled with the greater flexibility and reduced bankruptcy costs that result from making fixed payment promises to limited partners rather than to outside creditors (Ribstein, 1988). 4.4 Subsidiaries and Enterprise Liability Incorporation has long been the predominant means of limiting liability. While this was not controversial for a long time, use of corporate subsidiaries has generated considerable commentary. While incorporation to protect the personal estates of passive individual investors has been accepted by many commentators as efficient, when a corporation subdivides its own activities into separate subsidiaries for the purpose of insulating corporate assets from the risk of particular activities, some commentators have argued that this is inefficient, because it allows corporations (not just individual investors) to externalize the costs of some risks (Blumberg, 1986; Dent, 1991; Leebron, 1991; LoPucki, 1997; Roe, 1986). As catastrophic liabilities for environmental disasters, product liabilities and other mass torts have increased, large corporations have resorted increasingly to the strategy of disaggregation through subsidiaries, which may not be an efficient arrangement of the firm, since integration through a firm rather than by contract previously appeared to be more efficient (Dent, 1991; Hansmann and Kraakman, 1991; Roe, 1986). On the other hand, if all corporate shareholders were to be subject to unlimited liability, corporations might spin off thinly capitalized high-risk subsidiaries to their individual shareholders as an evasion (Hansmann and Kraakman, 1991). Leebron, (1991) argues that this spin-off process would depend in part on the operational costs of separating integrated operations among entities, and the relative cost of insurance. One author has argued that limited liability was not designed to protect corporate shareholders; in the United States, at least, corporate power to own shares in other corporations followed limited liability (Landers, 1975). Following Modigliani and Miller, Leebron (1991) argues that there is no economic justification for letting pure conglomerates separate risky activities to further diversification, because individual shareholders can make their own diversification. Thompson (1994) argues that while credit markets will discipline many corporations that choose excessively risky activities, this is less obvious for subsidiaries, where parents are the suppliers of credit. Regardless of the arguments against honoring the corporate veil with parent-subsidiary corporations, changing basic liability rules in any society would require such radical changes as to make them highly unlikely (LoPucki, 1997). One article argues for a higher tax on profits that would be used to finance a subsidy to creditors to reduce managers’ preference for risky activities under limited liability (Banerjee and Besley, 1990).

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5. Exceptions to Limited Liability: Lifting or Piercing the Veil Numerous countries have provided exceptions from limited liability where actions inconsistent with the separate personality of entity and owners have been taken (Presser, 1991). Germany has developed the doctrine of ‘lifting’ or ‘piercing’ the corporate veil to hold shareholders liable where there is misrepresentation to third parties or commingling of assets (Alting, 1995; Schiessl, 1986; Thümmel, 1978; Weber-Ray, 1995). Veil-piercing is far more likely in the closely-held corporation (including subsidiaries), where the justifications for limited liability are weaker, because of shareholder ability to monitor and participate in management (Easterbrook and Fischel, 1985; Klein and Zolt, 1995; Leebron, 1991). Indeed, veil-piercing is virtually non-existent in the large publicly-held corporation (Easterbrook and Fischel, 1985). On the other hand, the relative ability of close corporation shareholders to bear risk is much weaker (Leebron, 1991). Further, where a corporation dominates the management of another without a formal contract, the dominant shareholder may be liable for liabilities of the servient firm (Alting, 1995). Veil-piercing in the United States is often triggered by activities that can generally be characterized as fraudulent conveyances under English traditions (Clark, 1977, 1986; Presser, 1991) or by actions of a shareholder that create confusion in third parties about whether they are dealing with the shareholder or a corporation (Presser, 1991). In some jurisdictions undercapitalization alone may be sufficient to trigger unlimited shareholder liability. France provides for liability of managers to the corporation, its shareholders and creditors if managers act in violation of the company’s constitution or law (Perrott, 1982). Similar rules exist in the US (Krendl and Krendl, 1978; Presser, 1991) and in Korea (Kim, 1995). Many countries have provided for shareholder liability where a legally required minimum number of shareholders is not maintained, although this rule is disappearing in Europe pursuant to European Community directives. Where some defects in the incorporation process are accompanied by an active role on the part of shareholders and plaintiffs’ belief that they were dealing with a corporation, American courts will also hold shareholders personally liable (McChesney, 1993). In European jurisdictions inadequate capitalization alone may be sufficient to trigger shareholder liability (Presser, 1991; Alting, 1995), while in others some evidence of fraud, such as commingling of assets may be required (Alting, 1995; Dobson, 1986; Presser, 1991), while in others mere close relationships between parent and subsidiary corporations may lead to parent liability (Pardinas, 1991). Anglo-American jurisdictions also use the doctrine to impose liability on shareholders where third parties are confused about whether they are dealing with shareholders or an entity (Halpern, Trebilcock and Turnbull, 1980; Presser, 1991). Doctrines of piercing the corporate veil are less-developed

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outside of common law countries, where notions of equity and agency are either non-existent or less well developed, and courts frequently have relied on notions of fraud or abuse of the purpose of the corporate form (Presser, 1991).

6. Statutory Limits on Liability Certain industries might not exist without special provision for limited liability. The US nuclear power industry, for example, needed the Price-Anderson Act, which limited liability in case of a nuclear accident, in order to raise capital. Other statutory compensation schemes, such as workers’ compensation statutes, and certain treaties, such as the Warsaw convention, which limits damages for airline passengers, also permit damage limitations (Coffey, 1994). In the case of new industries where potential liabilities, while huge, are uncertain, such limits may prove to be efficient, although it is difficult to know how such judgments could be made ex ante where individual losses are likely to be catastrophic, if they occur.

7. Bankruptcy Bankruptcy provides a means for limitation of liability (Easterbrook and Fischel, 1985; LoPucki, 1997). Limited liability for a firm, which limits investor risk to assets dedicated to the firm, is similar to a discharge in bankruptcy, which limits a debtor’s liability to current assets, thus protecting future assets (Posner, 1976). In bankruptcies involving corporations with subsidiaries, American courts may use the device of consolidating the assets and creditors’ claims of all the related corporations as a means of disregarding the separateness of corporate entities, and thus piercing corporate veils (Frost, 1993).

8. Limited Liability and the Supply of Capital The principal argument in favor of limited liability stems from the common law rule of liability for partners - joint and several liability - in which any one partner may be held liable for the entire amount of the firm’s debt (Livermore, 1935). This appears to be the general European rule as well (Medici, 1982). Under these conditions there are three economic arguments in favor of limited liability: (1) it fosters economic growth by encouraging investors to take risks; (2) it facilitates the efficient spreading of risks among corporations and their voluntary creditors; and (3) it avoids the enormous litigation costs that would be required for creditors to seek recovery from shareholders (Menell, 1990).

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The first justification is treated in Sections 9 and 10; the second in Section 14 (limited liability in contract); and the third in Section 12.

9. Encouraging Risky Investments It has long been argued that joint and several unlimited liability would discourage wealthy investors from investing in risky enterprises, particularly when they intended to play a passive role where they could not monitor and supervise the firm’s risky activities (Blumberg, 1986; Diamond, 1982; Easterbrook and Fischel, 1985; Grossman, 1995; Halpern, Trebilcock and Turnbull, 1980; Hansmann and Kraakman, 1991; Leebron, 1991; Manne, 1967; Woodward, 1985). This is supported by one study that suggests that the choice of limited liability is positively correlated with the wealth of owners (Horvath and Woywode, 1996). 9.1 Encouraging Diversification by Wealthy Investors Limited liability permits the diversification which is necessary to risk minimization in a specialized firm, where passive investors specialize in risk-bearing, and not monitoring of management (Easterbrook and Fischel, 1985; Hovenkamp, 1991; Mitchell, 1989). Under joint and several liability, wealthy investors would be the first targets of firm creditors upon failure, and thus would be forced to forego the benefits of diversification in order to concentrate their investments to allow them to monitor effectively (Grossman, 1995; Hansmann and Kraakman, 1991; Hicks, 1982; Kraakman, 1984; Leebron, 1991; Manne, 1967). Indeed, diversification would increase the expected risk of wealthy shareholders; the maximum possible loss is invariant with diversification, but its probability increases with diversification (Leebron, 1991 Ribstein, 1991). One result of unlimited liability might be larger firms engaged in more diversified activities, to protect shareholders from personal losses (Presser, 1992; Roe, 1986). This diversification would, of course, be limited by the increasing agency costs associated with management of conglomerates, and the costs of using internal capital markets, with their limited monitoring ability, rather than external markets. Because such diversification and increase in size would convey more benefits on wealthy investors under a joint and several liability regime, the benefits of this strategy would not be symmetrically distributed across investors, which could lead to constituency effects, in which wealthy investors would specialize in owning large diversified firms. Such diversification at the firm level is generally inefficient because investors can home-make their own diversification, absent unlimited liability rules.

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9.2 Reducing Shareholder Monitoring of Co-Owners A joint and several liability rule would force shareholders to monitor not only firm activities, but also the wealth of their fellow shareholders, which leads to excessive monitoring costs (Carr and Mathewson, 1988; Easterbrook and Fischel, 1985; Halpern, Trebilcock and Turnbull, 1980; Hansmann and Kraakman, 1991; Leebron, 1991; Woodward, 1985). The result would be higher costs and lower returns to equity, which would limit the supply of equity for industry (Carr and Mathewson, 1988). One article rejects this, arguing that shareholders would not need to increase monitoring of either firms or fellow shareholders, since share prices in efficient markets provide them with all required information (Meiners, Mofsky and Tollison, 1979). But other authors respond that joint and several liability of shareholders would destroy efficient capital markets, because the value of shares would be a function of the expected cash flows of the business and the wealth of each individual buyer, and of expected fellow shareholders (Easterbrook and Fischel, 1985, 1991; Halpern, Trebilcock and Turnbull, 1980).

10. Evidence on the Effects of Unlimited Shareholder Liability on Investment There is some evidence that unlimited liability, at least on a joint and several basis, would reduce the number of shareholders and thus the amount of capital contributed to firms. Both limited liability and unlimited liability banks co-existed in eighteenth and early nineteenth century Scotland. From the beginning of the nineteenth century the average size of the limited liability banks was ten times that of the unlimited liability banks, and when the unlimited liability banks were later given the choice of forms, all chose limited liability (Carr and Mathewson, 1988). Unlimited liability banks had lower levels of capital than limited liability banks in relation to total assets, and shareholders in unlimited liability banks earned higher returns (risk premiums) on their investments (Evans and Quigley, 1995). Depositors in eighteenth- and nineteenth-century Scottish unlimited liability banks were provided no information about the bank’s assets, but rather received a list of shareholders (Evans and Quigley, 1995). A study of German enterprises showed that limited liability firms tend to be larger than unlimited liability firms among start-ups (Horvath and Woywode, 1996). There is some evidence to the contrary. Evans and Quigley’s study showed that the majority of banking assets in Scotland were held by unlimited liability banks, which they explain as a function of depositor preference for unlimited liability banking and the higher shareholder returns available (Evans and Quigley, 1995). Outside banking, some English joint stock companies had thousands of stockholders; whether they would have had more as limited

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liability corporations is not testable (Blumberg, 1986; Hansmann and Kraakman, 1991). Gilson (1991) reports that law firm size in the United States is invariant with the choice of liability rule, once tax considerations are eliminated. This result may have changed with the introduction of new limited liability forms more readily available to US law firms in the 1990s, which resulted from the catastrophic liability of some US lawyers in the wake of the failures of client financial institutions in the late 1980s (Hamilton, 1995). One modern anomaly occurred in the era of efficient capital markets: the American Express Company remained a joint stock company with unlimited shareholder liability until 1965. From its creation in 1850 until conversion to a limited liability corporation it had as many as 25,000 shareholders, with only one 10 percent shareholder. There was neither illiquidity nor perverse stock pricing (Grossman, 1995). This limited evidence, based on a company with pro rata shareholder liability, rejects the theories that an efficient capital market with diversified shareholders could not exist without limited liability, although it does not reject the theory that joint and several liability would preclude such markets (Grossman, 1995). The unanswered question is whether American Express faced serious expected risk of large contract liability (much less catastrophic tort liability) prior to its conversion. It seems unlikely that American Express had a high risk of tort liability; it provided financial services of a limited sort - at the time, primarily travelers’ checks and credit cards - so it produced no products capable of producing either strict product liability or mass tort liability. There was some risk of massive forgery of travelers’ checks that could have deterred investors. While it was sued for more than twice its net assets in 1963 in connection with its certification of soybean oil inventories, it is not clear that creditors or stockholders would have understood this risk in advance, nor is it clear how much had to do with its 1965 conversion to the limited liability form of corporation (Grossman, 1995).

11. The Effects of Pro Rata Liability on Investment Subsequent to the development of theories about the impact of joint and several liability the literature began to examine the effects of pro rata shareholder liability. While this rule does not appear to play a significant role today, there are companies limited by guarantee, which is a form of pro rata multiple liability. Subsequent to reform of English company law in the mid nineteenth century, many registered limited liability companies voluntarily provided multiple liability through assessable shares, and Scottish banks shifted to this form after 1879 (Evans and Quigley, 1995). Further, to the extent shareholders were personally liable in the early nineteenth century in the US, and in California until 1931 by statute (Blumberg, 1986), it was pro rata (Presser, 1992; Blumberg, 1986; Livermore, 1935; Macey and Miller, 1992). Similarly,

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US bank stockholders were subject to pro rata double liability from 1865 to 1932 (Blumberg, 1986; Macey and Miller, 1992). 11.1 Effects of Pro Rata Liability on Wealthy Investors and Securities Markets Pro rata liability solves the problem of imposing disproportionate liability on wealthy investors. This reduces the need of wealthy investors to concentrate their investments so they can monitor them more closely (Grossman, 1995; Halpern, Trebilcock and Turnbull, 1980; Leebron, 1991). Pro rata liability also eliminates the cost of monitoring other shareholders’ wealth (Leebron, 1991). It also solves the problem of differential pricing of securities based on the expected losses of buyers with different wealth levels (Grossman, 1995; Hansmann and Kraakman, 1991; Leebron, 1991; Presser, 1992). By doing so, it solves the diversification problem for investors, because the probability of a wealth-erasing assessment would not increase with each single stock purchased. The differences between joint and several liability rules and pro rata rules may be exaggerated if a joint and several rule is coupled with a rule of contribution. Under these circumstances, a joint and several rule shifts the transaction costs of collection from corporate creditors to shareholders (Leebron, 1991). 11.2 Effects of Pro Rata Liability on the Market for Corporate Control A pro rata rule would discourage wealthy investors from investing in large blocks of risky companies and thus would reduce shareholder monitoring of management activities (Hansmann and Kraakman, 1991; Leebron, 1991; Ribstein, 1992). Under limited liability concentrated block ownership occurs where the payoffs from monitoring are greatest (Demsetz and Lehn, 1985). Modern arguments for pro rata liability in tort argue that diversification would remain at efficient levels with such a rule (Halpern, Trebilcock and Turnbull, 1980; Leebron, 1991). Hansmann and Kraakman argue that most liability would be borne either by wealthy investors or institutions. What they ignore is that such a rule could have the effect of discouraging the formation of investment pools from which judgments are easily collectible; the cost to investors of holding through mutual funds and collective pension plans could rise to the point where individual diversification through mutual funds becomes uneconomic (Leebron, 1991; Coffey, 1994; Thompson, 1994). Grundfest (1992) believes mutual funds would be able to avoid this problem by establishing themselves off-shore and using various hedging strategies involving derivatives.

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12. Costs of Collection The costs of collecting judgments under a joint and several liability rule would be high, as firm creditors collected from wealthy shareholders who in turn would need to seek (probably incomplete) contribution from less wealthy shareholders (Woodward, 1985). While a pro rata liability rule would be less disruptive of capital markets, it would also be less effective in collecting damage awards for judgment creditors because of the presence of large numbers of small investors, where collection costs would be high. It would have the effect of transferring collection costs from shareholders to creditors (Leebron, 1991). This would weaken both the deterrent effect and compensation value of unlimited liability. Anglo-American courts of equity developed a relatively effective collection device, the creditors’ bill, which allowed all creditors to seek a determination of both corporate and shareholder pro rata liability, which was res judicata, even for nonresidents, as to all issues other than defenses personal to each shareholder, such as the number of shares held or one’s actual identity as a shareholder (Blumberg, 1986). Posey (1993) argues that the effects of limited liability on the ability of tort victims to recover is less obvious. With unlimited liability, a firm’s expenditures on prevention increase, thus reducing net assets (and increasing collection costs from shareholders). In the alternative, unlimited liability might reduce firm activity levels, and with it the stock of capital (and the ease of collection). Hansmann and Kraakman assert that for publicly held firms the increased transaction costs of unlimited liability under a pro rata rule are less than the increased costs of externalized liability under limited liability, but they offer no evidence to support this statement (Hansmann and Kraakman, 1991). Further, this conclusion assumes that companies should be strictly liable for unforeseeable accident costs - that such a rule is efficient - even where the costs to individual plaintiffs are small but the damages to a firm are catastrophic (although these authors do not discuss this issue). Leebron notes that the difference between joint and several liability with a right of contribution and pro rata liability is a question of who will bear the transaction costs of collection - individual wealthy shareholders or plaintiffs. Leebron also argues that because of this, which rule is better depends not on collection costs, but on which rule creates more shareholder monitoring, and believes that joint and several liability is superior in this respect. This analysis assumes that transaction costs of collection are ultimately not significant. At the same time, he concedes that for public corporations with many small shareholders, unlimited pro rata liability to tort victims may be pointless because of high collection costs, and that because of transaction costs, it is unclear what is the best rule (Leebron, 1991). Other authors argue that none of the policy arguments in favor of limited liability have any real application to closely held

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firms where owners are also managers and thus can control their risks (Klein and Zolt, 1995).

13. Evidence about Joint and Several versus Pro Rata Liability American law provided experience with both pro rata and joint and several liability: both New York and California law provided for pro rata liability (Blumberg, 1986; Livermore, 1935). American banks from 1865-1932 provided for double pro rata shareholder liability. While American courts were innovative in enforcing this liability, the collection rate on shareholder assessments was only 50.8 percent. Macey and Miller regard this as a success, because it is probable that many shareholders were insolvent (Macey and Miller, 1992). Grundfest has argued that capital markets would respond to pro rata liability by generating a large number of investors who are attachment-proof to specialize in holding equity of risky companies. These will include foreign investors and individuals of modest means holding small amounts of equity, where collection costs will exceed the amount collected (Grundfest, 1992). They will also include separation of substantial assets from risky enterprises through leasing and thin capitalization (Lopucki, 1997; Note, 1994). Recent evidence from Germany, however, supports the hypothesis that for investors in large firms risk aversion (and the liability rule) does not influence the choice of firm (Horvath and Woywode, 1996).

14. Limited Liability in Contract Early literature concentrated on limited liability for contract obligations. It may be that these writers thought tort liability was trivial. It was only later that writers, recognizing that liabilities for mass torts that could bankrupt even large firms, turned to analysis of the impact of limited liability on tort risks. 14.1 The Theory of Limited Liability in Contract In a perfect capital market with zero transaction costs the value of the firm and its optimal investment policy would not be affected by the liability rule chosen. Unlimited liability would reduce creditors’ risks and the interest rates and other contractual protections demanded, and increase returns to shareholders to compensate for this risk (Halpern, Trebilcock and Turnbull, 1980). Firms that choose a limited liability regime will face higher borrowing costs (Anderson and Tollison, 1983; Posner, 1976), although it is argued that trade creditors typically fail to incur the transaction costs to investigate credit risk (Landers, 1967). In the case of one-shareholder corporations with little capital, creditors will either charge higher interest rates for risky loans or insist on personal

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guarantees, so that credit terms are invariant to the liability rule (Ekelund and Tollison, 1980; Meiners, Mofsky and Tollison, 1979). If we introduce transaction costs, where lenders are uncertain about the extent of shirking and risky behavior by owners with limited liability they may increase interest costs to the point where owners prefer to finance without borrowings at the firm level (Eswaran and Kotwal, 1989). This analysis has been extended to stock insurance companies: if shareholder liability is limited, policyholders will presumably recognize the risk they bear and pay less for policies. Insurers can bond against risky investments by writing participation rights into insurance policies (Garven and Pottier, 1995). They can also submit to regulation that assures minimum capital and constrains risky investments. Under an unlimited liability regime, Leebron argues that shareholders would probably prefer to borrow using their interest in the firm as collateral, because they would each only be liable for their own borrowing (pro rata), while if the firm borrows, each would be liable for everyone’s borrowings (joint and several) (Leebron, 1991). Corporate borrowing with limited liability is equivalent to nonrecourse borrowing by shareholders who pledge their shares as collateral, but the transaction costs of such borrowing would be higher, because so many lenders would have to investigate the firm in markets with large numbers of potential lenders (Leebron, 1991). Limited liability creates a state of the world where the worst possible state of the world is known to all investors, both creditors and shareholders, while unlimited liability does not allow shareholders the same certainty (Leebron, 1991). The evidence from eighteenth- and nineteenth-century Scottish banking is consistent with this model. Shareholders in unlimited liability banks earned higher returns than shareholders in limited liability banks (Evans and Quigley, 1995). But despite such differences in returns, in small firms risk aversion leads to a preference for limited liability, especially as firm projects grow riskier, according to a study of German firms (Horvath and Woywode, 1996). 14.2 The Cost of Limited Liability in Contract There are at least three costs borne by firm owners for achieving limited liability, at least two of which apply to both contract and tort liability. First, under limited liability, voluntary creditors will impose higher costs on firms (see above). Second, in many legal regimes, tax costs will be higher for limited liability, because the entity may be treated as separate, although this is not a necessary condition for limited liability. In the United States the development of the Limited Liability Company and Limited Liability Partnership have eliminated the tax cost for closely held enterprises in recent years. Third, in most legal systems except the United States, forming a limited liability entity will subject the firm to extensive public disclosures (Horvath and Woywode, 1996). This apparently is designed to provide potential creditors with information about the firm’s capital where unlimited liability is not available.

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While Posner argues that creditors are the most efficient risk-bearers (Posner, 1992), Easterbrook and Fischel (1991) reject this, arguing that the evidence is otherwise: creditors accept lower returns because they prefer less risk, presumably because they are not the least-cost monitors of firms. Johnsen argues that creditors accept lower returns because they monitor only the value of debtors’ assets in alternative and less specialized uses, rather than in the present use, which is left to shareholders (Johnsen, 1995). Recent literature on domination of large corporations by big banks in Germany and Japan has raised the question of whether at least some creditors are superior monitors of firms, but fails to bring any evidence to bear on the subject (Roe, 1994). Some authors treat small trade creditors as if they were involuntary creditors, because they face high transaction costs in assessing the riskiness of their credit extensions (Landers, 1967; Easterbrook and Fischel, 1985, 1991). These arguments ignore both the ability of trade creditors to monitor current payments on a monthly or more frequent basis and their ability to free ride on the negative covenants imposed by larger creditors with scale economies in negotiating credit contracts. Further, they ignore the ability of many trade creditors to bear risk by diversifying their customer base (Carney, 1990). The costs of limited liability imposed on creditors depend on capital structure; thus, secured creditors monitor assets, not firms, so their monitoring costs are not increased by limited liability (Ribstein, 1991; Johnsen, 1995). To the extent that limited liability imposes unmonitored risk on creditors, it has been suggested that increasing the tax on firm profits and paying subsidies to creditors can solve the risky behavior problem. The creditor subsidy will reduce interest costs to the firm, while raising managerial efforts, thus leaving managers better off, because managers exert less effort when liability is limited (Banerjee and Besley, 1990). A similar suggestion has been made with respect to the level of taxation of profits on US financial institutions, to reduce incentives to take risks (John, John and Senbet, 1991). The difficulty with these proposals is that profits taxes do not distinguish returns to risk from returns to superior management. 14.3 The Benefits of Limited Liability in Contract Many of the benefits of limited liability in contract are related to capital markets. With limited liability, investors have the ability to diversify their investments in shares of corporations. This is true in part because without limited liability, for a wealthy investor, each investment would increase the risk of being held personally liable for the debts of a failed firm (Blumberg, 1981; Carr and Mathewson, 1988; Diamond, 1982; Easterbrook and Fischel, 1985, 1991; Grossman, 1995; Halpern, Trebilcock and Turnbull, 1980; Leebron, 1991; Woodward, 1985). It is also true because it reduces the need for any

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shareholder to monitor management for risky choices (Blumberg, 1986; Easterbrook and Fischel, 1985, 1991). It also seems likely that given modern techniques for reporting financial results of firms, that monitoring shareholder wealth is more costly than monitoring firm wealth. Evans and Quigley (1995) argued that unlimited liability was observed in Scottish banking at a time when it was cheaper to monitor shareholder wealth than bank solvency. Finally, limited liability reduces the transaction costs of collection.

15. Limited Liability in Tort Limited liability’s externalization creates three problems: (1) firms make excessively risky decisions because they do not consider externalized costs; (2) corporations fail to insure fully; and (3) product costs do not reflect full social costs (Dent, 1991; Leebron, 1991). Many authors apparently believed that the problem of tort liability under a limited liability system was not a serious one, either because they felt that other parts of the legal system had dealt with the principal forms of business accidents, through workers’ compensation, unemployment insurance and mandatory automobile insurance (Manne, 1967), or because they focused on the large publicly held corporation, where the risk that individual tort liability would bankrupt a firm seemed trivial. For this reason, much of the early literature focused on contract liability (Easterbrook and Fischel, 1985; Halpern, Trebilcock and Turnbull, 1980; Meiners, Mofsky and Tollison, 1979; Posner, 1976). The development of the mass tort, stemming either from industrial accidents or strict products liability, has changed the analysis (Hansmann and Kraakman, 1992; Leebron, 1991; Roe, 1986; Schwartz, 1985). 15.1 Externalizing the Costs of Torts The general wisdom states that with limited liability managers loyal to shareholders will select unduly risky projects, because the owners of the firm can externalize some of the social costs of their choices (Blumberg, 1986; Brander and Lewis, 1986; Hansmann and Kraakman, 1991; Leebron, 1991). This may be borne out by a study showing that limited liability firms have a higher incidence of bankruptcy than unlimited liability firms. At the same time, they appear to have higher growth rates - the reward for undertaking riskier projects (Horvath and Woywode, 1996). In oligopoly, the effect of limited liability may provide a signaling effect for firms that take on more debt - that they intend to pursue output strategies that raise returns in good states and lower returns in bad states (Brander and Lewis, 1986). The extent of any reductions in precautions may be a function of the profitability and wealth of the firm, however; the more profitable the firm, the more the owners have at risk, and the greater their precautionary expenses. But where firms are

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marginally profitable, owner-managers may choose a lower level of precautions under limited liability (Craig and Theil, 1990). Generally the risk of bankruptcy is treated as a last-period problem; but if it is seen as an expected cost of a firm with positive cash flows, the incentive to take excessive risk may be less than static models would suggest (Suen, 1995). 15.2 The Impact of Agency Costs on Firm Risk-Taking Decisions Agency costs will also influence the amount of firm risk assumed. While firms may increase their risk where there is a unity of ownership and control, as in closely held owner-managed corporations, it is less obvious that this holds with public corporations. Managers of public corporations often hold large undiversified investments in firm-specific human capital, and often in the stock of the firm as well. They are also holders of large fixed claims on the firm in the form of salaries (Jensen and Meckling, 1976). As a result, they may be unduly careful in making choices for the firm, and may retain excess equity in the firm (LoPucki, 1997). Further, their primary concern will be with failure of the firm, because that will cost them their jobs. Easterbrook and Fischel (1985, 1991) argue that with unlimited liability managers will reject some positive net present value projects as too risky, but will accept all such projects under limited liability. Presser argues that such managers would seek to diversify (and perhaps expand) firm activities to reduce the risk of total loss (Presser, 1992). To alleviate the managerial risk-aversion problem, many compensation plans give managers some claim on the upper tail of expected outcomes. To the extent that managers assume unlimited liability as shareholders, the value of incentive compensation tied to stock is reduced, and managers may be excessively cautious (Hansmann and Kraakman, 1991). One benefit of limited liability thus is to neutralize some part of a manager’s risk aversion. Easterbrook and Fischel (1985) further argue that the moral hazard of engaging in overly risky activities under limited liability can also be dealt with through (1) minimum capital requirements; (2) mandatory insurance; (3) managerial liability; and (4) regulation of inputs. Minimum capital requirements are widely employed throughout Europe (Carney, 1997). They represent a relatively crude form of protection, since they are not related to either the riskiness of firm activities nor its capital structure. All states in the United States have moved away from such requirements, providing evidence that in a competitive market for corporate law, these requirements do not survive as efficient (Carney, 1995). Mandatory insurance and managerial liability are discussed in Sections 17 and 18, below. Direct regulation of inputs, such as regulation of nuclear plants, presents problems, in that regulators have weak incentives to balance costs and benefits (Easterbrook and Fischel, 1985). 15.3 The Effectiveness of Shareholders as Monitors of Risky Activities There is little discussion of the relative efficiency of shareholders, managers and creditors as monitors. While Posner (1992) argues that creditors are the

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most efficient risk-bearers, Easterbrook and Fischel (1991) reject this, arguing that the evidence is otherwise: creditors accept lower returns because they prefer less risk, presumably because they are not the least cost monitors of firms. Manager liability suggests the function of tort law is deterrence, while shareholder liability suggests the function is loss-spreading (Thompson, 1994). In public corporations, at least, passive shareholders are entirely dependent on management for a flow of information about risk management, as well as all other details of operations (Arlen and Carney, 1992). Most writers believe that limited liability will reduce shareholder monitoring of managers. Easterbrook and Fischel (1985) believe that such monitoring will be replaced by creditor monitoring. Even with limited liability, firms subject to high agency costs (which presumably includes excessively risky behavior) generate large block owners better able to monitor (Demsetz and Lehn, 1985). With constant returns to monitoring managers, the incentive of shareholders is not affected directly by the liability regime, but if managerial effort were to vary with the liability regime, then different levels of shareholder monitoring would be efficient (Carr and Mathewson, 1988). While Hansmann and Kraakman concede that passive shareholders in large corporations are unlikely monitors of risk, they believe markets will perform this function, and that share prices will reflect managerial risk-taking. Ironically, they also argue that managers will not be excessively cautious under an unlimited liability regime because many large uninsured tortious activities create a risk of catastrophic loss only many years later and thus will be heavily discounted by today’s management (Hansmann and Kraakman, 1991). If this is true, it is not clear how markets will be able to provide effective monitoring. 15.4 Catastrophic Tort Liability Only one author has addressed the effect of unlimited liability on deterrence of catastrophic torts. Schwartz (1985) argues that to the extent many mass torts are not foreseeable, strict liability coupled with unlimited liability has no deterrent value. If this is so, the arguments in favor of unlimited liability in tort are thrown back on risk-spreading ability, where the evidence is thus far inconclusive. Where class action claims involve relatively small amounts per claimant and joint and several liability runs the risk of imposing most of the liability on a few wealthy shareholders, it may well be that leaving liability with the injured class places it with the group best able to bear it.

16. Limiting the Cost of Limited Liability in Tort The social costs of externalizing the costs of accidents through limited liability have been discussed in Section 15. This section examines the factors that may

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limit the size of the externalized costs. Managers of large firms facing catastrophic mass tort liability typically do not seek liquidation, which might be in the shareholders’ interest, because it ends the firm and with it their employment. Indeed, managers engaging in activities likely to result in catastrophic liability should probably maximize current distributions to shareholders in order to reduce the pool of assests subject to creditor claims. Rather, managers facing such a last period problem may have imposed agency costs on shareholders when they have kept resources within firms and then acquiesced in reorganizations that give mass tort claimants significant ownership in the firm (Roe, 1986). While this creates an agency cost for shareholders, it ameliorates the effects of externalization of the cost of accidents for these firms. Ribstein argues that owners of limited liability enterprises internalize most costs of tort by virtue of the fact that voluntary creditors will either impose higher credit costs or force additional firm monitoring, or both. Because unsecured contract creditors are at risk of some loss (or loss sharing with tort creditors) in the case of tort liability, he argues that tort risk is sufficiently internalized that the benefits of limited liability outweigh its costs to involuntary creditors (Ribstein, 1991). Obviously this arrangement does not internalize the expected cost of accidents in excess of a firm’s unsecured assets. But to the extent that voluntary creditors insist that debtors carry tort insurance, at least some of these costs may also be internalized (Ribstein, 1991). Further, in close corporations, shareholders have significant personal investments to protect, and have incentives to insure to protect them (Ribstein, 1992).

17. The Benefits of Limited Liability in Tort 17.1 Shareholders as Inefficient Monitors of Risky Activities Ex Ante The capital market benefits discussed earlier apply equally to limited liability in tort. The exposure of railroads to heavy tort liability, in connection with large scale operations that could not be readily monitored by shareholders, was one of the original justifications for English limited liability rules in the nineteenth century (Blumberg, 1986). Shareholders in public corporations are often poor monitors of much tort liability, which depends on a constant and candid flow of information about agents’ behavior (Arlen and Carney, 1992). As specialists in providing capital, these passive investors lack the skills to be effective monitors, so their monitoring activities would be inefficient (Easterbrook and Fischel, 1995). With unlimited liability in tort, the relevant domain for monitoring by stockholders expands and agency costs increase (Orhnial, 1982). Imposing default liability on the monitor is consistent with the theory of imposing liability on the party who can avoid it most cheaply

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(Ribstein, 1991). In large corporations, this will almost never be dispersed public shareholders. Limited liability eliminates the disincentive for wealthy investors to take large (perhaps controlling) ownership positions in risky firms, which increases shareholder monitoring where it is efficient (Hansmann and Kraakman, 1991). 17.2 Reducing Collection Costs of Judgments Limited liability also reduces the transaction costs of collecting judgments, by shifting some risk to plaintiffs. A system of pro rata liability would increase collection costs, but it would lead to incomplete collections because of the difficulties of obtaining jurisdiction over many individual shareholder defendants (Alexander, 1992; Grundfest, 1992; but see Hansmann and Kraakman, 1992a; Patterson, 1995). Grundfest argues that a class of attachment-proof investors would develop that would specialize in holding risky common stocks, which would arbitrage away any price differences between risky and less risky businesses that should send managers signals about behavior (Grundfest, 1992). But Grundfest’s argument ignores managers’ personal incentives to avoid risk, in order to protect their firm-specific human capital. Bainbridge argues that limited liability encourages investors to more fully capitalize firms, so that tort claimants are better off collecting from firm assets than bearing the transaction costs of collection from shareholders (Bainbridge, 1993). Bainbridge’s argument is stronger under a pro rata liability rule than a joint and several liability regime. 17.3 Incomplete Insurance Markets Easterbrook and Fischel suggest that limited liability was more important in the nineteenth century because insurance markets were less developed, but this ignores the more recent development of mass tort liability, where insurance markets are probably as incomplete as were nineteenth-century markets (Easterbrook and Fischel, 1985; Schwartz, 1985). One solution proposed for the problem of high collection costs under unlimited liability is to provide for personal liability of shareholders only when a corporation is uninsured against the risk, which would increase incentives to insure (Alexander, 1992; Dent, 1991; Leebron, 1991; Schwartz, 1985). The difficulty is that insurance markets are incomplete (Blumberg, 1986; Dent, 1991). The existence of insurance markets will depend on (i) information costs; (ii) moral hazard, (iii) adverse selection and (iv) ability to bear risk (Halpern, Trebilcock and Turnbull, 1980). Because many firms will fail because of systematic risk, insurers will be unable to diversify this risk (Easterbrook and Fischel, 1985; Halpern, Trebilcock and Turnbull, 1980; Leebron, 1991). Further, the potential for mass torts, which are uncertain in both their incidence and extent of liability, may make some activities uninsurable (Hansmann and Kraakman, 1991; Ribstein, 1991). Finally, because lower-risk firms will self-insure rather than purchase costly insurance, the insurance market will be dominated by higher-risk purchasers, raising insurance costs and causing even more firms to self-insure (Ribstein,

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1992). Finally, firms cannot be expected to insure against remote risks to their full extent, in part because of bounded rationality (Schwartz, 1985). Mandatory insurance may create new moral hazard problems, encouraging managers to take risks, if insurers are not efficient monitors (Easterbrook and Fischel, 1985). Some manufacturing activities may create potential liabilities decades in the future, where managers will heavily discount the risk (Hansmann and Kraakman, 1991). Further, the high loading costs of insurance (as much as 25 percent) reduce its efficiency (Hansmann and Kraakman, 1991). If liability insurance were mandatory, it would create a new barrier to entry of small firms (LoPucki, 1997).

18. Substitutes for Shareholder Liability 18.1 Tort Creditor Superpriority One substitute for unlimited liability for shareholders is to provide tort creditors with greater priority in a bankruptcy system. Under US law, secured creditors have priority over tort creditors. Providing tort creditors with a priority over all voluntary creditors would shift risk from involuntary creditors to voluntary creditors (Buckley, 1986; Presser, 1992). While this would increase monitoring by creditors, their comparative advantage in monitoring for this kind of risk over shareholders is not always clear. One author suggests that contract creditors specialize in valuing firm assets in alternative uses, while shareholders capture the quasi-rents from the current firm-specific use (Johnsen, 1995). Whether credit terms would be set to reflect accurately the new risks that the firm’s owners (including creditors) could not escape is an empirical question, but the increasing use of public markets for borrowings in the US suggests that these markets might become efficient, so prices would accurately reflect risks. At the same time, securitization of financial assets enhances their availability to the same passive investors likely to hold stocks, which probably reduces any comparative advantages in monitoring formerly held by creditors. Leebron argues that tort victims might consent to the priority of secured creditors if the loan made additional assets available to satisfy their claim or provided increased creditor monitoring. If new funds are provided to operate the business by the loan, tort creditors will suffer if firm assets subsequently shrink (Leebron, 1991). 18.2 Lender Liability Another substitute for unlimited shareholder liability is to treat contract creditors as owners of the firm, and subject them to unlimited liability. Leebron argues that in many public corporations creditors can exercise more control than public shareholders, and are better able to diversify risk than tort victims. Further, private contract lenders (as opposed to bondholders) are superior

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monitors when compared to tort victims (Leebron, 1991). Indeed, some creditors may well be superior monitors to public shareholders as well (Easterbrook and Fischel, 1985). At the very least, large creditors are in a position to monitor firms for adequate capitalization, and to adjust interest rates to create incentives to capitalize the firm (Ribstein, 1992). On the other hand, unlimited liability for creditors would exacerbate the stockholder-bondholder conflict, and because of liability for catastrophic torts, lenders’ negative covenants would be of less value (Leebron, 1991). 18.3 Managerial Liability To the extent that neither shareholders nor creditors are effective monitors of managers’ risky choices, one solution might be to make managers personally liable for corporate obligations. But managers, while perhaps best able to monitor themselves, are inefficient risk-bearers, so that imposing liability on them will lead to even more risk aversion in firm decisions than managers may now choose (Thompson, 1994). Further, their investments in firm-specific human capital are uninsurable (Easterbrook and Fischel, 1985). Apparently because of the large risk premiums that would be required to persuade managers to bear liabilities personally, Kraakman has argued that managerial liability does not provide enough additional deterrence over enterprise liability to offset the greater costs involved (Kraakman, 1984). In the context of deliberate torts such as securities fraud, it is precisely managerial liability - both civil and criminal - that is required to deter these actions, given the last period problems facing managers tempted to commit securities fraud (Arlen and Carney, 1992). Indeed, Kraakman also states that enterprise (limited) liability fails when costs are shifted to third parties through firm wrongdoing, and firms lack sufficient assets to respond in damages. But he also argues that imposing liability on managers while permitting indemnification provides managerial incentives to keep firms solvent and able to respond to judgments. Dual liability of firms and managers lessens the risk that penalties were set too low for either, because now two levels of decision-makers must calculate costs and benefits (Kraakman, 1984). If French managers violate the company’s constitution or law, they can be made personally liable to the company, its shareholders and creditors. France is thus in the forefront of the movement to extend the liability of management, and not simply of the membership (Perrott, 1982).

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19. Risk-Bearing Ability and the Role of Insurance There is general consensus that diversified shareholders are superior risk-bearers to tort victims (Leebron, 1991; Menell, 1990; Murphy, 1995; Thompson, 1994). But some authors have argued that the risk-bearing superiority of shareholders is not obvious. Tort victims may be superior risk-bearers if they can obtain insurance more cheaply (Leebron, 1991) or if individual harms are small while corporate (and shareholder) liability is large, relative to wealth. The principal argument in favor of limited liability with respect to risk-bearing is that insurance markets are incomplete, and would not allow investors to insure against personal liability for corporate failures. The occurrence of corporate bankruptcies will be positively correlated with the business cycle, and with the systematic risk of shares. Because of this, insurers will find they cannot easily diversify such risk, and will decline to write such insurance (Halpern, Trebilcock and Turnbull, 1980). Further, there may be an adverse selection problem: shareholders will choose to insure only their risk attached to ownership of high beta companies. Because managers are undiversified, they have incentives to have firms insure against liability to protect the life of the firm (Thompson, 1994). Additional insurance caused by unlimited liability only serves to reduce the cost of accidents if insurance companies are efficient monitors, and can adjust premiums to reflect experience (Ribstein, 1992). The ability and incentives of insurers to monitor for risky activities may be limited in several ways. First, insurers will retain some ability to contest claims if contract conditions are violated. Second, experience-based rates are set ex post, so that rates will lag observation of risky behavior. Third, where an insured believes it is in the last period of insurance coverage, incentives to avoid higher premiums are eliminated (Price, 1995). While involuntary tort claimants cannot diversify their risk in the same way tortfeasors can because their entire future wealth and earning power may be at stake, they can insure against their loss (Leebron, 1991; Meiners, Mofsky and Tollison, 1979). Because potential victims can decide how much insurance they desire, forcing either corporations or shareholders to carry additional insurance may cause overinsurance, except for the fact that most individuals do not insure against pain and suffering (Hansmann and Kraakman, 1991), perhaps because this is a risk they are willing to bear (Leebron, 1991). Indeed, it is not clear such insurance is available to individuals, perhaps because no market for it has been demonstrated. Where tortfeasors are in risky industries or in cyclical industries, they may be more efficient risk-bearers than the tortfeasors or their shareholders because of their superior ability to purchase all-risk insurance (Ribstein, 1992). Analysis may also change when the corporation is closely held, so that tort victims may be better able to diversify and insure than shareholders. Similarly, where unlimited liability discourages diversification

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and forces investors to hold fewer stocks to improve monitoring, the risk-bearing ability of shareholders declines (Thompson, 1994). Further, analysis may change if mass tort liability involves relatively small injuries to large numbers of victims, and the possibility of catastrophic shareholder liability. The nature of mass tort liabilities has been explored with respect to this issue by only one writer (Schwartz, 1985).

Bibliography on Limited Liability (5620) Adams, Michael (1991), ‘Eigentum, Kontrolle und Beschränkte Haftung (Property, Control and Limited Liability)’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Ökonomische Probleme des Zivilrechts, Berlin, Springer-Verlag, 193-225. Alexander, Janet Cooper (1992), ‘Unlimited Shareholder Liability Through a Procedural Lens’, 106 Harvard International Law Journal, 387-445. Alting, Carsten (1995), ‘Piercing the Corporate Veil in American and German Law - Liability of Individuals and Entities: A Comparative View’, 2 Tulsa Journal of Comparative and International Law, 187-251. Amsler, Christine E., Bartlett, Robin L. and Bolton, Craig J (1981), ‘Thoughts of Some British Economists on Early Limited Liability and Corporate Legislation’, 13 History of Political Economy, 774-793. Anderson, Gary M. and Tollison, Robert D (1983), ‘The Myth of the Corporation as a Creation of the State’, 3 International Review of Law and Economics, 107-120. Bainbridge, Stephen M (1993), ‘In Defense of the Shareholder Wealth Maximization Norm: A Reply to Professor Green’, 50 Washington and Lee Law Review, 1423-1446. Banerjee, Anindya and Besley, Timothy (1990), ‘Moral Hazard, Limited Liability and Taxation: A Principal-Agent Model’, 42 Oxford Economic Papers, 46-60. Blumberg, Phillip L (1986), ‘Limited Liability and Corporate Groups’, 11 Journal of Corporation Law, 573-631. Boyd, James and Ingberman, Daniel E (1996), ‘The Polluter Pays Principle: Should Liability be Extended when the Polluter Cannot Pay?’, 21 Geneva Papers on Risk and Insurance. Brander, James A. and Lewis, Tracy R (1986), ‘Oligopoly and Financial Structure: The Limited Liability Effect’, 76 American Economic Review, 956-970. Brander, James A. and Spencer, Barbara J (1989), ‘Moral Hazard and Limited Liability: Implications for the Theory of the Firm’, 30 International Economic Review, 833-849. Buckley, Francis H (1986), ‘The Bankruptcy Priority Puzzle’, 72 Virginia Law Review, 1393-1470. Byam, John I (1982), ‘The Economic Inefficiency of Corporate Criminal Liability’, 73 Journal of Criminal Law and Criminology, 582-603. Carney, William J (1995), ‘Limited Liability Companies: Origins and Antecedents’, 66 University of Colorado Law Review, 855-880. Carr, Jack L. and Mathewson, G. Frank (1988), ‘Unlimited Liability as a Barrier to Entry’, 96 Journal of Political Economy, 766-784. Coffey, Michael P (1994), ‘Note: In Defense of Limited Liability - A Reply to Hansmann and Kraakman’, 1 George Mason Law Review, 59-91. Craig, Ben and Thiel, Stuart E (1990), ‘Large Risks and the Decision to Incorporate’, 42 Journal of Economics and Business, 185-194.

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Demsetz, Harold (1986), ‘A Commentary on Liability Rules and the Derivative Suit in Corporate Law’, 71 Cornell Law Review, 352-356. Dent, George W., Jr (1991), ‘Limited Liability in Environmental Law’, 26 Wake Forest Law Review, 151-182. Diamond, Aubrey L (1982), ‘Corporate Personality and Limited Liability’, in Orhnial, Tony (ed), Limited Liability and the Corporation, London and Canberra, Croom Helm, 22-43. Dobson, Juan (1986), ‘“Lifting the Veil” in Four Countries: The Law of Argentina, England, France and The United States’, 35 International and Comparative Law Quarterly, 839-863. Dodd, E. Merrick (1948), ‘The Evolution of Limited Liability in American Industry: Massachusetts’, 61 Harvard International Law Journal, 1351-1379. Easterbrook, Frank H. and Fischel, Daniel R (1985), ‘Limited Liability and the Corporation’, 52 University of Chicago Law Review, 89-117. Ekelund, Robert B., Jr and Tollison, Robert D (1980), ‘Mercantilist Origins of the Corporation’, 11 Bell Journal of Economics, 715-720. Eswaran, Mukesh and Kotwal, Ashok (1989), ‘Why are Capitalists the Bosses?’, 99 Economic Journal, 162-176. Evans, Lewis T. and Quigley, Neil C (1995), ‘Shareholder Liability Regimes, Principal-Agent Relationships, and Banking Industry Performance’, 38 Journal of Law and Economics, 497-520. Fischel, Daniel R (1989), ‘The Economics of Lender Liability’, 99 Yale Law Journal, 131-154. Forbes, Kevin F (1986), ‘Limited Liability and the Development of the Business Corporation’, 2 Journal of Law, Economics, and Organization, 163-177. Frost, Christopher (1993), ‘Organizational Form, Misappropriation Risk and the Substantive Consolidation of Corporate Groups’, 44 Hastings Law Journal, 449 ff. Garven, James R. and Pottier, Stephen W (1995), ‘Incentive Contracting and the Role of Participation Rights in Stock Insurers’, 62 Journal of Risk and Insurance, 253-270. Gillman, Max and Eade, Tim (1995), ‘The Development of the Corporation in England, with Emphasis on Limited Liability’, 22 International Journal of Social Economics, 20-32. Gilson, Ronald J (1991), ‘Unlimited Liability and Law Firm Organization: Tax Factors and the Direction of Causation’, 99 Journal of Political Economy, 420-428. Grossman, Peter Z (1995), ‘The Market for Shares of Companies with Unlimited Liability: The Case of American Express’, 24 Journal of Legal Studies, 63-85. Grundfest, Joseph A (1992), ‘The Limited Future of Unlimited Liability: A Capital Markets Perspective’, 102 Yale Journal on Regulation, 387-425. Halpern, Paul J., Trebilcock, Michael J. and Turnbull, Stuart M (1980), ‘An Economic Analysis of Limited Liability in Corporation Law’, 30 University of Toronto Law Journal, 117-150. Hansmann, Henry B. and Kraakman, Reinier H (1991a), ‘The Uneasy Case for Limiting Shareholder Liability in Tort’, 101 Yale Law Journal, 1879-1934. Hansmann, Henry and Kraakman, Reinier (1991b), ‘Toward Unlimited Shareholder Liability for Corporate Torts’, 101 Yale Law Journal, 1879-1934. Hansmann, Henry B. and Kraakman, Reinier H (1992a), ‘A Procedural Focus on Unlimited Liability’, 106 Harvard Law Review, 446-459. Hansmann, Henry B. and Kraakman, Reinier H (1992b), ‘Do the Capital Markets Compel Limited

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Liability?’, 94 Yale Law Journal, 427-436. Hellwig, Martin F (1981), ‘Bankruptcy, Limited Liability, and the Modigliani-Miller Theorem’, 71 American Economic Review, 155-170. Hicks, John R (1982), ‘Limited Liability: The Pros and Cons’, in Orhnial, Tony (ed), Limited Liability and the Corporation, London and Canberra, Croom Helm, 11-21. Horvath, Michael T.K and Woywode, Michael J (1996), Entrepreneurs and the Choice of Limited Liability, Working paper No. 129, John M. Olin Program in Law and Economics, Stanford University Law School. John, Kose, John, Teresa and Senbet, Lemma W (1991), ‘Risk-Shifting Incentives of Depository Institutions: A New Perspective on Federal Deposit Insurance Reform’, 15 Journal of Banking and Finance, 895-915. Johnston, David (1995), ‘The Development of Law in Classical and Early Medieval Europe: Limiting Liability: Roman Law and the Civil Law Tradition’, 70 Chicago-Kent Law Review, 1515-1538. Katz, Wilbur G (1960), ‘Responsibility and the Modern Corporation’, 3 Journal of Law and Economics, 75-85. Kim, Sung Bae (1995), ‘A Comparison of the Doctrine of Piercing the Corporate Veil in the United States and in South Korea’, 3 Tulsa Journal of Comparative and International Law, 73-94. Klaus Macharzina (1982), ‘Corporate Forms and Limited Liability in German Company Law’, in Orhnial, Tony (ed), Limited Liability and the Corporation, London and Canberra, Croom Helm, 44-72. Kornhauser, Lewis A (1982), ‘An Economic Analysis of the Choice Between Enterprise and Personal Liability for Accidents’, 70 California Law Review, 1345-1392. Kraakman, Reinier H (1984), ‘Corporate Liability Strategies and the Costs of Legal Controls’, 93 Yale Law Journal, 857-898. Krendl, Kathy S. and Krendl, James R (1978), ‘Piercing the Corporate Veil: Focusing the Inquiry’, 55 Denver Law Journal, 1-59. Landers, Jonathan M (1967), ‘Another Word on Parents, Subsidiaries and Affiliates in Bankruptcy’, 43 University of Chicago Law Review, 527-540. Landers, Jonathan M (1975), ‘A Unified Approach to Parent, Subsidiary and Affiliate Questions in Bankruptcy’, 42 University of Chicago Law Review, 589-652. Lawrence, William H (1989), ‘Lender Control Liability: An Analytical Model Illustrated with Applications to the Relational Theory of Secured Financing’,62 Southern California Law Review, 1387-1447. Leebron, David W (1991), ‘Limited Liability, Tort Victims, and Creditors’, 91 Columbia Law Review, 1565-1650. Lehmann, Michael (1986), ‘Das Privileg der Beschränkten Haftung und der Durchgriff im Gesellschafts- und Konzernrecht. Eine Juristische und Ökonomische Analyse (The Privilege of Limited Liability and the Piercing of the Corporate Veil in Association and Trust Law)’, 3 Zeitschrift für Unternehmens- und Gesellschaftsrecht, 345-370. Livermore, Shaw (1935), ‘Unlimited Liability in Early American Corporations’, 43 Journal of Political Economy, 674-687. Llebot Majo, José Oriol (1996), ‘Doctrina y Teoría de la Empresa en el Derecho Mercantil (Una Aproximación al Significado de la Teoría Contractual de la Empresa) (Doctrine and Theory of the Firm in Contract Law: Approaching the Meaning of Corporate Contractual Theory)’, 210 Revista de Derecho Mercantil, 319-388.

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LoPucki, Lynn M (1996), ‘The Death of Liability? A Systems/Strategic Analysis’, 106 Yale Law Journal, 1-92. Macey, Jonathan R. and Miller, Geoffrey P (1992), ‘Double Liability of Bank Shareholders: History and Implications’, 27 Wake Forest Law Review, 31-62. Macharzina, Klaus (1982), ‘Corporate Forms and Limited Liability in German Company Law’, in Orhnial, Tony (ed), Limited Liability and the Corporation, London and Canberra, Croom Helm, 44-72. Manne, Henry G. (1967), ‘Our Two Corporate Systems: Law and Economics’, 53 Virginia Law Review, 259-284. McChesney, Fred S. (1993), ‘Doctrinal Analysis and Statistical Modeling in Law: The Case of Defective Incorporation’, 71 Washington University Law Quarterly, 193-534. Medici, Maria Teresa Guerra (1982), ‘Limited Liability in Mediterranean Trade from the 12th to the 15th Century’, in Orhnial, Tony (ed.), Limited Liability and the Corporation, London and Canberra, Croom Helm, 122-136. Meiners, Roger E., Mofsky, James and Tollison, Robert D (1979), ‘Piercing the Veil of Limited Liability’, 4 Delaware Journal of Corporate Law, 351-367. Menell, Peter S (1990), ‘Legal Advising on Corporate Structure in the New Era of Environmental Liability’, Columbia Business Law Review, 399-413. Minchinton, Walter E (1982), ‘Chartered Companies and Limited Liability’, in Orhnial, Tony (ed), Limited Liability and the Corporation, London and Canberra, Croom Helm, 137-160. Mitchell, Lawrence E (1989), ‘Close Corporations Reconsidered’, 63 Tulane Law Review, 1143-1190. Murphy, N. Scott (1995), ‘Note: It’s Nothing Personal: The Public Costs of Limited Liability Law Partnerships’, 71 Indiana Law Journal, 201-233. Old, J.L (1985), ‘Some Economic Considerations of Limited Liability’, 19 Law Teacher, 84-89. Orhnial, Tony (1982), ‘Liability Laws and Company Finance’, in Orhnial, Tony (ed), Limited Liability and the Corporation, London and Canberra, Croom Helm, 179-190. Pardinas, Claudia M (1991), ‘The Enigma of the Legal Liability of Transnational Corporations’, 14 Suffolk Transnational Law Journal, 405-456. Patterson, Mark R (1995), ‘Is Unlimited Liability Really Unattainable?: of Long Arms and Short Sales’, 56 Ohio State Law Journal, 815-898. Paz-Ares, Cándido (1983), ‘Sobre la Infracapitazación de las Sociedades (Infracapitalization of Ventures)’, ADC, 1587-1639. Paz-Ares, Cándido (1994), ‘La Infracapitalización. Una Aproximación Contractual (A Contractual Approach to Infracapitalization)’, Rds. nº. extraordinario, 253-269. Perrott, David L (1982), ‘Changes in Attitude to Limited Liability - the European Experience’, in Orhnial, Tony (ed), Limited Liability and the Corporation, London and Canberra, Croom Helm, 81-121. Posey, Lisa Lipowski (1993), ‘Limited Liability and Incentives when Firms can Inflict Damages Greater than Net Worth’, 13 International Review of Law and Economics, 325-330. Posner, Richard A (1976), ‘The Rights of Creditors of Affiliated Corporations’, 43 University of Chicago Law Review, 499-526. Presser, Stephen B (1991), Piercing the Corporate Veil, Deerfield, Ill., Clark Boardman Callaghan.

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Presser, Stephen B (1992), ‘Commentary: Thwarting the Killing of the Corporation: Limited Liability, Democracy, and Economics’, 87 Northwestern University Law Review, 148-179. Price, Andrew (1995), ‘Tort Creditor Superiority and Other Proposed Solutions to Corporate Limited Liability and the Problem of Externalities’, 2 George Mason Law Review, 439-476. Ribstein, Larry E (1988), ‘An Applied Theory of Limited Partnership’, 37 Emory Law Journal, 837 ff. Ribstein, Larry E (1991), ‘Limited Liability and Theories of the Corporation’, 50 Maryland Law Review, 80 ff. Ribstein, Larry E (1992), ‘The Deregulation of Limited Liability and the Death of Partnership’, 70 Washington University Law Quarterly, 417 ff. Ribstein, Larry E. and Kobayashi, Bruce H (1995), ‘Uniform Laws, Model Laws and Limited Liability Companies’, 66 University of Colorado Law Review, 947-999. Ringleb, Al H. and Wiggins, Steven N (1990), ‘Liability and Large-Scale, Long-Term Hazards’, 98 Journal of Political Economy, 574-595. Roe, Mark J (1986), ‘Corporate Strategic Reaction to Mass Tort’, 72 Virginia Law Review, 1-59. Roth, Günter H (1986), ‘Zur “Economic Analysis” der Beschränkten Haftung (On the “Economic Analysis” of Limited Liability)’, 3 Zeitschrift für Unternehmens- und Gesellschaftsrecht, 371-382. Roth, Günter H (1991), ‘Kommentar (Comment on Adams, Eigentum, Kontrolle und beschrän)’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Ökonomische Probleme des Zivilrechts, Berlin, Springer-Verlag, 226-233. Saville, John (1956), ‘Sleeping Partnerships and Limited Liability, 1850-1856', 8 Economic History Review, Second Series, 418-433. Schiessl, Maximilian (1986), ‘The Liability of Corporations and Shareholders for the Capitalization and Obligations of Subsidiaries under German Law’, 7 Journal of International Law and Economics, 480-506. Schwartz, Alan (1985), ‘Products Liability, Corporate Structure, and Bankruptcy: Toxic Substances and the Remote Risk Relationship’, 14 Journal of Legal Studies, 689-736. Shannon, Herbert A (1931), ‘The Coming of General Limited Liability’, 2 Economic History, 267-291. Siliciano, John A (1987), ‘Corporate Behavior and the Social Efficiency of Tort Law’, 85 Michigan Law Review, 1820-1864. Suen, Wing (1995), ‘Risk Avoidance under Limited Liability’, 65 Journal of Economic Theory, 627-634. Sundow, Gerardo (1982), ‘Some Reflections on Company Law in Europe’, in Orhnial, Tony (ed), Limited Liability and the Corporation, London and Canberra, Croom Helm, 73-80. Thompson, Robert B (1994), ‘Unpacking Limited Liability: Direct and Vicarious Liability of Corporate Participants for Torts of the Enterprise’, 47 Vanderbilt Law Review, 1-41. Thümmel, Hans (1978), ‘Piercing the Corporate Veil - Germany’, 6 International Business Law, 282-287. Walter, E. Minchinton (1982), ‘Chartered Companies and Limited Liability’, in Orhnial, Tony (ed), Limited Liability and the Corporation, London and Canberra, Croom Helm, 137-160. Weber-Ray, Daniela (1995), ‘Insolvency of a German Limited Liability Company: De Facto

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Shareholders, Group Liability for Individual Shareholders’, 7 Pace International Law Review, 523-531. Woodward, Susan (1985), ‘Limited Liability in the Theory of the Firm’, 141 Journal of Institutional and Theoretical Economics, 601-611. X (1994), ‘Note: Investor Liability: Financial Innovations in the Regulatory State and the Coming Revolution in Corporate Law’, 107 Harvard Law Review, 1941-1958.

Other References Arlen, Jennifer and Carney, William J (1992), ‘Vicarious Liability for Fraud on the Market: Theory and Evidence’, 1992 University of Illinois Law Review, 691-740. Carney, William J. (1990), ‘Does Defining Constituencies Matter?’, 59 University of Cincinatti Law Review, 385-424. Carney, William J (1997), ‘The Political Economy of Corporate Laws’, 26 Journal of Legal Studies, 303-329. Clark, Robert C (1977), ‘The Duties of the Corporate Debtor to its Creditors’, 90 Harvard Law Review, 505-562. Clark, Robert C (1986), Corporate Law, Boston, Little, Brown & Co. Demsetz, Harold and Lehn, Kenneth (1985), ‘The Structure of Corporate Ownership: Causes and Consequences’, 93 Journal of Political Economics, 1155-1177. Easterbrook, Frank H. and Fischel, Daniel R (1991), The Economic Structure of Corporate Law, Cambridge, Harvard University Press, 40-62. Hamilton, Robert W (1995), ‘Registered Limited Liability Partnerships: Present at the Birth (Nearly)’, 66 University of Colorado Law Review, 1065-1103. Hessen, Robert (1979), In Defense of the Corporation, Stanford, Hoover Institution, 17-21. Holdsworth, W.S. (1925), A History of English Law, London, Methuen & Co. Ltd., Vol. VIII, 192-222. Hovenkamp, Herbert (1991), Enterprise and American Law, Cambridge, MA, Harvard University Press, 49-55. Jensen, Michael C. and Meckling, William H (1976), ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, 3 Journal of Financial Economics, 305-360. Johnsen, D. Bruce (1995), ‘The Quasi-Rent Theory of Corporate Enterprise: A Transaction Cost Theory,’ 44 Emory Law Journal, 1277-1356. Klein, William A. and Zolt, Eric M (1995), ‘Business Form, Limited Liability, and Tax Regimes: Lurching Toward a Coherent Outcome?’, 66 University of Colorado Law Review, 1001-1041. Posner, Richard A (1992), Economic Analysis of Law (5th edn), Boston, Little, Brown & Co., 393-398, 406-409. Roe, Mark J (1994), Strong Managers, Weak Owners: The Political Roots of American Corporate Finance, Princeton, NJ, Princeton University Press. Smith, Adam (1776) (Cannan, Edwin, ed., 1937), The Wealth of Nations, New York, Random House, 690-715.

5630 THE SEPARATION OF OWNERSHIP AND CONTROL Stephen G. Marks Professor, Boston University School of Law © Copyright 1999 Stephen G. Marks

Abstract The separation of ownership and control refers to the phenomenon associated with publicly held business corporations in which the shareholders (the residual claimants) possess little or no direct control over management decisions. This separation is generally attributed to collective action problems associated with dispersed share ownership. The separation of ownership and control permits hierarchical decision making which, for some types of decisions, is superior to the market. The separation of ownership and control creates costs due to adverse selection and moral hazard. These costs are potentially mitigated by a number of mechanisms including business failure, the market for corporate control, the enforcement of fiduciary duties, corporate governance oversight, managerial financial incentives and institutional shareholder activism. JEL classification: K22 Keywords: Separation of Ownership and Control, Corporate Law, Market for Corporate Control, Corporate Governance

1. Introduction The separation of ownership and control refers to the phenomenon associated with publicly held business corporations in which the shareholders (the residual claimants) possess little or no direct control over management decisions. Reference to the separation of ownership and control, and concern over its effect, go back at least to Adam Smith. In The Wealth of Nations, Smith (1776), writing about joint stock companies, stated: The directors of such companies ... , being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore,

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must always prevail, more or less, in the management of the affairs of such a company. It is upon this account that joint stock companies for foreign trade have seldom been able to maintain the competition against private adventurers. (Book 5, Chapter 1, Part 3, Art. 1)

Modern interest in the separation of ownership and control is often associated with Berle and Means (1932) who documented the rise of the modern corporation in the United States. This chapter is organized as follows. Section 2 discusses the legal and economic factors that separate ownership and control. Section 3 lays out the economic benefits of this separation. Section 4 outlines the costs of the separation of ownership and control. Section 5 surveys the various mechanisms for mitigating the costs of the separation of ownership and control. Section 6 considers briefly the origins of these mechanisms. Section 7 summarizes. The examples and motivations will be taken from corporate law in the United States. This chapter will lay out some of the important issues and point the reader to some of the literature in this area as well as give some examples of the economic reasoning involving some of the issues.

2. Ownership and Control We can define the separation of ownership and control with reference to the owner managed firm. In such a firm, the owner/manager possesses two principal attributes. The owner/manager (1) makes management decisions of the firm and (2) has a claim to the profits of the firm. (These claims are sometimes called residual claims to reflect that they accrue after all costs and fixed claims have been satisfied.) In a large publicly-held corporation, the shareholders own residual claims but lack direct control over management decision making. Correspondingly, managers have control but possess relatively small (if any) residual claims. The lack of control by shareholders is generally attributed to what is variously called free-rider, collective action or coordination problems. Shareholders in a publicly held corporation typically have limited legal rights to control the corporation. Shareholders do not have the right to engage in any day-to-day management of the corporation. Nor are they able to direct policy or to set compensation. And although shareholders have the right to elect directors, the management controls the voting (proxy) machinery. Typically in the US, management may use corporate funds to solicit proxies while insurgents may use corporate funds only if successful. In spite of this, voting could be an effective instrument of control absent collective action problems. However, the existence of collective action problems greatly weakens and, in many cases, eliminates voting as an effective control mechanism. In order for

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a shareholder to oust current management such a shareholder faces significant expected costs. The expected return on such an investment to the shareholder, however, is a small fraction of the total return and, more importantly, small relative to the costs incurred. As an example, suppose that a shareholder possesses one-hundredth of 1 percent of a corporation’s stock. Suppose that a change in management would be worth $10,000,000 to the corporation and thus $1000 to the shareholder. Let us suppose that the cost of a proxy solicitation is $100,000. Given these costs, a shareholder would be unwilling to engage in a proxy solicitation unless almost certain of winning. (In such a case, the expenses would be reimbursed.) What is the chance of winning? Consider the collective action problems facing the solicited shareholder. The likelihood that an individual shareholder’s vote will affect the outcome is so small that most shareholders will not take the considerable time and effort of reading and understanding the competing proxy solicitations. (This phenomenon is sometimes called rational apathy.) The result is that the chance that a challenger will win with even a meritorious position, is small. If the chances are, say, 10 percent then the expected gain to the would-be challenger is now $100. The expected costs are 90 percent the chance of failure) times the cost of solicitation. In our example, this expected cost is $90,000. Thus shareholders typically have little incentive to engage in such challenges even where the total expected gain of such an action is large relative to the costs.

3. The Benefits of the Separation of Ownership and Control The benefits of separating ownership and control come from the interaction of three factors. First, under certain conditions and for certain types of decisions, hierarchical decision making may be more efficient than market allocation. Second, due to economies of scale in both production and decision making, optimal firm size can be quite large. Third, optimal investment strategy requires investors to be able to diversify and pool and to be able to change their allocations in response to changing market conditions. Under some conditions, hierarchical decision making may be more efficient than market transactions. Both hierarchical structures and market structures impose transaction costs. For some types of transactions, market costs may be particularly high. If so, then hierarchical decision making may be more efficient. (see, among others, Coase, 1937 and Williamson, 1979). As an example, suppose that a firm is considering either purchasing or making an input product. Let us consider two types of costs. Production costs refer to the cost of making the good or to the purchase price if the good is purchased from an outside supplier. Transaction costs refer to the costs of negotiating the transaction. If the input good is a standardized good then it

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makes sense for a firm to go to the market and simply buy the input. Since the good is standardized, production costs will be much lower to outside producers who already are producing the good than it will be to produce in-house. In addition, transaction costs will be lower through the market. The purchasing manager simply has to check a couple of prices and then make the purchase. The competitive market will constrain prices and make extensive negotiations unnecessary. In-house production, on the other hand, involves significant transaction costs including communication costs and agency costs. Thus it makes no sense to make the product in-house. Instead, suppose that the input product is a highly idiosyncratic custom design. Suppose that, because of the uniqueness of the input product, it will cost about the same to build the product in-house as to have someone else build it. In addition, the transaction costs of building it in-house are likely to be lower. Because of the idiosyncratic nature of the product, the amount of negotiation and dispute resolution between a buyer and an outside supplier will be very large. If the product is made in-house, management can communicate to the engineers and the production people what they want. Later, if redesign is necessary, this too can be ordered. (Such redesign negotiations with outside suppliers can be long and tense and can lead to disputes over pricing, delivery dates, and so on.) Although there are principal-agent problems associated with hierarchical decision making within the firm, being able to make command decisions may be much less time-consuming than the extensive negotiations required when dealing with an idiosyncratic product and outside suppliers. Since production costs are the same and the transaction costs are less, the company will likely decide to make the product rather than buy it on the market. (For a more detailed discussion of idiosyncrasy and contractual governance, see Williamson, 1979.) For many firms, the number of idiosyncratic inputs is large. An organizational form that combines hierarchical organization and large size with diversified and liquid investment may possess informational, transactional and productive efficiencies that make it superior to other organizational forms. The separation of ownership and control permits the existence of an organization with these characteristics. In cases where the benefits outweigh the costs (including agency costs) we would expect to see organizations in which ownership and control are separated (see also, Knight, 1921; Arrow, 1974; Chandler, 1977 and Fama and Jensen, 1983).

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4. The Cost of the Separation of Ownership and Control Much attention has been focused on the costs of the separation of ownership and control and policies that do or might reduce these costs. In this section we will consider the framework for examining these costs and these policies. Section 5 will consider the costs and policies specifically. Adam Smith considered the separation of ownership and control to be problematic in that managers of such companies would lack the incentives to operate the corporation in the same manner as owner-managers and would thus operate the business in an inefficient manner. Following Adam Smith, Jensen and Meckling (1976) characterized the separation of ownership and control as an agency problem. In the agency approach, shareholders are modeled as principals and managers are modeled as agents. Agents, in this model, maximize personal utility. The issue is how to provide the agent with incentives to induce behavior beneficial to the principals, the shareholders. Agency analysis studies the costs of providing such incentives and the costs resulting from the extent to which agents will still deviate from the interests of the principal even in the presence of such incentives. The costs of the separation of ownership and control are thus the usual principal-agent costs: the monitoring expenditures by shareholders, the bonding expenditures by managers and the residual loss from the divergence of behavior (even with monitoring and bonding) from the ideal. Agency analysis was important first step for the study of the separation of ownership and control. Agency analysis treated managers as economic actors with utility functions distinct from those of their principals and thus formalized Adam Smith’s concern over managerial behavior. Agency analysis focused on incentive schemes by which managers’ objective functions could be more closely aligned with those of the principals. Such schemes require the ability to monitor and to reward performance. Ultimately, however, agency analysis proved to be an imperfect fit for the study of the separation of ownership and control. As Stiglitz (1989) has stated, the problem addressed by the principal-agent literature is ‘how one individual, the principal ... can design a compensation system ... which motivates another individual, his agent ... to act in the principal’s interest’. Embodied in this statement are two concepts that are at odds with current analyses of the separation of the ownership and control. First, modern analyses do not take as its ideal the notion that the shareholder should have the ability to monitor or control management. Indeed, policies that encourage shareholder control may undermine the benefits of the separation of ownership and control outlined above. Rather, much modern analysis has focused how actors other than shareholders may effectively monitor and constrain managerial behavior. These other actors include other stakeholders (such as bondholders), lawyers (in the prosecution of derivative and class action suits), regulatory authorities

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(such as the SEC in the United States) and market participants (such as potential acquirers). Second, and perhaps more importantly, many modern analyses do not assume that it is socially desirable for managers to act in the best interests of their current principals. This is made clear in the following example. Suppose that a publicly-traded company has made an ore discovery. Immediate announcement of the discovery will increase share value by 10 percent. However, if the corporation delays its announcement by eight months, allowing it to buy up property surrounding the ore discovery site, then the share price will double. Finally suppose that this is an actively traded corporation and that it is certain that the shareholders eight months from now will be different from the current shareholders. If we were to require that management act as agents of current shareholders, an immediate announcement would be required. Most modern analyses would reach a different result (see below). Berle and Means (1932) suggested treating shareholders as investors who have no necessary claims to control: On the one hand, the owners of passive property, by surrendering control and responsibility over the active property, have surrendered the right that the corporation should be operated in their sole interest ... Neither the claims of ownership nor the those of control can stand against the paramount interests of the community.

Under this framework shareholders are just another set of investors. The issue thus becomes one of determining socially desirable policies for the governance of the corporation. The goals of such policies could include encouraging the efficient flow of investment funds into production and the efficient production and distribution of goods and services. This, in turn, requires a consideration of shareholder protection and looks to policies that provide managers with optimal incentives. Under this model, managers could have duties toward shareholders, but not exactly the same duties that would be suggested by the agency model. Such a model could also include considerations of social justice and could require duties towards other constituencies. As an example of an approach that eschews the strict agency framework, consider the argument by Easterbrook and Fischel (1982) that managerial resistance to takeovers is socially counterproductive. Under a strict agency approach management should resist takeovers in situations where resistance and subsequent bargaining would lead to a higher premium for the corporation’s shareholders. Easterbrook and Fischel argue that even if resistance produces a higher premium for the shareholders the result is socially inefficient. Gains to the target’s shareholders are offset by losses to the acquirer’s shareholders. In addition there are a number of deadweight losses

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such as those flowing from bargaining breakdowns, dilution of managerial incentives for good management and discouragement of search. Analysis of the costs of the separation of ownership and control is a several step process involving (1) the articulation of societal goals, (2) the determination of how managerial behavior affects those goals and (3) the evaluation of institutional arrangements in terms of how they affect managerial behavior and at what cost. Broadly speaking, there are two reasons why managerial behavior might not conform to the ideal. The first is that managers might not have the incentives to do so. This is sometimes called the moral hazard problem. The second is that managers may not have the ability to do so (that is, managers may be incompetent). This is sometimes called the adverse selection problem. (see, for example, Ayres and Crampton, 1994 and Smith, 1996). In the following section I will consider some of the institutional mechanisms that mitigate the costs of the separation of ownership and control.

5. Mechanisms for Mitigating the Costs of the Separation of Ownership and Control The separation of ownership and control gives rise to costs in that managers may act in ways that are inefficient or antisocial. Scholars have explored a number of mechanisms that might give managers an incentive to better conform their behavior to the ideal and that might weed out incompetence. Many (but not all) of these mechanisms rely on actors other than the shareholders. I will group these mechanisms into the following six categories: (1) business failure, (2) the market for corporate control, (3) managerial duties, (4) direct managerial financial incentives, (5) corporate governance oversight and (6) shareholder empowerment. In what follows, I give a brief account of some of the issues and analyses that have arisen in the literature surrounding each mechanism. 5.1 Business Failure Even in the absence of any other mechanism we would expect business failure to eliminate incompetent managers and thus to mitigate problems of adverse selection. We might also expect business failure to constrain moral hazard. However, absent additional mechanisms to control moral hazard, a market that depended solely on business failure might simply eliminate certain types of otherwise efficient organizations. If managers are unable to credibly commit to behavior that benefits residual claimants, these claimants may be unwilling to make investments in organizations in which they lack direct control. As Akerlof (1970) has demonstrated, asymmetric information can result in the wholesale elimination of markets. In other words, absent other control mechanisms, large publicly owned corporations might not be viable.

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In modern corporations, other mechanisms do exist to mitigate the problems of adverse selection and moral hazard. These are discussed in the following sections. Some of these mechanisms operate in conjunction with business failure. For example, managers of failing businesses may be replaced by outside directors or through the market for corporate control. This threat of removal mitigates the problem of moral hazard and removal itself mitigates the problem of adverse selection long before the corporation is actually allowed to fail. 5.2 The Market for Corporate Control Some scholars have argued that if a market for corporate control is allowed to function, directors will be forced to take action to maximize share value or risk a takeover and the resultant loss of job. The proper functioning of such a market reduces the costs of the separation of ownership and control because, even though shareholders lack direct control, managers will be forced by market pressures to act to maximize share price. In addition, incompetent managers will be removed through the takeover process. In this manner, the market for corporate control mitigates both moral hazard and adverse selection problems. (see, among others, Manne, 1965; Butler, 1989; Easterbrook and Fischel, 1991; Romano, 1992; Macey and Miller, 1995). Two interesting variants of this story are related to dividend policy and capital structure. Some scholars argue that a corporate policy of paying steady dividends, in spite of adverse tax consequences, signals to the market that the corporation will not squander free cash flows. The market recognizes this signal and elevates stock price. (Presumably, firms that did not engage in this practice would suffer from lower stock price and be subject to a takeover; see, for example Easterbrook, 1984a). Other scholars have suggested that capital structure can provide the same sorts of signals. A capital structure that is weighted towards debt creates an obligation on the part of management to pay out future cash flows. Again this reflects a commitment by management not to squander future cash flows. This commitment is valued by the market and is reflected by higher share prices. Corporations that do not make this commitment have depressed share prices and are subject to takeover. The takeover of corporations in leveraged transactions may represent the market for corporate control operating to impose these debt constraints (see, for example, Jensen, 1986). The notion that capital markets can help reduce costs of the separation of ownership and control is parasitic on the notion that managerial performance is reflected in stock price. The idea that stock prices reflect information is known as the Efficient Capital Market Hypothesis (ECMH) and it comes in three flavors. Weak-form efficiency occurs when stock prices reflect all past stock price information (if the market is weak-form efficient, then technical analysis is unavailing). Semi-strong-form efficiency occurs when stock prices

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reflect all public information (if the market is semi-strong-form efficient then both technical and fundamental analysis is unavailing). Strong-form efficiency occurs when stock prices reflect all public and private, information. Empirical evidence seems to suggest that capital markets are semi-strong form efficient in the sense that it is not possible to make abnormal returns through either technical or fundamental analysis (see Brealey and Myers, 1991; Ross et al., 1993). Critiques of the market for corporate control as a mechanism for mitigating the costs of the separation of ownership and control have had to deal with the efficient market hypothesis. The critiques come in a variety of forms. Note that in order for the market for corporate control to be effective that (1) managerial incompetence or misbehavior must be correlated with takeover activity, and in order for this to occur it is necessary that (2) that there be a correlation between managerial incompetence or misbehavior and stock price. Various critiques of the market for corporate control attack one or both of the above correlations. For example, one critique attacks the notion that managerial behavior and stock price are highly correlated. Even if stock prices reflect fundamental values, the determinants of these values contain a large random element (that is, random events unrelated to managerial performance are a significant factor in success). This random element weakens the correlation between managerial performance and stock price. Another critique allows that while the efficient market hypothesis may be correct in that it prevents the extraction of abnormal profits, it nonetheless does not imply that stock prices reflect the fundamental values of the firm. For example, noise traders could randomly cause stocks to diverge from fundamental value. Again, this random element weakens the correlation between managerial performance and stock price (see, among others, Black, 1986 and Stout, 1988). Another set of critiques attacks the correlation between managerial activity and takeover activity. Under this critique, takeovers are the result not only of managerial incompetence or misbehavior but also of synergies, the accumulation of market power, expropriation (of creditors or of the government, vis à vis taxes, or of labor), of empire-building, and so on. All of these other reasons weaken the correlation between managerial performance and takeover activity. For evaluations of possible determinants of takeover activity, including some empirical studies, see, among others, Kaplan (1989), Lee (1992), Ippolito and James (1992) and Romano (1992). Other critiques focus on the observability of managerial performance by the market participants. If managerial performance is not observable, or is systematically misobserved, then the market is unable to correctly correlate managerial performance and stock price. One such critique focuses on the informational asymmetry between the market and management. Managers may simply have better information than the market but may have difficulty in conveying this message to the markets. A version of this story is known in the

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literature as ‘signal jamming’ and involves the classic prisoner’s dilemma (see Fudenberg and Tirole, 1986). Consider a manager who has the choice between Strategy L (long term) and Strategy S (short term). Neither strategy is certain. Associated with each strategy are two outcomes, one better than the other, and two probabilities: Strategy S (Short term): Outcome S1 (0.2 probability): Short-term earnings = 10, earnings = 60 Outcome S2 (0.8 probability): Short-term earnings = 20, earnings = 80 Strategy L (Long term): Outcome L1 (0.5 probability): Short-term earnings = 10, earnings = 80 Outcome L2 (0.5 probability): Short-term earnings = 20, earnings = 100

Total discounted Total discounted

Total discounted Total discounted

In this example, Strategy L is clearly superior (the worst outcome under Strategy L is equal to Strategy S’s best outcome). Suppose, however, that the market cannot observe the chosen strategy or the expected total discounted earnings flowing therefrom. Rather, only current earnings are observable in the short term. Management chooses a strategy, short-term earnings are revealed, and, on the basis of these short-term earnings, the market values the shares. The market uses the short-term earnings as a signal for total discounted earnings. The signal the market uses depends on what firms in the market typically do. As an example, suppose that every other firm picks Strategy S. In this case, the market will associate short-term earnings of $20 with total discounted earnings of $80, and thus bid the short-term share price to $80. The market will associate short-term earnings of $10 with total discounted earnings of $60, and thus bid the short-term share price to $60. The manager in this environment faces the following choice: Strategy S (Short term): Outcome S1 (0.2 probability): Short-term earnings = 10, Market valuation = 60 Outcome S2 (0.8 probability): Short-term earnings = 20, Market valuation = 80 Expected Market Valuation = 76 Strategy L (Long term): Outcome L1 (0.5 probability): Short-term earnings = 10, Market valuation = 60 Outcome L2 (0.5 probability): Short-term earnings = 20, Market valuation = 80 Expected Market Valuation = 70 Note that the market is valuing solely on the short-term earnings signal. Instead, if every other firm adopted strategy L, the signals would be different:

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Strategy S (Short term): Outcome S1 (0.2 probability): Short-term earnings = 10, Market valuation = 80 Outcome S2 (0.8 probability): Short-term earnings = 20, Market valuation = 100 Expected Market Valuation = 96 Strategy L (Long term): Outcome L1 (0.5 probability): Short-term earnings = 10, Market valuation = 80 Outcome L2 (0.5 probability): Short-term earnings = 20, Market valuation = 100 Expected Market Valuation = 90 This leads to the following prisoner’s dilemma. Every other firm:

Our Firm:

Strategy S

Strategy L

Strategy S

76

96

Strategy L

70

90

The dominant strategy for the firm, indeed for all firms, is to adopt the short-term strategy. It is interesting to note that in equilibrium, with all firms adopting the short-term strategy, the market indeed values shares correctly. In equilibrium, the market is not being fooled. Yet even though the market is not being fooled, and cannot be fooled in the long term, managers still have the incentive to adopt short-term strategies. In this model, a market for corporate control would drive managers to make inefficient decisions. As another example, consider a two-period model in which the present-value discounted revenues are as follows: Strategy S (Short term): PV of Period 1 revs = 100, PV of Period 2 revs = 100 Strategy L (Long term): PV of Period 1 revs = 80, PV of Period 2 revs = 130 Suppose that labor costs in period 1 are fixed by contract at 50 but that the period 2 labor bill will be renegotiated. Suppose that bargaining strengths of labor and management are equal so that second period revenues will be equally split between labor and shareholders. Thus the return to shareholders of Strategy S is 50 in both periods or a total of 100. Returns to shareholders of Strategy L is 30 in the first period and 65 in the second or a total return of 95. Thus share price is maximized by S, even though L produces more value. In this case, even though Strategy S benefits shareholders, it is socially inefficient. Again, the market for corporate control drives managers to make inefficient decisions.

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It should be noted that market-induced myopia, though theoretically possible, is difficult to identify empirically due to the difficulty in establishing a benchmark. 5.3 The Specification and Enforcement of Managerial Duties Some scholars have viewed the establishment of managerial duties legislatively, administratively, judicially, or contractually, and then the establishment of an enforcement mechanism as a means of mitigating the costs associated with the separation of ownership and control (see, for example, Brudney, 1966). We can divide enforcement regimes into two general categories. The first is enforcement through private rights of action. Typically, in such a system, attorneys are provided incentives, through attorneys’ fees in derivative or class action suits, to prosecute cases in which directors violate their duties. Without the provision of attorneys’ fees, individual shareholders have little incentive to prosecute such cases themselves since they would bear all of the costs but receive a very small fraction of the benefit. The provision of attorneys’ fees solves this problem by creating large incentives for attorneys to prosecute these cases. In effect, such a system provides private attorneys general who operate to enforce managerial duties (see Romano, 1991). This system represents one in which someone other than shareholders (that is, attorneys) provides the enforcement mechanism (the shareholder is just a nominal presence). A number of duties are enforceable in this manner, such as, in the US, the duties of care and loyalty. The second enforcement mechanism is direct enforcement by the government. In the US, a number of duties are enforceable in this manner, including many duties created through the securities acts. Many duties are enforceable through both private and public enforcement. The following issues have occupied scholars who have studied this class of mechanisms. What is the optimal set of managerial duties? Should they be broad or narrow? To whom should duties be owed? Should duties be mandatory (state-imposed) or optional (contained in charter provisions)? Should enforcement be private (through derivative and class action suits) or public? Is enforcement effective? Who should be liable, managers, the corporation or both? As to private enforcement, what sort of incentives and disincentives should lawyers have to bring such suits? To what extent should managers be able to immunize themselves through insurance and indemnification? (In addition, there is a question as to the history and origins of the duties and whether the process of producing duties is a good one. I put this last question off to a later section since it relates to corporate law in general and not just to this particular mechanism.) As to the issue of which duties are best privately enforced and which are best publicly enforced, there is a large literature which is not limited to

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corporate law. For example, Calabresi and Melamed (1972) and Cooter (1984) both discuss rationales for different enforcement regimes (see also Boston University Law Review (1996). In private enforcement, there exists a large literature on optimal incentives to sue which again is not limited to the corporate area (see, for example, Shavell, 1982). Specific to corporate law, there is much debate on whether private enforcement through derivative actions is effective (see, for example, Kraakman, Park and Shavell (1994). An additional enforcement issue which has been treated by law and economics scholars is whether liability should run to organizations, natural persons or both (see, for example, Arlen, 1994; Arlen and Kraakman, 1997). One important issue that has been addressed by law and economics scholars is whether duties should be mandatory or optional. Under an optional (opt-out) regime, the law would provide a standard set of duties that would be optimal for a large number of corporations. However, individual corporations would be allowed to opt out of these duties through provisions in the corporate charter. Under this view, the corporation is seen as a nexus of voluntary contracts designed to minimize agency costs. (This nexus of contracts view of the firm probably dates from Coase, 1937. See also Alchian and Demsetz, 1972; Jensen and Meckling, 1976; Klein, 1982; Cheung, 1983; Williamson, 1984; Butler, 1989; Butler and Ribstein, 1990; Easterbrook and Fischel, 1991). Proponents of the opt-out regime point out that the same set of provisions is unlikely to be optimal for every corporation. They also assert that the existence of relatively efficient markets for securities will create incentives for corporations to adopt provisions that are efficient. Those corporations with inefficient provisions will have depressed share prices and will invite takeovers. As such, the adoption of managerial duties by a corporation is similar to any other managerial decision. (For examples of analyses in support of an opt-out regime, see, Winter, 1977; Carlton and Fischel, 1983; Easterbrook and Fischel, 1982; Macey, 1984; Easterbrook, 1984, among others.) Proponents of mandatory managerial duties point to market failure. Consider the case for the mandatory provision of information. One argument is that efficient markets depend on the availability of information. Without a duty to disclose there will be an inadequate provision of information. Efficient charter provisions, including efficient disclosure provisions, are unlikely to be produced if the market for securities is inefficient. Thus efficient disclosure provisions are unlikely to be produced in an inefficient market and an efficient market is unlikely to develop absent efficient disclosure provisions (Joseph Heller referred to this type of situation as a Catch-22). Thus, the argument goes, mandatory disclosure provisions are necessary. A similar argument could be made for provisions (such as poison-pill provisions) that insulate management from the market. Again, efficient takeover provisions are unlikely to be produced in an inefficient market and an

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efficient market is unlikely to develop absent efficient take-over provisions. Even if markets are relatively efficient, market forces may provide inadequate incentives. For example, Bebchuk (1989) argues that a charter amendment that redistributes corporate money to management would affect the probability of a takeover only marginally given that such transfers are probably small relative to corporate assets though large relative to individual assets. Other market failure critiques point to the public-goods nature of managerial duties. This argument asserts that a change in duties could have a large negative impact on the corporation. However, the impact on individual shareholders could be small due to small individual share holdings and thus it would not be worth the cost of resistance. For example, imagine a relaxation of the duty of loyalty. Such a change could result in large benefits for the manager by allowing the manager to expropriate a percentage of corporate wealth. Since the change is small to individual shareholders, such shareholders would not bother to resist. Share price could fall representing the amount that managers have taken. Such an expropriation could not be remedied through the market for corporate control since corporate wealth has already been removed from the corporation. Yet other critiques point to the lack of sophistication of shareholders. The previous story is enhanced, for example, if the change in the charter is relatively complex. An unsophisticated shareholder would then have to invest more heavily in order to understand and resist such a change. Another critique of the opt-out duties, attacks the wealth-maximization criterion. Under this critique, even if opt-out duties did result in efficiency, mandatory duties would be necessary to accomplish other societal goals such as distributive goals. Several empirical studies have attempted to determine whether corporate decisions to opt out of managerial duties are efficient. (For analyses in support of a mandatory regime see Bebchuk, 1989; Brudney, 1985, and Coffee, 1988, among others.) 5.4. Corporate Governance Structure and Oversight Under this rubric I include policies directed at the structure and procedures of the board of directors. Some important questions are: How should the board be selected? Who should be on the board of directors? Who should the board represent? What should be the goal of the board? How should the board be compensated? Boards of directors in US corporations are typically elected by shareholders. In Europe, there has been some experience with boards that represent other constituencies, such as labor. In addition, large share-holdings by banks in countries such as Germany and Japan have provided oversight by lenders. A body of literature examines the costs and benefits of these various representational schemes (see, for example, Aoki, 1984; Jensen and Meckling, 1979; Summers, 1980, and Williamson, 1984). Additionally there exists

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literature as to whether boards, however chosen, have responsibilities narrowly to shareholders or broadly to the society as a whole. For example, Dodd (1932) has argued that managers have responsibilities to the community and not just to shareholders. Friedman (1970), on the other hand, has argued that the manager has a duty to maximize shareholder value subject only to legal and ethical constraints. Recently, the debate has been reenergized by the passage in several states of ‘other-constituency’ statutes. Proponents view these statutes as providing boards with the right to consider other constituencies, such as labor. Opponents view these statutes as merely providing cover for managerial entrenchment. An additional issue concerns the role of boards in active management and oversight. Some scholars have examined the separation of roles between the chairman of the board (oversight) and the chief executive officer (management). Others have examined the division between outside directors (oversight) and inside directors (management). In the US, boards are typically composed of inside and outside directors. Inside directors manage the day-to-day operations of the corporation. Outside directors provide oversight. Ideally, monitoring by outside directors could mitigate problems of moral hazard and adverse selection (see, for example, Weisbach, (1988). The reward structure for inside and outside directors differ markedly. For example, in the takeover context, both inside and outside directors stand to lose their jobs. However, whereas for the insider directors this loss is potentially great, including loss of a large income, important responsibilities, prestige and the like, for the outside director this involves the loss of a very part-time job and a very part-time salary. Thus the outside director has diminished incentives to oppose the takeover for personal reasons. Although outside directors may be more likely to act in the interests of the corporation, the position of outside directors is weakened, however, by the fact that such directors are typically chosen by inside directors and that their continued employment depends on getting along with the insiders. In addition, inside directors and outside directors often find their positions reversed with respect to other corporations. There is thus an incentive for mutual back-scratching. In addition, insider directors typically control the flow of information. This has led some commentators to be skeptical over the efficacy of this mechanism. Scholars and investors (particularly institutional investors) have made proposals for corporate governance reform that are designed to increase the independence and influence of outside directors. Plans for reform often include one or more of the following proposals: (1) increase the number of outside directors relative to inside directors (most proposals specify that outside directors should be in the majority); (2) remove inside directors from the process of nominating new directors; (3) remove inside directors from the

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process of setting directorial compensation; (4) set a mandatory retirement age or term limits for directors; (5) prohibit interlocking directorship (where inside directors of one company are outside directors of another and vice versa, and (6) require that directors own stock in the company. (For additional analysis, see, among others, Mace, 1971; Jensen, 1993, and Lin, 1996.) 5.5 The Alignment of Direct Managerial Financial Incentives Through derivative financial instruments, particularly warrants, it may be possible to give managers greater incentives to maximize share value. To the extent that share price maximization is desirable this mechanism may reduce the costs associated with the separation of ownership and control. Note, however, that compensatory incentive mechanisms address primarily the problem of moral hazard, not adverse selection. Imagine, for example, a corporation whose shares are currently trading for $100. Suppose that at-the-money warrants are trading at $1. Now imagine the following compensation schemes. Scheme 1 pays the manager $200,000 cash per year. Scheme 2 pays the manager $100,000 cash plus $100,000 worth of restricted shares (that is, 1000 shares). The restricted shares cannot be traded for five years. Scheme 3 pays the manager $100,000 cash plus $100,000 worth of warrants (that is, 100,000 warrants). The warrants would be exercisable in five years. Each scheme provides the same value of compensation. However, the incentive effects are quite different. Under scheme 1, the manager is not required to take an equity interest in the corporation. Under scheme 2, the manager will have accumulated 5000 shares after five years. Under scheme 3, the manager will possess 500,000 warrants after five years. Imagine now that a takeover offer for the corporation develops involving a 100 percent premium. Under scheme 1, the manager has an incentive to resist the takeover even if the price is a good one since the manager will likely lose his or her job. Under scheme 2, the manager has something of an incentive to consider the opportunity of a good price since the manager will receive $500,000 in increased value for selling into the offer as opposed to resisting it. Under scheme 3, the share price is likely to dominate the managers thinking since the premium represents $50,000,000 to the manager. (Assume that the manager may exercise the warrants in a takeover situation.) To the extent that maximization of share price is a desired outcome this mechanism creates stronger incentives for managers than might otherwise exist. The warrant mechanism could be combined with corporate governance structures in order to create even stronger incentives. For example, one could imagine governance structures in which outside directors constituted a majority and in which outside directors were compensated exclusively through warrants. In such a case, outside directors would have small adverse incentives (since the salary is small) and significant correct incentives since their compensation would depend almost exclusive on share price performance.

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One should note that warrants create asymmetric incentives. That is, they pay if share price is above the exercise price. However, the payoffs are the same (that is, zero) for all prices below the exercise price. Thus warrants could create incentives for inefficient risk-taking. Nevertheless, since cash compensation creates incentives for inefficiently risk-averse behavior it is not clear what the net effect of warrants would be (see, among others, Jensen and Murphy, 1990; Gilson, 1992; Milgrom and Roberts, 1992). 5.6 Shareholder Empowerment A number of scholars have made proposals to increase the power of shareholders over management. Shareholder empowerment as a mechanism for managerial control has a different emphasis from the previously discussed mechanisms in that those mechanisms relied on actors other than shareholders to restrain management. Those mechanisms sought to maintain the advantages of the separation of ownership and control while mitigating the costs. By contrast, shareholder empowerment reduces the separation and gives shareholders more say in management. Thus some of the critiques of these proposals point to the compromising of centralized management and reduction of the benefits that flow therefrom (see, for example, Boyer, 1993). Shareholder empowerment proposals seek to give public shareholders a greater voice in management by endowing them with greater rights to manage and by reducing the costs of involvement. An important subset of this research notes the increasing prominence of institutional investors in the securities markets and evaluates the costs and benefits of legal changes that would encourage greater activism by institutional investors. Current proxy regulation in the United States gives incumbent management a tremendous advantage over challengers to their authority. Very few matters are required to be put to the vote of shareholders. Managers can fund proxy battles out of the corporate treasury while challengers must incur the high costs themselves unless they ultimately prove successful. In addition, corporations have the ability to restrict voting rights in certain classes of shares (see, for example, Seligman, 1986). This system, combined with collective action problems (see Section 2 above), discourages challenges even where the total benefit of the challenge to the corporation is great compared to the costs. Some proposals for corporate reform would alter proxy rules to put more decisions in the hands of shareholders (that is, to provide for binding shareholder resolutions) and to change the cost structure to make challenges significantly cheaper, for example, by putting some of the resources of the corporation into the hands of shareholder challengers (see, among others, Bernstein and Fischer, 1940; Caplin, 1953; Eisenberg, 1970; Dent, 1989; Goforth, 1994; Smith, 1996). Evaluation of such proposals must trade the gains of greater managerial accountability against both the costs of increased use of corporate funds for such purposes and the cost of decreased centralization of management

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decisionmaking. In the US, equity securities are held increasingly by institutions, i.e., pension funds, insurance funds and investment funds. Although any individual fund holds a small percentage of the shares of any given corporation, the holdings are significant enough to encourage some monitoring. In addition, a small number of funds could control enough of a corporation to possess significant voting power if their actions are coordinated (see, among others, Gilson and Kraakman, 1991, 1993a; Black, 1992a, 1992b; and Maug, 1997). In the US, laws exist which work to discourage cooperation among funds to exercise voting control. Some proposals have suggested reducing these barriers to cooperation in order to allow funds to exert control over management and thus to reduce the separation of ownership and control and thereby reduce the costs associated with the separation of ownership and control. Some of this scholarship has been comparative in nature, focusing on institutional ownership by banks in countries such as Germany and Japan (see, among others, Gilson and Roe, 1993). Skeptics of institutional monitoring point to a number of costs associated with institutional investor oversight. Fund managers are themselves agents whose interests are not aligned with their own investors. In addition, managers represent only some of the shareholders. Control and access to information may lead to insider trading and other abuses vis-à-vis other shareholders. Although fund managers may have incentives to cooperate with other fund managers in order to exercise control, they are also in competition. Strategic behavior may result in inefficient control. Some managers, particularly managers of government pension funds, may be susceptible to political influence. Debates over institutional investor voice involve assessing these costs (see, among others, Garten, 1992; Romano, 1993; Calio and Zahralddin, 1994; Bainbridge, 1993, 1995; Fisch, 1994; Utset, 1995).

6. Origins of the Mechanisms for Mitigating the Costs of the Separation of Ownership and Control In the United States, most of the mechanisms for mitigating the costs of ownership and control are regulated by state law. Some commentators have suggested that the optimal development of mechanisms has been impeded through the process of state competition for corporate charters. This has become known as the ‘race-to-the-bottom’ thesis. This has led some commentators to support a federal (that is, national) chartering of corporations and the development of a federal corporate law. Other commentators argue that jurisdictions that compete for charters will offer efficient corporate laws. Yet other scholars have applied public choice tools to explain the development of corporate law as the result of the interest group interaction (see Cary, 1974;

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Dodd and Leftwich, 1980; Romano, 1985, 1994; Hovenkamp, 1988; Macey and Miller, 1987; Bebchuk, 1992; Bratton, 1994; and Ayres, 1995).

7. Summary Many of the issues in corporate law can be traced to the separation of ownership and control. This separation has made viable large, centrally-managed firms with diversified and liquid investors. It has provided the means for the efficient mobilization of large amounts of private capital towards productive uses. The same separation of ownership and control has created potential costs. Much of corporate law can be explained as mechanisms designed to mitigate these costs. Economic analysis of law, with its emphasis on incentive effects and on the costs and benefits that flow therefrom, provides an important tool for the analysis of corporate law and policy.

Selected Bibliography on the Separation of Ownership and Control (5630) Adams, Walter and Brock, James W. (1990), ‘Efficiency, Corporate Power, and the Bigness Complex’, 21 Journal of Economic Education, 30-50. Agrawal, Arun and Knoeber, Charles R. (1996), ‘Firm Performance and Mechanisms To Control Agency Problems Between Managers and Shareholders’, 31 Journal of Financial and Quantitative Analysis, 377-397. Agrawal, Arun and Mandelker, G.N. (1987), ‘Managerial Incentives and Corporate Investment and Financing Decisions’, 42 Journal of Finance, 823-837. Agrawal, Arun and Mandelker, G.N. (1990), ‘Large Shareholders and the Monitoring of Managers: The Case of Antitakeover Charter Amendments’, 25 Journal of Financial and Quantitative Analysis, 143-161. Agrawal, Arun and Nagarajan, N.J. (1990), ‘Corporate Capital Structure, Agency Costs and Ownership Control: The Case of All-equity Firms’, 45 Journal of Finance, 1325-1331. Agrawal, Arun and Walkling R. (1994), ‘Executive Careers and Compensation Surrounding takeover Bids’, 49 Journal of Finance, 985-1014. Agrawal, Arun, Makhija, A.K. and Mandelker, G.N (1991), ‘Executive Compensation and Corporate Performance in Electric and Gas Utilities: Some Empirical Evidence’, 20 Financial Management, 113-124. Akerlof, George A. (1970), ‘The Markets for ‘Lemons’: Qualitative Uncertainty and the Market Mechanism’, 84 Quarterly Journal of Economics, 488-500. Alchian, Armand A. and Demsetz, Harold (1972), ‘Production, Information Costs, and Economic Organization’, 62 American Economic Review, 777-795. Alchian, Armen A. (1965), ‘The Basis of Some Recent Advances in the Theory of Management of the Firm’, 14 Journal of Industrial Economics, 30-41. Alchian, Armen A. (1969), ‘Corporate Management and Property Rights’, in Manne, Henry G. (ed.), Economic Policy and the Regulation of Corporate Securities, Washington, American Enterprise Institute for Public Policy Research.

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5640 THE MARKET FOR CORPORATE CONTROL (INCLUDING TAKEOVERS) George Bittlingmayer Professor of Management Graduate School of Management University of California, Davis © Copyright 1999 George Bittlingmayer

Abstract Mergers, acquisitions and takeovers often imply dramatic changes for employees, competitors, customers and suppliers. Not surprisingly, the market for corporate control has generated controversy and is frequently regulated by law or business custom. Though transfers of control take place in many countries, explicit and public struggles for control occur most frequently in the US and UK. During most of the twentieth century, critics of mergers and acquisitions in the US pointed to the danger of monopoly and increased concentration. Partly in response to the emergence of new control transactions such as the hostile takeover and leveraged buyout, more recent criticism has focused on the consequences for corporate productivity, profitability and employee welfare. Subject to qualifications, the market for corporate control reallocates productive assets - in the form of going concerns - to the highest bidder. In cases where the bidder uses his own money or acts on behalf of the bidding firm’s shareholders, the asset goes to the highest value use. In cases where managers of the bidding firm are able to serve their own interests rather than the interests of shareholders, the market for corporate control plays a paradoxical role. It simultaneously provides (1) a means by which managers may acquire companies using other people’s money and (2) a means by which they may themselves be disciplined or displaced. JEL classification: G3, K2, L2, L4, L5 Keywords: Corporate Control, Mergers, Acquisitions, Takeovers, Securities Regulation, Antitrust, Corporate Law

1. Introduction The shareholders of the modern, publicly held corporation buy and sell their shares freely, though ordinarily in small quantities and without major consequence for the corporation itself. Occasionally, a new owner - typically

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another firm - will acquire a large fraction of a corporation’s shares, elect a new board of directors, replace or absorb its top management, and alter its methods of doing business. Consequently, when a substantial fraction of shares does change hands - through a negotiated acquisition, market purchase or tender offer - the new owner often expects to gain. What the acquirer expects to gain and what the acquirer actually receives have been the subject of a long-standing, lively and often acrimonious debate. During most of the twentieth century, merger, acquisition and the control of corporations in the United States were intimately related with the twin problems of monopoly and the concentration of economic power. The acquisition of a substantial stake in a corporation by another entity - whether another corporation, a bank or other financial intermediary - appeared to pose a threat to some part of the non-corporate sector, typically small business, labor or consumers. By mid-century, corporate control and the transfer of that control began to raise other policy issues besides the threat of corporate power. Academic attention, for example, turned to possible strategic or financial objectives in mergers and acquisitions, or to managers’ hunger for more turf. This shift came about partly because stricter antitrust laws had ruled out traditional monopoly explanations. In addition, the merger waves of the 1960s and the 1980s witnessed the emergence of hostile tender offers, new and controversial forms of debt financing, and new control transactions such as the leveraged buyout. Frequently, the acquisitions wrought dramatic and far-reaching changes in the marketplace and in the lives of employees. Acquired firms, even in cases involving hostile takeovers, came increasingly from the ranks of America’s largest corporations. Scholarly discussion and public debate covered a wide territory, but focused in large part on mergers and takeovers as a solution to mismanagement. In fact, the widespread restructuring that followed many acquisitions, leveraged buyouts and other transactions helped in large measure to rekindle interest in the problems raised by the ‘separation of ownership and control’. Subsidiary questions concerned the effects of changes in state and federal takeover policy; the degree to which stock prices represented the underlying asset value of takeover targets; and the effects of takeovers and mergers on wages, investment, and research and development. The transfer of corporate control in other developed countries, in particular Western Europe and the Far East, has been less dramatic and less controversial than in the United States. One might argue that these other countries do not need an active market for corporate control. Large financial intermediaries, in particular banks, monitor corporate performance more closely and exert a greater influence than they do in the US, in particular when a corporation gets into trouble. Major financial institutions may also see their own interests better

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served by continuity. The impact of the state on mergers, though still powerful, has been more subtle than in the US, perhaps reflecting a lower level of concern with monopoly and the concentration of business. Finally, business in other developed countries makes less intensive use of the stock market as a source of finance than do American corporations, further limiting the scope for a market for corporate control. So, while the control of corporations and the transfer of control is a worldwide phenomenon, the use of explicit, market-based mechanisms is most advanced and most conspicuous in the United States.

2. Types of Control Transactions An acquirer can gain of control of a large fraction of a corporation’s shares using the following methods, either singly or in combination. Open Market Purchase. This involves purchase of shares on an exchange. In the absence of any regulation, an acquirer will take pains to conceal his intentions and purchase as many shares as possible before the news leaks out. Since 1934, American law has required the disclosure of 10 percent ownership, and with the passage of the 1970 Amendment to the Williams Act, 5 percent ownership. This regulation effectively forces an acquirer to show his hand. Even without regulation, the attempt to gain control of a corporation without arousing suspicion and without increasing the stock price of the target firm is likely to prove difficult. Block Purchase. A shareholder may purchase a large block of shares in a negotiated acquisition. Large blocks, especially those that confer the right to elect the board, typically trade at a premium to small blocks sold on an exchange, presumably because of the value of control. Tender Offer. A potential acquirer may issue a tender offer - promising to pay a fixed amount per share for shares submitted by stockholders, subject to specified conditions. This price is typically greater than the market price. A tender offer may be made for only some fraction of the shares outstanding, it is likely to expire at some point, and the actual transaction may be made contingent on a minimum number of shares being tendered. The terms may be for cash or securities, and the offer may be made with or without the consent of the target management and board. If management is opposed, and especially if it offers active resistance, the offer is viewed as ‘hostile’. An acquirer will often first buy a relatively cheap ‘toe-hold’ on the open market and then follow up with a tender offer. In the US, tender offers are subject to federal securities laws. Negotiated Purchase. Often, the acquirer deals directly with the management and board of the target firm and negotiates the terms of an acquisition. This method usually involves the transfer of all outstanding shares of the target, for

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either cash or securities. It may also involve other terms, such as employment contracts for the management of the acquired firm, provision for a ‘break-up fee’ if the company to be acquired backs out, or so-called lock-up agreements conferring on the acquirer the right to purchase shares. The transfer of control over shares is typically but one step in a longer negotiated transaction that includes the ultimate formal absorption of the acquired firm through merger. Proxy Contest. Typically, shareholders of a publicly held corporation may delegate their vote. Small shareholders and institutions who do not wish to take an active role typically delegate their vote to management. (In some countries the proxies of small shareholders may be held by a large bank, with the bank itself being a substantial shareholder.) A group of dissident shareholders may stage a proxy contest, by which the group solicits proxies from other shareholders. With sufficient votes, such a group is able to change the composition of the board and ultimately effectuate changes in the management of the corporation. A group of insurgent shareholders will typically hold a fraction of outstanding shares in order to certify their seriousness and to capitalize on any gain in share value from a successful effort. In American practice, the acquirer is usually another publicly-held firm, and the transaction results in the merger of two publicly-held firms. Increasingly, however, acquirers take minority positions for longer periods of time. Partial acquisitions without any immediate plans for merger have had a longer tradition in Europe. Recent American practice has also seen the rise of leveraged buyouts (LBOs) and management buyouts (MBOs). In a leveraged buyout, a private firm uses borrowed funds to make a tender offer that - if successful - would give the acquirer sufficient votes to ‘take the firm private’. The acquirer is then free to effectuate changes in the board and management, or require that top managers increase their equity stake. A management buyout typically involves the same substitution of debt for widely held public equity as an LBO, but the transaction takes place at the initiative of management, and management takes on a large stake in the remaining equity of the private firm. Finally, corporations often repurchase their own shares on the open market or by means of a tender offer or block purchase, with the intention of influencing the balance of control (Gilson, 1986, Part III; Brudney and Chirelstein, 1987, Part IV; Weston, Kwang and Hoag, 1990, chs. 18-19).

3. Explanations for Mergers and Acquisitions The transfer of control through merger and acquisition emerged at the end of the nineteenth century and is linked, at least in time and quite likely in substance, with the development of the modern corporation. Early American

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economists regarded the growth of firms such as Standard Oil, US Steel and DuPont through merger as largely natural and efficiency-enhancing. The emergence through merger of large industrial firms in the UK and continental Europe generated largely similar reactions. Subsequent generations of economists, in particular in the US, came to view merger largely in terms of monopoly, perhaps because the development of economic theory seemed to leave little choice. For a good deal of the twentieth century, economic explanations for merger focused on the interaction of monopoly and scale economies, with scale economies playing a paradoxical role. If scale economies did not exist, that is, if a single large firm could not produce more cheaply than two or more smaller ones, then the motive for a merger of two firms in the same or related line of business could only be monopoly. If scale economies did exist and a larger firm was more efficient, then the large firm would take over the whole business and set its price above marginal cost but below the level that would lead to significant entry. Either way, the acquisition of one firm by another was linked with monopoly. Stigler’s (1950) influential analysis of ‘Oligopoly and Monopoly by Merger’ appealed to the ‘survivor principle’ to argue that economies of scale were unimportant. He explained the emergence of large firms at the turn of the century and again in the 1920s as grabs for monopoly power facilitated by the growth of the stock market, which allowed firms to capitalize monopoly rents. It is worth noting that the textbook models of competition and monopoly both assume a unitary, profit-maximizing firm. Those models have little to say about the mechanisms by which a group of individuals control a corporation, how the effectiveness of that control varies according to the concentration of stockholdings and the identity of stockholders, or how optimal control mechanisms might vary by type of business or over the life-cycle of the business. Regardless of the intellectual origins, the concern with possible monopoly motives and monopoly effects of mergers and acquisitions ultimately moved beyond horizontal mergers (involving firms making identical products or very close substitutes) to vertical mergers (involving merger of successive levels of production, such as cement and concrete) and even to conglomerate mergers (involving mergers of firms in unrelated businesses). However, the arguments and evidence supporting a monopoly explanation were particularly weak in the last case. Beginning in the 1960s, the economic literature turned to a number of other, non-monopoly explanations. These new explanations struck one of several broad themes. Acquisitions may allow the implementation of managerial knowledge across businesses; they may allow firms to implement strategic goals; they may promote financial synergies such as diversification or the use of increased leverage; they may allow managers to indulge their appetites for more control using other people’s money; and, paradoxically, they may be the mechanism by which new owners can impose much-needed

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discipline on managers. The last explanation gained more and more adherents during the 1980s, when an increasing number of mergers were financed by debt and resulted in a leveraging up of the corporate sector. According to Jensen’s (1986) ‘free cash-flow’ theory, companies with excess cash are likely to undertake negative net present value projects. For example, oil companies flush with cash from high oil prices may drill negative net present value oil wells and engage in dubious diversification efforts instead of returning cash to shareholders. An acquisition financed with debt forces the new management to generate cash and reject dubious projects. According to oral tradition, the ‘free cash-flow’ explanation originated with the colorful 1980s takeover king, T. Boone Pickens. Gilson (1986, Part II), Scherer and Ross (1990, pp. 159-167), Weston, Kwang and Hoag (1990, ch. 10), and Carlton and Perloff (1994, pp. 36-40) offer surveys of possible explanations for mergers and acquisitions.

4. Manne and Corporate Control Though control transactions have a long history in fact and in law, the academic literature on the ‘market for corporate control’ and indeed the term itself begin with Henry Manne (1965). His analysis focused on control transactions that would address the problem of poor management, and he introduced a number of enduring themes. He viewed the competition for corporate control as encompassing (1) proxy fights, (2) direct purchase of shares and (3) merger. Manne also argued that control of the corporation was a valuable asset, he suggested that many mergers took place because the bidder valued that asset, and he advanced the idea of a ‘positive correlation between corporate managerial efficiency and the market price of shares’ (Manne, 1965, p. 112). He also viewed proxy fights as needlessly cumbersome and expensive, a conclusion shared by much subsequent commentary. Direct purchase of shares (open market purchases, block purchases, and tender offers) and merger differ in one important respect. Direct purchase does not require approval of the target management. In a merger that requires board approval, management would typically demand some compensation for its consent to be displaced. ‘When we find incumbents recommending a control change, it is generally safe to assume that some side payment is occurring’ (Manne, 1965, p. 118). He also observed that firms in the same industry are likely to be well situated to discover mismanagement and act on that knowledge by proposing merger, thus weakening the case for the stringent horizontal merger policy practiced in the 1960s. Consistent with Manne’s original approach, the subsequent literature has included negotiated merger among the panoply of control transactions that includes open market purchases, tender offers and control block purchases.

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Doing so recognizes that many mergers take place under the threat of takeover or because the merger itself amounts to a takeover with side payments to secure the cooperation of target management. Though control of managers has become an important theme in discussions of the market for corporate control, it bears emphasis that other mechanisms exist that also promote efficient operation of a corporation. Jensen and Meckling (1976) argue that managers act as agents of shareholders and that shareholders have an incentive to use resources efficiently to monitor managers. In common with the textbook model of the profit-maximizing firm, their model views shareholders as unitary agents and neglects the issue of incentives in the case of widely held corporations. As Manne himself observed, ‘the separation of ownership and control’ deals with the problem faced by diffuse ownership. ‘So long as we are unable to discern any control relationship between small shareholders and corporate management, the thrust of Berle and Means’s famous phrase remains strong’ (Manne, 1965, p. 112). Even in the case of the diffusely held corporation, however, various influences tend to promote efficient management. Competition in product markets imposes discipline on management because inefficiency may lead to the ultimate demise of a firm. State law allows shareholders to vote for directors, and these in turn are responsible for the appointment and dismissal of top management. States with corporate laws that encourage or allow inefficient management will not get their share of new incorporations. The job market for managers will penalize those who do not perform well. Finally, managers may own a large fraction of outstanding shares, which will tend to align their interests with those of shareholders. Clearly, none of these and other possible forces is perfect. The workings of competition in the product market may be slow; shareholders may not have the incentives or abilities to assess corporate performance and the need for a new board of directors; states will still be able to retain and compete for established corporations that management controls by means of relatively small ownership stakes; entrenched top management may not care about moving to another job; and large shareholdings are the exception rather than the rule. Even jointly, then, these other disciplinary mechanisms may fail to protect shareholders.

5. Overview of Regulation A variety of laws affect mergers and the market for corporate control. These include the law of corporations, antitrust policy and securities regulation. In the United States, corporate law is largely a creature of the individual states. About half of all large, publicly-held corporations choose Delaware, a small, east-coast state, and the remainder tend to gravitate toward large states such as New York,

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California, Illinois and Pennsylvania. The states compete to grant corporate charters and to attract the fees and legal business that comes with them. Indeed, critics charge that this competition is a ‘race to the bottom’, with the states offering insufficient protection to shareholders and overly generous protection to managers. The influence of state corporate law on corporate control runs deep. State law affects the voting rights of shareholders, the duties of corporate directors, and the defensive tactics available to target management, for example. This influence over the mechanics of control ultimately affects the value of control. In contrast to state law, the influence of American federal law is less direct, though perhaps no less important. Early federal law focused on antitrust, which limited mergers, acquisitions, cross-holdings of stock and interlocking directorates. The federal role increased dramatically with the 1934 Securities Exchange Act, and with subsequent legislation, notably the 1968 Williams Act, which imposed disclosure requirements on acquisitions above threshold levels and restricted the terms of a tender offer. Federal securities law also governs proxy fights and communication among shareholders. Finally, Federal law restricts the stock holdings of banks, mutual funds and other financial intermediaries, with subtle but arguably powerful consequences for corporate control. In the late 1980s, the regulatory initiative passed back to the individual states, which passed antitakeover legislation when the federal government did little to restrict a wave of takeovers. In contrast to early state initiatives to control the takeover process, the courts gave their approval. Indeed, this last development illustrates one of the recurrent themes in the American approach to corporate control, namely regulatory competition between the federal government, the judiciary and the states (particularly Delaware). The other constant theme in America is the hostility toward concentrated power (Roe, 1994; Romano, 1987; Pound, 1992b, 1993).

6. Early Corporation Policies and Their Effects The federal government may interfere with the transfer of control on various grounds. Chief among these is alleged monopoly, which has played an important role since 1890, when the modern corporation was in its infancy. The original trusts enabled a trustee to hold and control shares of several corporations, thus facilitating coordinated operation of several nominally independent enterprises. The device was pioneered by Standard Oil in 1882 but other groups of firms soon adopted the form. More broadly, a variety of related cooperative forms, also called ‘trusts’, emerged over the following two decades.

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These included cartels, pools, holding companies, ‘communities of interest’ (later termed ‘interlocking directorates’) and merged firms. The chief chartering states (notably New Jersey and Delaware) shaped and accelerated this development by allowing corporations to buy each other’s stock and by permitting merger. Both measures facilitated the conversion of possibly illegal ‘trusts’ into statutorily sanctioned forms. In contrast, populist states and the federal government responded to the widespread cartelization with ‘anti-trust’ statutes, in particular the 1890 Sherman Antitrust Act. It bears emphasis that most commentary at the time regarded the various trust forms as different manifestations of the same underlying phenomenon - a single ‘trust and corporation problem’. According to early Supreme Court interpretation, notably E.C. Knight (1895), the new antitrust law applied only to cartels. Cartels implied an agreement to restrain interstate trade. Acquisition and merger, in contrast, involved the purchase and sale of corporate shares created under state law and no agreement to restrain trade. This odd legal situation - cartels always illegal, merger always OK - laid the basis for the Great Merger Wave of 1898-1902, including the formation or growth through merger of firms such as US Steel, DuPont and American Tobacco, as well as the conversion of the Standard Oil Trust into a holding company. Some very dramatic takeover struggles took place in that era, notably the fight between railroad magnates Hill and Harriman for control of the Northern Pacific in 1901. The aims and effects of these early innovations in corporate control - the classic trusts and the holding companies and merged firms that replaced them - were controversial at the time and have remained controversial to the present day. Modern business historians, notably Chandler (1977), view the early acquisitions and mergers as part of the process by which ‘the visible hand’ of management was substituted for the invisible hand of arms-length market agreements, allowing greater efficiency in management. Modern legal historians have tended to view the cartels as, at best, mixed blessings (Hovenkamp, 1991; Freyer, 1992). Economists since mid-century have followed Stigler’s (1950) analysis - discussed above - which emphasized the formation of monopolies through merger. Scherer and Ross (1990, ch. 5), who share this view, provide a representative treatment from the perspective of the late twentieth century. One approach, which was popular early on only to be rejected in favor of the monopoly view, has recently experienced a revival. Early economists defended both the cartels and the mergers that often replaced them as efficient responses to the problems posed by high fixed costs, in particular the danger of ‘cutthroat competition’. In more recent work, Bittlingmayer (1982, 1983, 1985) and Telser (1987, ch. 2) rely on the theory of cooperative games, in particular the theory of the core, to explain the widespread use of cooperative forms including merger in many industries marked by high fixed costs and fluctuating demand.

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On this view, a competitive equilibrium is not possible with an ‘empty core’, leaving cartelization, tacit collusion, merger or single-firm monopolization as the only alternatives. This squares the circle, explaining how the early ‘trusts’ could have been both collusive and more efficient than the businesses they replaced. On all three views of the late nineteenth- and early twentieth-century mergers - managerial, monopoly and empty core - the market for control provided a mechanism by which previously independent units achieved coordinated action. The managerial view also allows the possibility that merger facilitated the transfer of new, more efficient managerial methods and comes closest to embodying modern notions about the function of the market for corporate control.

7. The Emergence of Merger and Corporate Control as Policy Issues Effective federal intervention in mergers and acquisitions began with President Theodore Roosevelt’s celebrated ‘trust-busting’. In response to the Great Merger Wave, 1898-1902, Roosevelt filed Northern Securities (1904), a case that originated in the battle for control of the Northern Pacific. His intention was to force a revision of merger policy. In a 5-4 decision, the Supreme Court reversed itself and placed merger under direct federal control. At the same time, Roosevelt established the Bureau of Corporations (the Federal Trade Commission’s predecessor) and the Antitrust Division of the Department of Justice. After a brief lull, Roosevelt used the government’s new powers under the Sherman Act in late 1906 and 1907 in an aggressive effort to divest some of the most notorious ‘trusts’, including John D. Rockefeller’s Standard Oil, American Tobacco and DuPont. These attacks were controversial and potentially immense if carried to their logical conclusion, since thorough ‘trust-busting’ would have meant a costly and protracted dismemberment of perhaps half of US industry. Indeed, public commentary at the time blamed Roosevelt’s ‘trust-busting’ for the Panic of 1907, which was marked by a remarkably steep decline in stock prices and output. A similar discussion flared up during the less dramatic bear market and recession that surrounded President William Howard Taft’s (1909-1913) attempt to break up US Steel. Though historians of the Progressive Era are aware of this controversy, economists have largely ignored it. Bittlingmayer (1993, 1996) has recently offered new supporting evidence, in particular a negative correlation between antitrust enforcement and changes in stock prices and output. Despite sporadic and controversial successes and continued anti-big-business rhetoric, the federal government eventually abandoned the aim of divesting the large corporations formed in the 1898-1902 merger wave. Arguably, attempts to do so had proven too costly. However, big business and

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in particular bank control of big business remained unpopular, and political attention turned to the later topic. The Pujo ‘Money Trust Investigations’ of 1912 drove banks off the boards of directors, thus undermining the role of banks as monitors of corporate performance (Roe, 1994, pp. 33-35). In recent work, Cantillo (1996) reports that the forced departure of banks from corporate boards depressed stock values of the affected corporations. Arguably, the erosion of bank power over corporations set the stage for management self-dealing and the emergence of alternative methods of disciplining management. The political controversy surrounding the corporation was suppressed during the First World War and, after a brief flurry of anti-business sentiment following the war, suppressed again during the 1920s. The administration of President Calvin Coolidge (1923-1929) deliberately attempted to scale back enforcement of the antitrust laws, especially the laws against merger. In an echo of experience at the turn of the century, this period of extraordinarily lax merger enforcement again coincided with a large wave of mergers. General Motors, Curtiss-Wright, General Mills and many other companies grew substantially during this period. The high-growth and new technology industries of the era - automobiles, aviation, food processing, radio, motion pictures and electric utilities - experienced particularly extensive consolidation through acquisition and merger. Corporate growth and the booming stock market of the 1920s also contributed to the growth of the modern managerial firm, that is, a large firm owned by many small shareholders but run by professional managers. It was precisely this emerging ‘separation of ownership and control’ that Berle and Means (1932) criticized only a few years later in their classic, The Modern Corporation and Private Property. The 1920s merger wave ended after the October 1929 stock crash. Perhaps the crash and 1930 recession ended the merger wave. This would be consistent with the view that merger waves are speculative phenomena or that merger waves are caused by business booms. Alternatively, and of some importance for our assessment of merger and takeover activity, and of the effects of swings in government policy, the boom and crash may have reflected swings in merger and antitrust policy under Presidents Coolidge (1923-1929) and Herbert Hoover (1929-1933). Coolidge’s administration, which was widely regarded as being aggressively ‘pro-business’, filed very few merger cases and almost none against mergers involving publicly traded firms. Outside observers, among them America’s leading economist at the time, Irving Fisher, regarded Hoover as simply continuing a policy favorable toward merger. This was a plausible inference in part because Hoover had been Coolidge’s Secretary of Commerce. However, it has only recently come to light that Hoover in fact viewed the merger wave with suspicion, and that Hoover’s attorney general announced a radical shift in antitrust policy in the middle of the October 1929 crash. The Hoover administration soon implemented a more restrictive policy, that

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included a resumption of merger case filings (Bittlingmayer, 1993). Experience in 1929 is consistent with the evidence from the Panic of 1907, and with the October 1987 crash, discussed below.

8. The New Deal and its Aftermath The presidency of Franklin Delano Roosevelt (1933-1945) left its mark on regulations affecting the market for corporate control, as it did on many other areas of economic life. However, most of the New Deal’s explicit legal and regulatory changes affected the market for control indirectly - by requiring disclosure of stock ownership, placing restrictions on proxy contests (originally a matter of state law only), and by restricting the stockholdings of financial intermediaries. Especially at the end of the 1930s, political attention turned again to the ownership and control of business. Though New Deal legislation contained few specific provisions dealing with the market for corporate control, the potential for federal intervention increased sharply. For example, the single most important piece of federal takeover legislation, the Williams Act, discussed below, was passed in 1968. It was an amendment to the 1934 Securities Exchange Act. Ultimately, the potential influence of federal legislation was also felt at the state level, because key states of incorporation, such as Delaware, defended their positions against federal encroachment. The danger to them stemmed from latent Securities and Exchange Commission powers under 1930s legislation, and from the possibility that Congress might extend that legislation. Other legislation from the New Deal had more direct effects on stock ownership. For example, the 1940 Investment Company Act, which was drafted by the newly founded Securities and Exchange Commission at the direction of Congress, limits mutual fund holdings of stock (Roe, 1994, p. 103). The connection between corporate control and the monopoly problem surfaced again after the Second World War. Based on a relatively small merger wave, and a concern about a ‘rising tide of concentration’, Congress passed the 1950 Celler-Kefauver Amendment to the Clayton Act, thus closing the so-called asset loophole. The 1914 Clayton Act had prohibited anticompetitive acquisitions of stock, but left acquisitions of asset untouched. As a consequence of the new law, and new Supreme Court interpretations in the late 1950s and 1960s, horizontal merger policy became very restrictive. Horizontal mergers involving market shares of as little as 5 and 10 percent were largely ruled out, and even vertical mergers came under attack. Conglomerate mergers - mergers of unrelated businesses - were not entirely immune because of ‘reciprocity’ and ‘potential competition’ theories, but did enjoy a relatively safe harbor.

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Not surprisingly, though mergers of all types continued to occur, the 1960s experienced an upsurge of conglomerate mergers. With hindsight many of these seem ill-advised. Why they occurred remains unclear. Antitrust policy favored them, but it did not compel them. Perhaps restrictions on the ownership of corporations by banks and other intermediaries and the development in state corporate law of the business judgment rule that gave wide discretion to managers and directors facilitated the formation of inefficient conglomerates. The origin of the conglomerates remains a riddle. The 1980s and 1990s wave of mergers, acquisitions and restructurings quite likely had their origins in changed state and federal policies. The Supreme Court declared restrictive state antitakeover laws unconstitutional in 1982, and the federal government reversed course under the Reagan administration and practiced a relatively permissive merger policy. In addition, the development of new forms of financing, notably high-yield ‘junk’ bonds, probably contributed to the increase in merger activity, though their emergence may have been as much an effect as a cause of the high level of restructuring. The consequences for American business were substantial. Table 1 shows that over half of a sample of large firms in existence in December 1981 became the targets of takeover attempts or themselves undertook defensive restructuring during the following eight years. These changes generated a political reaction that is not surprising in hindsight. The states enacted new antitakeover laws that passed muster at the Supreme Court. In a sequence of events reminiscent of the Panic of 1907 and the 1920s boom and crash, the US Congress briefly considered federal antitakeover legislation that is implicated as a precipitating factor in the October 1987 crash (Mitchell and Netter, 1989). On the other hand, the American political process has tolerated well into the 1990s a pace of mergers, acquisitions and restructuring that would have been unimaginable in earlier decades.

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Table 1 Frequency of takeover and restructuring over 1982-1989 for 1,064 large US firms in existence December 1981 Category Number Percentage Percentage of of firms of firms market value Friendly takeover target 286 26.9 13.6 Successful 268 25.2 13.0 Unsuccessful 18 1.7 0.6 Hostile takeover target 243 22.8 23.4 Successful 85 8.0 7.3 Unsuccessful 35 3.3 2.2 Unsuccessful followed by 87 8.1 7.0 friendly takeover Unsuccessful followed by 36 3.4 6.9 restructuring Defensive asset restructuring 78 7.3 11.8 Asset restructuring 64 6.0 9.0 Financial recapitalization 14 1.3 2.8 Remainder of sample 457 43.0 51.2 Total sample 1064 100.0 100.0 Source: Mitchell and Mulherin (1996, Table 2).

9. The Regulation of Takeovers The emergence of the unsolicited, often unfriendly and sometimes hostile takeover in the 1950s and its subsequent growth sparked various attempts at regulation. Though intensively studied, many aspects of takeover regulation remain controversial to the present day. Should acquirers be forced to disclose their holdings? Disclosure raises the cost of the shares purchased and may give target management warning and an opportunity to mount a defense. On the other hand, knowledge that a bidder is acquiring shares may allow target management to encourage an auction for the asset at stake, namely control of the corporation. Should tender offers be open for a fixed period of time? A long open period again allows target management to mobilize a defense, but it may also encourage others to enter the bidding. Should non-tendering shareholders have options other than forced sale at a price below the tender-offer price? Such a forced sale may compel shareholders to part with their shares for a price less than their valuation or the true value, but a price equal to or greater than the tender dilutes shareholder incentives to tender in the first place.

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9.1 Regulation of Takeovers by Exchanges Though not well known, US stock exchanges themselves placed limits on takeovers in the 1950s and sixties. The New York Stock Exchange required listed firms to keep open offers for their own and other firms’ shares at least ten, but preferably thirty, days, and tendered shares had to be taken up on a pro-rata rather than a first-come-first-serve basis (NYSE Company Manual, 1963, pp. A179-A180). The American Stock Exchange apparently had a similar informal policy (Fleischer and Mundheim, 1965, p. 330, n. 24). Such policies were limited in scope, however, because the NYSE and AMEX had no power over non-listed firms. 9.2 The Williams Act Passed in July 1968, the Williams Act stipulated that tendering shareholders had the right to withdrw their tendered shares during the first seven days, and after 60 days it required pro-rationing of tendered shares, and specified that increased offers applied retroactively to shares tendered in response to earlier offers. It also stipulated that acquirers that had bought 10 percent of outstanding shares on the open market disclose their acquisitions to the US Securities and Exchange Commission, though this added little to existing disclosure requirements. The 1970 Amendment lowered the disclosure requirement to 5 percent. Effects of the Williams Act A number of studies, among them Smiley (1975), Jarrell and Bradley (1980), Guerin-Calvert, McGuckin and Warren-Boulton (1987), and Asquith, Bruner and Mullins (1983) found that target firms experienced higher abnormal stock returns after passage of the Williams Act. Some of these early studies also investigated bidder returns and found that they were lower after passage of the act, suggesting that the legislation increased returns to target shareholders at the expense of bidding shareholders. Moreover, Schipper and Thompson (1983b) found that bidders who were engaged in merger programs experienced stock price declines with the passage of the Williams Act. Given the higher target premia and the lower bidder returns, the law arguably reduced the number of takeovers, though that proposition has not been tested. It is also unclear from this evidence whether the aggregate gains to all shareholders (all potential bidders and targets) were positive or negative. Other, more recent work even casts doubt on the conclusion that the Williams Act raised takeover premia and hindered the market for corporate control. Franks and Harris (1989) found that UK takeover premia also increased after 1968 in the absence of similar legislation. Nathan and O’Keefe (1989) place the increase in takeover premia at 1973-74, well after passage of the law.

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9.3 First-Generation State Takeover Laws The increased use of the hostile or unfriendly takeover had repercussions at the state level in the passage of so-called first-generation takeover statutes. Virginia led the way in 1968, the year Congress passed the Williams Act. By 1979, every state with a substantial share of corporate headquarters or a substantial share of incorporations had passed an antitakeover statute (Smiley, 1981). Romano (1985) documents the spread of these laws. The Illinois law, for example, prohibited acquisition of any firm with substantial assets in Illinois unless a state official approved. Jarrell and Bradley (1980) and Smiley (1981) found that these laws lowered takeover activity. However, the Illinois statute and with it most of the first-generation statutes were declared illegal in Edgar v. Mite 457 U.S. 624 (1982) because they interfered with interstate commerce. 9.4 Second-Generation State Takeover Legislation The states responded to Mite with statutes more narrowly focused on corporate law, the traditional prerogative of the states. Not surprisingly, states that were leaders in the adoption of first generation statutes were also more likely to adopt a second generation statute (Romano, 1987, p. 114). These laws fell into three categories. For example, Indiana passed a ‘control share acquisition’ statute stipulating that the shares of acquirer cannot be voted without the authorization of the target’s board of directors or shareholders not affiliated with the bidder. A second set of states, following Maryland’s lead, passed ‘fair-price’ provisions that stipulate a minimum price in a two-tier takeover bid (involving an initial price for tendered and accepted shares, and a second price for any remaining shares in any ‘back-end’ transaction such as merger, liquidation, and so on). A third set of states adopted ‘freeze-out’ laws that restrict the ability of an acquirer to effectuate a business combination (merger) with the target firm unless the bidder obtains prior approval from the board of directors. The new laws were generally upheld. One line of studies found significant negative, though generally small, effects on the share prices of companies incorporated in states adopting such takeover amendments. These include Schumann (1988) for New York, Ryngaert and Netter (1988, 1990) for Ohio, Sidak and Woodward (1990) for Indiana, and Szewcsyk and Tsetsekos (1992) for Pennsylvania. On the other hand, Romano (1987) finds no effects in Connecticut, Missouri and Pennsylvania, and Margotta, McWilliams and McWilliams (1990) conclude that the Ohio law had no effect. Similarly, Pugh and Jahera (1990) found no effects in Ohio, Indiana, New York and New Jersey, and Jahera and Pugh (1991) find no effect from the introduction of an antitakeover law in Delaware, the major state of incorporation. To resolve these findings, Karpoff and Malatesta (1989) examine all second-generation of laws passed from 1982 through 1988 and find small but statistically significant negative effects of about -0.3 percent on average upon

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publication of the first newspaper article that reported on the upcoming legislation. Surprisingly, Karpoff and Malatesta found that corporations headquartered but not incorporated in a state passing an antitkakeover law experienced similar stock-price declines. In their view, passage of a law reflects a state’s willingness to help corporations doing business there to defend themselves against takeover. They also find that companies without takeover provisions in their corporate charters experienced significant negative effects, while those with such provisions did not. Surprisingly, a recent study by Comment and Schwert (1995) find little effect of these state laws and firm-level antitakeover measures on the firm-level probability of a takeover. They found that the monthly rate of takeover offers for firms listed on the New York Stock Exchange (NYSE) and the American Stock Exchange (Amex) was typically below 1 percent from 1975 through the mid 1980s. That rate increased above 1 percent in the late 1980s and early 1990s, and then declined below 0.5 percent in the early 1990s. (Note that a takeover rate of 0.5 or 1 percent per month implies a substantial cumulative risk of takeover over several years.) Comment and Schwert found that for a sample of over 20,000 firm-years covering January 1977 through January 1991, the existence of a state control share or business combination law had, if anything, a positive effect on takeover probability. However, the existence of such laws was related to the adoption of poison pills. The use of a poison pill in turn, taking into account other factors, including the existence of a state antitakeover law, did lower the likelihood of takeover. Comment and Schwert conclude that not state laws, but rather the adoption of firm-level antitakeover defenses and changing financial conditions may explain the decline in takeovers. The demise of the junk-bond market, a demise that arguably had political origins, may also have played a role. 9.5 The Politics of Takeover Legislation Roe (1990, 1993, 1994) argues that political forces hinder effective control by shareholders in the United States. For example, the distinctively American opposition to centralized power has kept banks weak and prevented them from playing an active role in the oversight of large corporations. Similarly, the law places limits on financial intermediaries, including investment and insurance companies. Along similar lines, Pound (1992a) argues that the political reaction to takeovers will channel the struggle over corporate control from takeovers to shareholder activism. Clearly, mergers and takeovers generate forceful and volatile political reactions because of the dramatic way they create winners and losers. Jarrell (1992) chronicles the interaction of state law, Supreme Court decisions and firm-level defensive tactics during the 1980s.

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10. Stock-Price Effects of Corporate Control Transactions The stock-price effects of corporate control transactions have been intensively studied. Acquired firms typically experience dramatic increases in their share prices, while the share prices of acquiring firms show little effect on average. Unfortunately, the method is based on short-term stock reactions to the announcement of a merger or tender offer and does not yield direct information about the long-term effects of such transactions on variables of underlying interest such as managerial efficiency. 10.1 Acquired Firms The early survey by Jensen and Ruback (1983) report average returns to US targets of 30 percent for tender offers, 20 percent for mergers and 8 percent for proxy contests. Franks and Harris (1989) find similar gains in the UK. Focusing only on tender offers, Jarrell and Poulson (1987) find returns to targets of 19 percent in the 1960s, 35 percent in the 1970s and 30 percent in the early 1980s. These studies routinely adjust for general changes in the market. In all of these cases, whether merger or tender offer, some of the gains may well have been anticipated. Consequently, these numbers probably understate the stock market gains to acquired firms or targets. In addition, systematic variation occurs across acquisition types. A recent study by Comment and Schwert (1995) investigates the determinants of the takeover premia in a sample of 648 successful takeovers. They found that high sales growth, low market-to-book ratio, the existence of multiple bidders, the use of cash and the use of a tender offer were associated with a higher merger premium. The existence of a poison pill and the existence of a ‘control share’ law also increased the premium. The substantial increase in the stock value of acquired firms is open to various interpretations. If stock markets are efficient, the joint increase in value of the acquired firm and the bidder should reflect the expected value of future increases in joint profitability. As discussed below, bidder stock prices remain essentially unchanged with a merger announcement. Consequently, the increase in value of acquired firm measures the total joint gains, under the assumption of market efficiency. If this interpretation is correct, from where does the extra expected profitability stem? Early work attempted to distinguish prospective monopoly gains from prospective efficiency gains. Given the very stringent horizontal merger policy of the 1960s and 1970s, large monopoly gains were unlikely. In those instances in which an arguably anticompetitive merger did take place, however, the stock prices of rivals to the merging firms should have gone up. (It must be noted though that even this inference may be incorrect if the announcement of a merger in an industry signals that other firms in that industry are ‘in play’.) Stillman (1983) found that rivals’ stock prices did not

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increase in a sample that examined mergers that were subsequently challenged on antitrust grounds. Eckbo (1983), in contrast, found that for a sample of subsequently challenged mergers, the stock prices of rivals increased at the announcement, but that they did not decline when the merger was challenged and actually increased when the challenging agency was the DOJ. Taken together, the results offer little support for the monopoly view, even for these sorts of restricted samples of horizontal mergers. Though monopoly seems largely ruled out, a number of other possible sources of increased expected profitability remain. One line of commentary argues that the expected gains measured by stock price changes came from various ‘stakeholders’. These include workers, suppliers and even bondholders (in the case of mergers that involve increased leverage). This line of inquiry has received at best only very limited support from the data. However, one party may have been hurt by the increased leverage. Since payments on interest are tax deductible, one possible source of gains is the reduced payments going to yet another possible ‘stakeholder’, the US Treasury. In response to the conglomerate mergers of the 1960s and 1970s, some researchers briefly speculated about risk reduction as a motive for merger. Today, most commentary views this possibility skeptically since investors can achieve risk reduction directly through portfolio diversification. Another strand of commentary rejects the assumption of efficient markets. Kraakman (1988) suggests that the shares of target firms may be discounted below their true, efficient-market value. Hence, stock-price gains may overstate the true expected gains in efficiency. In a similar vein, some commentary has argued that the merger gains come from slashing various current expenses that the stock market does not fully value: investment in physical plant, research and development, and the expertise of middle management. Market analysts and investors are fooled by the boost in short-term profits that result when these items are cut and they undervalue the future returns from these expenditures. Other points also deserve mention. The size of the premium depends on the fraction of shares acquired. Bradley, Desai and Kim (1988) found that the supply of tendered shares has an upward slope - an increase of ten percentage points in the fraction of shares acquired resulted in a 1.7 percent increase in the merger premium. Hence, the premia in mergers and tender offers may simply reflect the higher price necessary to elicit a greater supply. Furthermore, control itself may have value even if the transaction does not result in any efficiencies. Consistent with this, control-share blocks trade at a premium. The possibility that a bid reveals previously private information about the value of the target is unlikely since blocked bids result in stock prices that revert to their old values.

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10.2 Bidding Firms Jensen and Ruback (1983) found that bidders on average experienced no net gain or loss as the result of merger activity. More recent work by Bradley, Desai and Kim (1988) and studies surveyed by Jarrell, Brickley and Netter (1988) found steadily decreasing returns to bidders from decade to decade from the 1960s through the 1980s. A changing regulatory environment more favorable to targets, the increased use of defenses that raise target premia, and greater competition for targets in a stronger merger market may explain this shift in financial gains. However, these results were still consistent with the notion that the market expects some bidders to increase and others to decrease corporate performance. An intriguing study by Lehn and Mitchell (1990), ‘Do Bad Bidders Become Good Targets?’, found that bidders whose stock prices declined upon the announcement of their bid were subsequently more likely to become targets of bids themselves. Arguably, then, the market for corporate control may be a two-edged sword. On the one hand, it allows managers to indulge their penchant for acquiring businesses they are not able to manage well and to pay too much when they do so, but, on the other hand, it also provides the ultimate corrective. Clearly, however, this corrective force has recent origins since mergers, takeovers and LBOs of large firms emerged only in the 1980s and 1990s. Morck, Shleifer and Vishny (1990) present similar results, showing the bidder returns are lower when a firm diversifies, when it buys a rapidly growing target and when it has performed poorly before the acquisition. Lang, Stulz and Walkling (1991) find that bidders with large cash flow and low ‘q’ (the ratio of stock value to replacement cost) experience negative returns.

11. Economic Causes and Effects of the Market for Corporate Control At the firm level, attempts to predict merger and takeover candidates have met with only modest success. For the US, Palepu (1986) found that firms are more likely to be acquired if they have had low stock returns, low growth and low leverage, and if they belonged to an industry with a history of recent acquisitions. However, the explanatory power of the model was low. Intriguingly, and not surprising on the efficient-market view, investing in likely targets would not have yielded abnormal positive returns. Though work on the US supports the view that poor performance leads to takeover, a recent study of the UK by Franks and Mayer (1996) found little evidence that targets of hostile bids performed poorly prior to the bid. Since even well-managed firms become targets, it seems unlikely that poor performance by itself would be a reliable precursor to takeover.

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Plant-, division- and firm-level studies appear to support the view that mergers improve performance, on average, though the results are not uniform. The study by Ravenscraft and Scherer (1987) based on Federal Trade Commission Line of Business data seemed to suggest that bidders purchased units with good performance and lowered their return. However, their sample was largely composed of acquisitions made in the 1960s and 1970s, that is, during the conglomerate merger wave. Lichtenberg’s (1992) study of plant-level ownership changes made in the 1970s and early 1980s found that plants with low productivity were more likely to change hands and that, having changed hands, they experienced increases in productivity. Other work based on relatively recent periods seems to confirm the impression that transfers of control raise productivity and profits. Palepu (1990) found that LBO firms experience increases in productivity and operating performance. Healy, Palepu and Ruback (1992) studied the post-acquisition performance of 50 large US mergers. They found increases in productivity and a strong relationship between the original stock price increase at the merger announcement and subsequent operating cash flow changes. It bears emphasis that plant- or firm-level increases in productivity may represent only part of the contribution of mergers and acquisitions to economic well being. A healthy merger market gives entrepreneurs incentives to establish new business since they know that those businesses, once up and running, will find a ready market. It is possible that the market for corporate control performs this function even in the absence of any identifiable short-term increase in productivity linked with a transfer of control. Though the effect of the market for corporate control on managerial efficiency has received the bulk of attention, it seems likely that we would still have mergers and acquisitions even in a world where the incentives of managers and stockholders were well aligned. The variation in merger intensity across industries suggests that merger and acquisition activity result from other factors, though what those factors are remains unclear. Gort (1969) explains the cross-industry variation with an ‘economic disturbance’ theory of merger. He finds that industries with high rates of growth and industries with a large fraction of ‘technical personnel’ - which he viewed as proxies for disturbances - had higher rates of merger. In more recent work, Mitchell and Mulherin (1996) find that 1980s takeover and acquisition activity clustered over time in particular industries. In addition, they find that deregulation, dependence on energy and a low ratio of R&D to sales were correlated with greater takeover and restructuring activity at the industry level. The last result, which contrasts with Gort’s finding for technical personnel, is probably attributable to the increased use in the 1980s of high-yield or ‘junk’ bond financing, which requires tangible assets - that is, not intangible R&D - as backing. Arguably,

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all three variables - deregulation, energy dependence and susceptibility to junk-bond financing - are proxies for shocks. Another line of work views merger as the response to endogenous industry forces or endogenous characteristics. Telser (1987) posits that firms have differential success in their innovative efforts, that merger provides a mechanism by which successful innovations can be applied across firms and that merger has advantages over other methods of transferring information. This prediction explains Gort’s results discussed above, as well as Telser’s results that industry merger and growth rates are positively related. Bittlingmayer (1996) advances a ‘merger as investment’ explanation, according to which acquisition and merger are firm-level alternatives to new investment in tangible and intangible capital. At the industry level, merger intensity depends on the need to replace or augment the stock of capital assets and the degree to which independent development of assets and subsequent acquisition and merger provide a cheaper solution than development of assets within the firm. This explanation emphasizes the link between merger, that is, changes in the scope of a firm, and the theory of the firm. Bittlingmayer found that industry merger intensity was related to industry investment and growth of value-added per employee in the US, and to investment and productivity growth in Germany, offering indirect support for the view that the same factors drive merger and investment.

12. Concluding Comments The purchase of corporate control by an individual, corporation or financial institution undoubtedly arises for a number of reasons. According to a former General Electric executive, GE chairman Jack Welch enjoys socializing with entertainers. That preference and Welch’s effective control over GE as long as it remains one of the best managed corporations in the US may very well explain why GE owns the National Broadcasting Company (NBC). Undoubtedly, some of General Electric’s other acquisitions have had more traditional strategic origins. Acquisitions by other companies may have been undertaken to improve the management of the acquired firm. Against this background, it would be difficult to conclude that the market for corporate control serves shareholders - and ultimately, the cause of economic efficiency - in each and every instance. Not just common sense but the record of the conglomerate merger wave of the 1960s supports a split verdict. However, if one accepts the view that the modern corporation has allowed substantial efficiencies in the organization and financing of business, and that the corporation gets things right on average and in the long run, it seems likely that - taking the good with the bad - the market for corporate control has aided the cause of efficiency. Perhaps the most suggestive evidence on the possible role of an active market in mergers and acquisitions comes from the historical

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correlation between merger activity and economic growth - at the turn of the century, in the 1920s, the 1960s and again the 1980s and 1990s. Economists have typically assumed causation runs from business booms to merger, but it also seems possible that mergers and acquisitions are among the means by which industrial economies come to use resources more efficiently. The importance of mergers, acquisitions and the market for corporate control is reflected in the volatile, often contradictory political reaction to them. Until the 1960s, discussion of mergers and acquisitions was dominated by the monopoly problem and the power of the corporation. Concern about the monopoly problem was probably overstated and seems to have been a pretext to slow the pace of economic change. Since the 1960s, the focus of discussion has shifted partly to the effects on employees and others connected with acquired corporations, reflecting the increase in hostile takeovers and radical restructuring. Ironically, restructuring was probably more severe because other, related political pressures had undermined effective control by shareholders, increasing the gap between potential and actual corporate performance, and thus increasing the extent of changes that were likely to ensue when a change in control did take place. Effective control mechanisms are the public’s best protection against substantial changes stemming from an unrestricted market for corporate control. Economists, lawyers and business historians have only slowly come to appreciate the consequences of legal intervention in the market for corporate control, and the subtle but powerful interplay between business, the presidency, the legislature and the courts. The initial effort to outlaw the trusts at the end of the nineteenth century hastened the growth of large firms through merger because the courts were reluctant to bring merger under the Sherman Act. Cartels were illegal but merger was not. Public opinion and public policy also opposed effective control by financial intermediaries, and state competition for corporate charters may have undermined effective control of corporations by shareholders. Episodes of lax merger policy stimulated merger waves, and the political reaction against those merger waves brought them to abrupt halts at the turn of the century and again in the 1920s. The effort to outlaw horizontal merger in the 1950s and 1960s aided the formation of inefficient conglomerates, a process no doubt hastened by other restrictions on effective shareholder control such as a cumbersome proxy machinery and limits on stock ownership. The states reacted to acquisitions of the 1960s with blatantly protectionist antitakeover laws, and the Supreme Court reacted by declaring those laws illegal. The Reagan administration’s laissez-faire antitrust policies and reluctance to cater to political pressure in the face of the resulting 1980s takeover wave led states to adopt and the Supreme Court ultimately to approve a new generation of more subtly crafted antitakeover measures.

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Three areas of research deserve more attention. First, what have been the effects of mergers, acquisitions and takeovers on economic efficiency? The existing evidence, based on plant-, division- or company-level data, is unlikely to capture the total effects. To put the matter differently, what would have been the effects on the efficiency of existing firms and on the formation of new firms of a complete ban on mergers? Second, what is the most efficient level of defense against an unwanted takeover? Some analysts say that no defense serves shareholders best, while others believe even aggressive measures serve shareholders. The socially optimal takeover defense deserves more attention. Finally, how will the political economy of takeover regulation change against the background of increasing public ownership of stocks, the internationalization of equity markets and greater use of equity markets worldwide?

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Morck, Randall, Shleifer, Andrei and Vishny, Robert W. (1989), ‘Alternative Mechanisms for Corporate Control’, 79 American Economic Review, 842-852. Morck, Randall, Shleifer, Andrei and Vishny, Robert W. (1990), ‘Do Managerial Objectives Drive Bad Acquisitions?’, 45 Journal of Finance, 31-48. Mueller, Dennis C. (1995), ‘Corporate Takeovers and Productivity’, 50 Journal of Finance, 383-387. Mukherjee, Tarun, K. and Verla, Oscar (1992), ‘Corporate Behavior After the Proxy Contest for Control: The Short, Intermediate and Long Term’, 18 Managerial Finance, 77-97. Murray, Louis, C. (1991), ‘A Study on the Wealth Effects of Irish Takeovers and Mergers’, 12 Managerial and Decision Economics, 67-72. Nagarajan, S. (1995), ‘On the Generic Efficiency of Takeovers Under Incomplete Information’, 65 Journal of Economic Theory, 522-556. Nathan, Kevin, S. and O’Keefe, Terrence B. (1989), ‘The Rise in Takeover Premiums: An Exploratory Study’, 23 Journal of Financial Economics, 101-109. New York Stock Exchange (1963), Company Manual, Published for the NYSE by Commerce Clearing House. Niden, D.M. (1993), ‘An Empirical Examination of White Knight Corporate Takeovers - Synergy and Overbidding’, 22 Financial Management, 28-45. Nyberg, S. (1995), ‘Reciprocal Shareholding and Takeover Deterrence International’, 13 Journal of Industrial Organization, 355-372. Palepu, Krishna, G. (1986), ‘Predicting Takeover Targets: A Methodological and Empirical Analysis’, 8 Journal of Accounting and Economics, 3-35. Palepu, Krishna, G. (1990), ‘Consequences of Leveraged Buyouts’, 27 Journal of Financial Economics, 247-262. Pelikan, Pavel (1989), ‘Evolution, Economic Competence, and the Market for Corporate Control’, 12 Journal of Economic Behavior and Organization, 279-303. Perkins, Rosewell, B. (1995), ‘Corporate Governance in the New Russia’, 14 International Financial Law Review, 12-15. Persons, J.C. (1994), ‘Signaling and Takeover Deterrence with Stock Repurchases - Dutch Auctions Versus Fixed Price Tender Offers’, 49 Journal of Finance, 1373-1402. Pickens, T. Boone, Jr (1988), ‘Takeovers: A Purge of Poor Managements’, 77 Management Review, 52-55. Png, Ivan Paak-Liang and Hirshleifer D. (1990), ‘Facilitation of Competing Bids and the Price of a Takeover Target’, 2 Review of Financial Studies, 587-606. Pontiff, Jeffrey, Shleifer, Andrei and Weisbach, Michael S. (1990), ‘Reversions of Excess Pension Assets After Takeovers’, 21 Rand Journal of Economics, 600-613. Pound, John (1987), ‘The Effects of Antitakeover Amendments of Takeover Activity: Some Direct Evidence’, 30 Journal of Law and Economics, 353-367. Pound, John (1988a), ‘The Information Effects of Takeover Bids and Resistance’, 22 Journal of Financial Economics, 207-227. Pound, John (1988b), ‘Proxy Contests and the Efficiency of Shareholder Oversight’, 20 Journal of Financial Economics, 237-265. Pound, John (1989), ‘Shareholder Activism and Share Values - The Causes and Consequences of Countersolicitations Against Management Antitakeover Proposals’, 32 Journal of Law and Economics, 357-379.

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Romano, Roberta (1993), ‘Public Pension Fund Activism in Corporate Governance Reconsidered’, 93 Columbia Law Review, 795-853. Ronen, Joshua (1988), ‘Sale of Controlling Interest: A Financial Economic Analysis of the Governing Law in the United States and Canada’, 13 Canada-United States Law Journal, 263-298. Rosenbaum, Robert D. and Bainbridge, Stephen M. (1988), ‘The Corporate Takeover Game and Recent Legislative Attempts to Define Insider Trading’, 26 American Criminal Law Review, 229 ff. Ryan, Patrick J. (1989), ‘Corporate Directors and the “Social Costs” of Takeovers - Reflections on the Tin Parachute’, 64 Tulane Law Review, 3-70. Ryngaert, Michael (1988), ‘The Effect of Poison Pill Securities on Shareholder Wealth’, 20 Journal of Financial Economics, 377-417. Ryngaert, Michael (1989), ‘Firm Valuation, Takeover Defenses and the Delaware Supreme Court’, 18 Financial Management, 20-28. Ryngaert, Michael and Netter, Jeffry M. (1988), ‘Shareholder Wealth Effects on the Ohio Antitakeover Law’, 4 Journal of Law, Economics, and Organization, 373-383. Ryngaert, Michael and Netter, Jeffry M. (1990), ‘Shareholder Wealth Effects of the 1986 Ohio Antitakeover Law Revisited: Its Real Effects’, 6 Journal of Law, Economics, and Organization, 253-262. Salancik, Gerald, R. and Meindl, James R. (1984), ‘Corporate Attributions as Strategic Illusions of Management Control’, 29 Administrative Science Quarterly, 238-254. Santerre, Rexford E. and Neun, Stephen P (1993), ‘’Corporate Control and Performance in the 1930s’, 31 Economic Inquiry, 466-480. Saul, Ralph, S. (1985), ‘Hostile Takeovers: What Should be Done?’, 63 Harvard Business Review, 18-24. Scherer, Frederic M. (1986), ‘Takeovers: Present and Future Dangers’, 4 Brookings Review, 15-20. Scherer, Frederic M. (1988), ‘Corporate Takeovers: The Efficiency Arguments’, 2 Journal of Economic Perspectives, 69-82. Scherer, Frederic M. and Ross David (1990), Industrial Market Structure and Economic Performance, Third Edition, Boston, Houghton Mifflin. Schipper, Katherine and Thompson, Rex (1983a), ‘Evidence on the Capitalized Value of Merger Activity for Acquiring Firms’, 11 Journal of Financial Economics, 85-119. Schipper, Katherine and Thompson, Rex (1983b), ‘The Impact of Merger-Related Regulations on the Shareholders of Acquiring Firms’, 21 Journal of Accounting Research, 184-221. Schnitzer, Monika (1995), ‘Breach of Trust in Takeovers and the Optimal Corporate Charter’, 43 Journal of Industrial Economics, 229-259. Schnitzer, Monika (1996), ‘Hostile Versus Friendly Takeovers’, 63 Economica, 37-55. Schranz, Mary, S. (1993), ‘Takeovers Improve Firm Performance: Evidence from the Banking Industry’, 101 Journal of Political Economy, 299-326. Schüller, Alfred (1979), ‘Eigentumsrechte, Unternehmenskontrollen und Wettbewerbsordnung (Property Rights, Corporate Control and Competition)’, 30 Ordo: Jahrbuch für die Ordnung von Wirtschaft und Gesellschaft, 325-364. Schumann, Laurence (1988), ‘State Regulation of Takeovers and Shareholder Wealth: The Case of New York’s 1985 Takeover Statutes’, 19 Rand Journal of Economics, 557-567. Schüttrumpf, Veit-G. (1995), ‘Comment: Hostile Takeovers: Some Reasons for the Different Legal Solutions and Some Thoughts about the Role of German Banks’, in Bouckaert, Boudewijn and De

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Geest, Gerrit (eds), Essays in Law and Economics II: Contract Law, Regulation, and Reflections on Law and Economics, Antwerpen, Maklu, 135-143. Schwartz, Alan (1986a), ‘Bebchuck on Minimum Offer Periods’, 2 Journal of Law, Economics, and Organization, 271-277. Schwartz, Alan (1986b), ‘Search Theory and the Tender Offer Auction’, 2 Journal of Law, Economics, and Organization, 229-253. Schwartz, Alan (1988), ‘The Fairness of Tender Offer Prices in Utilitarian Theory’, 17 Journal of Legal Studies, 165-196. Schwartz, Alan (1989), ‘Defensive Tactics and Optimal Search’, 5 Journal of Law, Economics, and Organization, 413-424. Sercu, P. and Van Hulle, C. (1995), ‘On the Structure of Take-over Models and Insider-Outsider Conflicts in Negotiated Take-overs’, 19 Journal of Banking and Finance, 11-14. Sercu, P. and Vanhulle, C. (1995), ‘Financing Instruments, Security Design, and the Efficiency of Takeovers - A Note’, 15 International Review of Law and Economics, 373-393. Servaes, Henri (1991), ‘Tobin’s Q and the Gains from Takeovers’, 46 Journal of Finance, 409-419. Servaes, Henri (1994), ‘Do Takeover Targets Overinvest’, 7 Review of Financial Studies, 253-277. Seward, J.K. and Walsh, J.P. (1996), ‘The Governance and Control of Voluntary Corporate Spin-Offs’, 17 Strategic Management Journal, 25-39. Sheard, Paul (1989), ‘The Main Bank System and Corporate Monitoring and Control in Japan’, 11 Journal of Economic Behavior and Organization, 399-422. Shivdasani, A (1993), ‘Board Composition, Ownership Structure and Hostile Takeovers’, 16 Journal of Accounting and Economics, 167-198. Shleifer, Andrei and Summers, Larry (1988), ‘Breach of Trust in Hostile Takeovers’, in Auerbach, Alan J. (ed.), Corporate Takeovers: Causes and Consequences, Chicago, IL, University of Chicago Press. Shleifer, Andrei and Vishny, Robert W. (1986), ‘Large Shareholders and Corporate Control’, 94 Journal of Political Economy, 461-488. Shleifer, Andrei and Vishny, Robert W. (1988), ‘Value Maximization and the Acquisition Process’, 2 Journal of Economic Perspectives, 7-20. Shleifer, Andrei and Vishny, Robert W. (1990), ‘The Takeover Wave of the 1980s’, 249 Science, 745-749. Shleifer, Andrei and Vishny, Robert W. (1991), ‘Takeovers in the 60s and the 80s - Evidence and Implications’, 12 Strategic Management Journal, 51-59. Shute, Laurence (1985), ‘J.M. Clark on Corporate Concentration and Control’, 19 Journal of Economic Issues, 409-418. Sidak, J. Gregory and Woodward, S. (1990), ‘Corporate Takeovers, the Commerce Clause, and the Efficient Anonimity of Shareholders’, 84 Northwestern University Law Review, 1092-1118. Simon, Carol J. (1989), ‘The Effect of the 1933 Securities Act on Investor Information and the Performance of New Issues’, 79 American Economic Review, 295-318. Sklar, Martin (1988), The Corporate Reconstruction of American Capitalism, 1890-1916: The Market, the Law, and Politics, Cambridge, Cambridge University Press.

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5650 INSIDER TRADING Stephen M. Bainbridge Professor, UCLA School of Law © Copyright 1999 Stephen M. Bainbridge

Abstract Insider trading is one of the most controversial aspects of securities regulation, even among the law and economics community. One set of scholars favors deregulation of insider trading, allowing corporations to set their own insider trading policies by contract. Another set of law and economics scholars, in contrast, contends that the property right to inside information should be assigned to the corporation and not subject to contractual reassignment. Deregulatory arguments are typically premised on the claims that insider trading promotes market efficiency or that assigning the property right to inside information to managers is an efficient compensation scheme. Public choice analysis is also a staple of the deregulatory literature, arguing that the insider trading prohibition benefits market professionals and managers rather than investors. The argument in favor of regulating insider trading traditionally was based on fairness, which predictably has had little traction in the law and economics community. Instead, the economic argument in favor of mandatory insider trading prohibitions has typically rested on some variant of the economics of property rights in information. JEL classification: K22, G30, G38 Keywords: Property Rights, Securities Regulation, Insider Trading, Securities Fraud

1. Introduction The law of insider trading is one way society allocates the property rights to information produced by a firm. In the United States, early common law permitted insiders to trade in a firm’s stock without disclosure of inside information. Over the last three decades, however, a complex federal prohibition of insider trading emerged as a central feature of modern US securities regulation. Other countries have gradually followed the US trend, although enforcement levels continue to vary substantially from country to country. Prohibiting insider trading is usually justified on fairness or equity grounds. Predictably, these arguments have had little traction in the law and economics community. At the same time, however, that community has not coalesced 772

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around a single view of the prohibition; instead, competing economic arguments produced an extensive debate that is still active. Those law and economics scholars who favor deregulation of insider trading typically argue that efficiency is the sole basis for analyzing a legal regime, and that the prohibition lacks any rational economic basis. Those who favor regulating insider trading typically respond either by rejecting the claim that efficiency is the controlling criterion or by attempting to show that the prohibition is justifiable on efficiency grounds. Most observers of the literature likely would conclude that neither side has carried the field, but that the argument in favor of regulation probably is winning at the moment.

A. Overview of US Insider Trading Law Because the vast bulk of law and economics scholarship on insider trading refers to United States law, a brief overview of the current state of that law seems appropriate. Insider trading, generally speaking, is trading in securities while in possession of material nonpublic information. Under current United States law, there are three basic theories under which trading on inside information becomes unlawful. The disclose or abstain rule and the misappropriation theory were created by the courts under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Pursuant to its rule-making authority under Exchange Act Section 14(e), the Securities and Exchange Commission (SEC) adopted Rule 14e-3 to proscribe insider trading involving information relating to tender offers. (Insider trading may also violate other statutes, such as the mail and wire fraud laws, which are beyond the scope of this chapter.)

2. The Disclose or Abstain Rule The modern federal insider prohibition began taking form in SEC v. Texas Gulf Sulphur Co. TGS, as it is commonly known, rested on a policy of equality of access to information. Accordingly, under TGS and its progeny, virtually anyone who possessed material nonpublic information was required either to disclose it before trading or abstain from trading in the affected company’s securities. If the would-be trader’s fiduciary duties precluded him from disclosing the information prior to trading, abstention was the only option. In Chiarella v. United States and Dirks v. SEC, the United States Supreme Court rejected the equal access policy. Instead, the Court made clear that liability could be imposed only if the defendant was subject to a duty to disclose prior to trading. Inside traders thus were no longer liable merely because they

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had more information than other investors in the market place. Instead, a duty to disclose only arose where the inside traders breached a pre-existing fiduciary duty owed to the person with whom they traded. (Chiarella; Dirks, pp. 653-655). Creation of this fiduciary duty element substantially narrowed the scope of the disclose or abstain rule. But the rule remains quite expansive in a number of respects. In particular, it is not limited to true insiders, such as officers, directors and controlling shareholders, but picks up corporate outsiders in two important ways. Even in these situations, however, liability for insider trading under the disclose or abstain rule can only be found where the trader - insider or outsider - violates a fiduciary duty owed to the issuer or the person on the other side of the transaction. First, the rule can pick up a wide variety of nominal outsiders whose relationship with the issuer is sufficiently close to the issuer of the affected securities to justify treating them as ‘constructive insiders’, but only in rather narrow circumstances. The outsider must obtain material nonpublic information from the issuer. The issuer must expect the outsider to keep the disclosed information confidential. Finally, the relationship must at least imply such a duty. If these conditions are met, the putative outsider will be deemed a ‘constructive insider’ and subjected to the disclose or abstain rule in full measure (see Dirks, p. 655 n.14). If they are not met, however, the disclose or abstain rule simply does not apply. The critical issue thus remains the nature of the relationship between the parties. Second, the rule also picks up outsiders who receive inside information from either true insiders or constructive insiders. There are a number of restrictions on tippee liability, however. Most important for present purposes, the tippee’s liability is derivative of the tipper’s, ‘arising from his role as a participant after the fact in the insider’s breach of a fiduciary duty’ (ibid. p. 659). As a result, the mere fact of a tip is not sufficient to result in liability. What is proscribed is not merely a breach of confidentiality by the insider, but rather a breach of the duty of loyalty imposed on all fiduciaries to avoid personally profiting from information entrusted to them (see ibid. pp. 662-664). Thus, looking at objective criteria, a court must determine whether the insider personally will benefit, directly or indirectly, from his disclosure. So once again, a breach of fiduciary duty is essential for liability to be imposed: a tippee can be held liable only when the tipper has breached a fiduciary duty by disclosing information to the tippee, and the tippee knows or has reason to know of the breach of duty.

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3. The Gap-Fillers Chiarella created a variety of significant gaps in the insider trading prohibition’s coverage. Consider this standard law-school hypothetical: Law Firm is hired by Raider Corp. to represent it in connection with a planned takeover bid for Target Co. Alex Associate is one of the lawyers assigned to the project. Before Raider Corp. publicly discloses its intentions, Associate purchases a substantial block of Target stock. Under the disclose or abstain rule, he has not violated the insider trading prohibition. Whatever the scope of the duties he owed Raider Corp., he owed no duty to the shareholders of Target Co. Accordingly, the requisite breach of fiduciary duty is not present in his transaction. Rule 14e-3 and the misappropriation theory were created to fill this gap.

4. Rule 14e-3 Rule 14e-3 was the SEC’s immediate response to Chiarella. The rule prohibits insiders of the bidder and target from divulging confidential information about a tender offer to persons who are likely to violate the rule by trading on the basis of that information. The rule also, with certain narrow and well-defined exceptions, prohibits any person who possesses material information relating to a tender offer by another person from trading in target company securities if the bidder has commenced or has taken substantial steps towards commencement of the bid. Note that the rule’s scope is very limited. One prong of the rule (the prohibition on trading while in possession of material nonpublic information) is not triggered until the offeror has taken substantial steps towards making the offer. More important, both prongs of the rule are limited to information relating to a tender offer. As a result, most types of inside information remain subject to the duty-based analysis of Chiarella and its progeny.

5. Misappropriation The misappropriation theory grew out of then-Chief Justice Burger’s dissent in Chiarella. As an employee of a financial printer, Chiarella had access to tender offer documents being prepared for takeover bidders. Although Chiarella owed no duties to the investors with whom he traded, he did owe a duty of confidentiality to his employer and thereby to the bidders. Chief Justice Burger argued that Chiarella’s misappropriation of material nonpublic information that

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had been entrusted to his employer was a sufficient breach of duty to justify imposing Rule 10b-5 liability (Chiarella v. U.S., 240-243, (Burger, C.J., dissenting)). Although Justices Blackmun, Brennan and Marshall supported the Chief Justice’s argument, the majority declined to reach the misappropriation question because that theory of liability had not been presented to the jury. The Second Circuit nevertheless adopted the misappropriation theory as a basis for inside trading liability in U.S. v. Newman, 664 F.2d 12 (2nd Cir. 1981), and followed it in a number of subsequent decisions; see, for example, U.S. v. Chestman, U.S. v. Carpenter SEC v. Materia. Like the traditional disclose or abstain rule, the misappropriation theory requires a breach of fiduciary duty before trading on inside information becomes unlawful. It is not unlawful, for example, for an outsider to trade on the basis of inadvertently overheard information (SEC v. Switzer). The fiduciary relationship in question, however, is a quite different one. Under the misappropriation theory, the defendant need not owe a fiduciary duty to the investor with whom he trades. Nor does he have to owe a fiduciary duty to the issuer of the securities that were traded. Instead, the misappropriation theory applies when the inside trader violates a fiduciary duty owed to the source of the information. Had the misappropriation theory been available against Chiarella, for example, his conviction could have been upheld even though he owed no duties to those with whom he traded. Instead, the breach of the duty he owed to Pandick Press would have sufficed. After two Circuit Courts of Appeals rejected the misappropriation theory, the United States Supreme Court took a case raising the theory’s validity (see U.S. v. O’Hagan, also concluding that the SEC lacked authority to adopt Rule 14e-3; U.S. v. Bryan). James O’Hagan was a partner in the Minneapolis law firm of Dorsey & Whitney. In July 1988, Grand Metropolitan PLC (Grand Met), retained Dorsey & Whitney in connection with its planned takeover of Pillsbury Company. Although O’Hagan was not one of the lawyers on the Grand Met project, he learned of their intentions and began buying Pillsbury stock and call options on Pillsbury stock. When Grand Met announced its tender offer in October, the price of Pillsbury stock rose to nearly $60 per share. O’Hagan then sold his Pillsbury call options and common stock, making a profit of more than $ 4.3 million. Following a SEC investigation, O’Hagan was indicted on various charges. The most pertinent charges for our purposes are: (1) O’Hagan violated 1934 Act Section 10(b) and Rule 10b-5 by trading on misappropriated nonpublic information; and (2) O’Hagan violated 1934 Act Rule 14e-3 by trading while in possession of nonpublic information relating to a tender offer. The Supreme Court upheld O’Hagan’s conviction on both counts. With respect to the misappropriation charge, the Court validated the theory as being designed to ‘protect the integrity of the securities markets

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against abuses by “outsiders” to a corporation who have access to confidential information that will affect the corporation’s security price when revealed, but who owe no fiduciary or other duty to that corporation’s shareholders’.

B. The Argument for Deregulation Henry Manne’s book Insider Trading and the Stock Market must be ranked among the truly seminal events in the economic analysis of corporate law (Manne, 1966a). It is only a slight exaggeration to suggest that Manne stunned the corporate law academy by daring to propose the deregulation of insider trading. The traditionalists’ response was immediate and vitriolic (see, for example, Schotland, 1967; Mendelson, 1969; see also Manne, 1970). In the long run, however, Manne’s daring was vindicated in at least one important respect. Although it is hard to believe at this remove, corporate law was regarded as moribund during much of the middle part of this century. Manne’s work on insider trading played a major role in ending that long intellectual drought by stimulating interest in economic analysis of corporate law. Whether one agrees with Manne’s views on insider trading or not, one must give him due credit for helping to stimulate the outpouring of important law and economics scholarship in corporate law and securities regulation during the 1980s and 1990s. Manne identified two principal ways in which insider trading benefits society and/or the firm in whose stock the insider traded. First, he argued that insider trading causes the market price of the affected security to move toward the price that the security would command if the inside information were publicly available. If so, both society and the firm benefit through increased price accuracy. Second, he posited insider trading as an efficient way of compensating managers for having produced information. If so, the firm benefits directly (and society indirectly) because managers have a greater incentive to produce additional information of value to the firm.

6. The Effect of Insider Trading on the Price of Securities There is general agreement that both firms and society benefit from accurate pricing of securities. The ‘correct’ price of a security is that which would be set by the market if all information relating to the security had been publicly disclosed. Accurate pricing benefits society by improving the economy’s allocation of capital investment and by decreasing the volatility of security prices. This dampening of price fluctuations decreases the likelihood of individual windfall gains and increases the attractiveness of investing in

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securities for risk-averse investors. The individual corporation also benefits from accurate pricing of its securities through reduced investor uncertainty and improved monitoring of management’s effectiveness. Although US securities laws purportedly encourage accurate pricing by requiring disclosure of corporate information, they do not require the disclosure of all material information. Where disclosure would interfere with legitimate business transactions, disclosure by the corporation is usually not required unless the firm is dealing in its own securities at the time. When a firm lawfully withholds material information, its securities are no longer accurately priced by the market. If the undisclosed information is particularly significant, the error in price can be substantial. In the famous Texas Gulf Sulphur case, for example, TGS discovered an enormously valuable mineral deposit in Canada. When the deposit was discovered, TGS common stock sold for approximately $18 per share. By the time the discovery was disclosed, four months later, the price had risen to over $31 per share. One month after disclosure, the stock was selling for approximately $58 per share (SEC v. Texas Gulf Sulphur Co.). Pricing errors of this magnitude eliminate the benefits of accurate pricing. However, requiring TGS to disclose what it knew would have reduced the value of the information and thus the incentive to discover it. Manne essentially argued insider trading is an effective compromise between the need for preserving incentives to produce information and the need for maintaining accurate securities prices. Manne offered the following example of this alleged effect: A firm’s stock currently sells at $50 per share. The firm has discovered new information that, if publicly disclosed, would cause the stock to sell at $60. If insiders trade on this information, the price of the stock will gradually rise toward but will not reach the ‘correct’ price. Absent insider trading or leaks, the stock’s price will remain at $50 until the information is publicly disclosed and then rapidly rise to the correct price of $60. Thus, insider trading acts as a replacement for public disclosure of the information, preserving market gains of correct pricing while permitting the corporation to retain the benefits of nondisclosure (Manne, 1966a, pp. 80-90) Texas Gulf Sulphur provides anecdotal evidence for this effect. The TGS insiders began active trading in its stock almost immediately after discovery of the ore deposit. During the four months between discovery and disclosure, the price of TGS common stock gradually rose by over $12. Arguably, this price increase was due to inside trading. In turn, the insiders’ profits were the price society paid for obtaining the beneficial effects of enhanced market efficiency. Despite this and similar anecdotes, empirical justification for the deregulatory position remains scanty. Early market studies indicated insider trading had an insignificant effect on price in most cases (Schotland, 1967, p. 1443). Subsequent studies suggested the market reacts fairly quickly when

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insiders buy securities, but the initial price effect is small when insiders sell (Finnerty, 1976). In an important study, Givoly and Palmon (1985) found that while transactions by insiders were followed by a strong price effect, identifiable insider transactions were only rarely based on exploitation of nonpublic information. If they are correct, then the market efficiency rationale for deregulation loses much of its force: insider trading simply is not communicating inside information to the market. These and similar studies are problematic, however, because they relied principally (or solely) on the transactions reports corporate officers, directors, and 10 percent shareholders are required to file under §16(a). Because insiders are unlikely to report transactions that violate rule 10b-5, and because much illegal insider trading activity is known to involve persons not subject to the §16(a) reporting requirement, conclusions drawn from such studies may not tell us very much about the price and volume effects of illegal insider trading. Accordingly, it is significant that a more recent and widely-cited study of insider trading cases brought by the SEC during the 1980s found that the defendants’ insider trading led to quick price changes (Meulbroek, 1992). That result supports Manne’s empirical claim, subject to the caveat that reliance on data obtained from SEC prosecutions arguably may not be conclusive as to the price effects of undetected insider trading due to selection bias, although Meulbroek’s study addressed that concern by segmenting the sample into subsets, one of which was less likely to be contaminated by selection bias, and finding that the results did not differ significantly across the subsets. Finally, the SEC’s chief economist has reached the perhaps debatable conclusion that pre-announcement price and volume run-ups in takeovers are most likely attributable to factors other than insider trading (Rosenbaum and Bainbridge, 1988, p. 235). In theory, of course, the supply/demand effects of insider trading should have only a minimal impact on the affected security’s price. A given security ‘represents only a particular combination of expected return and systematic risk, for which there is a vast number of substitutes’ (Gilson and Kraakman, 1984, p. 630). The correct measure for the supply of securities is not simply the total of the firm’s outstanding securities, but the vastly larger number of securities with a similar combination of risk and return. Therefore, the supply/demand effect of a relatively small number of insider trades should not have a significant price effect. The price effect of undisclosed insider trading is an example of what Gilson and Kraakman (1984, p. 630) call the ‘derivatively informed trading mechanism’ of market efficiency. Derivatively informed trading affects market prices through a two-step mechanism. First, those individuals possessing material nonpublic information begin trading. Their trading has only a small effect on price. Some uninformed traders become aware of the insider trading

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through leakage or tipping of information or through observation of insider trades. Other traders gain insight by following the price fluctuations of the securities. Finally, the market reacts to the insiders’ trades and gradually moves toward the correct price. The problem is that while derivatively informed trading can affect price, it functions slowly and sporadically. Given the inefficiency of derivatively informed trading, the market efficiency justification for insider trading loses much of its force.

7. Insider Trading as an Efficient Compensation Scheme Even Manne (1966a, p. 110) admitted that price effect is not a strong argument against a bar on insider trading. Instead, Manne’s deregulatory argument rested mainly on the claim that allowing insider trading was an effective means of compensating entrepreneurs in large corporations. Manne (1966b, p. 116) distinguished corporate entrepreneurs from mere corporate managers. The latter simply operate the firm according to predetermined guidelines. Because the firm and the manager know what the manager will do and what his abilities are, salary is an appropriate method of compensation. By contrast, an entrepreneur’s contribution to the firm consists of producing new valuable information. The entrepreneur’s compensation must have a reasonable relation to the value of his contribution to give him incentives to produce more information. Because it is rarely possible to ascertain the information’s value to the firm in advance, predetermined compensation, such as salary, is inappropriate for entrepreneurs.

8. Insider Trading as Entrepreneurial Compensation Manne (1966a, pp. 116-119) asserted insider trading is an effective way to compensate corporate agents for innovations. The increase in the price of the security following public disclosure provides an imperfect but comparatively accurate measure of the value of the innovation to the firm. The entrepreneur can recover the value of his discovery through buying the firm’s securities prior to disclosure and selling them after the price rises. (Manne, 1970) later implicitly retreated from the distinction between entrepreneurs and managers, which vitiated some of the criticisms directed at his thesis. Because Manne did not retreat from the more general claim that insider trading was an efficient compensation scheme, most of the criticisms discussed in the next section remained viable.) Carlton and Fischel (1983, pp. 869-871) suggested a further refinement of Manne’s compensation argument. They likewise believed advance payment

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contracts fail to compensate agents for innovations. The firm could renegotiate these contracts later to account for innovations, but renegotiation is costly and thus may not occur frequently enough to provide appropriate incentives for entrepreneurial activity. Carlton and Fischel suggested that one of the advantages of insider trading is that an agent revises his compensation package without renegotiating his contract. By trading on the new information, the agent self-tailors his compensation to account for the information he produces, increasing his incentive to develop valuable innovations. Because insider trading provides the agent with more certainty of reward than other compensation schemes, it also provides more incentives.

9. Evaluating the Compensation Thesis In evaluating compensation-based justifications for deregulating inside trading, it is crucial to determine whether the corporation or the manager owns the property right to the information in question. Some of those who favor deregulating insider trading deny that the property rights of firms to information produced by their agents include the right to prevent the manager from trading on the basis of that information. In contrast, those who favor regulation contend that when an agent produces information the property right to that information belongs to the principal. Where the property right to agent-produced information should be assigned is a question deferred to Section 20 below. This section focuses on the contention by those who favor regulating insider trading that it is an inefficient form of compensation. Manne (1966b, pp. 117-119) rejected contractual and bonus forms of compensation as inadequate incentives for entrepreneurial inventiveness on the ground that they fail to accurately measure the value of the innovation to the firm. Some contend, however, that insider trading is not any more accurate. They assert, for example, that even assuming the change in stock price accurately measures the value of the innovation, the insider’s compensation is limited by the number of shares he can purchase. This, in turn, is limited by his wealth. As such, the insider’s trading returns are based not on the value of his contribution, but on his wealth. Another objection to the compensation argument is the difficulty of restricting trading to those who produced the information. Where information is concerned, production costs normally exceed distribution costs. As such, many firm agents may trade on the information without having contributed to its production. A related objection is the difficulty of limiting trading to instances in which the insider actually produced valuable information. In particular, why should

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insiders be permitted to trade on bad news? Allowing managers to inside trading reduces the penalties associated with a project’s failure because trading managers can profit whether the project succeeds or fails. If the project fails, the manager can sell his shares before that information becomes public and thus avoid an otherwise certain loss. The manager can go beyond mere loss avoidance into actual profitmaking by short selling the firm’s stock. Easterbrook (1981) focused on the contingent nature of insider trading as a ground for rejecting compensation-based arguments. Because the agents trading returns cannot be measured in advance, neither can the true cost of his reward. As a result, selection of the most cost-effective compensation package is made more difficult. Moreover, the agent himself may prefer a less uncertain compensation package. If an agent is risk averse, he will prefer the certainty of $100,000 salary to a salary of $50,000 and a 10 percent chance of a bonus of $500,000 from insider trading. Thus, the shareholders and the agent would gain by exchanging a guaranteed bonus for the agents promise not to trade on inside information (see also Levmore, 1982). As with the market efficiency argument, little empirical evidence supports or counters the compensation argument. The only useful empirical evidence is Givoly and Palmon’s (1985) finding that while insiders do earn abnormal returns from trading in their firm’s securities, these abnormal returns are based on the insiders’ superior assessment of their firm’s status and not on exploitation of inside information. If so, the compensation argument rests on fundamentally flawed assumptions.

10. Public Choice Some critics of the insider trading prohibition contend that the prohibition can be explained by a public choice-based model of regulation in which rules are sold by regulators and bought by the beneficiaries of the regulation. This section focuses on slightly different, but wholly compatible, stories about insider trading told by Dooley (1980) and Haddock and Macey (1987). One explains why the SEC wanted to sell insider trading regulation, while the other explains to whom it has been sold.

11. The Sellers’ Story Dooley (1980) explained the federal insider trading prohibition as the culmination of two distinct trends in the securities laws. First, as do all government agencies, the SEC desired to enlarge its jurisdiction and enhance

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its prestige. Administrators can maximize their salaries, power and reputation by maximizing the size of their agency’s budget. A vigorous enforcement program directed at a highly visible and unpopular law violation is surely an effective means of attracting political support for larger budgets. Given the substantial media attention directed towards insider trading prosecutions, and the public taste for prohibiting insider trading, it provided a very attractive subject for such a program. Second, during the prohibition’s formative years, there was a major effort to federalize corporation law. In order to maintain its budgetary priority over competing agencies, the SEC wanted to play a major role in federalizing matters previously within the state domain. Regulating insider trading was an ideal target for federalization. Rapid expansion of the federal insider trading prohibition purportedly demonstrated the superiority of federal securities law over state corporate law. Because the states had shown little interest in insider trading for years, federal regulation demonstrated the modernity, flexibility and innovativeness of the securities laws. The SEC’s prominent role in attacking insider trading thus placed it in the vanguard of the movement to federalize corporate law and ensured that the SEC would have a leading role in any system of federal corporations law.

12. The Buyers’ Story Haddock and Macey (1987) argue that the insider trading prohibition is supported and driven in large part by market professionals, a cohesive and politically powerful interest group, which the current legal regime effectively insulates from insider trading liability (see also Macey, 1991). Only insiders and quasi-insiders such as lawyers and investment bankers have a greater degree of access to nonpublic information that might affect a firm’s stock price than do market professionals. By basing insider trading liability on breach of fiduciary duty, and positing that the requisite fiduciary duty exists with respect to insiders and quasi-insiders but not with respect to market professionals, the prohibition protects the latter’s ability to profit from new information about a firm. Market professionals benefit in a variety of ways from the present ban. When an insider trades on an impersonal secondary market, the insider takes advantage of the fact that the market maker’s or specialist’s bid-ask prices do not reflect the value of the inside information. Because market makers and specialists cannot distinguish insiders from non-insiders, they cannot protect themselves from being taken advantage of in this way. When trading with insiders, the market maker or specialist thus will always be on the wrong side of the transaction. If insider trading is effectively prohibited, however, the

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market professionals are no longer exposed to this risk. Professional securities traders likewise profit from the fiduciary duty-based insider trading prohibition. Because professional investors are often active traders, they are highly sensitive to the transaction costs of trading in securities. Prominent among these costs is the specialist’s and market-maker’s bid-ask spread. If a ban on insider trading lowers the risks faced by specialists and market makers, some portion of the resulting gains should be passed on to professional traders in the form of narrower bid-ask spreads. Analysts and traders are further benefited by a prohibition on insider trading, because only insiders are likely to have systematic advantages over market professionals in the competition to be the first to act on new information. Market professionals specialize in acquiring and analyzing information. They profit by trading with less well-informed investors or by selling information to them. If insiders can freely trade on nonpublic information, however, some portion of the information’s value will be impounded into the price before it is learned by market professionals, which will reduce their returns (Haddock and Macey, 1987). Circumstantial evidence for Haddock and Macey’s thesis is provided by SEC enforcement patterns. The frequency of insider trading prosecutions rose dramatically after the US Supreme Court’s decision in Chiarella v. U.S., 445 U.S. 222 (1980), which held that insider trading is only unlawful if the trader violated a fiduciary duty owed to the party with whom he trades. Strikingly, however, in the years immediately prior to Chiarella, enforcement proceedings often targeted market professionals. After Chiarella, market professionals were rarely charged (Dooley, 1995, pp. 832-834).

C. The Argument for Regulation Efficiency-based arguments for regulating insider trading (as opposed to those grounded on legislative intent, equity, or fairness) fall into three main categories: (1) insider trading harms investors and thus undermines investor confidence in the securities markets; (2) insider trading harms the issuer of the affected securities; and (3) insider trading amounts to theft of property belonging to the corporation and therefore should be prohibited even in the absence of harm to investors or the firm. This section considers these arguments seriatim.

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13. Does Insider Trading Injure Investors? Insider trading is said to harm the investor in two principal ways. Some contend that the investor’s trades are made at the ‘wrong price’. A more sophisticated theory posits that the investor is induced to make a bad purchase or sale. Neither argument proves convincing on close examination. An investor who trades in a security contemporaneously with insiders having access to material nonpublic information likely will allege injury in that he sold at the wrong price; that is, a price that does not reflect the undisclosed information. If a firm’s stock currently sells at $10 per share, but after disclosure of the new information will sell at $15, a shareholder who sells at the current price thus will claim a $5 loss. The investor’s claim, however, is fundamentally flawed. It is purely fortuitous that an insider was on the other side of the transaction. The gain corresponding to shareholder’s ‘loss’ is reaped not just by inside traders, but by all contemporaneous purchasers whether they had access to the undisclosed information or not (Bainbridge, 1986, p. 59). To be sure, the investor might not have sold if he had had the same information as the insider, but even so the rules governing insider trading are not the source of his problem. The information asymmetry between insiders and public investors arises out of the federal securities laws’ mandatory disclosure rules, which allow firms to keep some information confidential even if it is material to investor decision making. Unless immediate disclosure of material information is to be required, a step the law has been unwilling to take, there will always be winners and losers in this situation. Irrespective of whether insiders are permitted to inside trade or not, the investor will not have the same access to information as the insider. It makes little sense to claim that the shareholder is injured when his shares are bought by an insider, but not when they are bought by an outsider without access to information. To the extent the selling shareholder is injured, his injury thus is correctly attributed to the rules allowing corporate nondisclosure of material information, not to insider trading. A more sophisticated argument is that the price effects of insider trading induce shareholders to make poorly advised transactions. In light of the evidence and theory recounted above in Section 6, however, it is doubtful whether insider trading produces the sort of price effects necessary to induce shareholders to trade. While derivatively informed trading can affect price, it functions slowly and sporadically (Gilson and Kraakman, 1984, p. 631). Given the inefficiency of derivatively informed trading, price or volume changes resulting from insider trading will only rarely be of sufficient magnitude to induce investors to trade. Assuming for the sake of argument that insider trading produces noticeable price effects, however, and further assuming that some investors are misled by

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those effects, the inducement argument is further flawed because many transactions would have taken place regardless of the price changes resulting from insider trading. Investors who would have traded irrespective of the presence of insiders in the market benefit from insider trading because they transacted at a price closer to the ‘correct’ price; that is, the price that would prevail if the information were disclosed (Dooley, 1980, pp. 35-36; Manne, 1966b, p. 114). In any case, it is hard to tell how the inducement argument plays out when investors are examined as a class. For any given number who decide to sell because of a price rise, for example, another group of investors may decide to defer a planned sale in anticipation of further increases.

14. Does Insider Trading Undermine Investor Confidence? In the absence of a credible investor injury story, it is difficult to see why insider trading should undermine investor confidence in the integrity of the securities markets. Instead, any anger investors feel over insider trading appears to arise mainly from envy of the insider’s greater access to information. The loss of confidence argument is further undercut by the stock market’s performance since the insider trading scandals of the mid-1980s. The enormous publicity given those scandals put all investors on notice that insider trading is a common securities violation. At the same time, however, the years since the scandals have been one of the stock market’s most robust periods. One can but conclude that insider trading does not seriously threaten the confidence of investors in the securities markets. Macey (1991, p. 44) contends that the experience of other countries confirms this conclusion. For example, Japan only recently began regulating insider trading and its rules are not enforced. The same appears to be true of India. Hong Kong has repealed its insider trading prohibition. Both have vigorous and highly liquid stock markets.

15. Does Insider Trading Injure Issuers? Unlike tangible property, information can be used by more than one person without necessarily lowering its value. If a manager who has just negotiated a major contract for his employer then trades in his employer’s stock, for example, there is no reason to believe that the managers conduct necessarily lowers the value of the contract to the employer. But while insider trading will not always harm the employer, it may do so in some circumstances. Specifically, there are four significant potential harms connected with insider

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trading that are worth considering. First, insider trading may delay the transmission of information or the taking of corporate action. Second, it may impede corporate plans. Third, it gives managers an incentive to manipulate stock prices. Finally, it may injure the firm’s reputation.

16. Delay Insider trading becomes a plausible source of injury to the firm if it creates incentives for managers to delay the transmission of information to superiors. Decision making in any entity requires accurate, timely information. In large, hierarchical organizations, such as publicly traded corporations, information must pass through many levels before reaching senior managers. The more levels, the greater the probability of distortion or delay intrinsic to the system. This inefficiency can be reduced by downward delegation of decision making authority, but not eliminated. Even with only minimal delay in the upward transmission of information at every level, where the information must pass through many levels before reaching a decision maker, the net delay may be substantial. If a manager discovers or obtains information (either beneficial or detrimental to the firm), he may delay disclosure of that information to other managers so as to assure himself sufficient time to trade on the basis of that information before the corporation acts upon it. As noted, even if the period of delay by any one manager is brief, the net delay produced by successive trading managers may be substantial (see Haft, 1982, pp. 1053-1060; but see Macey, 1991, pp. 36-37). Unnecessary delay of this sort harms the firm in several ways. The firm must monitor the manager’s conduct to ensure timely carrying out of his duties. It becomes more likely that outsiders will become aware of the information through snooping or leaks (Easterbrook, 1981). Some outsider may even independently discover and utilize the information before the corporation acts upon it. Although delay is a plausible source of harm to the issuer, its importance is easily exaggerated. The available empirical evidence scarcely rises above the anecdotal level, but does suggest that measurable delay attributable to insider trading is rare (Dooley, 1980, p. 34). Given the rapidity with which securities transactions can be conducted in modern secondary trading markets, moreover, a manager need at most delay corporate action long enough for a five minute telephone conversation with his stockbroker. Even if the manager wished to cover his tracks by trading through an elaborate network of off-shore shell corporations, very little delay is entailed once the network is up and running. Delay (either in transmitting information or taking action) also often will be readily detectible by the employer. Finally, and perhaps most importantly,

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insider trading may create incentives to release information early just as often as it creates incentives to delay transmission and disclosure of information.

17. Interference with Corporate Plans Trading during the planning stage of an acquisition is the paradigm example of how insider trading may affect corporate plans. If the managers charged with overseeing the acquisition buy shares in the target, the price of the target’s shares may rise, making the takeover more expensive. Price and volume changes caused by their trading also might tip off others to the secret, interfering with the bidder’s plans, as by alerting the target to the need for defensive measures. The trouble with this argument, of course, is its dependence upon price and volume effects. As the theory and empirical evidence recounted above in Section 6 suggest, price or volume changes resulting from insider trading may raise the marginal cost of corporate plans but will only rarely pose significant obstacles to carrying corporate plans forward. The risk of premature disclosure poses a more serious threat to corporate plans. The issuer often has just as much interest in when information becomes public as it does in whether the information becomes public. Suppose Target, Inc., enters into merger negotiations with a potential acquirer. Target managers who inside trade on the basis of that information will rarely need to delay corporate action in order to effect their purchases. Having made their purchases, however, the managers now have an incentive to cause disclosure of Target’s plans as soon as possible. Absent leaks or other forms of derivatively informed trading, the merger will have no price effect until it is disclosed to the market, at which time there usually is a strong positive effect. Once the information is disclosed, the trading managers will be able to reap substantial profits, but until disclosure takes place, they bear a variety of firm-specific and market risks. The deal, the stock market, or both may collapse at any time. Early disclosure enables the managers to minimize those risks by selling out as soon as the price jumps in response to the announcement. If disclosure is made too early, a variety of adverse consequences may result. If disclosure triggers competing bids, the initial bidder may withdraw from the bidding or demand protection in the form of costly lock-ups and other exclusivity provisions. Alternatively, if disclosure does not trigger competing bids, the initial bidder may conclude that it overbid and lower its offer accordingly. In addition, early disclosure brings the deal to the attention of regulators and plaintiffs’ lawyers sooner than necessary. An even worse case scenario is suggested by the classic insider trading case, SEC v. Texas Gulf Sulphur Co. In TGS, insiders who knew of a major ore

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discovery traded over an extended period of time. During that period the corporation was attempting to buy up the mineral rights to the affected land. Had the news leaked prematurely, the issuer at least would have had to pay much higher fees for the mineral rights, and may well have lost some land to competitors. Given the magnitude of the strike, which eventually resulted in a 300-plus percent increase in the firm’s market value, the harm that would have resulted from premature disclosure was immense. Although insider trading probably only rarely causes the firm to lose opportunities, it may create incentives for management to alter firm plans in less drastic ways to increase the likelihood and magnitude of trading profits. For example, trading managers can accelerate receipt of revenue, change depreciation strategy, or alter dividend payments in an attempt to affect share prices and insider returns (Brudney, 1979). Alternatively, the insiders might structure corporate transactions to increase the opportunity for secret-keeping. Both types of decisions may adversely affect the firm and its shareholders. Moreover, as Levmore (1982, p. 149) suggests, this incentive may result in allocative inefficiency by encouraging overinvestment in those industries or activities that generate opportunities for insider trading. Easterbrook (1981, p. 332) identifies a related perverse incentive created by insider trading. Managers may elect to follow policies that increase fluctuations in the price of the firm’s stock. ‘They may select riskier projects than the shareholders would prefer, because if the risks pay off they can capture a portion of the gains in insider tradings and, if the project flops, the shareholders bear the loss.’ In contrast, Carlton and Fischel (1983, pp. 874-876) assert that Easterbrook overstates the incentive to choose high-risk projects. Because managers must work in teams, the ability of one or a few managers to select high-risk projects is severely constrained through monitoring by colleagues. Cooperation by enough managers to pursue such projects to the firm’s detriment is unlikely because a lone whistle-blower is likely to gain more by exposing others than he will by colluding with them. Further, Carlton and Fischel argue managers have strong incentives to maximize the value of their services to the firm. Therefore they are unlikely to risk lowering that value for short-term gain by adopting policies detrimental to long-term firm profitability. Finally, Carlton and Fischel alternatively argue that even if insider trading creates incentives for management to choose high-risk projects, these incentives are not necessarily harmful. Such incentives would act as a counterweight to the inherent risk aversion that otherwise encourages managers to select lower risk projects than shareholders would prefer. Carlton and Fischel are correct that shareholders may prefer higher-risk projects. Because shareholders hold residual claims, they will prefer that the firm invest in projects with a significant upside potential. This is true even if

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such ventures pose a substantial risk because shareholders earn no return until all prior claims are paid. However, shareholders would not approve high-risk projects where the increased risk is not matched by a commensurate increase in potential return. Allowing insider trading may encourage management to select negative net present value investments, not only because shareholders bear the full risk of failure, but also because failure presents management with an opportunity for profit through short-selling. As a result, shareholders might prefer other incentive schemes.

18. Manipulation Manipulation of stock prices, as a form of fraud, harms both society and individuals by decreasing the accuracy of pricing by the market. Some of those who favor regulation of insider trading argue that if managers are permitted to trade on inside information they have a strong interest in keeping the stock pricing stable or in moving it in the correct direction while they are trading. Therefore, they have a strong incentive to use manipulative practices (see, for example, Schotland, 1967, pp. 1449-1450). Manne (1970, p. 575) acknowledged that manipulation is harmful and that manipulation of stock prices would cease if insider trading could be effectively eliminated because nobody would then benefit from it. Manne’s principal response to the manipulation argument is not that it is wrong, but that the costs of producing perfect compliance with a prohibition against insider trading are unacceptably high. Like most arguments in this debate, the thrust of the manipulation rationale depends on whose estimate of the costs is correct.

19. Injury to Reputation Suppose that insider trading was shown to harm not the issuer, but the issuer’s shareholders. It has been said that insider trading by corporate managers may ‘cast a cloud on the corporation’s name, injure stockholder relations and undermine public regard for the corporation’s securities’ (Diamond v. Oreamuno; compare Macey, 1984, pp. 42-43; discussing threat of reputational injury posed for the Wall Street Journal when one of its reporters traded on confidential information. But see Freeman v. Decio, arguing that injury to reputation is ‘speculative’.) Reputational injury of this sort translates into direct financial injury, by raising the firm’s cost of capital, if investors demand a premium (by paying less) when buying stock in a firm whose managers inside trade.

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Because shareholder injury is a critical underlying premise of the reputational injury story, however, this argument would appear to collapse at the starting gate. As we have seen, it is very hard to create a plausible shareholder injury story. As such, the reputational injury story must turn to more generalized notions of fairness. At this stage in the analysis, virtually all commentators make one of two moves. One group tries to find sources of unfairness unrelated to the question of shareholder injury, while the other simply asserts that insider trading is not unfair absent a credible story of investor injury. The former move fails. As Bainbridge (1986, pp. 56-61) argues, insider trading is not unfair to investors in any meaningful sense of the term (see also Easterbrook, 1981, pp. 323-330; Macey, 1991, pp. 23-31). Some contend that the latter move also fails precisely because most people do not examine the problem dispassionately. Even though insider trading is not actually unfair, the reputational injury story may remain viable if most investors believe it to be unfair. This perception of unfairness most likely proceeds from resentment of the insider’s informational advantage, which suggests that it may be based on envy as much as on fairness norms. As an advertising slogan once put it, however, image is everything. If one’s definition of efficiency takes into account seemingly irrational preferences, perhaps a prohibition of insider trading can be justified as a means of avoiding this sort of reputational injury. Whether efficiency should include such preferences is a question beyond the scope of this essay. Assuming the validity of the reputational injury story, arguendo, the reputational impact of insider trading probably is minimal in most cases. The principal problem is the difficulty investors have in distinguishing those firms in which insider trading is frequent from those in which it is infrequent. If they are unable to do so, individual firms are unlikely to suffer a serious reputational injury in the absence of a truly major scandal.

20. Insider Trading as Theft: A Property Rights Analysis There is an emerging consensus that the federal insider trading prohibition is most easily justified as a means of protecting property rights in information (see, for example, U.S. v. Chestman; Bainbridge, 1993, pp. 21-23; Dooley, 1995, pp. 820-823; Easterbrook, 1981; Macey, 1984). For an argument that the property rights approach has explanatory as well as justificatory power, see Bainbridge (1995, pp. 1256-1257). In contrast, for a vociferous critique of the law and economics literature on insider trading generally and the property rights approach in particular, see Karmel (1993).

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There are essentially two ways of creating property rights in information: allow the owner to enter into transactions without disclosing the information or prohibit others from using the information. In effect, the federal insider trading prohibition vests a property right of the latter type in the party to whom the insider trader owes a fiduciary duty to refrain from self-dealing in confidential information. To be sure, at first blush, the insider trading prohibition admittedly does not look very much like most property rights. Enforcement of the insider trading prohibition admittedly differs rather dramatically from enforcement of, say, trespassing laws. The existence of property rights in a variety of intangibles, including information, however, is well-established. Trademarks, copyrights, and patents are but a few of the better-known examples of this phenomenon. In context, moreover, even the insider trading prohibition’s enforcement mechanisms are not inconsistent with a property rights analysis. Where public policy argues for giving someone a property right, but the costs of enforcing such a right would be excessive, the state often uses its regulatory powers as a substitute for creating private property rights. Insider trading poses just such a situation. Private enforcement of the insider trading laws is rare and usually parasitic on public enforcement proceedings (Dooley, 1980, pp. 15-17). Indeed, the very nature of insider trading arguably makes public regulation essential precisely because private enforcement is almost impossible. The insider trading prohibition’s regulatory nature thus need not preclude a property rights-based analysis. The rationale for prohibiting insider trading is precisely the same as that for prohibiting patent infringement or theft of trade secrets: protecting the economic incentive to produce socially valuable information. (An alternative approach is to ask whether the parties, if they had bargained over the issue, would have assigned the property right to the corporation or the inside trader. For a hypothetical bargain-based argument that the property right would be assigned to the corporation in the lawyer-corporate client context, see Bainbridge (1993, pp. 27-34).) As the theory goes, the readily appropriable nature of information makes it difficult for the developer of a new idea to recoup the sunk costs incurred to develop it. If an inventor develops a better mousetrap, for example, he cannot profit on that invention without selling mousetraps and thereby making the new design available to potential competitors. Assuming both the inventor and his competitors incur roughly equivalent marginal costs to produce and market the trap, the competitors will be able to set a market price at which the inventor likely will be unable to earn a return on his sunk costs. Ex post, the rational inventor should ignore his sunk costs and go on producing the improved mousetrap. Ex ante, however, the inventor will anticipate that he will be unable to generate positive returns on his up-front costs and therefore will be deterred

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from developing socially valuable information. Accordingly, society provides incentives for inventive activity by using the patent system to give inventors a property right in new ideas. By preventing competitors from appropriating the idea, the patent allows the inventor to charge monopolistic prices for the improved mousetrap, thereby recouping his sunk costs. Trademark, copyright, and trade secret law all are justified on similar grounds. This argument does not provide as compelling a justification for the insider trading prohibition as it does for the patent system. A property right in information should be created when necessary to prevent conduct by which someone other than the developer of socially valuable information appropriates its value before the developer can recoup his sunk costs. Insider trading, however, often does not affect an idea’s value to the corporation and probably never entirely eliminates its value. Legalizing insider trading thus would have a much smaller impact on the corporation’s incentive to develop new information than would, say, legalizing patent infringement. The property rights approach nevertheless has considerable justificatory power. Consider the prototypical insider trading transaction, in which an insider trades in his employer’s stock on the basis of information learned solely because of his position with the firm. There is no avoiding the necessity of assigning the property right to either the corporation or the inside trader. A rule allowing insider trading assigns the property right to the insider, while a rule prohibiting insider trading assigns it to the corporation. From the corporation’s perspective, we have seen that legalizing insider trading would have a relatively small effect on the firm’s incentives to develop new information. In some cases, however, insider trading will harm the corporation’s interests and thus adversely affect its incentives in this regard. This argues for assigning the property right to the corporation, rather than the insider. Those who rely on a property rights-based justification for regulating insider trading also observe that creation of a property right with respect to a particular asset typically is not dependent upon there being a measurable loss of value resulting from the asset’s use by someone else. Indeed, creation of a property right is appropriate even if any loss in value is entirely subjective, both because subjective valuations are difficult to measure for purposes of awarding damages and because the possible loss of subjective values presumably would affect the corporation’s incentives to cause its agents to develop new information. As with other property rights, the law therefore should simply assume (although the assumption will sometimes be wrong) that assigning the property right to agent-produced information to the firm maximizes the social incentives for the production of valuable new information.

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Because the relative rarity of cases in which harm occurs to the corporation weakens the argument for assigning it the property right, however, the critical issue may be whether one can justify assigning the property right to the insider. On close examination, the argument for assigning the property right to the insider is considerably weaker than the argument for assigning it to the corporation. As we have seen, some have argued that legalized insider trading would be an appropriate compensation scheme. In other words, society might allow insiders to inside trade in order to give them greater incentives to develop new information. As we have also seen, however, this argument appears to founder on grounds that insider trading is an inefficient compensation scheme. Even assuming that the change in stock price that results once the information is released accurately measures the value of the innovation, the insider’s trading profits are not correlated to the value of the information. This is so because his trading profits are limited not by the value of the information, but by the amount of shares the insider can purchase, which in turn depends mainly upon his ex ante wealth or access to credit. A second objection to the compensation argument is the difficulty of restricting trading to those who produced the information. The costs of producing information normally are much greater than the costs of distributing it. Thus, many firm employees may trade on the information without having contributed to its production. The third objection to insider trading as compensation is based on its contingent nature. If insider trading were legalized, the corporation would treat the right to inside trade as part of the manager’s compensation package. Because the manager’s trading returns cannot be measured ex ante, however, the corporation cannot ensure that the manager’s compensation is commensurate with the value of her services. The economic theory of property rights in information thus cannot justify assigning the property right to insiders rather than to the corporation. Because there is no avoiding the necessity of assigning the property right to the information in question to one of the relevant parties, the argument for assigning it to the corporation therefore should prevail.

D. Open Questions If the property rights justification for regulating insider trading is accepted, several questions remain open. Among these are: (1) Should the insider trading prohibition apply to all confidential information relating to the firm, or only to information whose use by an insider poses some serious threat of injury to the corporation? (2) Should the insider trading regulatory scheme consist of a

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mandatory prohibition or a default rule? (3) In the United States, the regulatory purview of the federal securities laws is normally regarded as being limited to issues of disclosure and fraud. Questions of theft and fiduciary duty are usually relegated to state law. Why is insider trading an exception to that scheme? We consider these questions seriatim.

21. Scope of the Prohibition In Diamond v. Oreamuno the New York (state) Court of Appeals concluded that a shareholder could properly bring a derivative action against corporate officers who had traded in the corporations stock. The court explicitly relied on a property rights-based justification for its holding: ‘The primary concern, in a case such as this, is not to determine whether the corporation has been damaged, but to decide, as between the corporation and the defendants, who has a higher claim to the proceeds derived from exploitation of the information.’ Critics of Diamond have frequently pointed out that the corporation could not have used the information at issue in that case for its own profit. The defendants had sold shares on the basis of inside information about a substantial decline in the firm’s earnings. Once released, the information caused the corporation’s stock price to decline precipitously. The information was thus a historical accounting fact of no value to the corporation. The only possible use to which the corporation could have put this information was by trading in its own stock, which it could not have done without violating the antifraud rules of the federal securities laws. The Diamond case thus rests on an implicit assumption that, as between the firm and its agents, all confidential information about the firm is an asset of the corporation. Critics of Diamond contend that this assumption puts the cart before the horse: the proper question is to ask whether the insiders use of the information posed a substantial threat of harm to the corporation. Only if that question is answered in the affirmative should the information be deemed an asset of the corporation (see, for example, Freeman v. Decio). Proponents of a more expansive prohibition might respond to this argument in two ways. First, they might reiterate that, as between the firm and its agents, there is no basis for assigning the property right to the agent. See above, Section 20. Second, they might focus on the secondary and tertiary costs of a prohibition that encompassed only information whose use posed a significant threat of harm to the corporation. A regime premised on actual proof of injury to the corporation would be expensive to enforce, would provide little certainty or predictability for those who trade, and might provide agents with perverse incentives.

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22. Mandatory or Default Rules For law and economics supporters of the insider trading prohibition, an interesting question is whether the corporate employer should be allowed to authorize its agents to inside trade. Because most property rights are freely alienable, treating confidential information as a species of property suggests that the information’s owner is presumptively entitled to decide whether someone may use it to inside trade. In other words, the insider trading prohibition arguably should be treated as simply a special case of the laws against theft. Another way of phrasing the question is to ask whether the prohibition of insider trading should be a default or a mandatory rule. Default rules in corporate law are analogous to alienable property rights. Just as shareholders generally are protected by the doctrine of limited liability unless they give a personal guarantee of the corporation’s debts, patentholders have exclusive rights to their inventions unless they authorize another’s use by granting a license. Continuing the analogy, mandatory rules in corporate law are comparable to inalienable property rights. Just as corporate law proscribes vote buying, the law prohibits one from selling one’s vote in a presidential election. So phrased, the insider trading problem becomes a subset of one of the fiercest debates in the corporate law academy; namely, the extent to which mandatory rules are appropriate in corporate law. A detailed analysis of this debate is beyond this chapter’s scope. Accordingly, it perhaps suffices to observe that the question of whether the insider trading prohibition should be cast as an alienable or an inalienable property right remains open (see generally Fischel, 1984; Macey, 1984; Ule, 1993).

23. How Should Insider Trading be Regulated? Even among those who agree that insider trading should be regulated on property rights grounds, there is no agreement as to how insider trading should be regulated. Bainbridge (1995, pp. 1262-1266) contends that the federal Securities and Exchange Commission has a comparative advantage in prosecuting insider trading questions, which justifies treating the prohibition as a matter of concern for the federal securities laws. Macey (1991, pp. 40-41) agrees that insider trading is difficult to detect and, moreover, that centralized monitoring of insider trading by the SEC and the self-regulatory organizations within the securities industry may be more efficient than private party efforts to detect insider trading. He nevertheless draws a distinction between SEC monitoring of insider trading and a federal prohibition of insider trading. Macey contends that the SEC should monitor insider trading, but refer detected

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cases to the affected corporation for private prosecution. A third option, favored by some commentators, would be to leave insider trading to state corporate law, just as is done with every other duty of loyalty violation and, accordingly, divest the federal SEC of any regulatory involvement. Although this debate has considerable theoretical interest, it is essentially mooted by the public choice arguments recounted in Section 10 above. There is no constituency that would support repealing the federal insider trading prohibition, while proposals to do so would meet strong opposition from the SEC and its securities industry constituencies that benefit from the current prohibition.

24. Some Suggestions for Further Empirical Research Those who approach the insider trading proposition assuming that the property right to inside information belongs to managers in the absence of a compelling reason for assigning it to firms will necessarily draw different conclusions than those who start out with the opposite assumption. Unfortunately, in the absence of decisive empirical evidence, the insider trading debate turns on who gets to choose the null hypothesis - the proposition that the other side must refute - and on that issue there is unlikely to be agreement. The problem is that serious empirical research on insider trading is obviously impeded by the subject matters illegality. The two principal sources of raw data for US transactions are insider stock transaction reports filed under Securities Act Section 16(a) and case files of actions brought under Securities Exchange Act Rules 10b-5 and 14e-3. The first option is unattractive for two reasons: (1) only a small percentage of individuals with access to inside information are obliged to file under Section 16(a); and (2) it seems unlikely that insiders would knowingly report the most interesting transactions - those that violate Rules 10b-5 or 14e-3. The second option is unattractive because of the potential for selection bias. Many insider trading cases result from computer analysis of stock market activity. As such, empirical studies of SEC case files will be inherently biased towards cases in which insider trading conincident with noticeable price or volume effects. A third option is cross-cultural studies, focusing on stock markets operating in countries where insider trading is either legal or not vigorously prosecuted. One must be careful, of course, to ensure that focusing on only one aspect of cross-cultural comparisons does not invalidate the results. Having said all of that, there remain several areas in which further empirical research might be helpful. First, the data on the price and volume effects of insider trading remain confused. Further research on this issue seems

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warranted. A related area of research would focus on the incentive effects of insider trading by corporate managers. Is there any empirical basis for the compensation argument? Second, it would be helpful to gather better data on the effect of insider trading on investor confidence. Here is one area in which cross-cultural comparisons are both promising and yet fraught with danger. As Macey (1991, p. 44) observes, Japan only recently began regulating insider trading and its rules are not enforced. Hong Kong has repealed its insider trading prohibition. Yet, both have vigorous and highly liquid stock markets. The question is to what extent the Japanese and Hong Kong experiences are relevant to an understanding of US capital markets. Assuming the validity of such comparisons, however, studying the effects of insider trading regulation (or the lack thereof) on other markets would be instructive with respect to the panoply of questions relating to investor confidence and injury.

Acknowledgments Although any remaining errors are my sole responsibility, I wish to thank Mitu Gulati and William Klein, both Professors of Law at UCLA, Lisa Meulbroek, Associate Professor at the Harvard Business School, and Thomas Ulen, Professor of Law and Economics at the University of Illinois, as well as the two anonymous referees, for helpful comments on earlier drafts. I also wish to thank my research assistant, Bradley Cebeci, for his excellent work in helping to assemble the bibliography.

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Announcements: Theory and Evidence’, 46 Journal of Finance, 1361-1389. John, Kose, John, Teresa and Mishra, Banikanta (1990), ‘Information Content of Insider Trading around Corporate Announcements: The Case of Capital Expenditures’, 45 Journal of Finance, 835-855. Johnson, Dana J., Serrano, Jan M. and Thompson, G. Rodney (1996), ‘Seasoned Equity Offering for New Investment and the Information Content of Insider Trading’, 19 Journal of Financial Research, 91-103. Jun, Meeka (1993), ‘New Capital Markets and Securities Regulations in Hungary: A Comparative Analysis of the Insider Trading Regulations in Hungary and the United States’, 19 Brooklyn Journal of International Law, 1047-1100. Kabir, R. (1990), Security Market Regulation: An Empirical Investigation of Trading Suspension and Insider Trading Restriction, Maastricht, Datawyse. Kabir, R. and Vermaelen, T. (1996), ‘Insider Trading Restrictions and the Stock Market : Evidence from the Amsterdam Stock Exchange’, 40 European Economic Review, 1591-1603. Kahan, Marcel (1992), ‘Securities Laws and the Social Costs of “Inaccurate” Stock Prices’, Duke Law Journal, 977-1044. Karjala, Dennis S. (1982), ‘Statutory Regulation of Insider Trading in Impersonal Markets’, 1982 Duke Law Journal, 627-649. Karmel, Roberta S. (1993), ‘The Relationship Between Mandatory Disclosure and Prohibitions Against Insider Trading: Why a Property Rights Theory of Inside Information is Untenable’, 59 Brooklyn Law Review, 149-174. Kelly, William A., Jr, Nardinelli, Clark and Wallace, Myles S. (1987), ‘Regulation of Insider Trading: Rethinking SEC Policy Rules’, 7 Cato Journal, 441-448. Keown, Arthur J. and Pinkerton, John M. (1981), ‘Merger Announcements and Insider Trading Activity: An Empirical Investigation’, 36 Journal of Finance, 855-869. Kerr, Halbert S. (1980), ‘The Battle of Insider Trading vs. Market Efficiency’, 6 Journal of Portfolio Management, 47-50. Kidd, Ronald F. (1993), ‘Insider Trading: The Misappropriation Theory Versus an ‘Access to Information’ Perspective’, 18 Delaware Journal of Corporate Law, 101-137. King, Raymond D. and O’Keefe, Terrence B. (1986), ‘Lobbying Activities and Insider Trading’, 61 Accounting Review, 76-90. Kitch, Edmund W. (1980), ‘The Law and Economics of Rights in Valuable Information’, 9 Journal of Legal Studies, 683-723. Kitch, Edmund W. (1995), ‘The Theory and Practice of Securities Disclosure’, 61 Brooklyn Law Review, 761 ff. Klein, Spencer Derek (1988), ‘Insider Trading, SEC Decision-Making, and the Calculus of Investor Confidence’, 16 Hofstra Law Review, 665-704. Klock, Mark (1994), ‘Mainstream Economics and the Case for Prohibiting Inside Trading’,10 Georgia State University Law Review, 297-335. Kraakman, Reinier H. (1991), ‘The Legal Theory of Insider Trading Regulation in the United States’, in Hopt, K. and Wymeersch, E. (eds), European Insider Dealing, Butterworths, London, 39-54. Kripke, Homer (1985), ‘Manne’s Insider Trading Thesis and Other Failures of Conservative Economics’, 4 Cato Journal, 945-957. Kyle, Albert S. (1985), ‘Continuous Auctions and Insider Trading’, 53 Econometrica, 1315-1335.

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Cases SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969). Diamond v. Oreamuno, 248 N.E.2d 910, 912 (N.Y. 1969) Freeman v. Decio, 584 F.2d 186, 194 (7th Cir. 1978) Chiarella v. United States, 445 U.S. 222 (1980) U.S. v. Newman, 664 F.2d 12 (2d Cir. 1981) Dirks v. SEC, 463 U.S. 646 (1983) SEC v. Switzer, 590 F. Supp. 756, 766 (W.D. Okla. 1984) SEC v. Materia, 745 F.2d 197 (2d Cir. 1984), cert. denied, 471 U.S. 1053 (1985) U.S. v. Carpenter, 791 F.2d 1024 (2d Cir. 1986) aff’d on other grounds 484 U.S. 19 (1987) U.S. v. Chestman, 947 F.2d 551 (2d Cir. 1991) (en banc), cert. denied, 112 S.Ct. 1759 (1992) U.S. v. Bryan, 58 F.3d 933 (4th Cir. 1995) U.S. v. O’Hagan, 92 F.3d 612 (8th Cir. 1996)

5660 REGULATION OF THE SECURITIES MARKET Edmund W. Kitch Professor University of Virginia Law School © Copyright 1999 Edmund W. Kitch

Abstract Securities regulation is a field that covers the interaction between the law and the securities industry. This includes many different topics, some addressed by some form of public law, some by private law and some by industry agreements, practices and customs. The literature on these numerous different topics is large and diffuse. Two exceptions are the literature on insider trading (Chapter 5650) and on the market for corporate control (Chapter 5640). An unresolved issued is what impact differences in legal regimes governing the securities industry actually have on the behavior of securities markets. The American laws of securities regulation have been viewed as (1) protecting investors, (2) increasing market efficiency, (3) completing organization of the market ‘firm’, (4) capturing wealth for some members of the industry and (5) affecting competition in the industry. The American literature on securities regulation has centered on two themes. One is the role and meaning of efficiency in the context of securities markets and their regulation. The second is the nature of the remedies for fraud or misrepresentations in connection with securities transactions. JEL classification: K22 Keywords: Investors, Firms, Fraud, Misrepresentation, Securities Transactions

1. Introduction There are many different interrelationships between securities markets and the law. For instance, securities are themselves contracts which create property rights. Participants in the securities markets buy and sell securities under the terms of specialized contracts. A principal concern of the law is fraud, deception and manipulation in securities markets, behavior that may be subject to private tort remedies, administrative penalties and criminal sanctions. Private organizations such as exchanges play an important role in organizing securities markets and regulating their participants. Securities markets are subject to some level of supervision and control by a public 813

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office or commission. The contract rights traded on securities markets may be issued by public or private bodies, or they may simply be, as is the case for exchange traded derivatives, obligations of the exchange clearing house itself. Because securities regulation encompasses so many disparate topics, the literature addresses numerous aspects of the legal rules and regulations which apply to the activity of issuing and trading securities without a focus on any particular issues. Two notable exceptions are the extensive literatures on insider trading, covered in Chapter 5650, and on takeovers and the market for corporate control in Chapter 5640. This chapter sketches out other topics related to the regulation of securities markets. The literature on securities regulation is diffuse and unfocused because securities regulation is understood as a field of public law that cuts across every aspect of the securities industry. Issues that in another industry would be private law issues of contract, property or tort, or matters that would be addressed by industry custom or practice, are issues of public law in securities regulation. For instance, the legal response to fraud or misrepresentation is a central preoccupation of the field of securities regulation, but is this response best analyzed and understood as an issue relating to the law’s general response to false statements in different contexts, or is the law of securities fraud a distinctive and different area, with its own unique problems and legal responses? It is interesting to speculate as to why insider trading and the market for corporate control have attracted a much more intensive and focused academic interest. The law of insider trading in securities regulation has presented a distinctive legal response to the issue of the right of persons to act on the basis of the information which they possess. The general approach of the law has been to permit persons to use their own heads for their own advantage. The traditional exceptions have been in the case of narrow categories of confidential, technical or marketing information or in the presence of specific contractual restraints, and then only in the form of private remedies for the person injured by the misuse of the information. In the securities regulation area, the US has pioneered (and exported to the rest of the world) legal rules that have made the use of material non-public information in securities markets a crime, as well as providing administrative sanctions and private remedies. The market for corporate control has attracted attention because it is a device by which the control of important economic institutions can be wrested from one incumbent management and transferred to another. Only because the tender offer procedures used to accomplish this are subject to

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securities regulations is the market for corporate control a securities regulation topic. In any jurisdiction, the law governing the issuance of and trading in securities is a mix of public laws and regulations, requirements of private industry organizations, industry custom and private contractual arrangements. The portion that is generated privately in the form, for instance, of industry agreements, customs and practices, is often difficult for scholars to access. The portion that is generated publicly will be more easily accessible in the form of published laws, regulations and regulatory and judicial decisions, and thus is more likely to be made the subject of academic description and analysis. In all jurisdictions the public portion will, like the part of an iceberg that is above the water, tell only a part of the story. The United States is a jurisdiction that imposed public regulation on securities markets at a relatively early date. In the first part of the twentieth century most states adopted what were called ‘Blue Sky Laws’ which subjected brokers and dealers to public oversight and required that securities be registered with a public agency before they were sold. Then in 1933 and 1934, partly in response to the market crash of 1929 and the ensuing Great Depression, the United States Congress created a national regulatory agency with similar powers. The national securities laws, in turn, have been the subject of a substantial US literature. Most of this literature has been descriptive, but much was at least implicitly normative. All of it assumed, usually implicitly, that markets were regulated in order to produce better economic results. A relatively small portion of the literature has used explicit economic analysis. Thus the line between the ‘law and economics literature’ on securities regulation and the ‘other’ literature on securities regulation is blurred. In recent decades, a central issue for many jurisdictions has been whether or not the US regulation is a desirable normative baseline for reform of the regulation of securities markets. The US consensus view - both academic and as expressed by US political and industry representatives - has been that it does. This view has been adopted to a greater or less extent in many different jurisdictions. The two major non-US markets - the United Kingdom and Japan - have pursued distinctive approaches. The UK in particular has had considerable success in building a London-based global securities market using a regulatory approach that self-consciously rejects many features of the US model. The bibliography that follows this article illustrates the disparate range of topics that can be thought to fall within the economic analysis of securities regulation. The remainder of this entry offers some thoughts on the problem of how to define the field, how to evaluate the regulation, and the present state of the literature.

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2. The Jurisdiction of the US Securities and Exchange Commission One way to delineate the varied topics that fall within securities regulation is simply to describe the matters that are within the jurisdiction of the United States Securities and Exchange Commission. The Securities and Exchange Commission administers the provisions of four securities statutes. The Securities Act of 1933, The Securities Exchange Act of 1934, The Investment Company Act of 1940, the Investment Advisor’s Act of 1940, and the Trust Indenture Act of 1939. The most important and far-reaching of these statutes is the Securities and Exchange Act of 1934, which, among many other things, created the Securities and Exchange Commission as an independent federal agency. The Securities and Exchange Act covers the following aspects of the securities industries. (1) Self-regulatory organizations or SROs, including all exchanges and the National Association of Securities Dealers (NASDA), (2) licensing of brokers and dealers, (3) margin credit, (4) manipulation of securities markets, (5) information reporting by issuers of securities, (6) solicitation of proxies by issuers of securities, (7) position reporting by officers and five percent shareholders, (8) position reporting by holders of large positions in securities markets, (9) misrepresentation, deception or insider trading in connection with the purchase or sale of a security, and (10) tender offers. A common structural feature of the statute is to require that the regulated entity (exchange, broker, dealer, issuer, and so on) be registered, and to give the Securities Exchange Commission discretion to control what the registered entity can, cannot and must do. The Securities Act of 1933 requires that public offerings of securities by issuers and issuer affiliates must be registered with the Securities and Exchange Commission. The Investment Advisor’s Act is a licensing statute for persons who offer investment advice to the public. The Investment Company Act of 1940 gives the Commission authority to regulate the structure and activities of investment companies, more commonly known as mutual funds. The Trust Indenture Act regulates some of the terms of the indentures that set the terms of bonds sold in public offerings. In the US, in addition to the Securities and Exchange Commission, the Commodities Futures Trading Commission (CFTC) regulates the futures markets, whose activities have expanded from trading in future contracts on agricultural commodities to trading in futures on securities indexes. The CFTC is a successor institution to an agency within the Department of Agriculture of the federal government that regulated the futures exchanges at a time when they dealt exclusively in agricultural commodities.

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3. The Functions of Securities Regulation Another way to look at regulation of securities markets is to look at the functions that are performed by the legal arrangements related to securities markets. This view of the subject is more appropriate for a comparative analysis, since it is not dependent on the particular provisions of any one country’s legal arrangements. 3.1 Functions of ‘Exchanges’ Securities markets existed before there was any explicit body of laws called ‘securities regulation’. These markets were based on private arrangements, backed up by the willingness of courts to enforce contracts and provide remedies for fraud. The core private arrangement was the Exchange, consisting of both a place where trading took place and set of understandings among its members. This private organization would be governed by a governing board, selected by its members. The Exchange performed a number of different functions. (a) Limited access to trading facility The exchanges required pre-clearance of the persons allowed to trade on the exchange, usually in the form of permitting only members to trade on the exchange. This procedure reduced the need for any one member of the exchange to be concerned about the identity and trust worthiness of any particular counter party. (b) Standardized trading rules The exchanges established standardized trading rules, governing such questions as standard units of trading, pricing increments, time of trading, delivery and payment procedures, and so on. This standardization made it possible for the transacting parties to focus on only one variable of the transaction - the price. (c) Clearing procedures The exchange would specify the rules relating to the obligations of the parties to an exchange contract to carry out the contract by delivery of the security and of payment. To facilitate the process, the exchange might operate a clearing office. (d) Exclusive roles for members The exchange may specify specialized roles for certain members, and specify in what roles members may act. For instance certain members may be allowed to function only as dealers, making a market in securities, and others only as brokers representing customers. Or the exchange may designate certain members as monopoly dealers or specialists for particular securities. (e) Dispute resolution Because it is important for traders on the exchange to know what their assets and obligations are as quickly as possible, exchanges provide for the resolution of disputes about trades outside the courts through a system of exchange sponsored arbitration. This avoids the problem of the

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uncertainty created by lengthy court proceedings, and forecloses the ability of parties to argue that any contract is unenforceable under public policy relating to gambling or other matters. (f) Exclusive rights in information The trading activity on exchanges generates information about the value of securities, information which is itself valuable. The exchange regulates access to that information and may attempt to exploit its value through, for instance, charges for access to the information. (g) Listing Requirements In order to ensure that securities trading on the exchange meet some minimum procedural and quality requirements, the exchanges set requirements for ‘listing’ a security on the exchange. This listing procedure was particularly important in connection with newly offered issues, since approval for listing helps the issuer’s underwriters sell the new issue to the public. These listing requirements set minimum size requirements (to ensure that there is a sufficient float of outstanding shares to make regular exchange trading possible), and specify requirements for information preparation and disclosure. These listing requirements often include the requirement that financial data be audited by recognized professional accountants. Even an entirely privately structured securities market will implicate the law of fraud. Legal systems usually provide both civil and criminal remedies for fraud. The existence of securities markets creates the possibility of generating large profits by the dissemination of false information. The law of fraud operates to deter this behavior. The fraud problem is, experience has shown, particularly acute in the case of equity securities. Because equities have no contractually fixed rights, but are simply a claim on the residual values of an enterprise, their value depends upon estimates about the future value of the enterprise, and the market’s estimate of that future value can be affected by false but credible information. Thus a fraud perpetrator can profit hugely by providing favorable but false information, and selling shares into the market at the inflated price. Such events, which are a recurrent aspect of the existence of securities markets, lead to demands, including demands by those involved in the securities industry itself, that the enforcement authorities and the courts take action.

3.2 Expanded Functions of Modern Securities Regulation Modern securities regulation has expanded far beyond the core functions of enforcing contracts and property rights and providing civil and criminal remedies for intentional fraud. These expanded functions include the following.

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1. Licensing of participants in the activity. A government agency may take over, in whole or in part, the function of licensing participants in the industry. Even though exchanges have membership restrictions, the exchanges will not reach participants in the trading that occurs off the exchanges. A government agency may be in a better position to screen applicants due to access to confidential government information and enforcement powers that can be used to deter false applications. Such licensing may also function to restrict non-exchange trading and strengthen the role of the exchanges, and to restrict competition in some or all parts of the industry. 2. The activities of exchanges may become subject to supervision by a government agency. This supervision helps to overcome the perception that exchanges are being operated only for the benefit of their members, to the detriment of the public, the customers for exchange services. 3. The regulation may attempt to control the use of leverage and trading in various types of derivative securities in order to reduce market fluctuations and the threat of insolvency of market participants when fluctuations occur. 4. Issuers of publicly traded securities and their managers may be made subject to direct regulation relating to issues such as the voting rights of securities holders, information disclosure, prohibition of insider trading, recovery of short-swing profits, and accounting and auditing procedures. 5. Securities laws may provide enhanced civil remedies, a variety of administrative remedies, and criminal penalties. These remedies may be enforced by criminal prosecutors, a specialized agency, or private parties, or by a combination of any of the three.

4. What Difference does the Modern Regulation Make? An important but largely unaddressed question about particular regimes of securities regulation is what actual effects they have on the markets to which they apply. For instance, what differences are there between the American securities markets after 1934, subject to national regulation, and the American securities markets before national regulation was imposed? What differences are there between the American securities markets, subject to American regulation, and the UK or Japanese securities markets, subject to different regulation? It is easy enough to observe various differences in the regulation, such as the comparative frequency of private, class-action damage actions based on Rule 10b-5 in the United States and the absence of a similar litigation in other countries. But do the differences in regulation

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have an impact on the way in which the markets behave, and if so, are those differences that have any economic or social importance? The proponents of national securities regulation in the US had a clear view on this question. In their view, the US stock market crash of 1929 was an important causal factor of the depression of the 1930s. The argument, most graphically set out by Galbraith (1955) at a later date, was that the stock market had been overvalued. As buyers and sellers became aware of this overvaluation, stock market prices fell. The fall in prices of securities caused a drop in personal wealth. The drop in personal wealth caused people to reduce their spending. This reduction in spending caused a reduction in demand, which caused producers to cut prices, cut production, and reduce employment. This caused a further fall in the value of their securities, which set off the whole downward spiral again. In addition, the reduced consumption of the unemployed fed the cycle. Thus the objective of the national securities acts of the 1930s was to force companies to provide accurate, if not pessimistic, information about their value and to reduce speculative excesses in securities markets. The legislative history of the acts shows that this view played an important role in the arguments for the regulation. This view of the role of the securities markets in the 1930s’ depression has been discredited. First, the magisterial monetary history of Friedman and Schwartz (1963) argued with considerable power that the depression had its genesis not in the securities markets but in the monetary policies of the Federal Reserve Board, which shrank the US money supply at a sharp and unprecedented rate. Second, the market crash of 1987, which was as large as the 1929 crash in percentage terms, but which was accompanied by monetary ease rather than monetary tightening, did not lead to any significant contraction in economic activity. The securities markets of 1929 were not a speculative cesspool whose rot spread to the large economy, rather they were an accurate predictor of the impending economic decline. The opposite view, that differences in the structure of securities regulation make no difference, is suggested by the work of finance economists. Finance is the part of economics focused on the study of financial markets. Finance economists have found that securities markets are efficient. Indeed, they have not identified any securities markets that are not efficient. This suggests that whatever differences there are in the regulation of securities markets, the differences are unimportant since all markets are efficient, and efficiency is the paramount normative criterion that an economic institution should meet. However, this result is an artifact of the unusual way in which finance economists define efficiency. They define efficiency in terms of the properties of the price series generated by

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securities markets. They have found that the price series generated by securities markets are random, and they equate this property with efficiency. In normal usage, efficiency is the property of a process in which the outputs generated from the inputs are maximized. Since securities markets make use of many different inputs, and their outputs affect many different aspects of the economy, it is difficult to determine whether particular arrangements are efficient in this sense. George Stigler, in pioneering work, attempted to determine whether the passage of the 1933 Securities Act had had a favorable impact on buyers of public offerings made under the provisions of the act. The question he asked was: have buyers who purchased the post-act regulated offerings done better than the buyers who purchased unregulated offerings? He studied a sample of pre-act offerings, comparing the returns to buyers of securities in public offerings with the return to buyers of a diversified portfolio of securities in the market at the same time. He then studied a similar sample of post-act offerings, making the same comparison. He found that the returns (as compared to the market) of the pre- and post-act buyers were the same. Thus purchasers protected by the regulation were no better off than they were before the act was passed. These findings suggested that the regulation did not help the purchasers of securities (Stigler, 1964). However, Stigler did find that the variance of the results was greater in the pre-act period. Stigler’s basic results were subsequently replicated in Jarrell (1981) and Simon (1989). Friend and Herman (1964) were highly critical of the Stigler study, and argued that this reduction in variance was a desirable effect, because it reduced the risk of investing in offerings subject to the act. Missing from this exchange was any analysis of whether securities regulation could or should be expected to either (1) improve the returns available to investors or (2) reduce the risk of a group of investments as a class. The idea that securities regulation could or should improve the returns obtained by investors is particularly improbable. The return that investors obtain will be the result of (1) the quality of the investment and (2) the price. The price, in turn, will be determined by the competition of investors to purchase the investment. To the extent that securities regulation is effective in making it easier and less risky to value the investment, that will increase the competition to purchase it and drive the price up. Any gain (less the costs of complying with the regulation) will be captured by the seller of the investment, not the buyer. Securities regulation can, on the other hand, reduce the riskiness of a the class of investments that investors are permitted to buy. For instance, if securities regulation permitted only conservative investments to be offered - say, for instance, only government bonds - then the investment risk would be reduced. But would that be a good thing? The reduction in risk would be achieved at the cost of suppressing the

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opportunity for risky investments that would be socially productive. The securities markets are themselves institutions that enable investors to assume risk by diversifying their portfolios. In the securities markets investments can be acquired in small amounts tailored to preserve the diversification of the buyer’s portfolio. The debate about the significance of the finding that the 1933 Securities Act reduced the variance of the buyer’s returns took precisely this form. Friend and Herman, and later Seligman (1982), argued that this was a good thing. Stigler argued that it was simply the result of raising the costs of making public offerings, and that the effect of raising the cost was to cut out the riskier offerings.

5. The Goals of the Regulation Further efforts to identify what impact different systems of securities regulation have on securities markets should be informed by an effort to first identify the impact which securities regulation is thought to have. There are numerous different goals or objectives that have been identified with securities regulation. The principal goals are: 5.1 Investor protection The most commonly asserted objective of securities regulation is the protection of investors. However, what this ‘protection’ constitutes is never spelled out. Given that investment transactions involve the transfer of money between consenting adults for a product that is not socially harmful, it is difficult to identify what the regulation is protecting investors from. The simple idea that the regulation will protect investors by providing them with higher returns is, as has already been discussed, implausible on its face. A more sophisticated variant of the theme of investor protection is that the purpose of the regulation is to protect investors in order to help issuers and securities salesman sell securities to the public. The public resists buying securities because of fears that any particular issue may be fraudulent. Potential buyers have to invest real resources to protecting themselves against fraud. The regulation, by providing an effective deterrent against fraud, reduces this cost for buyers and makes it possible to sell securities at higher prices, helping issuers and the securities industry. Whether or not contemporary securities regulation actually achieves a reduction in the amount of fraud is unclear. First of all, securities fraud has always been subject to criminal and civil remedies. Second, buyers are not helpless. They can, for instance, deal with established firms with good reputations for honesty and integrity, diversify their portfolios, and insist upon and examine carefully information about the investment. The

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additional strategy of contemporary securities regulation is to add a network of advance licensing procedures. It is made a crime to attempt to sell securities without a license, and it is made a crime to offer securities that have not been registered with public officials. Can this licensing network screen out the potential fraudulent actors? Or is it inevitably overwhelmed by the administrative routine and volume of paper work, so that even scam artists can obtain the required licenses, and use them to increase the credibility of their offering? American newspapers regularly report enormous swindles involving the sale of fraudulent securities. In the US there has been a persistent problem with ‘Penny Stock’ frauds, operated out of high pressure sales offices called ‘boiler rooms’ because of the selling heat put on the salesmen. These frauds are usually conducted by licensed securities salesman employed by licensed securities firms, and offer their victims the opportunity for quick profits in stocks that at least superficially appear to have satisfied regulatory requirements. In spite of the fact that regulators have made control of penny stock frauds an enforcement priority, and in spite of the fact that federal statues have been extensively amended to make penny stock scams more difficult to operate, they appear to continue to flourish. It is not particularly plausible that criminal activity can be reduced by requiring criminals to register with the government before they commit the crime. A sales practice permitted by US securities regulation but not permitted in many other jurisdictions such as the UK is cold calling. This is the practice of calling potential investors at their homes and inducing them to invest over the phone. This is a sales technique used by boiler room sales operations, and also used by large and established US brokerage houses. A ban on cold calling confines securities salesman to their existing customer base and persons who affirmatively seek out the services of the securities salesman. The very fact that the potential investor knows enough to seek out the securities salesman ensures that the investor has at least some knowledge of securities markets. Another view of investor protection is that securities regulation helps sophisticated investors help themselves. By requiring that material information be made available to investors, the regulation makes it possible for sophisticated investors to analyze the information and separate the good investments from the bad ones. It is not clear, however, why sophisticated investors need the help of regulation to get this information. Any potential investor can require, as a condition of investing, that he or she be provided with specified information. And providing the requested information fraudulently has always been a crime.

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5.2 Efficiency Beginning around 1980 there appeared in the literature an argument by scholars trained in law and economics that the purpose and effect of securities regulation is to make securities markets specifically, and capital markets generally, more efficient. The style of this argument echoed the many arguments in the law and economics literature that the common law is efficient. Here the argument was applied to a scheme of statutory regulation. The argument was that securities regulation required the production of more public information by firms than they would provide in an unregulated market. Because information is valuable to actors other than the firm itself, an unregulated firm would produce less information than would be produced by an unregulated firm motivated only by its own interests. This increased information results in more accurate pricing of securities, and contributes to more accurate or correct economic decisions throughout the economy, with a consequent increase in economic output by the whole society or perhaps, even, the world (Easterbrook and Fischel, 1984, 1991; Gilson and Kraakman, 1984; Kahan, 1992; Langevoort, 1992). Needless to say, this story has a happy and reinforcing congruence with the view of the financial economists that securities markets are efficient, even though they use efficiency in a quite different sense. It is a story that purports to explain why securities markets have the properties they have been found to have. This Panglossian story is based only on the stated aspiration of the securities laws: to require the production of all information material to investors. It is not based on an examination of the actual information contained in the disclosure documents produced under the securities laws, on any analysis of whether the information they contain is in fact the information required to increase the accuracy of pricing decisions, or on any explanation of how the regulators could identify what that information is. It depends on the simple argument that more information always leads to better decisions, no matter what the information is, and ignores the fact that the production of information itself has costs, which in a complete efficiency analysis must be balanced against any benefits resulting from its production. I, for instance, have pointed out that not only are there the direct administrative costs of collecting, organizing and presenting the information, which may be different information than the firm would otherwise collect, but that making the information public has direct costs to the firm because it will affect the actions of competitors and others, and that the risk of harm is increased the more economically (and hence competitively) relevant the information is (Kitch, 1995).

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5.3 Complete the organization of the market ‘firm’ Another perspective is to view the public and private aspects of securities regulation as a combined effort to create competitive market institutions which will attract securities business. This aspect of securities regulation has been more prominent in recent years as US and UK firms and regulators have adjusted their regulation in order to attract or keep business from each other and other jurisdictions. Or, to take another example, in the United States exchange-traded derivatives regulated by the CFTC compete with over- the-counter derivatives which are largely unregulated. Many users prefer the exchange-traded derivatives because of their transparency, the ease of entering and leaving positions, and the elimination of counter party risk through the exchange clearing house. Other users prefer over the counter derivatives because of their confidentiality, and the fact that the terms of the contract can be customized. These two markets, one regulated by the CFTC and the other largely unregulated, compete. In this view, the public, regulatory aspects are designed to deal with coordination problems that face the individual securities firms. The government agency helps the private firms coordinate the basic structure and organization of the markets so that the markets are attractive to potential customers. A public agency, unlike private firms, can impose collective solutions and engage in coordination relatively free of antitrust scrutiny. The principal feature of securities regulation that is inconsistent with this view of its function is that most of its provisions are mandatory. Buyers and sellers are not permitted to choose whether or not they wish to enter into a transaction subject to the regulation. If the transaction falls within the regulation it applies. If the regulation was in fact designed to increase the attractiveness of the market to the transacting parties, it would not need to force unwilling parties to accept its costs and benefits. Recently, a number of US scholars have argued that securities regulation should, at least to a greater extent than it does now, permit party choice. For instance Roberta Romano has argued that the ‘Delaware model’ of US corporate law competition should be extended to securities regulation, and that issuers should be permitted to choose the jurisdiction whose securities laws would apply to their securities. This would force regulators, just like issuers, to compete for investors. In the case of the regulators, this competition would be a competition to offer a regime of securities regulation that enhances the value of the securities offered under it (Romano, 1998; see also Choi and Guzman, 1996; Mahoney, 1997). 5.4 Capture Wealth Public choice analysis has also been applied to the securities laws, most notably in the area of insider trading (see Chapter 5650, Section 10; Phillips

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and Zecher, 1981). The public choice analysis views the securities laws as the product of political competition among groups whose wealth is affected by the provisions of the laws. Macey and Miller (1991a) have suggested, for instance, that the blue sky laws originated with concern on the part of bankers, who viewed securities as competition for deposit dollars. The passage of the securities laws in the 1930s moved the important decisions about securities regulation to the federal level. As long as currency exchange controls made it difficult for US businesses to access foreign capital markets, the national legislators and SEC Commissioners had a monopoly on the terms and conditions imposed on access to securities markets. This gave the national politicians considerable leverage to extract concessions from the industry. 5.5 Protect the Industry from Competition The view that securities regulation is a device for organizing the industry into a cartel has had considerable influence in the area of securities regulation (Baxter, 1970). In the 1970s this led to an attack under the antitrust laws on the New York Stock Exchange fixed commissions. The Exchange, as part of its membership rules, had required that members adhere to specified minimum commissions. These antitrust actions were unsuccessful (Gordon v. New York Stock Exchange, 422 US 659 (1975)). However, Congress amended the Securities and Exchange Act in 1975 to change provisions in the act that sanctioned fixed commissions, and the SEC abolished them as of May 1, 1975. Subsequently, commission rates have dropped significantly. However, turnover rates increased even more, leading to an increase in industry income. This ‘big bang’ strategy was subsequently followed in the UK (Poser, 1991), and in other countries. At the same time, Congress empowered the SEC to engage in form of central planning for the securities industry by a series of statutory amendments designed to spur the creation of a ‘National Market System’. It is fair to say that in spite of its enhanced statutory powers, the SEC’s planning has not played an important role in the subsequent evolution of the industry (Macey and Haddock, 1985; Poser, 1991). Recently, Christie and Schultz (1994) reported that market makers on the National Market System of the NASDA (the ‘NASDAQ’ market) never quoted prices in 1/8ths in many important stocks. This was suggested as evidence that the market makers were colluding to keep the spread from falling below 1/4th of a dollar (Dutta and Madhavan, 1997). These findings have led to civil and administrative actions, a reorganization of the NASDA and its affiliated NASDAQ market, and the introduction of quotations in 1/64ths on that market.

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6. The Literature A principal concern of the law and economics literature on securities markets has been the role and meaning of the concept of efficiency in this area (Gordon and Kornhauser, 1985; Lee and Bishara, 1985; Stout, 1988, 1995; Wang, 1986). This is a discussion that has been made more confusing by the special meaning that the finance economists have given the term efficiency, and it is the financial economists’ concepts of efficiency that have been the focus of the discussion. There has not been even a preliminary examination of the question of what characteristics or regulatory structure would make a securities market more efficient in the usual sense of that term. Most writing in the securities area in the United States has focused on the remedies for fraud. The private cause of action which arises in the United States under section 10(b)-5 of the 1934 Securities and Exchange Act is a distinctive feature of US securities law. This cause of action exists for misrepresentations that are unintentional, and can be enforced by a class action composed of all those who purchased after the misrepresentation without a showing that the members of the class relied on the misrepresentation. Some writers are of the view that this cause of action is an important incentive to insure the accuracy of statements made by market actors. Others view the cause of action skeptically, and express the concern that the threat of 10(b)-5 simply operates to increase the cost of providing information and to enrich lawyers (Alexander, 1991; Arlen and Carney, 1992; Carney, 1989). Since a similar cause of action is not available in other jurisdictions, it might be possible to demonstrate differences between the behavior of US and non-US markets resulting from this difference in legal remedies.

Bibliography on Regulation of the Securities Market (5660) Adams, Michael (1994), ‘Macht von Banken und Versicherungen - Wettbewerb im Finanzdienstleistungssektor-, Stellungnahme zur öffentlichen Anhörung des Deutschen Bundestages - Ausschuß für Wirtschaft -, 8. Dezember 1993 (Power of Banks and Insurances)’, Zeitschrift für Bank- und Börsenrecht, 77-86. Alexander, Janet Cooper (1991), ‘Do the Merits Matter? A Study of Settlements in Securities Class Actions’, 43 Stanford Law Review, 497-598. Alfaro Aguila-Real, Jesús (1995), Interés Social y Derecho de Suscripción Preferente. Una Aproximación Económica (Economic Efficiency of a Strict Construction of the ‘Interest of the Corporation’ Clause in Corporate Law), Madrid, Ed. Cívitas, 160 p. Arlen, Jennifer H. and Carney, William J. (1992), ‘Vicarious Liability for Fraud on Securities Markets: Theory and Evidence’, University of Illinois Law Review, 691-740. Reprinted in

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Andersen, Jensen and Mortensen (eds) (1993), Governance by Legal and Economic Measures, Copenhagen, Gad. Arrow, Kenneth J. (1964), ‘The Role of Securities in the Optimal Allocation of Risk Bearing’, 31 Review of Economic Studies, 91-96. Arruñada, Benito (1990a), Control y Regulación de la Sociedad Anónima (Control and Regulation of Joint-Stock Companies), Madrid, Alianza Editorial. Arruñada, Benito (1990b), ‘La Regulación de la Información Empresarial (Regulation of Corporate Information)’, 51 Boletín del Círculo de Empresarios, 11-42. Arruñada, Benito (1992a), ‘Crítica a la regulación de las Opas (A Critic on the Regulation of Takeovers)’, 203-4 Revista de Derecho Mercantil, 29-67. Arruñada, Benito (1992b), ‘La Conversión Coactiva de Acciones Comunes en Acciones sin voto para Lograr el Control de las Sociedades Anónimas: De Cómo la Ingenuidad Legal Prefigura el Fraude (Mandatory Conversion of Common Shares into Non-Voting Shares to Reach Corporate Control over Joint-Stock Companies: How Legal Simplicity Leads to Fraud)’, 71 Revista Española de Financiación y Contabilidad, 283-314. Arruñada, Benito and Paz Ares, Cándido (1995), ‘Conversion of Ordinary Shares into Non-Voting Shares’, 15 International Review of Law and Economics, 351-392. Ayres, Ian (1991), ‘Back to Basics: Regulating How Corporations Speak to the Market’, 77 Virginia Law Review, 945-999. Bainbridge, Stephen M. (1991), ‘The Short Life and Resurrection of SEC Rule 19c-4', 69 Washington University Law Quarterly, 565 ff. Reprinted in 1992 Securities Law Review 377. Bainbridge, Stephen M. (1994), ‘Revisiting the One-Share/One-Vote Controversy: The Exchanges’ Uniform Voting Rights Policy’, 22 Securities Regulation Law Journal, 175-219. Bainbridge, Stephen M. (1995), ‘Securities Act Section 12(2) After the Gustafson Debacle’, 50 Business Lawyer, 1231-1271. Banoff, Barbara Ann (1984), ‘Regulatory Subsidies, Efficient Markets, and Shelf Registration: An Analysis of Rule 415', 70 Virginia Law Review, 135-185. Barclay, Michael J. and Holderness, Clifford G. (1992), ‘The Law and Large Block Trades’, 35 Journal of Law and Economics, 265-294. Baxter, William F. (1970), ‘NYSE Fixed Commission Rates: a Private Cartel Goes Public’, 22 Stanford Law Review, 675-712. Beaver, William H. (1980), ‘The Nature of Mandated Disclosure’, in Posner, Richard A. and Scott, Kenneth E. (eds), Economics of Corporation Law and Securities Regulation, Boston, Little Brown. Benston, George J. (1973), ‘Required Disclosure and the Stock Market: An Evaluation of the Securities Exchange Act of 1934', 63 American Economic Review, 132-155. Benston, George J. (1976), Corporate Financial Disclosure in the U.K. and the U.S.A., Farnborough, Hants, Saxon House. Berglof, Erik (1994), ‘A Control Theory of Venture Capital Finance’, 10 Journal of Law, Economics, and Organization, 247-267. Booth, Richard A. (1994), ‘The Uncertain Case for Regulating Program Trading’, 1994 Columbia Business Law Review, 1-71. Bradford, C. Steven (1996), ‘Transaction Exemptions in the Securities Act of 1933: An Economic Analysis’, 45 Emory Law Journal, 591-672.

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Butler, Henry N. and Ribstein, Larry E. (1994), ‘Corporate Governance Speech and the First Amendment’, 43 University of Kansas Law Review, 163-206. Carney, William J. (1989), ‘The Limits of the Fraud on the Market Doctrine’, 44 Business Lawyer, 1259-1292. Choi, Stephen J. and Guzman, Andrew T. (1996), ‘The Dangerous Extraterritoriality of American Securities Law’, 17 Northwestern Journal of International Law and Business, 207-241 Christie, W. and Schultz, P. (1994), ‘Why do Nasdaq Market Makers Avoid Odd-eighth Quotes?’, 49 Journal of Finance, 1813-1860. Cochrane, James L. (1994), ‘Are US Regulatory Requirements for Foreign Firms Appropriate?’, 17 Fordham International Law Journal, 58-67. Coffee, John C. (1984), ‘Market Failure and the Economic Case for a Mandatory Disclosure System’, 70 Virginia Law Review, 717-753. Corgill, Dennis S. (1993), ‘Securities as Investments at Risk’, 67 Tulane Law Review, 861-954. Reprinted 26 Securities Law Review, 1994. Cox, James D. (1993), ‘Regulatory Competition in Securities Markets: an Approach for Reconciling Japanese and United States Disclosure Philosophies’, 16 Hastings International and Comparative Law Review, 149-173. Cox, James D. (1996), ‘Just Desserts for Accountants and Attorneys after Bank of Denver’, 38 Arizona Law Review, 519-545. Reprinted in 29 Securities Law Review, 427. Cox, James D. (1997), ‘The Fundamentals of an Electronic-Based Federal Securities Act (Markets and Information Gathering in an Electronic Age, Securities Regulation in the 21st Century)’, 75 Washington University Law Quarterly, 857-886. Cox, James D. (1997), ‘Making Securities Fraud Class Actions Virtuous (Rule 23: Class Actions at the Crossroads)’, 39 Arizona Law Review, 497. Dennis, Roger J. (1988), ‘This Little Piggy Went to Market: The Regulation of Risk Arbitrage After Boesky’, 52 Albany Law Review, 841-892. Dietl, Helmut and Picot, Arnold (1995), ‘Information (De-)Regulation of Capital Markets from the Viewpoint of New Institutional Economics’, 30 Hitotsubashi Journal of Commerce and Management, 29-46. Dutta, Prajit K. and Madhavan, Ananth (1997), ‘Competition and Collusion in Dealer Markets’, 52 Journal of Finance, 245-276. Easterbrook, Frank H. and Fischel, Daniel R. (1984), ‘Mandatory Disclosure and the Protection of Investors’, 70 Virginia Law Review, 669-715. Easterbrook, Frank H. and Fischel, Daniel R. (1991), Mandatory Disclosure’, Chapter 11 of The Economic Structure of Corporate Law, Cambridge, Cambridge University Press. Fanto, James A. (1996), ‘The Absence of Cross-Cultural Communication: SEC Mandatory Disclosure and Foreign Corporate Governance’, 17 Northwestern Journal of International Law & Business, 119-206. Fischel, Daniel R. (1987), ‘Organized Exchanges and the Regulation of Dual Class Common Stock’, 54 University of Chicago Law Review, 119-152. Fischel, Daniel R. and Ross, Robert R. (1991), ‘Should the Law Prohibit ‘Manipulation’ in Financial Markets?’, 105 Harvard Law Review, 503-553. Fox, Merritt B. (1984), ‘Shelf Registration, Integrated Disclosure, and Underwriter Due Diligence: An Economic Analysis’, 70 Virginia Law Review, 1005-1034.

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McGee, Robert W. (ed.) (1989), Commentaries on the Law of Accounting and Finance, Dumont, NJ, Dumont Institute. McGee, Robert W. (1992), ‘Ethical Issues in Acquisitions and Mergers’, in McGee, Robert W. (ed.), Business Ethics and Common Sense, Westport, Quorum Books, 167-185. Miller, Geoffrey P. and Macey, Jonathan R. (1990), ‘Good Finance, Bad Economics: An Analysis of the Fraud on the Market Theory’, 42 Stanford Law Review, 1059-1092. Miller, Geoffrey P. and Macey, Jonathan R. (1991a), ‘Origin of the Blue Sky Laws’, 70 Texas Law Review, 347 ff. Miller, Geoffrey P. and Macey, Jonathan R. (1991b), ‘The Fraud on the Market System Revisited’, 77 Virginia Law Review, 1001-1016. Miller, Geoffrey P., Litt, David, Macey, Jonathan R. and Rubin, Edward L. (1990), ‘Politics, Bureaucracies, and Financial Markets: Bank Entry Into Commercial Paper Underwriting in the United States and Japan’, 139 University of Pennsylvania Law Review, 369-453. Miller, Geoffrey P., Macey, Jonathan R., Netter, Jeffrey and Mitchell, Mark L. (1991), ‘Lessons From Financial Economics: Materiality, Reliance, and the Utility of Empirical Methodology in Extending the Reach of Basic V. Levinson’, 77 Virginia Law Review, 1017-1049. Mofsky, J.S. (1972), ‘SEC Financial Requirements for Broker-Dealers: Economic Implications of Proposed Revisions’, 47 Indiana Law Journal, 232-248. Nielsen, Niels Chr. (1993), ‘Minoritetsaktionærbeskyttelse - Eller et Velfungerende Market for Virksomhedskontrol (Minority Protection or a Well-functioning Market for Corporate Control)’, Revision og Regnskabsvæsen. Nielsen, Niels Chr. and Ebbesen, Jan (1993), ‘Stemmelofter - En¢konomisk analyse af den retlige analyse (Restrictions on Voting Rights, An Economic Analysis of the Legal Analysis)’, 6 Juristen, 251-264. Palmer, Matthew S.R. (1986), ‘The Economics of Law: the Sharebrokers Act 1908', 16 Victoria University of Welington Law Review, 277-301. Phillips, S. and Zecher, R. (1981), The SEC and the Public Interest, Cambridge, MA, MIT Press. Pille, G. (1987), ‘Financiële Instellingen en Markten: 2. Secundaire Effectenmarkt (Financial Institutions and Markets: Secundary Securities Market)’, in X (ed.), 18de Vlaams Wetenschappelijk Economisch Congres, Brussel 8 en 9 mei 1987, Sociaal-economische Deregulering, Brussel, V.E.H.U.B., 649-663. Pitt, Harvey L., Hardison, David B. and Shapiro, Karen L. (1987), ‘Problems of Enforcement in the Multinational Securities Market’, 9 University of Pennsylvania Journal of International Business Law, 375-452. Poser, Norman S. (1981), ‘Restructuring the Stock Market. A Critical Look at the SEC’s National Market System’, 56 New York University Law Review, 883-958. Poser, Norman S. (1991), International Securities Regulation, Boston, Little Brown. Posner Richard A. and Scott Kenneth E. (eds) (1980), Economics of Corporation Law and Securities Regulation, Boston, Little Brown. Prasad, Ravi (1995), ‘Review of Licensing Regime for Security Advisers’, Office of Regulation Review. Ribstein, Larry E. (1991), ‘Private Ordering and the Securities Laws: The Case of General Partnerships’, 41 Case Western Reserve Law Review, 1-64.

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5700 INSURANCE REGULATION Seth J. Chandler Professor of Law,University of Houston Law Centre © Copyright 1999 Seth J. Chandler

Abstract This chapter summarizes the economic understanding of insurance regulation with a focus on solvency regulation, underwriting regulation, contract regulation and competition law exemptions. Insurance industry solvency regulation is viewed as a solution to a collective action problem that might otherwise induce insurers to take excessive risk. The chapter analyzes the economics of regulations addressing adverse selection, including traditional doctrines of warranty and misrepresentation as well as recent laws relating to genetic testing. Traditional doctrines examined from an economic perspective include contra proferentum, ‘extra-contractual damages’ and resolution of conflict of interest problems arising out of typical liability insurance policies. Competition law exemptions are seen as perhaps an overly broad vehicle to foster the economies of scale in production of information needed to prevent adverse selection and insolvency. JEL classification: K20, K29 Keywords: Insurance Regulation, Solvency Regulation, Underwriting Regulation, Adverse Selection, Genetic Testing, Warranty, Misrepresentation, Competition Law, Contra Proferentum, Contract Remedies

A. Introduction and Scope Note In almost all jurisdictions, government heavily regulates the business of insurance. To varying degrees in different states and nations, it uses its legislative and judicial branches to regulate solvency, underwriting practices and contract structure. It likewise often distinguishes the business of insurance from other businesses regarding the extent to which separate enterprises must behave competitively rather than cooperatively. While economics-oriented scholarship has not yet spanned the breadth of these varying forms of insurance regulation or plumbed the intricacies of every doctrine thereunder, an increasing mass of literature has begun to review these regulatory practices. This entry seeks to develop the main contours of the existing body of research. It should be noted that several critical topics are addressed only briefly in this chapter. The focus is on insurance regulation through legislative action and 837

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judicial rulings as it has developed in the United States. The chapter does not discuss purely legal analyses of insurance regulation or analyses that draw on other disciplines such as political philosophy, nor does it discuss purely economic analyses of the insurance industry, including the extensive empirical work in the field. Rather, the focus is on analyses that have attempted to bring the tools of economic analysis to bear on the laws regulating insurance. Economic analysis of laws requiring purchase of insurance is addressed in a separate chapter.

B. Solvency Regulation 1. Traditional Economic Understanding Economic theory has often understood efforts by government to monitor and regulate the solvency of insurers as a solution to a collective action problem not unlike that arising with banks and other financial intermediaries (Winter, 199b). Insureds in this view are analogous to fixed-debt investors putting money into insurers who reinvest that money and return sums to the insured in the event certain events come to pass (Hansmann, 1985). This beneficial intermediation of investment requires an expectation by the investor/insured that the insurer will actually be able to pay those sums when the events occur at some point in the relatively near future (property/casualty insurance) or in the distant future (life insurance). Given the incentive of insurer/owners with limited liability to invest in high risk ventures, however, the likelihood of repayment is hardly assured. This incentive exists because insurer/owners capture all the upside of a favorable materialization of the risk while they are able to shift part of the downside of an unfavorable materialization onto the investor/insureds. While economic theory suggests that investor/insureds may be able to constrain this ‘agency cost’ or ‘moral hazard’ by use of monitored conditions in contracts (Smith and Warner, 1979; Mayers and Smith, 1981) or through bonding (mutual ownership) (Fama, 1980) few individual investor/policyholders can structure the complex arrangements needed to achieve this end. Free ridership problems hinders groups of investor/policyholders from coalescing to accomplish this aim. These problems are particularly weighty with respect to insurance because non-payment to the investor/insured occurs after the insured has suffered an often catastrophic loss at times when prompt payment is particularly valuable. It is this understanding of the insurance industry that motivates the predominant regulatory structure: governments intervene by licensure and public insurance mechanisms often known as ‘guaranty funds’ that provide at least partial indemnity to selected policyholders of an insolvent, licensed insurer (Winter, 1991b). The licensure mechanism generally imposes severe

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punishment for sale of insurance without a license and conditions licensure on regulation and monitoring of insurer finances. The public insurance mechanism transfers the risk that this system will fail in the case of a particular insurer away from the individual insured to a collective of all insurers and, derivatively, their insureds, although this backup form of risk transfer, if effective, minimizes the incentive of insured/policyholders to monitor insurer solvency. Although this mode of regulation is prevalent throughout the world, different systems of shared sovereignty differentially allocate responsibility for solvency regulation. In the United States, a complex system exists under which, for most insurers, each of the states may regulate the solvency of insurers ‘doing business’ in that state. Regulations need not be consistent among the states (Lewis and Coates, 1991). The danger of excessive regulation posed by this system, particularly with respect to sophisticated insureds, is tempered, however, by two co-existing alternative forms of insurance regulation: captive regulation and surplus lines regulation. So-called captive insurers have their access restricted to relatively sophisticated policyholders capable of banding together to monitor the insurer. With some exceptions, they are generally regulated only by one state even when policies are sold outside that state. Surplus lines insurers, instead of being regulated by all states into which the insurer is admitted to do business, likewise have their solvency seriously regulated by only one of the states. With surplus lines insurers, however, states in which these insurers do business without a license may nonetheless regulate their market conduct. Moreover, most states make their own regulated surplus lines brokers responsible for appropriate investigations and disclosures with respect to the solvency of the surplus lines insurers. These alternative modes of insurance regulation in which a home state has greater responsibility for solvency regulation of the insurer, res embles, in certain respects, that applying in the European Community (Hogan, 1995).

2. Recent Economic Analysis of Solvency Regulation Economic scholarship regarding the laws governing insurance regulation is divided into two categories: studies of rules relating premium revenue to surplus and studies of price regulation. 2.1 Rules Relating Premium Revenue to Surplus Either through the so-called Kenney Rule or its more modern equivalent via the ‘IRIS’ system of insurance solvency monitoring used in much of the United States, most jurisdictions attempt to enhance solvency by restricting the ratio between the volume of premiums an insurer can write in some given period and

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its stock of capital surplus. The notion is that restrictions on the rate at which a financial intermediary such as an insurer can engage in new borrowing decreases the likelihood of insolvency and preserves the ability of monitoring agencies to provide early warning of problems (Mayerson, 1969). Several scholars have challenged this implementation of solvency regulation by arguing that it creates or exacerbates positive feedback cycles in insurance pricing and availability (Winter, 1988, 1991b; Gron, 1994a, 1994b).These instabilities hamper the economy. The Winter model assumes that this method of regulation creates a topology known as a ‘fold catastrophe’. Winter argues that the regulatory constraint establishes a peculiar short-run supply curve for insurance which, when coupled with a relatively inelastic demand curve for insurance, can establish a dynamic relationship between surplus and insurance price. This dynamic process, while often equilibrating insurance markets in a relatively smooth fashion, can also lead to almost instantaneous increases in insurance price and a correlative decrease in insurance supplied - a phenomenon last observed in the late 1970s and early 1980s. 2.2 Price Regulation Other scholars have considered the economic effects of government price regulation. This regulation may occur either through the direct setting of a price for various forms of insurance or by constraining the prices an insurer may charge to some range. By requiring that rates be ‘adequate’, insurers are protected from ‘trembling hand’ instabilities (Selten, 1975) in the system whereby the perhaps irrational decision of one insurer to underprice insurance can drive out more rational insurers and lead to the collapse of an insurance system (Kimball, 1992). While history suggests that fear of insurance underpricing is not irrational, the ability of pricing regulation to combat insolvency is questionable. If insurers compete, suppression of price competition merely bolsters non-price competition in areas such as marketing (Stigler, 1968). It lowers consumer welfare because consumers no longer get the product they desire most. The loss to the United States economy from this non-price competition was estimated in 1980 at $1 billion (Frech and Sambrone, 1980). Moreover, to the extent the insurers do not compete, price regulation based on assuring an adequate return may deter efficient methods of production by insurers. Price regulation is also troublesome to the extent that permitted rates do not encompass those which would clear the market. If permitted rates fall below the market clearing rate, insurance shortages may exist that harm insureds and insurers alike (Winter, 1991a). While the existence of legal ‘black markets’ such as the surplus lines market and the captive market may reduce the impact of the distortions and hardships created thereby, the transaction costs associated with purchase of these sorts of policies, coupled with their limited availability,

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renders these alternatives at best only a partial cure. If permitted rates stay atop the market clearing rate, a deadweight loss occurs resulting from a reduction in profitable transfers of risk. Insurers, under such a system, obtain economic rents. Costs incurred by insurer in obtaining or preserving such a hospitable regulatory state may also constitute economic waste.

C. Underwriting Regulation 3. Adverse Selection with Costly Sorting Adverse selection, the tendency of persons with private and accurate beliefs about their high risk to transfer risk more extensively than persons with low risk or without private and accurate beliefs, is the central economic problem of insurance contracting. Unchecked adverse selection can destroy an insurance market and the benefit conferred thereby (Akerlof, 1970). The law has thus developed various mechanisms to support ‘underwriting’, the process of curbing the ‘asymmetric information’ between insured and insurer that causes adverse selection. Doctrines such as representation and warranty have been central in this effort. These mechanisms have long come in occasional tension with concerns regarding insurer power and the misallocation of risk that results when these doctrines are interpreted by imperfect courts. These tensions have led only to adjustments to the central legal doctrines. In recent years, however, it has become increasingly common for laws in support of private adverse selection control to collide with other social goals such as wealth redistribution or antidiscrimination entitlements. Accordingly, the law of underwriting has, in recent years, undergone significant chance. As shown by Borenstein (1989), Rea (1992) and others, when individuals with different expected losses are ‘pooled’ and charged the identical premium, the result is a loss that depends on the elasticity of demand for insurance. In general, however, the loss results from (1) the consumption of insurance by high-risk insureds beyond the point where the marginal value they attach to risk transfer equals the marginal cost of their risk transfer and (2) the consumption of insurance by low-risk insureds in an amount less than that where the marginal value they attach to risk transfer equals the marginal cost of their risk transfer. Although, as noted by Rea (1992) and Chamberlain (1985), this efficiency loss from pooling should perhaps be offset by the gain that pooling - which itself amounts to insurance of a particular ‘commodity’ price - creates for those who, at some earlier position (Harsanyi, 1967) behind a ‘veil of ignorance’ (Rawls, 1971), do not know their risk class and are unable to adjust measured indicia of their expected loss.

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Separation of otherwise pooled classes is generally considered to be efficient when the cost of the separating program is less than the gains resulting from enhanced allocative efficiency through pricing that more closely reflects the marginal costs of risk transfer posed by each potential insured. Separation thus becomes more sensible as the (1) cost of the developing and implementing the separation algorithm decreases; (2) the homogeneity of expected losses posed by the separated risk classes increases; and (3) the elasticity of demand for insurance increases. Reduction of the cost of a separation program in turn depends on (a) technological advances in testing, (b) reduction of variable costs by administration of binary tests only to those likely to be in the numerically smaller of the two separated classes, and (c) legal rules supporting separation. As also shown by Schmalensee (1984), Borenstein (1989) and Rea (1992), however, low-risk individuals and insurers may develop a separation program even when these efficiency conditions are not met. The low-risk insureds, this argument contends, fail to take into account the interests of the high-risk insureds in not implementing a testing program that, while it restores allocative efficiency, ends the cross-subsidization they enjoyed under pooling. Coasean bargaining by the high-risk insureds to pay off the low-risk insureds not to be tested is even more difficult than usual here, because, almost by definition, the high-risk insureds do not know the identity of the low-risk insureds. The unregulated market equilibrium in favor of separation is also troubling, as suggested by Abraham (1986), because it favors separation techniques that examine readily ascertainable characteristics such as race or gender that may have no causal relationship to expected loss but that bear a statistical correlation with the difficult-to-observe factors that indeed determine loss. In theory, the unregulated market equilibrium described above operates by establishing different pricing terms for identical contracts and achieves separation through verification mechanisms that reliability and validly classify individuals by risk. A second mechanism described first by Rothschild and Stiglitz (1976) and explicated by various scholars (Rasmusen, 1994) achieves separation by having insurers offer a menu of contracts with varying shortfalls in the indemnity to be paid - and commensurately lower prices. This menu of contracts induces only low-risk insureds (who know themselves to be low risk) to purchase the most incomplete contracts. The mechanism saves the cost of verification but results in inefficiently low levels of risk transfer to the low-risk insureds.

4. Classification of Legal Responses to the Problem of Adverse Selection Legal responses to the tensions between adverse selection control and other goals, such as non-discrimination, differ in the way that they control the

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problem of ‘error’ and in the zones of legality they establish according to classification cost and classificatgion benefit. One prevailing response is ‘libertarian’, to give the insurer and insured complete freedom to use whatever classification devices they choose. Perhaps hoping that the market will punish inaccurate classifiers, the government itself makes no effort to control error. The government likewise fails to evaluate whether the classification method employed is inefficient, either classifying too coarsely or too finely. In some ways, this response, which at least prevents the possibility of government-created error in classification, has been the prevailing legal response in the United States and elsewhere for many years. Laws that focus primarily on error control represent a second response mode to the tension between adverse selection control and other goals. Laws, for example, that prohibit classification for automobile insurance based on marital status of the driver or that prohibit different health insurance charges for disabled individuals absent ‘sound actuarial principles’ for doing so exemplify this sort of law. Such laws act as a safeguard against the cooperative behavior generally permitted in the insurance industry by prohibiting ‘irrational’ collective discrimination by insurers against disfavored groups. They fail, however, either to require classification in this way or, apparently, to prohibit overly coarse classification in which separated groups have apparently different expected losses but in which that difference is actually caused by an underlying variable that greater classification expense would have revealed. Such laws likewise generally fail to criticize insurance classifications that result in reasonably accurate separation of applicants into groups with equivalent expected losses but that do so too finely through testing methods that are so costly as to make the whole classification enterprise inefficient. A third response mode makes classification impermissible, except when it is extremely fine, even where the cost of fine separation exceeds the economic benefit. Laws generally prohibiting use of gender as a basis for classifying individuals for life insurance or annuity policies exemplify this mode of response (Arizona Governing Committee v. Norris, 1983). In the western world, gender correlates with life expectancy and it is unclear whether many other underlying variables that determine expected life expectancy may be ascertained at any reasonable cost. Gender is nonetheless sometimes prohibited as a classification device. Laws of this sort protect both against ‘irrational’ collective discrimination but also against the ‘accident’ of certain variables that correlate with expected losses being cheaper to observe that others that actually determine expected loss. They also may serve as a safeguard against the perpetuation of irrational collective prejudices whose existence is difficult to prove. A fourth response (‘non-actuarialism’) is to prohibit classification even if it is efficient and even if it is accurate. Laws barring use of race for classifying

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applicants for life insurance and annuities exemplify such laws. Such laws redistribute wealth according to political and social preferences apart from notions of economic efficiency. Interestingly, laws that implement the ‘efficiency concept’ described above - do not appear yet to exist, although, as noted below, restrictions on use of genetic information may fall into this category of regulation. This absence of ‘efficient actuarialism’ from the law as it actually exists may in part be due to the extraordinarily high legal and administrative costs that would be incurred in determining accurately whether any particular classification system met the efficiency standard.

5. Traditional Regulation via Legal Doctrines of Misrepresentation and Warranty As part of a libertarian impulse, the law has long facilitated separation and the economic benefits it often entails by permitting the insurer to investigate the risk characteristics of a potential insured even where this investigation probes generally private information about the insured. Moreover, subject to recent restraints on use of cheap observables such as race or gender, the law has not intervened in insurer’s selection of characteristics used to determine expected loss, even where this selection - often done in concert - causes substantial loss to identifiable social groups. Pre-contractual investigations of all potential insureds can, in many instances, be quite costly. The doctrines of warranty and representation represent potentially cheaper vehicles to create symmetric information and thereby reduce adverse selection. Under both doctrines, the insured is given an opportunity prior to contract formation to make statements that, if true, demonstrate a lower risk and thereby lower premiums in the event a contract is formed. The insured accepts some penalty in the event that some subset of otherwise insurable events come to pass and the statements made prior to contract formation turn out to have been false to some pre-specified extent as determined by some post-event investigation. The economic concept behind both warranty and representation is to restructure the ‘game’ being played by the insured and insurer into one where the insured’s dominant strategy is to reveal truthfully all private information about his risk and therefore to render the information symmetrical. The success of this concept becomes more likely as (a) the amount of the potential penalty increases, (b) the scope of the subset of events triggering the potential penalty increases, (c) the degree of falsity required to trigger the penalty decreases; and (d) the likelihood that falsity will be detected increases. The joint benefit to both insurer and insured increases as the expected cost of this post-event

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determination decreases. Measurements of this expected cost should reflect both the cost of the investigation itself and the risk cost imposed on the insured as the result of a determination that is either incorrect or that occurs absent truly asymmetric belief structures. The traditional doctrine of warranty is a structure that results in strong inducements to tell the truth but creates substantial costs. Under a polar version of the traditional doctrine, the penalty (defeasance of an otherwise existing insurance obligation) is exacted whenever any claim for insurance benefits arises and any statement made by the insured is shown to have been false to any degree. Thus, with warranty, a claim for insurance is defeated by the making of even minimally false statements even when the complete truth would not have lowered the premium for a policy providing indemnity only for the event that actually occurred. Because warranty bars claims even when the insured cannot be shown to have known that the statement was false, the doctrine protects the insurer (and, in a competitive market, insureds) from statements that the insured in fact knew to be false in conditions where the insurer cannot prove that knowledge. The downsides of the warranty mechanism include the frequent investigations into the truthfulness of pre-contractual statements and the undesirable transfer of risk to the insured in situations where belief structures were indeed symmetric but the insured was careless in his pre-contractual statements. The doctrine of representation represents another method of controlling adverse selection. Although many variants of the doctrine exist, it may generally be idealized as a rule under which the insured is penalized (defeasance of an otherwise existing insurance obligation) whenever the insured knowingly made a false statement, a claim for insurance benefits arise, and the premium for a policy providing indemnity for the event that in fact occurred would have been materially higher had the insured been truthful. Since fewer events trigger an inquiry into the truthfulness of pre-contractual statements and since exaction of the penalty depends on the insured’s being shown to have knowingly lied, the expected penalty for false statements is less than that under traditional warranty. The incentive to be truthful and the correlative reduction in adverse selection may be tempered as well. On the other hand, representation rather than warranty lowers expected investigation costs and substantially reduces the chance of imposing a penalty on the insured in situations where beliefs were truly symmetric. During the early nineteenth century, many American and English courts saw considerable virtue in a legal regime where warranties were unfettered in their ability to control adverse selection (Horwitz, 1992). In recent years, however, legal authorities, apparently believing representation either to be a superior vehicle for controlling adverse selection or in an effort at protecting insureds from the costs of warranty, have generally imposed a preference for

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representation, at least in situations where the legal status of pre-contractual statements has been ambiguous. Some legislatures have thus enacted statutes that deem statements to be representations absent clear statements to the contrary. Others have enacted ‘contribute to cause’ statutes that permit penalization of the insured only where the premium for a policy providing indemnity for the event that in fact occurred would have been materially higher had the insured been truthful. Few jurisdictions have considered a contribute to cause standard coupled with a significant penalty (beyond mere defeasance of otherwise existing contractual obligations) for discovery of a material falsehood, although such a mechanism with low policing costs and high penalties would fit well with economic theory regarding control of illegal behavior (Polinsky and Shavell, 1979). Also reducing the efficacy of the pre-contractual statement mechanism, though arguably decreasing its undesirable side effects, has been the doctrine of incontestability. Incontestability, which acts as a kind of statute of limitations against insurer defenses of misrepresentation of breach of warranty, generally addresses situations where there is a high risk of an erroneous determination that a pre-contractual statement was false: the insured is dead and thus unable to testify regarding knowledge of falsity or falsity itself against a life insurer seeking to avoid an indemnity obligation. Thus, at least for the subset of risk factors that the insurer could reasonably have determined by an investigation either before the contract or during some period of time (1 or 2 years) after formation of the contract, the law refuses to let post-event investigations result in a penalty to the insured (Simpson v. Phoenix Mutual Life Insurance Company, 1969). Laws reducing the penalty for false statements likewise potentially weaken the use of post-event investigations as an underwriting tools for controlling adverse selection. These laws reduce, however, the costs associated with erroneous determinations of falsity and determinations of falsity in the face of symmetric beliefs. Legislative distrust of the market’s determination of optimal methods of adverse selection control may explain statutes limiting the penalty for false declarations of age on a life insurance policy to a reduction in the indemnity equal to the difference between the face amount of the policy and the amount of insurance that could have been purchased for the same premium had the insured been truthful about age. Similar judicial distrust of the market may explain occasional rulings limiting the penalty for false representations to a reduction in indemnity equal to that which the insured would have been entitled to had it told the truth in the application process.

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6. Genetic Testing Legal support for both investigatory and post-event methods of separation has recently collided with the growing interest in acquisition of information regarding the genetic make-up of individuals. The result has been the emergence of new laws or ‘voluntary’ agreements on the part of insurers restricting use of genetic information. The Health Insurance Portability and Accountability Act of the United States, laws recently passed in several American states, and laws enacted in Austria and Belgium, all restrict the ability of insurers either to investigate genetic information or to rely on traditional doctrines such as representation with respect to genetic information. Indeed, the Belgian law would appear to prohibit even voluntary disclosure of favorable genetic information. Insurers in Australia, France, the Netherlands, Norway and Switzerland have restricted use of genetic information through industry trade associations. Most scholars who have examined ‘genetic information privileging laws’ from an economic perspective have been critical of these efforts. They fear it will lead to serious problems of adverse selection in health and life insurance (Christianson, 1996; Pokorski, 1995, 1997). Those with privileged information of a genetic defect that increases the probability of early death but without other symptomatic manifestation might, for example, purchase large amounts of life insurance, knowing it to be a tremendous investment under those circumstances. The investment could be liquidated prior to death through viatical settlements and accelerated death benefit provisions now becoming more prevalent within insurance policies. Similarly, those with knowledge of a genetic predisposition to debilitating illnesses such as Alzheimer’s disease might stock up on long-term disability insurance. Others, however, have suggested that permitting insurance underwriting to deter genetic testing may lead to delayed diagnosis and treatment of disease. The harm caused thereby outweighs dislocations to the insurance market caused by privileging genetic information (McGoodwin, 1996). The economic component of this argument rests, however, on the value to the insured (and perhaps related parties) regarding foreknowledge of genetic defect. Moreover, this argument for privileging genetic information has greater weight with respect to health insurance and possibly long-term care insurance than it does for life insurance. With respect to the latter, it is hard to develop a traditional economic argument supporting genetic privileging laws, except perhaps one that sees the prohibition as the solution to a collective action problem under which individuals with ‘good genes’ would benefit from testing by costly methods even when the harm done to those with bad genes, coupled with the cost of testing, outweighed the total benefit created by the classification scheme.

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Still others (Rothstein, 1993, 1997; Stone, 1996; Jacobi, 1997) have argued that genetic testing poses a perilous dilemma for a system that relies heavily on private risk-based insurance for basic health insurance. If genetic tests are not privileged, few will take them and those who do may find themselves denied financial access to good health care. If genetic tests are not privileged, the private insurance market is seriously endangered. An intriguing escape from the dilemma is suggested by one scholar, however, who proposes to bar individuals from undergoing genetic tests absent prior purchase of insurance to indemnify the insured for the higher health or life insurance premiums that would result from a finding of defect (Tabarrok, 1994). Such a system might itself be subject to some adverse selection, however. People rationally suspecting a genetic defect based either on family history or testing not covered by the law (such as testing in a foreign nation), would purchase this bundle of genetic testing and ‘insurance premium insurance’ with greater frequency than those without suspicion.

D. Contract Regulation 7. Introduction Two significant themes pervade regulation of insurance conflicts: the first is the extent to which government intervention is desirable to protect the insured from the presumed power of the insurer; a second is the extent to which government intervention is desirable to protect non-parties to the transaction from the coalition created by insurer and insured.

8. Insured Protection 8.1 Contra Proferentum Construing ambiguous contracts against the drafter, usually the insurer, has long been part of American insurance law. One economic theory for understanding this doctrine of ‘contra proferentum’ sees it as beneficially internalizing the social costs fostered by ambiguity. Imposing a ‘penalty’ for ambiguous drafting in the form of expanding the enforceable promises made by the drafter or contracting the conditions protecting the drafter theoretically induces the drafter to avoid ambiguity. An overlapping economic theory sees contra proferentum as correcting information problems in the insurance market: interpreting ambiguities in the contract in favor of the insured provides the insured with the optimal expected coverage; the insurer’s foreknowledge of

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the doctrine insures that the insured pays the correct premium for the expanded coverage (Abraham, 1996). While the theory behind contra proferentum, so stated, may not be particularly controversial, its application in sculpting existing insurance law is. To begin with, if the non-drafting party can understand the terms of the contract without incurring significant cost, as is the case when the insured is sophisticated or a ‘repeat player’ in the transactional form, the assignment of liability to the drafting party appears arbitrary. Indeed, under such circumstances the labeling of one party as ‘the drafter’ appears arbitrary as well. Many courts nonetheless hold the doctrine still to apply in this circumstance (Ostrager and Newman, 1995). This arbitrariness might be tempered, to be sure, if the parties were costlessly able to reallocate the private burdens of ambiguity through the insurance contract itself, but impasse costs, bargaining costs, and the risk that a court would not recognize the reallocation of risk would hinder such a cure (Rappaport, 1995). Second, while the burdens of ambiguity fall substantially on society in the form of higher dispute resolution costs, the benefits of the doctrine accrue largely to the non-drafting party (at least in the case of ambiguity unrecognized by the drafter). The doctrine thus creates a disincentive for non-drafting parties to become educated and, indeed, creates a possible incentive for non-drafting parties to prefer contracts that have unrecognized ambiguities. Moreover, some have argued that the doctrine of contra proferentum discourages innovative terms in contract drafting because new terms are subject to the doctrine whereas old terms, already having been interpreted by the courts, are better understood (Goetz and Scott, 1985). The social costs of ambiguity - more judicial disputes - are thus not reduced as much as might initially be thought by the existing judicial doctrine of contra proferentum. Examination of contract terms by government officials before litigation arises, though creating its own difficulties, may thus have some place in an economic theory of insurance regulation. Scholars have also profitably used the tools of economics to classify the variants of contra proferentum found in American courts. Professor Abraham, for example, drawing on traditional law and economics scholarship, describes the optimal degree of clarity as one that would minimize the sum of maldrafting costs (uncertainty, unwarranted reliance) plus maldrafting avoidance costs (lawyer time and lengthier policies, Rappaport, 1995; Abraham, 1996). Negligence-like regimes are those in which contra proferentum is invoked only where the degree of clarity created by the drafter falls short of the optimal level. Strict liability regimes are those in which contra proferentum is invoked whenever an ambiguity is found. Drawing on recent scholarship regarding contract default rules (Ayres and Gertner, 1989), Abraham further classifies legal regimes regarding contra proferentum as penalty or majoritarian-oriented. ‘Majoritarian’ approaches alter the terms of a contract deemed ambiguous (by one of the above measures) to that which a

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majority of policyholders would prefer - and be willing to pay for. Penalty approaches alter the terms of the contract to that which the policyholder would prefer if the expanded coverage were provided for free. While negligence/majoritarian approaches to the doctrine of contra proferentum have some appeal, the popular strict liability/penalty approach has the virtue of avoiding expensive fact-finding on issues that courts are unlikely to resolve correctly much more often than chance. 8.2 Extracontractual Damages A significant development in American insurance law has been the willingness of courts and legislatures to grant insureds injured by breach of an insurance contract damages in excess of that which would have been paid by the insurer had it honored its contractual obligations. These ‘extra-contractual damages’ have been controversial since their inception, have been the subject of some retrenchment in recent years (Macintosh, 1994), and have the subject of considerable economic analysis. There are two sorts of arguments made for augmenting damages for breach of an insurance contract. One, not the subject of examination in this entry, rests on the general inadequacy of traditional contract damages and applies those grounds in the insurance arena (Sebert, 1986). A second type of argument justifying extracontractual damages is that otherwise the winning strategy for insurers is frequent ‘opportunistic breach’ with respect to meritorious claims. This strategy is particularly effective against those who show no signs of sophistication and with respect to smaller claims (Abraham, 1986). Economic arguments in favor of extracontractual damages generally rest on forms of information failure. Unsophisticated insureds, often ignorant of their actual rights under the policy, particularly as expanded by doctrines such as contra proferentum, fear that if they sue and lose they will be out significant time and money. Attorneys are unlikely to correct any misinformation because insureds have imperfect access to the legal marketplace even for advice (Curtis, 1986). Moreover, even insureds accessing the legal market are likely to stall there because attorneys will have difficulty cheaply determining the merits of the insured’s case, particularly where the insurer has failed to create a detectable pattern signaling wrongful denials. And even an attorney determining that the case has merit will be unlikely to bring it because of the small rewards relative to the cost of the case. The reward is small because the insurer pays only what it owed in the first place, plus any positive difference between court-system interest rates and the money earned by holding on to the money, plus some attorneys fees, possibly including those of the insured (Jerry, 1986). According to this theory, the ‘equilibrium’ under a legal regime denying extracontractual damages is for the insurer to breach frequently and the insured frequently to do nothing about it. The consequence is lesser entry into insurance

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transactions and less risk transfer than desirable. Extracontractual damages thus creates a Pareto superior contract as a default rule (Perlstein, 1992). Against this theory rests a basic question: if extracontractual damages are so superior why do they not exist in a competitive insurance market absent legal intervention? If insureds operating in a competitive insurance market really felt it were necessary and desirable to have extracontractual damages, some sort of mechanism would be built in to the contract, such as a formula damage clause for some subset of failures by the insurer timely to pay a meritorious claim. Yet such a system was seldom if ever seen. In part, economic critics of extracontractual damages say, this absence may exist because the harmful reputation an insurer would acquire through consistent bad faith denials of a claim would lead to market punishment at least as harsh as any the legal system could provide. And even if the market failed, public regulators and licensure mechanisms could succeed. It may not exist because insurers and insureds know that the legal system would be unable to distinguish ‘bad faith’ breach from simple mistake. This inability would lead to precisely what has occurred: perversions of desired coverages, induced breach (Richmond, 1994; Schmidt, 1994), and needlessly higher premiums for insureds. And it may be absent in part because the legal market functions better than proponents of extracontractual damages assert (Sykes, 1994a). Awards of legal fees to prevailing parties substantially correct the attorney incentive problems without resort to radical reformulation of contract law. The ability of some insureds to ‘sell’ their rights against insurers in a competitive market to others whose need for funds is less immediate may sometimes hinder the ability insurers would otherwise possess to force cheap settlements out of insureds. Finally, some economic scholars have argued that (ex ante) insureds subject to suffering a catastrophic loss of an irrepaceable commodity want less than full compensation for their financial loss rather than the extra compensation provided by much current law on extra-contractual damages (Cook and Graham, 1977; Fenn, 1987). This attack on extracontractual damages is not without problems. Deterrence of opportunistic breach through reputational injury rests on the dubious ability of the market accurately to distinguish breach from lawful claims denial. Public regulators are often underfunded, incompetent or captured by insurers. The competitive market that supposedly exists in fact consists of insurers who may lawfully collude. An award of simple legal fees to prevailing insureds may not entice attorneys uncertain of their clients’ prospects. The supposed cure of the insurer’s ability to exploit the weakness of an insured through assignment of claims relies on markets that seldom exist precisely because such transactions are often difficult and, in some instances, illegal (State Farm Fire and Casualty Co. v. Gandy, 1996).

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8.3 Conflicts of Interest in Liability Insurance Policies Protection of the insured is likewise illustrated by judge-made law in the United States governing conflicts of interest created by the contract between a liability insurer and its insured over private settlement of legal actions brought against the insured. The conflict, which resembles that arising in the corporate context between various forms of claimants against corporate assets, arises from the extraordinarily complex decomposition of responsibility liability insurance policies almost always create. The responsibilities created by typical liability insurance policies in conjunction with legal doctrine may be crudely represented by positions along three not entirely orthogonal axes. One axis distinguishes responsibility for ‘discharge’ payments such as settlements and judgments made to reduce the liability of the insured from ‘defense’ payments made on behalf of the insured in defending against claims of liability. Certain discharge payments such as those that ‘exhaust’ certain limits of the policy may eliminate future defense obligations of the insurer. This feature of conventional liability insurance contracts effectively gives the insurer a ‘put’ on future defense obligations provided it can completely discharge its insured’s liability to one potential victim of the insured. Thus, a conflict occasionally arises between insurers, who want to exercise this put (at a price negotiated with a victim of the insured) and an insured, who does not want to take on defense responsibilities even when the insurer’s failure to exercise the put increases at least one insured’s expected payments in discharging liabilities to various victims (Texas Farmers Ins. Co. v. Soriano, 1994). The law is not yet well developed on whether the insurer will be permitted unfettered discretion in exercising its apparent contractual authority in this area. One axis that creates frequent conflicts distinguishes responsibility for ‘discharge’ payments made to reduce the liability of the insured based on the amount of the payment in question. Often, the insured takes the first level of responsibility pursuant to deductible or ‘self-insured retention’ provisions in its policy. A primary insurer will often take the next level of responsibility up to some policy limit, but with payments thereunder reducing its responsibility for certain other judgments against the insured and, potentially, litigation expenses in other cases. An excess insurer may take the next level of responsibility up to some policy limit, with the insured having responsibility for judgments beyond the final layer of excess. All of these responsibilities can be shifted in whole or in part to reinsurers. To the extent that litigation strategies, such as reactions to settlement offers, can shape the probability distribution of future discharge and defense obligations, which distribution in turn determines the expected loss from the case suffered by each party, the decomposition along this axis creates conflicts of interest among the various parties regarding litigation strategy (Chandler, 1993; Sykes, 1994a, 1994b; Silver and Syverud, 1995; Pryor, 1997).

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In the absence of clear language to the contrary in the insurance contract, courts typically react to this conflict by simplifying the decomposition in a way somewhat analogous to a judically-imposed corporate restructuring. In the face of an opportunity to settle for some ‘reasonable amount’ with the plaintiff, the insurer that fails to tender the requisite amount or who acts in bad faith with respect to settlement of the case, is held to ‘own’ all layers above the one it nominally owns by contract. The faulty layer is thus liable directly to the victim for judgments piercing that layer or, through subrogation and other mechanisms, to higher layers who discharged the responsibilities that would have been theirs absent the fault of a lower layer (Stuhr, 1992). And, in most American jurisdictions, this liability exists even where the higher layer would not actually have the resources to pay the judgment. Economic theory might well view this restructuring as one vehicle (among others) for correcting inefficient behavior through internalizing of the costs created when parties in control of litigation strategy are otherwise able to foist the costs of certain strategies on to others. The restructuring often induces insurers with settlement responsibility to make decisions that maximize the joint wealth of insurer and insured, thereby leading to optimal consumption of liability insurance. The problem, as noted by two scholars (Sykes, 1994a; Logue, 1994), occurs when the higher layer (usually the insured) would not have the financial resources to pay the judgment. Under these circumstances, the conventional legal rule induces settlements that fail to maximize joint wealth, which in turn leads to underconsumption of liability insurance, which in turn leads to undercompensation of victims. A minority legal doctrine has recently re-emerged that limits the liability of the faulty layer to no more than the higher layers would actually have been able to pay. While this ‘Michigan rule’ may cure the distortions in the settlement process caused by the traditional legal decomposition of responsibility, it may create other problems such as undercompensation of victims and underdeterrence of wrongful conduct. Whatever the merits of the various rules, however, there is always the theoretical possibility of Coasean bargaining to restore efficiency (Sykes, 1994b) but it is unlikely to be particularly useful here given (a) the high costs of bargaining in this extraordinarily complex field and (b) a likely judicial reluctance to accept private party modification of legal rules. Interestingly, consonant with economic theory, liability insurance contracts tend not to grant the insurer authority to settle cases without trial absent the consent of the insured when the insured’s reputation and future income depend on exoneration from the allegations made in the lawsuit (Mayers and Smith, 1981). Courts, concerned about the major change in expected discharge responsibilities created by such a provision, generally refuse, however, to imply it into contracts otherwise silent on the matter (Dear v. Scottsdale Insurance Company, 1997; McKinley, Moody and Barlow, 1997). Insurers and insureds

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protect against exploitation of this consent clause by frequently providing that a settlement held up by the insured’s non-consent re-layers discharge responsibilities such that the insured takes on responsibility for discharge payments in excess of the amount of the rejected settlement (Rauch et al., 1986). A third axis in which conflicts of interest arises surrounds the liability insurance contract’s decomposition of responsibility for various types of events. The insurer, for example, generally has discharge obligations arising out of liability from negligence but generally does not have discharge obligations arising out of more serious types of fault. This conflict leads to an intricate ballet of litigation strategies and counterstrategies described well by one recent scholar (Pryor, 1997). In essence, however, the injured party may ‘underlitigate’ the dispute in an effort both to induce the insurer to incur heightened expected defense and discharge obligations, which increase may be partly appropriated by the injured party through offering to withdraw the triggering underlying dispute against the insured in exchange for a payment mostly from the insurer.

9. Public Protection 9.1 Anti-Diminution In the past, some liability or indemnity insurers sought to reduce the amount they paid victims of their insureds based on the insolvency of their insureds. The insurers’ theory was that their own liability derived from actual payment or the possibility of payment by the insured, which possibility was reduced by the insured’s insolvency. ‘Anti-diminution laws’, or ‘bankruptcy provisions’ now frequently prohibit this practice (Jerry, 1987) and are a classic example of insurance regulation acting to the detriment of the insured and in favor of the public at large. Assuming with Huberman that an insured’s utility of wealth is constant below some ‘insolvency’ level, but that the indemnity owed as a function of insured loss does not have to be non-decreasing, an insured would prefer a policy whose indemnity obligation disappeared above some threshhold level of loss to a policy that had some constant upper limit regardless of the amount of the loss. Indemnity obligations on the part of the insurer that fail to increase the utility of the insured in the event of some serious adverse increase needlessly decrease wealth in all other states by increasing the actuarially justified premium owed by the insured for the insurance. And, indeed, during the early years of indemnity/liability insurance, such ‘diminution clauses’ existed in insurance policies. The problem with such ‘diminution clauses’ is that they result in inadequate compensation to victims of the insured and exacerbate the moral hazard problem caused by the existence of insurance (Shavell, 1986). Many American states now require that insurance policies not diminish on account of the

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insolvency of the insured. 9.2 Treatment of Proceeds in Insolvency The conflict between the interests of the insured and those of potential stranger victims of the insured shows itself again in the legal treatment of liability insurance proceeds upon the insolvency of the insured. Treating these proceeds as property of the estate and thus available to all creditors of the insured, including contract creditors, has the potential generally to enrich the insured by permitting it to borrow at lower interest rates, which inures to the benefit of the insured in the event a subsequent insolvency does not occur. Treating the proceeds as dedicated to the victims of conduct covered by the insurance policy, as the law now often does, means that uncovered claimants such as contract creditors or victims of tortious conduct excluded from the insurance policy’s indemnity obligations must look solely to the insured’s non-insurance assets in the event of an insolvency. This treatment thus has the potential to increase the interest rate the insured must pay. This result likewise may occur where the proceeds of the policy are nominally part of the insured’s estate but where the law permits victims of conduct covered by the insurance policy to ‘cut through’ and bargain with the insurer for a direct payment in exchange for a reduction of the claim against the insured. 9.3 Extreme Conduct Limitations Government limitations on the ability of insureds to protect themselves against liability either for their intentional misconduct to others or for conduct deemed appalling or sadistic enough to be worthy of ‘punitive’ or ‘exemplary’ damages further illustrates intervention in the market to protect potential victims of the insured’s and insurer’s cooperation (Chandler, 1996). Generally, these limitations restrict coverage for appalling conduct. Other times, however, notably in the area of automobile insurance, government requires coverage for appalling conduct so as not to defeat a ‘compulsory insurance’ regime (State Farm Fire and Casualty Co. v. Tringali, 1982). Many commentators applaud limitations on the insurability of punitive damages or damages for intentional conduct on grounds that such restrictions prevent undesirable moral hazard (Ellis, 1982). These efforts generally fail to confront the questionable need for such governmentally imposed constraints, however, given the ability of insurers who fear moral hazard and who will pay the price for failure to control it on their own through exclusions and conditions in the insurance contract. One explanation is that the refusal to enforce contracts permitting indemnification for severely deviant conduct lets insurers and insureds, apparently confused at the time of contracting, ‘come to their senses’. Such a legally created ‘reprieve’ from a faulty contract may be particularly important given the possibility that indemnity for punitive damages

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will increase the frequency of wrongful behavior by insureds and the frequent inability of the law, even with punitive damages, to restore their victims to the status quo ex ante. This argument explanation draws support from simulations conducted by one scholar suggesting that few rational contracting parties would want to provide indemnity for conduct grossly below an efficient level of care, even with court systems prone to error (Chandler, 1996). Perhaps the simplest explanation made with respect to the non-insurability of punitive damages is that deterrence models are irrelevant to punitive damages and that punishment is destroyed where punishment is indemnified (Ellis, 1982).

E. Competition Law Exemptions In the United States and in Europe, insurers have been exempt from many ‘competition’ or ‘antitrust’ laws prohibiting forms of cooperative behavior by distinct insuring entities. In the United States, this exemption occurs via the McCarran-Ferguson Act (15 United States Code § 1011-15) insulating insurers from most of federal antitrust laws, and by ‘mini McCarran-Ferguson Acts’ enacted by some states insulating insurers to varying degrees from the states’ own laws barring combinations and conspiracies in restraint of trade. In Europe, it occurs via Commission Regulation promulgated in 1992 under Article 85(3) of the Treaty of Rome. This regulation generally permits certain cooperative practices in the ‘insurance sector’ such as cooperation with respect to establishment of premiums, standard policy forms and coverages that might otherwise be prohibited by Article 85(1) of the Treaty and the regulations thereunder. An economic theory has emerged to justify this departure from the general notion that competition rather than cooperation maximizes welfare: the significant economies of scale in production of information needed to prevent adverse selection and insolvency (Achampong, 1991; Danzon, 1992; Macey and Miller, 1993b). Without significant data on the experience of policyholders, it becomes difficult reliably to model the expected loss posed by individual policyholders and therefore accurately to establish actuarially sound premiums. Individual insurers, even large insurers operating multiple lines in many jurisdictions, may lack adequate internal historic data to perform the necessary analyses with confidence. Some have argued that this inability extends even to projections of future losses on future policies. Collective analysis on this point should thus be exempt from antitrust scrutiny (Danzon, 1992). Advocacy of cooperation rather than competition in the business of insurance extends to collective drafting of policy forms. Without common forms, the data needed to make reliable predictions would be ‘noisy’ and thus less amenable to accurate, fine-grained statistical analysis (Macey and Miller,

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1993a, 1993b). Consumers are thought better able to shop when policies have only a few varying parameters, such as price. Uniformity in policy provisions thus actually favors competition, this argument proceeds. Moreover, reinsurance, which serves an economically beneficial specialization function, would be hampered were collective policy forms barred and certain lines of insurance made more custom and less of a ‘commodity’ (Ayres and Siegelman, 1989). Two other economic arguments also frequent debates about application of competition laws to the insurance industry. First, scholars such as Bork (1978) generally question whether collusive behavior between entities should ever be illegal so long as the law would permit those entities to merge. Limited cooperation between competitors might well be better than the elimination of competition through merger (Bork, 1978). Exemption from competition laws thus fosters the existence of numerous small insurers and, derivatively, competition (Danzon, 1992). Second, and somewhat relatedly, some scholars have suggested that legally supported cooperation helps prevent ‘cut-throat’ or ‘anarchic’ competition that, at least historically, appears to have jeopardized the solvency of insurers (Carlson, 1979; McDowell, 1987). Several scholars have noted, however, the scope of the American exemption from competition laws is considerably broader than the arguable economic justification (Achampong, 1991; Macey and Miller, 1993a) Collective data gathering would almost certainly be protected by modern interpretations of existing American competition laws, even were the McCarran-Ferguson Act not in place. Moreover, a need for collective data gathering would not seem to justify collective data analysis, nor would it justify collective pricing of insurance policies, both of which are frequently permitted in the United States though practiced somewhat less frequently than in years past. Moreover, if there are economies of scale in data collection, it is not clear why for insurance but not for other industries the law would ‘prop up’ small companies operating at less than an efficient scale by permitting them to collude with each other in a way other than lawful merger or joint research permitted for all industries under federal laws enacted in the 1980s. This critique would appear to be supported by empirical research suggesting that the economies of scale in the insurance industry are limited and that many insurers could survive at the minimum efficient scale (Geehan, 1986; Joskow, 1992). It has also been suggested that the collusive rating practices facilitated by the exemption from competition laws induces sloppy and inefficient cost control measures by insurers (Angoff, 1988). Finally, collective data gathering may trap underwriting practices in some local optimum whereas the greater experimentation facilitated by barring collusion might lead to more accurate methods of assessing policyholder risk. Interestingly, the more recent regulations of the European Community appear to echo at least some of these criticisms of the broad American exemption from competition laws. Under Regulation 3932/92, for example,

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collaborative compilation of statistics on expected losses is permitted as is statistical analysis of that data. Collective determinations of actual premiums, after expense loading and other cost factors are taken into account, is prohibited, however. Obligations among competitors to adhere to a joint pricing mechanism are void. While development of common policy forms and coverages are permitted, insurers are not permitted to enter into contracts with each other than would compel use of these forms and coverages.

F. Conclusion Sensible regulation of insurance requires an understanding of a broad span of economics including finance theory, price theory, game theory, dynamics, international trade and econometrics as well as ancillary subjects such as statistical and information theory. It also requires an understanding of jurisprudential issues such as the appropriate specificity of rules, the appropriate centralization of legal authority across networked cultures, the appropriate allocation of law-making authority between legislature and judiciary, and the costs of various forms of dispute resolution. While the broad contours of insurance regulation have been profitably and extensively examined using tools from each of these disciplines separately, and while this entry evidences some considerable progress in a more interdisciplinary approach, many of the intricacies of legal doctrine that determine the actual course of insurance transactions remain unconquered by the powerful combination of law and economics.

Bibliography on Insurance Regulation (5700) Abraham, Kenneth S. (1985), ‘Efficiency and Fairness in Insurance Risk Classification’, 71 Virginia Law Review, 403-451 Abraham, Kenneth S. (1986), Distributing Risk: Insurance, Legal Theory and Public Policy, New Haven, Yale University Press. Abraham, Kenneth S. (1991), Environmental Liability Insurance Law, Prentice Hall Law and Business. Abraham, Kenneth S. (1996), ‘A Theory of Insurance Policy Interpretation’, 95 Michigan Law Review, 531-569. Achampong, Francis (1991), ‘The McCarran-Ferguson Act and the Limited Insurance Antitrust Exemption: An Indefensible Aberration’, 15 Seton Hall Legislative Journal, 141-169. Akerlof, George (1970), ‘The Market for Lemons: Quality Uncertainty and the Market Mechanism’, 84 Quarterly Journal of Economics; 488-500. Angoff, Jay (1988), ‘Insurance Against Competition: How the McCarran-Ferguson Act Raises Prices

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and Profits in the Property-Casualty Insurance Industry’, 5 Yale Journal on Regulation, 397-415. Ayres, Ian and Siegelman, Peter (1989), ‘The Economics of the Insurance Antitrust Suits: Towards an Exclusionary Theory’, 63 Tulane Law Review, 971-997. Borenstein, Severin, (1989), ‘The Economics of Costly Risk Sorting in Competitive Insurance Markets’, 9 International Review of Law and Economics 25-39. Carlson, Larry D. (1979), ‘The Insurance Exemption from the Antitrust Laws’, 57 Texas Law Review 1127 ff. Chamberlain, John R. (1985), ‘Assessing the Fairness of Insurance Classifications’, 7 Research in Law and Economics, 65-87. Chandler, Seth J. (1993), ‘Reconsidering The Duty to Settle’, 42 Drake Law Review, 741-806. Chandler, Seth J. (1996), ‘The Interaction of the Tort System and Liability Insurance Regulation: Understanding Moral Hazard’, 2 Connecticut Insurance Law Journal, 91-177. Christianson, David J. (1996), ‘Genetic Testing: Risk Classification and Adverse Selection’, 15 Journal of Insurance Regulation, 75-79. Cook, P.J. and Graham, D.A. (1977), ‘The Demand for Insurance and Protection: The Case of Irreplaceable Commodities’, 91 Quarterly Journal of Economics,143-156. Crocker, Keith J. and Snow, Arthur (1986), ‘The Efficiency Effects of Categorical Discrimination in the Insurance Industry’, 94 Journal of Political Economy, 321-344. Cummins, J. David (1988), ‘Risk-Based Premiums for Insurance Guaranty Funds’ 43 Journal of Finance, 823-839. Curtis, Linda (1986), ‘Damage Measurements for Bad Faith Breach of Contract: An Economic Analysis’, 39 Stanford Law Review, 161-185. Danzon, Patricia M. (1992), ‘The McCarran-Ferguson Act: Anticompetitive or Procompetitive’, Regulation, Spring 38-47. Ellis, Dorsey D. (1982), ‘Fairness and Efficiency in the Law of Punitive Damages’, 56 Southern California Law Review, 1-78. Fama, Eugene F. (1980), ‘Agency Problems and the Theory of the Firm’, 88 Journal of Political Economy, 288 ff. Fenn, Paul (1987), ‘Evaluating Irreplaceable Loss: Some Implications for Insurance and Liability Rules’, 12 Geneva Papers on Risk and Insurance,158-167. Finsinger, Jorg and Pauly, Mark (1992), ‘Reserve Levels and Reserve Requirements for Profit-maximizing Insurance Firms’, in Dionne, George and Harrington, Scott E. (eds), Foundations of Insurance Economics, Boston, Kluwer. Finsinger, Jörg, Hammond, Elizabeth and Trapp, Julian (eds) (1985), Insurance: Competition or Regulation?, London, The Institute for Fiscal Studies. Frech, H.E. and Samprone, Joseph C. (1980), ‘The Welfare Loss of Excess Nonprice Competition: The Case of Property-Liability Insurance Regulation’ 23 Journal of Law and Economics, 429-440. Geehan, Randall (1986), ‘Economies of Scale in Insurance: Implications for Regulation’, in: Wasow, Bernard and Hill, Raymond D. (eds), The Insurance Industry in Economic Development, New York, New York University Press, 137-159. Goetz, Charles J. and Scott, Robert E. (1985), ‘The Limits of Expanded Choice: An Analysis of the Interactions Between Express and Implied Contract Terms’, 73 California Law Review, 261-322.

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Gron, Anne (1994a), ‘Evidence of Capacity Constraints in Insurance Markets’, 37 Journal of Law and Economics, 349-377. Gron, Anne (1994b), ‘Capacity Constraints and Cycles in Property-Casualty Insurance Markets’, 25 RAND Journal of Economics, 110-127. Hansmann, Henry (1985), ‘The Organization of Insurance Companies: Mutual versus Stock’, 1 Journal of Law, Economics and Organization 125-153. Hogan, Arthur M.B. (1995), ‘Regulation of the Single European Insurance Market’, 13 Journal of Insurance Regulation, 329-358. Huberman, Gur, Mayers, David and Smith, Clifford W. (1983), ‘Optimal Insurance Policy Indemnity Schedules’, 14 Bell Journal of Economics, 415-425. Jacobi, John V. (1997), ‘The Ends of Health Insurance’, 30 University of California Davis Law Review 311-404. Jerry, Robert H., II (1986), ‘Remedying Insurer’s Bad Faith Contract Performance: A Reassessment’, 18 Connecticut Law Review, 271-321. Jerry, Robert H., II (1987), Understanding Insurance Law, § 95c, New York, Matthew Bender. Jones, Brian A. (1996), ‘Insurance Regulation in the European Union’, 47 Federation of Insurance and Corporate Counsel Quarterly, 75-93. Joskow, Paul L. (1992), ‘Cartels, Competition and Regulation in the Property-Liability Insurance Industry’ in Dionne, Georges and Harrington, Scott E. (eds), Foundations of Insurance Economics, Boston, Kluwer. Kimball, Spencer L. (1961), ‘The Purpose of Insurance Regulation: A Preliminary Inquiry in The Theory of Insurance Law’, 41 Minnesota Law Review 471-524. Kimball, Spencer L. and Denenberg, Herbert S. (eds) (1969), Insurance, Government, and Social Policy, Homewood, IL, Richard D. Irwin. Logue Kyle D. (1994), ‘Solving the Judgment-Proof Problem’, 72 Texas Law Review, 1345-1394. Macey, Jonathan R. and Miller, Geoffrey, P. (1993a), ‘The McCarran-Ferguson Act of 1945: Reconceiving the Federal Role in Insurance Regulation’, 68 New York University Law Review, 13-88. Macey, Jonathan R. and Miller, Geoffrey P. (1993b), Costly Policies: State Regulation and Antitrust Exemption in Insurance Markets, Washington, DC, American Enterprise Institute Press. Macintosh, Kerry L. (1994), ‘Gilmore Spoke too Soon: Contract Rises from the Ashes of the Bad Faith Tort’, 27 Loyola of Los Angeles Law Review, 483 ff. Mayers, David and Smith, Clifford W., Jr (1981), ‘Contractual Provisions, Organizational Structure, and Conflict Control in Insurance Markets’, 54 Journal of Business, 407-434. Mayerson, Allen L. (1969), ‘Ensuring The Solvency of Property and Liability Insurance Companies’ in: Kimball, Spencer L. and Denenberg, Herbert S. (eds), Insurance, Government, and Social Policy, Homewood, IL, Richard D. Irwin. McDowell, Banks (1987), ‘Competition as a Regulatory Mechanism in Insurance’, 19 Connecticut Law Review, 287-310. McGoodwin, Wendy L. (1996), ‘Genetic Testing: A Tool for Doctors, not for Insurers’, 15 Journal of Insurance Regulation, 71-74. Perlstein, Barry (1992), ‘Crossing The Contract-Tort Boundary: An Economic Argument for the Imposition of Extracompensatory Damages for Opportunistic Breach of Contract’, 58 Brooklyn Law Review, 877-911.

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Pokorski, Robert J. (1995), ‘Genetic Information and Life Insurance’, Nature, July 6, 1995, 13-14. Pokorski, Robert J. (1997), ‘Insurance Underwriting in the Genetic Era’, 60 American Journal on Human Genetics, 205-216. Pryor, Ellen S. (1997), ‘The Stories We Tell: Intentional Harms and the Quest for Insurance Funding’, 75 Texas Law Review, 1721-1764. National Association of Insurance Commissioners (1996), ‘Report of the NAIC Genetic Testing Working Group’, 15 Journal of Insurance Regulation, 7-65. Rappaport, Michael B. (1995), ‘The Ambiguity Rule and Insurance Law: Why Insurance Contracts Should not be Construed Against the Drafter’, 30 Georgia Law Review 171-257. Raviv, Artur (1992), ‘The Design of an Optimal Insurance Policy’ in: Dionne, George and Harrington, Scott E. (eds), Foundations of Insurance Economics, Boston, Kluwer. Rea, Samuel A., Jr (1992), ‘Insurance Classifications and Social Welfare’, in Dionne, Georges (ed.), Contributions to Insurance Economics, Boston, Kluwer. Rea, Samuel A., Jr (1993), ‘The Economics of Insurance Law’, 13 International Review of Law and Economics, 145-162. Rothschild, Michael and Stiglitz, Joseph E. (1976), ‘Equilibrium in Competitive Insurance markets: An Essay on the Economics of Imperfect Information’, 90 Quarterly Journal of Economics, 629-649. Rothstein, Mark A. (1993), ‘Genetics, Insurance and the Ethics of Genetic Counseling’, 3 Molecular Genetic Medicine, 159-177. Rothstein, Mark A. (1997), ‘Genetic Secrets: A Policy Framework’, in Rothstein, Mark A. (ed.), Genetic Secrets: Protecting Privacy and Confidentiality in the Genetic Era, New Haven, Yale University Press. Schmalensee, Richard (1984), ‘Imperfect Information and the Equitability of Competitive Prices’, 99 Quarterly Journal of Economics 441-460. Sebert, John A., Jr (1986), ‘Punitive and Nonpecuniary Damages in Actions Based Upon Contract: Toward Achieving The Objective of Full Compensation’,33 University of California Los Angeles (UCLA) Law Review 1565-1678. Shavell, Steven (1986), ‘The Judgment Proof Problem’, 6 International Review of Law and Economics, 45-58. Shavell, Steven (1987), An Economic Analysis of Accident Law, Cambridge, MA, Harvard University Press. Silver, Charles and Syverud, Kent (1995), ‘The Professional Responsibilities of Insurance Defense Lawyers’, 45 Duke Law Journal 255-363. Smith, Clifford W. and Warner, Jerold B. (1979), ‘On Financial Contracting: An Analysis of Bond Covenants’, 7 Journal of Financial Economics, 117-161. Stigler, George J. (1968), ‘Price and Nonprice Competition’, 76 Journal of Political Economy, 149 ff. Stone, Deborah A. (1996), ‘The Implications of the Human Genome Project for Access to Health Insurance’, in The Human Genome Project and the Future of Health Care, Indiana University Press. Sykes, Alan O. (1994a), ‘Bad Faith: Refusal to Settle by Liability Insurers: Some Implications of the Judgment-Proof Problem’, 23 Journal of Legal Studies, 77-110. Sykes, Alan O. (1994b), ‘Judicial Limitations on the Discretion of Liability to Settle or Litigate: An Economic Critique’, 72 Texas Law Review 1345-1374.

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Sykes, Alan O. (1996), ‘Bad Faith Breach of Contract by First-Party Insurers’, 25 Journal of Legal Studies, 405-444. Tabarrok, Alexander (1994), ‘Genetic Testing: an Economic and Contractarian Analysis’, 13 Journal of Health Economics, 75-91. Van Den Berghe, Lutgart (1990), ‘(De)Regulation of Insurance Markets’ in Louberge, Henri (ed.), Risk, Information and Insurance: Essays in the Memory of Karl H. Borch, Boston, Kluwer, 199-220. Winter, Ralph A. (1988), ‘The Liability Crisis and the Dynamics of Competitive Insurance Markets’, 5 Yale Journal on Regulation, 455-499. Winter, Ralph A. (1991a), ‘Solvency Regulation and the Property-Liability “Insurance Cycle”’, 29 Economic Inquiry, 458-71. Winter, Ralph A. (1991b), ‘The Liability Insurance Market’, 5 Journal of Economic Perspectives, 115-136. Wortham, Leah (1986), ‘The Economics of Insurance Classification: The Sound of One Invisible Hand Clapping’, 47 Ohio State Law Journal, 835-890.

Other References Ayres, Ian and Gertner, Robert (1989), ‘Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules’, 99 Yale Law Journal, 87-130. Bork, Robert H. (1978), The Antitrust Paradox: A Policy At War With Itself, New York, Basic Books. Harsanyi, John (1967), ‘Games with Incomplete Information Played by “Bayesian” Players I: The Basic Model’, 14 Management Science, 159-182. Horwitz, Morton J. (1992), The Transformation of American Law, New York, Oxford University Press. Howard, Lisa S. (1996), ‘Genetic Testing Debate Starts to Bubble in U.K.’, National Underwriter, August 5, 45-46. Kimball, Spencer L. (1992), Cases and Materials on Insurance Law, Boston, Little Brown. Lewis, Stephen and Coates, Katherine (1991), ‘European Perception of U.S. State Regulation’, in Semaya, Francine and Vitkowsky, Vincent J. (eds), The State of Insurance Regulation, Chicago, American Bar Association. Ostrager, Barry R. and Newman, Thomas R. (1995), Handbook of Insurance Coverage Disputes, New York, Prentice Hall Law and Business, §1.03. McKinley, Hall F., III, Moody, G. Randall and Barlow, Peter B. (1997), ‘Issues in the Selection of Counsel and Control of Litigation when the Insured has a Self-Insured Retention’, 32 Tort and Insurance Law Journal, 769-786. Polinsky, A. Mitchell and Shavell, Steven (1979), ‘The Optimal Tradeoff Between the Probability and Magnitude of Fines’, 69 American Economics Review, 880 ff. Rasmusen, Eric (1994), Games and Information: An Introduction to Game Theory, 2nd edn, Cambridge, MA, Blackwell. Rauch, Michael, et al. (1986), ‘Settlement of Professional Liability Claims’, in Professional Liability Insurance for Attorneys, Accountants, and Insurance Brokers 1986, New York, Practicing Law Institute. Rawls, John (1971), A Theory of Justice, Cambridge, MA, Belknap Press of Harvard University Press.

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Richmond, Douglas R. (1994), ‘The Two-Way Street of Insurance Good Faith: Under Construction, but Not Yet Open’ 28 Loyola University Chicago Law Journal 95-140. Riegel, Robert (1916), ‘Fire Insurance Rates: Problems of Cooperation, Classification, Regulation’, 30 Quarterly Journal of Economics, 704-737. Schmidt, Stephen R. (1994), ‘The Bad Faith Setup’, 29 Tort and Insurance Law Journal 705-739. Selten, Reinhard (1975), ‘Re-examination of the Perfectness Concept for Equilibrium Points in Extensive Games’, 4 International Journal of Game Theory, 25-55. Sankey, Keith (1997), ‘UK: Insurers Measure Up Genes’, Reinsurance, April 30, 1997. Stuhr, V. Eileen (1992), ‘Excess Carrier Tort Suits: Are Primary Insurers Up The Canal Without a Paddle?’, 29 Houston Law Review, 661-717.

Cases Arizona Governing Committee v. Norris (1983), 463 United States Reports 1073-1011. Dear v. Scottsdale Insurance Co. (1997), 947 Southwestern Reporter (Second Series) 908-919. Simpson v. Phoenix Mutual Life Insurance Co. (1969), 24 New York Reporter (Second Series) 262-268. State Farm Fire and Casualty Co. v. Gandy (1996), 39 Texas Supreme Court Journal 696-719. State Farm Fire and Casualty Co. v. Tringali (1982), 686 Federal Reporter (Second Series) 821-825. Texas Farmers Ins. Co. v. Soriano (1994), 881 Southwestern Reporter (Second Series) 312-318.

5810 MARRIAGE CONTRACTS Antony W. Dnes Associate Dean (Research) University of Hertfordshire, England. © Copyright 1999 Antony W. Dnes

Abstract This chapter is an examination of the incentive structure set up by the law of marriage and divorce. Two forms of opportunistic behaviour are of particular interest: the ‘greener-grass’ effect and the ‘Black-Widow’ effect. There is a case for seriously considering expectation damages as a basis for post-divorce support obligations and asset division. The current focus of marital law on a mixture of needs-based and contractual elements in divorce settlements is vulnerable to the charge that behaviour is encouraged in both males and females that is predatory in nature. The contractual uncertainty that follows from this may well deter some good quality marriages that might otherwise occur. JEL classification: K12 Keywords: Family, Remedies, Needs, Opportunism, Breach of Contract

1. Introduction The growth of divorce, reduction in rates of marriage, growth of co-habitation, and similar trends in western society have all caused concern in recent years. Families are less stable and this has implications for the welfare of children. From an economic perspective, a major issue is the incentive structure set up by the law of marriage and divorce. The dependency and vulnerability of one marriage partner to opportunistic behaviour by the other is foreseeable under current laws, opportunism being defined as self-seeking with guile (definition of Williamson, 1985, p. 47). This chapter is specifically concerned with the extent to which laws may have set up incentives encouraging divorces that would otherwise be avoided and discouraging marriages that might otherwise have occurred Two adverse incentives are of particular interest. Financial obligations may create incentives for a high-earning partner to divorce a low-earning, or possibly simply ageing, spouse if the law does not require full compensation of lost benefits. Elsewhere, I have called this the ‘greener-grass’ effect (Dnes, 1978). Under current social conditions and present marital law, the 864

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greener-grass effect will typically induce wealthy men to abandon poorer wives. There could also be an incentive for a dependent spouse to divorce if payments based on dependency allow the serial collection of marital benefits without regard to the costs imposed on the other party. I call the second adverse incentive the ‘Black-Widow’ effect (Dnes, op cit.). Under current conditions, Black Widows are likely to be women with relatively poor husbands in marriages where the husband cannot transfer benefits to deter her exit.

2. Marriage as a Long-Term Contract A useful starting point is to think of marriage as a contract between two parties and divorce as resulting from breach of contract, although it should be noted that marriage predated the development of contract. A purely contractual starting point would be modern, although contractual elements are present in the case law (Lloyd Cohen, 1987, p. 270). A contractual approach is also capable of considerable sophistication and it is unhelpful to dismiss it out of hand, particularly where inherently economic issues like asset division are at stake. Becker was a pioneer among economic theorists of marriage and is often regarded as a bête noir by writers hostile to economics-based approaches to the family. Becker’s work is admirable but was not focused on opportunism. It has lead to more recent bargaining theories of the family. The interested reader may see Becker (1974a) and Becker (1991) to inspect the origins of economic analysis of the family. Lloyd Cohen (1987) describes marriage as an unusual contract in which the parties exchange promises of spousal support, where the value of the support is crucially dependent on the attitude with which it is delivered. In a traditional marriage, many of the domestic services provided by the wife occur early in the marriage, whereas the support offered by the male will grow in value over the longer term. The opportunities of the parties may change so that one of them has an incentive to breach the contract. Divorce imposes costs on both parties, equal to at least the cost of finding a replacement spouse of equivalent value (in contract terms this cost is technically a measure of expectation damages, that is the replacement cost of the anticipated spousal support). Cohen argues that the risks and costs of being an unwilling party to divorce are asymmetrically distributed: the husband might be tempted to take the wife’s early services and dump her to enjoy his later income without her (the ‘greener-grass’ effect), and she will tend to be worth less on the remarriage market than a male of similar age (Lloyd Cohen, 1987, p. 278). Why do people marry? There are both psychic and instrumental benefits to marriage.

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The willingness of someone to commit themselves to oneself is evidence of worthiness of such love, and marriage gives a means of protecting long-term investments in marital assets. According to Cohen the spouses may be regarded as ‘unique capital inputs in the production of a new capital asset, namely ‘the family’. In particular, children are shared marital outputs. Another instrumental gain is the provision of insurance: parties give up their freedom to seek new partners, if their prospects improve, for a similar commitment from a spouse, which is rational if the gains from marriage exceed the cost of losing freedom to separate (see Posner, 1992). The gains from marriage reflect surpluses that can be seen as appropriable and may tempt a spouse to opportunistic behaviour, comparable to the incentives in more regular long-term contracts (see Klein, Crawford and Alchian, 1978). Cohen also draws attention to the role of marriage-specific investments like the effort expended on raising children, or the prospect of losing association with one’s children, as ‘hostages’ that may suppress opportunistic exit from the marriage. Cohen favours the preservation of restraints on opportunistic divorce, which he sees as requiring understanding that marriage is a long-term contractual relationship. The ‘wrong’ judicial approach to obligations like long-term support can lead to too much or too little divorce. This observation brings in the idea of an optimal level of divorce, which might be encapsulated in a rule like ‘let them divorce when the breaching party (the one who wants to leave, or who has committed a “marital offence”) can compensate the victim of breach’. (I pursue the idea of optimal breach further below.) A contractual focus on marriage is of value but the underlying view of the marriage contract needs to be sophisticated. Marriage contracts revolve around direct and instrumental benefits, bargaining influences (Lundberg and Pollak, 1996), shared goods, long-term marriage-specific investments, incentives for due performance and incentives for opportunism. These factors are of considerable consequence. If the law covering the financial obligations attached to divorce fails to suppress opportunism, then people will be hurt: fewer marriages will occur than otherwise and there may be less investment in marriage-specific activities like child raising. People will not be certain of obtaining predictable returns on marital investments.

3. Efficient Marital Breach Breach of contract may be optimal, providing compensation is paid to the breached-against party for lost expectation. Awarding ‘expectation damages’ is indeed the standard remedy for breach among commercial parties, and has the characteristic of placing the parties in the position they would have been in

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if the contract had been completed (see Dnes, 1996). The common law may be considered efficient (wealth maximizing for the parties) in awarding expectation damages for breach. One would not insist on specific performance of a commercial contract. However, so as not to over-insure the victim of breach there is an important requirement for the victim to take any steps possible to mitigate the loss. Later in this chapter I shall show that a sophisticated view of the marriage contract, drawing on modern ideas of long-term relational contracting could give a useful direction to policy. For the moment, I examine a more limited, classical form of contract. Marriage vows would be taken quite literally and promises would be seen as binding. For example, a traditionalist view of the marriage contract is as an exchange of lifetime support for the wife, in which she shares the standard of living (‘output’) of the marriage, for domestic services such as housekeeping and child rearing. The classical-contract view could easily include less traditionalist frameworks. Breach of contract by one party would allow the other to reclaim lost expectation subject to an obligation to mitigate losses. All the traditional marital offences, such as adultery, unreasonable behaviour and abandonment, would be relevant to a divorce system based on classical breach of contract, in determining who had breached. Equally, no-fault divorce would be consistent with the notion of efficient breach as it would simply represent either (i) a decision by one party to breach the marital contract and pay damages, or (ii) a mutual decision to end the contract with a negotiated settlement. Consider a lengthy marriage that ends in divorce. The parties met when they left university. After working for some years the wife gave up work to have children and care for them. When the youngest child started school, she returned to work but at a lower wage than previously. After 20 years of marriage, the husband petitions for divorce on the grounds of separation. Their housing and other assets have always been held jointly. The husband would be expected to share property and income to maintain the standard of living his ex-wife would have enjoyed for the remainder of the marriage. Expectation damages are identical to the minimum sum that he would have to pay to buy from her the right to divorce her, if divorce were only available by consent. (He might have to pay up to his net benefit from divorcing if this were higher and his ex-wife were able to hold out.) The court would assess what that standard of living was and determine who had breached the contract. The breaching partner would not generally be difficult to detect if attention is focused, as is common across the law, on proximate causes. The fact that the divorced wife gave up work for a while or now earns less than might have been the case without child-care responsibilities is immaterial in finding expectation damages: broadly, if it can be judged that

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she would have enjoyed the use of a large house and of other assets and available monetary sums, she would be awarded the assets and income to support that lifestyle. Her own income would contribute to that expectation, as would her own share of the house and other assets. The divorcing husband would be expected to contribute from his income and his share of the assets to provide that support for his ex-wife, regardless of the impact on his own lifestyle or on any subsequent marriage partner. Any common-law or statutory requirement to maintain the standard of living of the children of the marriage could be dealt with separately by the court, although the requirement would probably be met by maintaining expectation in the example. Following the principle of loss mitigation, if separation from allows the former wife to increase her income or assets in some way, or there are opportunities to avoid losses (including opportunities for remarriage) those amounts should be deducted from the settlement. In addition, if she contrived an apparent breach, for example by pursuing oppressive forms of behaviour, the husband could excuse his breach under the doctrine of duress (other classical contract doctrines would also be needed, for example misrepresentation, but do not seem central to the issues at this point). Without such safeguards, couples might be careless in preserving the marriage. With these qualifications, expectation damages would ensure that only efficient breach occurred, that is when someone’s gain from the divorce exceeded the compensation needed to put the other party, as far as money could, in the same position as before. From a traditionalist perspective, the approach would give security to a woman contemplating an investment in home-making rather than labour-market activities - although it is actually supportive of a wide range of possible marriage types. Under a classical-contracting approach, the courts would recreate the expected living standard of the victim of breach of the marital contract by adjusting the property rights and incomes of the parties at divorce. Fault would matter to the extent that the court would need to establish who was the breaching party but this would not rule out no-fault divorce (actually, unilateral breach where one party wishes to leave the marriage without citing marital offences and can divorce the other party against his or her will). It would only be irrelevant in a system of mutual consent, where both parties negotiated a settlement stating that neither was at fault; where bargaining would safeguard expectations. The classical-contracting approach preserves incentives for the formation of traditional families, if that were considered important. Any costs incurred by the victim of breach in raising children would be more than compensated since expectation normally exceeds such costs. The parties would only enter the marriage and incur costs (possibly as opportunities forgone, which we discuss further below) if they expected their personal welfare to be higher - hence, expectation exceeds (reliance) costs.

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Classical contracting is also consistent with the simultaneous existence of separate legal obligations for the maintenance of children. However, it would only be consistent with a literal interpretation of the clean-break principle favoured in much recent family law if sufficient property rights can be transferred to avoid the need for subsequent periodical payments. A classical-contract view would not be consistent with views emphasizing the sanctity of marriage, which insists upon specific performance. No more difficulty should arise in family law than in commercial law in carrying out calculations of expectation damages. Typically, both parties will be at a mature stage of their lives where their lifestyles are reasonably foreseeable. It would be harder to calculate alternatives like reliance damages (see below). The courts might well discover they faced a great deal of argument over who had caused the breach. There might also be a tendency to apply rigid views of what constituted a party’s reasonable expectation in a marriage, although, historically, there has been more of a problem of discretion and inconsistency in the case law on long-term support of ex-wives. Other criticisms of an expectation-damages approach tend to be based on sectional views of social welfare. Thus, the arguments of feminists may be used to reject the idea of divorce rules that reinforce the dependency of women on men. Some liberals (for example, Kay, 1987) argue for measures to increase equality between males and females in their social roles. Others (for example, Gilligan, 1982) argue that men and women are different (women’s art, women’s ways of seeing, women’s writing, and so on). Recent moves in divorce law to compensate women for forgoing career opportunities, or to ‘rehabilitate’ them have been sympathetically received by these groups. Such moves focus on opportunity cost and amount to using restitutionary or possibly reliance standards of compensation.

4. The Reliance Approach In The Limits of Freedom of Contract, Michael Trebilcock (1993) contrasts an analysis of the financial consequences of divorce based on classical-contract ideas with contemporary trends towards compensating opportunity costs. Trebilcock argues strongly for an expectation-damages approach to marital breakdown, particularly because this will suppress opportunistic abandonment of dependent spouses. According to Trebilcock, the feminist dilemma is that divorce laws that are protective of women legitimize the subordinate role of women in society, whereas treating the divorcing couple as equals ignores the

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labour-market disadvantages that domestic specialization confers on many divorcing women. What would happen if we compensated the abandoned spouse (usually the woman) or the woman choosing to leave the marriage, for the opportunity cost of marrying? Opportunity cost comprises the value of alternative prospects she gave up. In contract terms, this amounts to awarding reliance damages: the opportunity cost has become akin to wasted expenditure and the suggested rule seeks to put her in the position she would have been in had the marriage never taken place (the status quo ante). Reliance draws attention to the loss of career opportunities for many women either on entering marriage or in stopping work to have children. An economically strong woman leaving a marriage might receive nothing under this approach, if she could be shown to have lost nothing through marriage. This form of compensation should strictly provide the difference between what has been obtained up to the point of divorce and what the lost opportunity might reasonably be expected to have provided over some targeted period of time. The court would be required to examine and adjust the property rights of the divorcing spouses to put the divorcing woman in the financial position she could claim marriage prevented her from attaining. The suggested operation of this standard is not strictly equivalent to the use of reliance damages, either in contract (when this occurs) or in tort, because there is no suggestion that the payment of reliance damages should be linked to breach of contract: the adjustment is usually simply to be made for the benefit of an economically weakened divorcing woman (or comparable male cases if they emerged, for example where he had given up work to carry out child care). Equally, there is no reason in principle why reliance damages could not be linked to breach of contract, either in the sense of marital offences (substantial breach) or simply as a decision by one party to leave the marriage. Trebilcock points out that the reliance approach is harsh in its treatment of divorcing women with poor pre-marriage career prospects, for example, the waitress who marries a millionaire. Such cases would receive very little compensation for marital breakdown. Reliance damages were rejected in 1980 by the English Law Commission as requiring too much speculation about what might have been. In comparison, expectation damages require less speculation: comparisons are not in the distant past and it is usually reasonably clear by the time of divorce how the standard of living would have developed. Nonetheless, reliance does have its supporters among some economics of law practitioners, notably in the valuation of the loss of a housewife’s services in fatal-accident cases and in establishing a bare incentive for investment in

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household production. (On accident valuation, see Knetsch, 1984.) In the case of a fatal accident, the wife is lost and in some jurisdictions the husband claims her opportunity cost of participating in the marriage as an alternative to claiming her replacement cost (that is, hiring a housekeeper). The reasoning is that the benefits to them both of her forgoing that opportunity must have been at least equal to the opportunity cost (for example wage in paid employment) or she would not have given up the opportunity. The advantage to the professional-class bereaved husband is that compensation will typically be higher. Although reliance damages would tend to be lower than expectation damages, assuming the marriage increased each party’s expected welfare, incentives for investments in domestic services would be preserved. A woman contemplating marriage-specific investments in child care by giving up labour-market opportunities (the reliance) for example, is better off in the marriage with those investments and is at least as well off if it all goes wrong. Therefore, the incentive remains for traditional marriages in which the woman exchanges domestic services for long-term support. The reliance approach could therefore easily support a public-policy objective of preserving traditional family lifestyles, which may not be appreciated by some of its supporters. Equally, one could support investments by males in child care by establishing their right to reliance damages upon divorce. Reliance damages will not be associated with efficient breach. Taking a contractual view first, if reliance damages are owed for breach of contract, a party may breach when the net benefit to them before damages is exceeded by the loss to the other party (opportunistic breach). This is because they only have to pay for reliance, which is normally less than expectation, so the socially suboptimal breach confers a private net advantage to the breaching party. In a system awarding reliance damages for breach of contract, we would expect additional, opportunistic divorces compared with an expectation standard. Women’s marriage-specific investments tend to be made early in marriage, and their remarriage opportunities are poorer than men’s owing to the different operation of ageing processes, demographic factors and the fact that the children of an earlier marriage will be a financial burden on a new husband. Men therefore would be more likely to divorce their wives (the ‘greener-grass effect’) and the increase in opportunistic divorces would tend to harm the interests of women on balance. Under a system awarding reliance damages for breach, we could expect a great deal of judicial effort to go into establishing fault (in the sense of who breached the marriage contract) just as under an expectation standard. If less

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were at stake because reliance is normally less than expectation, there would be a lower incentive to pursue disputes and there might be fewer resources devoted to such conflict. However, the main driving force is that a finding of fault will result in a large bill under both standards so the difference is unlikely to be great. In a system awarding reliance damages of right to a divorcing party regardless of the cause of breach (typically an award to a wife - but possibly a husband - who has specialized in child care) there may also be an incentive for opportunism of a different kind. The problem is not peculiar to the reliance standard but affects all non-fault standards, for example, consider an award from a spouse divorced against his or her will under the Matrimonial and Family Proceedings Act 1984. The apparently vulnerable wife (or husband) might decide to divorce when the net gain from divorce including the reliance award exceeds her (or his) expected net benefit from the marriage continuing, which is a form of inefficient breach. This problem could not happen under a more contractual approach, because a decision to end the marriage would be breach of contract and would attract a damages penalty rather than an award. The practical problem here is that the woman in the example will either not care (on financial grounds) whether the marriage survives, or may feel she will be better off without it. The law will have effectively written an insurance contract that perversely influences behaviour: a case of moral hazard. This type of opportunism (the ‘Black-Widow’ effect) would lead to the prediction that divorces initiated by women would increase whenever such specified damages were introduced. The reliance approach could encourage opportunistic behaviour and would encounter problems of definition and calculation of the status quo ante. It is not kind to divorced women who start out with poor career prospects. Like the expectation standard, reliance implies no special status for any particular family asset: houses, pensions, and anything else, are all candidates for trading off with the aim of achieving the targeted level of support for a party. Reliance could be criticized for introducing a tort focus into the financial obligations of divorce, treating decisions to invest in domestic services as like sustaining injury, and carrying the implication that home building and child raising are activities with no benefits for the domesticated provider. As with expectation damages, a reliance approach could be operated around a separate system of child-support obligations.

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5. Restitutionary Damages Carbone and Brinig (1991) identify a modern development in divorce law that they describe as a restitution approach. In a US context, they argue that academic analysis has been led by developments in the courts, which have increasingly emphasized settlements that repay lost career opportunities, particularly in the context of a wife’s domestic support of her husband and children during periods that allowed for the development of business capital, and other contributions to a spouse’s career (see, for example, Jamison v. Churchill Truck Lines, 632 S.W. 2d. 34, 3536 (Missouri Ct. App. 1982), awarding part of business for domestic contributions; see also Carbone, 1990; Krauskopf, 1980, 1989, and O’Connell, 1988). Restitution might be considered appropriate when a wife supports her husband through college: if they later divorce, the question is whether it is right that he should keep all the returns on this human-capital investment. The canonical example would be where the wife undertakes the child care so that her husband can develop his professional or business life. Restitution is often cited as an appropriate remedy in contract law when not returning money paid out by the victim of breach would lead to unjust enrichment of the breaching party. Restitution is ideologically acceptable to cultural feminists who wish to emphasize the repayment of sacrifices. A restitution approach is distinct from a reliance approach, although both often emphasize the same life choices, for example the opportunity forgone for a separate career. Under a restitution approach, compensation is in the form of a share in the market gain supported by the (typically) wife’s supportive career choice, for example a share in the returns to a medical degree, or a share of the business. Restitution is therefore only possible where measurable market gains have resulted from the ‘sacrifice’. The reliance approach, in contrast, is based on measuring the value of the opportunity forgone, for example estimating the value of continuing with a career instead of leaving work to raise children - an input rather than output measure. Reliance puts the victim of breach in the same position as if the contract had not been made, whereas restitution puts the breaching party in the same position as if the contract not been made (Farnsworth, 1990, p. 947). Restitution damages may be difficult to calculate. Who can really say how much a wife’s contribution was to a husband’s obtaining a medical training? Under a tort-style ‘but-for’ test, perhaps a case could be made that all of his earnings (and assets bought with income) belong to her. Yet, the ex-wife must have got something from the marriage, that is, was not supporting him purely

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for the later return on his income. How much should we offset? Another problem might be negative restitution, where a party can show that the other spouse held them back and was a drain rather than an asset (the ‘Mayor of Casterbridge effect’). In practice, interest in restitution awards arises in US states with no-fault divorce and community-property rules, as a basis for obtaining alimony for an abandoned wife. Restitution will probably be kinder to divorcing women who had poor career prospects before entering the marriage. From an efficiency angle, restitution damages suffer from all of the problems already cited for reliance: the difficulties are logically identical. In a contractual setting (using restitution as a remedy for breach) restitution damages will lead to inefficient breach as liability for damages will again be too low. There will be too much breach (divorce) compared with expectation damages as restitution will normally be less than expectation damages (as long as the victim of breach expected more from the marriage than the returns reflected in the victim’s investment in the breaching party’s career). The higher level of opportunistic divorce will be to the disadvantage of women, if earlier comments about the differential effects of age on remarriage prospects for males and females hold true. Outside of a contractual setting, if support payments are set by statute for ex-spouses regardless of fault, there will be an incentive for opportunistic breach by the party for whom the restitution payment plus other expected benefits from divorce exceed the expectation within the marriage (the Black-Widow effect exactly as above, with restitution substituted for reliance). Compared with reliance damages, the level of divorce could be higher or lower under a restitution standard. This is because there is no necessary connection between the value of investment in the other spouse’s career and a person’s own alternative career prospects. Therefore, reliance can be greater or less than restitution (measured as the market return on the investment in the other spouse’s career). The restitution standard will give the incentive necessary to bring forth investments in domestic activities, particularly child raising. This would operate a little differently from the reliance standard. A person contemplating marriage-specific investments in child care by giving up labour-market opportunities would be entitled to compensation for each such investment decision. Therefore, the incentive remains for traditional marriages. As with expectation damages, a restitution approach could be operated around a separate system of child-support obligations.

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6. Partnership, Property Rights and Rehabilitation There is a trend towards the use of a partnership model in some jurisdictions, notably where community-property is the norm in marriage. Singer (1989) argues that post-divorce income disparity between ex-spouses is the result of joint decisions and that the higher income is strictly joint income (which could carry over to property bought from income). Singer also points out that the equal division of property and income would meet demands for compensation for lost career opportunities, and could further the aims of ‘rehabilitating’ an abandoned spouse. According to Carbone and Brinig (1991), Singer’s analysis uses conventional justifications for post-divorce support without identifying the links between them, fails to determine initial property rights and does not achieve a precise calculation. Singer actually has a spuriously precise system of sharing the joint income for a number of years (she suggests one year of post marriage support for each year of marriage). A partnership model is possibly consistent with an updated contractual model of marriage. There is some evidence that divorcing couples do see themselves as jointly owning at least their assets, that is, their expectations are built around partnership. Weitzman (1981a) found that 68 percent of women and 54 percent of men in her sample of divorcees in Los Angeles County, California believed ‘a woman deserved alimony if she helped her husband get ahead because they are really partners in his work’. This was similar to the proportion supporting alimony on the grounds of the need to maintain small children. Davis, Cretney and Collins (1994) note the prevalence of the presumption of an equal split in their discussion of ‘folk myths’ associated with divorce. Without repeating the detailed analysis of earlier sections, I note that, unless rehabilitation, or equal shares, are the parties’ expectations from marriage, the model could lead to inefficient breach. In turn this can give rise to incentives for opportunistic behaviour, including the greener-grass and the Black-Widow effects, which reflect the adverse incentive effects from using less-than-expectation damages. If the true expectation of the dependent party went beyond equal shares or temporary support plus rehabilitation then a move from expectation damages to rehabilitation would encourage breach of contract by the non-dependent party.

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7. Need A focus on meeting post-divorce housing and other needs, particularly of the spouse with childcare responsibilities, is the dominant element operating several jurisdictions (for example , England and some US states). In such law, need is the starting point, and the majority of cases do not reveal sufficient family resources to go much beyond the allocation of housing to the spouse with responsibility for care of the children, particularly as the clean-break principle favours transferring assets in lieu of periodical payments. There is no necessary inconsistency between a contractual view and needs-based awards, as meeting the needs of the children of the marriage and a breached-against spouse could be the remedy for breach of the marriage contract. However, the welfare consequences of the standard are not encouraging. If we assume that meeting need is a minimal expectation in marriage, need awards for breach would be less than or equal to expectation damages and excessive breach would occur: the by now familiar greener-grass effect as (most likely) husbands find they are not expected fully to compensate abandoned wives for removing the husband’s high, late career earnings. Also, if, as is the case, need awards are not linked to substantial breach, the Black-Widow effect can follow, if the value of a need award plus the expectation from the changed situation (possibly, re-marriage, cohabitation, or single status) exceeds the expectation from the current marriage. There is a direct analogy with the fourth condition above. Needs-based awards of spousal support do meet a concern that people should not be trapped into unhappy marriages. ‘Fault served to restrain men from leaving or flouting their marital obligations too egregiously, but it also left women with little bargaining power within the relationship. Women ... could not leave ... without facing financial ruin’ (Carbone and Brinig, 1991, p. 997). However, from the perspective of maximizing the sum of benefits from a marriage, it is impossible to justify the removal of costs for one person when this will impose similar or greater costs upon another: that would amount to ‘taking sides’. Furthermore, the possibility of inducing the Black-Widow effect might encourage some men to avoid marriage altogether, which is generally a problem when contracts cannot be secured against opportunism: a form of long-term, dynamic inefficiency (see Dnes, 1995). The argument that public policy requires men rather than women to bear the financial costs of divorce is vulnerable to the observation that it is difficult to distinguish between the unhappy divorcing wife and the opportunistically divorcing wife. The weight of the criticism in this paragraph could be undermined by finding that there is

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typically a heavy spillover effect (externality) from the unhappiness of one marriage partner to the welfare of other parties, for example onto children.

8. Revising the Contract Approach to Marriage The problems following from avoiding the use of expectation damages, or of separating awards from the issue of breach of contract are that (i) generally, breach will be inefficient, and (ii) breach may be opportunistic (exploitative). However, the problems with expectation damages in marriage contracts are that (i) implications of lifetime support appear to militate against a modern emphasis on independence in life, and (ii) protracted arguments over the identification of breach would be costly, which is particularly relevant when the court system is run largely from public funds. The problems of identifying breach are at least as severe if non-expectation standards (for example reliance) are used. Would a more sophisticated view of the marriage contract resolve any of these issues? The movement away from highly restrictive divorce laws coupled with lifetime support obligations towards wives was followed by the evolution of liberal laws characterized often by needs-based, discretionary systems of property adjustment and spousal support. The social norms surrounding marriage have clearly changed over time, in particular towards favouring serial marriages and cohabitation. A number of points stand out. One is that marriage rates are falling, cohabitation rates are rising, and divorce rates are rising in many countries, which suggests that the current legal view of marriage does not correspond with the wishes of the population at large. A second important point is that liberalization in a sense allows people to change their minds as circumstances change and to revise the marriage contract. Consequently we need to ask whether a more flexible view of marriage is useful and what the limits to it would be. The history of marital law, showing an evolving view of the nature of the marriage contract that has been heavily shaped by surrounding social norms, is consistent with modern views of ‘relational’ contracts shaped by a surrounding mini-society of norms (relational contracting is explored in Macneil, 1978; Williamson, 1985 and Macaulay, 1991). One possibility might be to encourage the use of clearer marriage contracts with the possibility of enforceable modifications that might be a substitute for divorce. The literature on contract modifications is extremely pessimistic over the prospect of welfare gain from enforcing mutually agreed and compensated modifications (see Jolls, 1997, and Dnes, 1998). This is because of the difficulty of distinguishing between genuinely beneficial revisions and those resulting

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from opportunistic behaviour, which can amount to duress. Consider the difficulty in marriage contracts in distinguishing between a genuine modification (because a party now has improved prospects) and the case where a party threatens to make their spouse’s life hell unless certain terms are agreed. Contract modifications will not set up incentives for opportunism if, in the context of unforeseen events, (i) it is not clear who is the lowest-cost bearer of the risk, (ii) the events were judged of too low a value to be worth considering in the contract, or (iii) it was infeasible for either party to bear the risk (as explained fully in Dnes, 1995, p. 232). Generally, the view that supporting all modifications is desirable because there appears to be a short-term gain is unsound: there may be undesirable long-term instability as a result, as already noted in the previous subsection, since fewer people will make contracts if it is difficult to protect them from opportunism. The idea that modifications can be legally supported when events unfold for which it would not have been clear early on who should have benefitted or borne a fresh cost does give a clue to a rôle for the court. It can determine whether some change was foreseeable and whether the attendant risk would have been clearly allocated, for example, one’s wife’s aging is not a reason for scooting off without compensating her, on the other hand mutually tiring of each other would have been hard to allocate to one party. Generally, the main focus of the law can be expected to remain the division of benefits and obligations on divorce, that is, the ending of a contract and move to new circumstances for the parties. A more appropriate fundamental model of the marriage contract would be as a relational contract. Macneil (1978) has suggested that complex long-term contracts are best regarded ‘in terms of the entire relation, as it has developed [over] time’. Special emphasis is placed on the surrounding social norms rather than on the ability of even well-informed courts to govern the relationship (Macneil calls governance that emphasizes third-party interpretation ‘neoclassical’ contracting). An original contract document (for example marriage vows) is not necessarily of more importance in the resolution of disputes than later events or altered norms. Courts are likely to lag behind the parties’ practices in trying to interpret relational contracts. A relational contract is an excellent vehicle for thinking of the fundamental nature of marriage but it may be of limited help in designing practical solutions to divorce issues unless it is possible to fashion legal support for the relational contracting process. Crucially though, the idea emphasizes flexibility. It is a fascinating mental experiment to put the idea of flexibility together with the persistent caution of this article over the dangers of creating incentives for opportunistic behaviour. Many of the problems associated with the division of

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marital assets arise because social norms change (for example the wife has no entitlement to life-time support) but the individual marriage partners fail to match the emerging marital norm (for example a homely wife married in 1966 is much more likely to have specialized in domestic services). Therefore, a possible approach to divorce law is to use expectation damages to guard against opportunism but to allow the interpretation of expectation to be governed by differing ‘vintages’ of social norms. As an example, the courts could take a retrospective view of the expectations associated with each decade. Consideration could also be given to making pre-nuptial, and post-nuptial, agreements between spouses legally binding. Modern marriages might be allowed to choose between several alternative forms of marital contract (for example traditional, partnership, or implying restitutionary damages on divorce). Providing expectations are clarified, inefficient and opportunistic breach could be broadly suppressed. Such a system could operate around a statutory obligation to meet the needs of children, which providing it does not overcompensate the parent with care should be neutral towards incentives.

9. Conclusions and Summary There is a case for seriously considering expectation damages as a basis for post-divorce support obligations and asset division. The foundation for this conclusion is the incentive for opportunistic behaviour set up by the use of reliance, restitution, partnership, rehabilitation and need approaches to post-divorce liabilities. The current focus of marital law is vulnerable to the charge that behaviour is encouraged in both males and females that is predatory in nature. The contractual uncertainty that follows from this may well deter some good quality marriages that might otherwise occur. Problems arise because a marriage partner can leave without meeting obligations incurred early on in the marriage, that is, will not be forced to pay expectation damages. Under the greener-grass incentive, a husband (usually) will leave the marriage if the gains in a new marriage or from single status exceed his gains in the first marriage, when he knows he will not have to compensate his first wife for the full loss of her married lifestyle. The Black Widow effect is similar but refers to cases where (typically) a female would find that a divorce award means she is better off leaving a first husband and possibly moving to a new relationship even when this would have lower net benefits for her in the absence of the award.

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The contractual view of marriage ultimately explored in this article is different from classical commercial contract law. Different vintages and varieties of marriage need to be recognized. In particular, partners in traditional and non-traditional marriages could be contractually protected against exploitation by recognizing the variety of promises they received. The approach is also consistent with a separate system of liability for support for children and with avoiding having the state pick up the bill for failed marriages.

Acknowledgements I wish to thank the Lord Chancellor’s Department in England for supporting parts of the research associated with this paper, and to thank participants at the June 1997 Lord Chancellor’s Department Economists’ Forum for helpful comments on an earlier draft. I also wish to thank everyone at the Private Enterprise Research Center, Texas A&M University, where I wrote part of this paper, for their kind hospitality and helpful discussions. The paper is developed from an earlier report (Dnes, The Division of Marital Assets Following Divorce with Particular Reference to Pensions, Research Report 7/97, Lord Chancellor’s Dept, 1997) and a journal article (Dnes, 1998).

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Carbone, June R. (1990), ‘Economics, Feminism, and the Reinvention of Alimony: A Reply to Ira Ellman’, 43 Vanderbilt Law Review, 1463-1501. Carbone, June R. and Brinig, Margaret F. (1991), ‘Rethinking Marriage: Feminist Ideology, Economic Change, and Divorce Reform’, 65 Tulane Law Review, 954-1010. Cass, Ronald A. (1987), ‘Coping With Life, Law, and Markets: A Comment on Posner and the Law-and-Economics Debate’, 67 Boston University Law Review, 73-97. Chami, Ralph and Fischer, Jeffrey (1996), ‘Altruism, Matching and Nonmarket Insurance’, 34 Economic Inquiry, 630-647. Cheung, Steven N.S. (1972), ‘The Enforcement of Property Rights in Children, and the Marriage Contract’, 82 Economic Journal, 641-657. Cohen, Jane Maslow (1987), ‘Posnerism, Pluralism, Pessimism’, 67 Boston University Law Review, 105-175. Cohen, Lloyd R. (1987), ‘Marriage, Divorce, and Quasi-Rents; or, ‘I Gave Him the Best Years of My Life’’, 16 Journal of Legal Studies, 267-303. Dnes, Antony W. (1998) The Division of Marital Assets, 25 Journal of Law and Society, 336-64. Fair, R.C. (1978), ‘A Theory of Extramarital Affairs’, 86 Journal of Political Economy, 45-61. Freiden, A. (1974), ‘The United States Marriage Market’, 82(S) Journal of Political Economy, 34-53. Friedman, Lawrence M. and Percival, Robert V. (1976), ‘Who Sues for Divorce? From Fault through Fiction to Freedom’, 5 Journal of Legal Studies, 61-82. Fuchs, Maximilian (1979), ‘Die Behandlung von Ehe und Scheidung in der ‘Ökonomischen Analyse des Rechts’ (The Treatment of Marriage and Divorce in the ‘Economic Analysis of Law’)’, 7 Zeitschrift für das gesamte Familienrecht, 553-557. Grossbard, Amyra (1978), ‘Towards a Marriage between Economics and Anthropology and a General Theory of Marriage’, 68 American Economic Review. Papers and Proceedings, 33-37. Grossbard-Shechtman, Amyra (1984), ‘A Theory of Allocation of Time in Markets for Labour and Marriage’, 94 Economic Journal, 863-882. Horton, Paul and Alexander, Lawrence (1986), ‘Freedom of Contract and the Family: A Skeptical Appraisal’, in Peden, Joseph R. and Glahe, Fred R. (eds), The American Family and the State, San Francisco, Pacific Research Institute for Public Policy, 229-255. Hudson, P. and Lee, W. (1990), Women’s Work and the Family Economy in Historical Perspective. Hutchens, Robert M. (1979), ‘Welfare, Remarriage and Market Search’, 69 American Economic Review, 369-379. Keeley, Michael C. (1977), ‘The Economics of Family Formation’, 15 Economic Inquiry, 238-250. King, Allan G. (1982), ‘Human Capital and the Risk of Divorce: An Asset in Search of a Property Right’, 49 Southern Journal of Economics, 536-541.

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Knetsch, J. (1984), ‘Some Economic Implications of Marital Property Rules’, 34 University of Toronto Law Journal, 263 ff. Kornhauser, Lewis A. and Mnookin, Robert H. (1979), ‘Bargaining in the Shadow of the Law: the Case of Divorce’, 88 Yale Law Journal, 950 ff. Krauskopf, J. (1980), ‘Recompense for Financing Spouse’s Education’ 28 Kansas Law Review, 379 ff. Krauskopf, J. (1989), ‘Theories of Property Division/spousal Support: Searching for Solutions to the Mystery’, 23 Family Law Quarterly, 253 ff. Landes, Elisabeth M. (1978), ‘The Economics of Alimony’, 7 Journal of Legal Studies, 35-63. Lemennicier, Bertrand (1980), ‘La Spécialisation des Rôles Conjugaux, les Gains du Mariage et la Perspective du Divorce (Specialization of Conjugal Role, Marital Gains, and Perspective of Divorce)’, Consommation. Lemennicier, Bertrand (1982), ‘Les Déterminants de la Mobilité Matrimoniale (The Determinants of Matrimonial Mobility)’, Consommation. Lemennicier, Bertrand (1988), Le Marché du Mariage et de la Famille (The Marriage Market and the Family), Paris, Presses Universitaires de France (PUF), Collection Libre Echange. Lemennicier, Bertrand (1990), ‘Bioéthique et liberté (Bio-Ethics and Liberty)’, 13 Droits: Revue Française de Théorie Juridique, 111-122. Lemennicier, Bertrand and Garboua, Levy (1981), ‘L’Arbitrage Autarcie-Marché: une Explication du Travail Féminin (Arbitration Autarchy-Market: An Explanation of Female Work)’, Consommation. Lichtenstein, Norman B. (1985), ‘Marital Misconduct and the Allocation of Financial Resources at Divorce: A Farewell to Fault’, 51 UMRC Law Review, 1-18. Lundberg, S. and Pollak, R. (1996), ‘Bargaining and Distribution in Marriage’ 10 Journal of Economic Perspectives, 139 ff. Lundberg, S., Pollak, R. and Wales, T. (1995), Do Husbands and Wives Pool Their Resources? Evidence from the UK Child Benefit, Manuscript, Economics Dept., Washington University, Seattle. Manser, Marilyn and Brown, Murray (1980), ‘Marriage and Household Decision-Making: A Bargaining Analysis’, 21 International Economic Review, 31-44. McGee, Robert W. (1998), ‘Polygamy’, in X. (ed.), Magill’s Legal Guide, Pasadena, CA, Salem Press. Michael, R. (1979), ‘Determinants of Divorce’, in Garboua, Levy (ed.), Sociological Economics, London, Sage. O’Connell, M. (1988), ‘Alimony after No-fault: A Practice in Search of a Theory’, 23 New England Law Review, 437 ff. Olsen, Frances E. (1983), ‘The Family and the Market: A Study of Ideology and Legal Reform’, 96 Harvard Law Review, 1497-1578. Pahl, J. (1989), Money and Marriage.

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Papps, Ivy (1980), For Love or Money? A Preliminary Economic Analysis, London, Institute of Economic Affairs, 63 p. (Hobart Paperback No.86). Parisi, Francesco (1998), ‘Family Law and Successions’, in Mattei, Ugo (ed.), Introduction to Italian Law, Boston, Kluwer Academic Publishers. Parisi, Francesco and Posner Richard A. (1997), International Library of Critical Writings in Europe, Volume III: Other Areas of Private and Public Law, London, Edward Elgar. Pask, E. Diane, McCall, M.L., Brown C.L., Bruce, Christopher J., Hass, C.A. and Vallance, D.P. (1989), How Much and Why?, Calgary, Canadian Research Unit for Law and the Family, 202 p. Pennington, Joan (1989), ‘The Economic Implications of Divorce for Older Women’, 23 Clearinghouse Review, 488-493. Peters, H. Elizabeth (1986), ‘Marriage and Divorce: Informational Constraints and Private Contracting’, 76 American Economic Review, 437-454. Pollak, Robert A. (1985), ‘A Transaction Cost Approach to Families and Households’, 23 Journal of Economic Literature. Polsby, Daniel D. and Zelder, Martin (1994), ‘Risk-Adjusted Valuation of Professional Degrees in Divorce’, 23 Journal of Legal Studies, 273-285. Posner, Richard A. (1989), ‘The Ethics and Economics of Enforcing Contracts of Surrogate Motherhood’, 6 Journal of Contemporary Health Law and Policy, 21-31. Posner, Richard A. (1992), Sex and Reason, Cambridge, MA, Harvard University Press. Ramseyer, J. Mark (1996), Odd Markets In Japanese History: Law and Economic Growth, New York, Cambridge University Press. Riboud, M. (1988), ‘Altruisme au Sein de la Famille, Croissance Economique et Démographie (Altruism in the Family, Economic Growth and Demography)’, 39 Revue Economique. Schultz, Theodore W. (ed.) (1974), Economics of the Family: Marriage, Children and Human Capital, Chicago, University of Chicago Press, 584 p. Singer, J. (1989), ‘Divorce Reform and Gender Justice’, 67 North Carolina Law Review, 1103 ff. Smith, I. (1997), ‘Explaining the Growth of Divorce in Great Britain’, 44 Scottish Journal of Political Economy, 519 ff. Smith, Vernon L. (1974), ‘Economic Theory and Its Discontents’, 64 American Economic Review. Papers and Proceedings, 320 ff. Sofer, C. (1985), La Division du Travail entre Hommes et Femmes (The Division of Labour Between Men and Women), Paris, Economica. Stake, Jeffrey E. (1992), ‘Mandatory Planning for Divorce’, 45 Vanderbilt Law Review, 397-454. Stout, Lynn A. (1981), ‘Note: The Case for Mandatory Separate Filing By Married Persons’, 91 Yale Law Journal, 363-382. Tsaoussis-Hatzis, Aspasia (1999), ‘Changes in Greek Marriage and Divorce Law: The Impact of the Family Law Reform of 1983', in Miller, Robin R. and Browning, Sandra Lee, Till Death Do Us Part: A Multicultural Anthology on Marriage, Greenwich, JAI Press.

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Tsaoussis-Hatzis, Aspasia (1999b), The Social and Economic Consequences of the Greek Divorce Law Reform of 1983, Ph.D. Thesis, University of Chicago Law School. Weiss, Yoram and Willis, Robert J. (1985), ‘Children as Collective Goods and Divorce Settlements’, 3 Journal of Labor Economics, 268-292. Weitzman, Lenore J. (1981a), The Marriage Contract: Spouses, Lovers and the Law, New York, Free Press, 536 p. Weitzman, Lenore J. (1981b), ‘The Economics of Divorce: Social and Economic Consequences of Property, Alimony and Child Support Awards’, 28 UCLA Law Review, 1181-1268. Weitzman, Lenore J. (1985), The Divorce Revolution: the Unexpected Consequences for Women and Children in America, New York, NY, Free Press. Wishik, Heather Ruth (1986), ‘Economics of Divorce: An Explanatory Study’, 20 Family Law Quarterly, 79-107. Zelder, Martin (1993), ‘Inefficient Dissolutions as a Consequence of Public Goods: The Case of No-Fault Divorce’, 22 Journal of Legal Studies, 503-520.

Other References Davis, G., Cretney, S. and Collins, J. (1994), Simple Quarrels, Oxford, Oxford Clarendon Press. Dnes, Antony W. (1995), ‘The Law and Economics of Contract Modifications: the Case of Williams v. Roffey’, 15 International Review of Law and Economics, 225-240. Dnes, Antony W. (1996), Economics of Law, London, Sweet & Maxwell. Farnsworth, E.A. (1990), Contracts (2nd edn), Boston, Little Brown. Gilligan, C. (1982), In a Different Voice: Psychological Theory and Women’s Development, Boston, MA, Harvard Univ Press. Jolls, Christine (1997), ‘Contracts as Bilateral Commitments: A New Perspective on Contract Modification’, 26 Journal of Legal Studies, 203-237. Kay, H. (1987), ‘Equality and Difference: A Perspective on No-fault Divorce and its Aftermath’, 56 University of Cincinnati Law Review, 1 ff. Klein, Benjamin, Crawford, Robert G. and Alchian, Armand A. (1978), ‘Vertical Integration, Appropriable Rents, and the Competitive Contracting Process’,21 Journal of Law and Economics, 297-326. Macaulay, Stewart (1991), ‘Long-term Continuing Relations: The American Experience Regulating Dealerships and Franchises’, in Joerges, Ch. (ed.), Franchising and the Law, 179 ff. MacNeil, Ian R. (1978), ‘Contracts: Adjustment of Long-Term Economic Relations Under Classical, Neoclassical, and Relational Contract Law’, 72 Northwestern University Law Review, 854-905.

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Trebilcock, Michael (1993), The Limits of Freedom of Contract, Cambridge, Cambridge University Press. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York, NY, Free Press.

5820 SEXUAL REGULATION © Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest

Bibliography Collected by the Editors Brinig, Margaret F. (1990), ‘Rings and Promises’, 6 Journal of Law, Economics, and Organization, 203-215. Brinig, Margaret F. (1995), ‘A Maternalistic Approach to Surrogacy’, 81 Virginia Law Review, 2377-2399. Gohmann, Stephan F. and Ohsfeldt, Robert L. (1994), ‘U.S. Senate Voting on Abortion Legislation: A More Direct Test for Ideological Shirking’, 16 Research in Law and Economics, 175-196. McGee, Robert W. (1998), ‘Polygamy’, in X. (ed.), Magill’s Legal Guide, Pasadena, CA: Salem Press. Posner Richard A. (1992), Sex and Reason, Cambridge, MA, Harvard University Press. Ramseyer, J. Mark (1991), ‘Indentured Prostitution in Imperial Japan: Credible Commitments in the Commercial Sex Industry’, 7 Journal of Law, Economics, and Organization, 89-116. Stout, Lynn A. (1981), ‘Note: The Case for Mandatory Separate Filing By Married Persons’, 91 Yale Law Journal, 363-382. Stout, Lynn A. (1992), ‘Strict Scrutiny and Social Choice: An Economic Inquiry Into Fundamen Tal Rights and Suspect Classifications’, 80 Georgetown Law Journal, 1787-1834. Zelder, Martin (1993), ‘Incompletely Reasoned Sex: A Review of Posner’s Somewhat Misleading Guide to the Economic Analysis of Sex and Family Law’, May Michigan Law Review, 1584-1608.

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5830 GIFTS, WILLS AND INHERITANCE LAW Pierre Pestieau CREPP, Université de Liège and CORE, Université Catholique de Louvain © Copyright 1999 Pierre Pestieau

Abstract This chapter provides a survey of recent theoretical and empirical work on bequeathing from the viewpoint of both economics, and law and economics. We focus on the interaction between individuals’ preferences, legal and fiscal institutions and bequeathing. Two conclusions emerge. First, it appears clearly that the level, the pattern and the timing of bequests depend on both the preferences of the donors and the type of regulation and taxation imposed on inheritance. Second, and conversely, the desirability of such taxation and regulation depends closely on the type of bequests (voluntary or involuntary) that one observes in a given country in a given period. JEL classification: D30, D64, D91, H24 Keywords: Bequests, Inheritance, Gift, Estate Duty

1. Introduction In this chapter, we want to focus on rather recent literature that studies the interaction between preferences, institutions and bequests. More explicitly, we want to convey the now well established idea that the level, the timing and the pattern of bequests is the outcome of the underlying preferences of the bequeathing parents on the one hand and the prevailing legal and fiscal institutions constraining bequests on the other. To do so, we start with the setting in which bequeathing is effected, that is, the complex network of family relations. The family is indeed the locus of various transfers and exchanges, either in competition with, or as a complement to, the state or the market. Admittedly, the distinction between exchange and transfer within the family is not all that clear-cut. Even though ‘pure’ transfers do not imply explicit counterparts, the simple fact that they bring utility to the donor makes them less free than it might seem. Our concern here is with the legal regulation and fiscal treatment of exchanges or transfers between parents and children, which may be monetary or in kind. In addition to wealth transfers such as bequests and gifts, there is also the education that parents provide to their offspring through an investment in both time and money, not to mention the transmission of intangible social 888

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capital. There are also different types of assistance, often in the form of services: these may be descending (providing accommodation or care to grandchildren) or ascending (care, visits or accommodating elderly parents). Even though we focus here on the most traditional type of intergenerational transfers, that is, bequests, all the other types play an important role, either as a complement or as a means of exchange. We survey recent work on the desirability of estate or inheritance taxation and of legal constraints imposed upon bequeathing. To deal with this issue, we introduce a taxonomy of the main types of bequests and models of inheritance developed by economists over the last decades. Each of these models, which focus on specific motivations for wealth transmission, is characterized by the kind of relations existing within the family, the structure of preferences, the type of information held by each member of the family and, of course, his or her own characteristics such as ability or life expectancy. It will become apparent that this taxonomy is very different from the popular image of inheritance and that the economic approach does not follow the same track as the one adopted by other social scientists (Masson, 1995). More importantly, we will point out the multiple and divergent implications that each of these types of inheritance may have when assessing the desirability of fiscal and legal regulation of inheritance.

2. Taxonomy of Bequests Inherited wealth is generally quite unequally distributed (a great deal more than income). In countries like France, it accounts for a large part of all wealth possessed (generally estimated at 40 percent) and represents the largest descending monetary transfer, three times as much as wealth received in the form of inter vivos gifts, for example. Although the inheritor may very well not know the motivations behind the decision to leave him or her a bequest, it is clear that they may be diverse and sometimes contradictory. In fact, there exist three large categories of inheritance: -

-

-

accidental, or unplanned, bequests, characterized not primarily by the desire to transmit wealth to offspring, but by precaution or consumption deferred over an uncertain life span; voluntary, or planned, bequests, falling into different categories depending on the motives for the transmission. They range from pure altruism to paternalistic behavior all the way to the most self-interested strategic exchange. capitalist, or entrepreneurial, bequests, which are the outcome of accumulation for its own sake.

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Our taxonomy of bequests is based on two dividing lines: the consumer’s horizon and the concern for family. Accidental bequests are typically limited to the consumer’s life cycle. Voluntary bequests are essentially based on family considerations. Capitalist bequests commonly have a horizon that extends well beyond the lifetime of the wealth holder; they are not primarily motivated by family considerations even though the dynastic family is used as the channel allowing for the perennity of the estate. These distinctions may sound superfluous. Yet, as we hope to make clear, they are of crucial importance. The implications and consequences that a bequest may have for the level and structure of estate duties (for example) largely depend on the category it belongs to. 2.1 Accidental Bequests Even if parents accumulate wealth only in provision for their old age, as the theory of the life cycle claims, and have no particular desire to leave something to their children, the latter will probably still receive an inheritance. This kind of bequest, termed accidental, is generally associated with the concepts of precautionary savings and deferred consumption. It owes its existence to three factors: the uncertainty over one’s life span, the imperfection of capital markets (pertaining to, for example, annuities or housing) and the impossibility of leaving a negative inheritance. In a world of certainty, savings would be adjusted to match the needs of the life cycle only; if annuities were available at an actuarially fair rate, one could protect oneself against the risk of an excessively long and penniless existence. Under these conditions, there seems to be no purpose in leaving a bequest that is of no particular use in itself. To illustrate the accidental bequest (see, for example, Davies, 1981), let us take the case of a couple of retirees who are entitled only to a small pension and have not taken out annuities. Anticipating a long and comfortable retirement, they have accumulated financial and real estate assets that they hope to live on. They subsequently die in a car accident, leaving their children an inheritance they were not counting on. All things being equal, the accidental inheritance is larger should death occur at the moment in the life cycle when wealth is at its peak, usually at the end of the person’s working life. In this type of inheritance, there is no exchange or altruism between parents and children. The children inherit only because their parents did not live as long as they had expected to and had not invested their savings in a life annuity. One could raise the question of why annuity markets are not well developed. There might be no demand for them because of some social norms. In France, for example, buying annuities is viewed as an act of distrust toward one’s children. This leads to another point about accidental bequests. Suppose that parents are altruistic toward their children but would not leave them anything

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if fair annuities were available, because their children are well-provided for through the secular growth in wages. In the absence of annuities, these parents know that some bequest will inevitably be left and may find this highly desirable. 2.2 Voluntary Bequests In accidental bequests, neither the presence of children nor even of heirs is required. Voluntary bequests, on the other hand, depend on the presence of children. It was long held that intentional bequests were the norm and, even more so, were motivated by altruism. The anthropology and sociology of the family have since taught us, however, that many different forms of voluntary bequests and family models exist. At one extreme, there is the family in which solidarity and generosity prevail, while, at the other extreme, there is the model of give and take in which exchange is sometimes equitable and sometimes not. We will move gradually from pure altruism to strategic exchange, which gives rise to an arrangement rather unfavorable to children. Altruistic Bequests The stereotyped representation of inheritance clearly corresponds to the model based on pure altruism; that is, parental love and filial piety (classical references are Becker, 1974, 1975, 1989, 1991; Becker and Tomes, 1979, 1986; and Barro, 1974). When making decisions on consumption and savings, parents take into account their children’s preferences while anticipating their income and future needs. Their utility function implies that, in the absence of constraints, they will attempt to distribute their incomes and those of their children over time so as to smooth out the consumption of both parties. The concept of smoothing is already present in the life cycle hypothesis, where the consumption path is independent of the income path, but it is here extended to the infinite duration of a dynasty (smoothing is clearly limited by the constraint of nonnegative bequests when children are wealthier than their parents). In this context, parents have two ways of raising their children’s resources: human capital (education) transfers increase their wages and nonhuman transfers, their financial wealth. The parents choose the amount they wish to invest in their children’s education and that to be given them in the form of inter vivos gifts or bequests. Their sole objective is to ensure that consumption will be divided fairly either between them and their children or among the children. Insofar as the return on education is variable - at first it is a great deal higher than that of financial assets, before it diminishes - parents cover educational costs until the return on education is equal to that of physical assets; thereafter, they make inter vivos gifts or bequests so as to maximize the utility of the extended family. Choices such as these have immediate implications. If inequalities of talents or fortune exist between parents and children or between children themselves, intergenerational transfers will be tuned so as to reduce them if not eliminate

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them entirely. Let us take the case of two brothers: one is gifted and will have no problem acquiring a top-flight education, while his brother, unable to obtain qualifications of any kind, will be forced to take a menial job. In an altruistic environment, the latter should receive a great deal more from his parents than his brother; however, it is probable that, strictly in terms of education costs, the opposite will be true. In a model where differences in talent are contingent on circumstances and where the brothers enjoy the same standard of living thanks to their parents’ compensatory transfers, the members of the following generation all start from the same position. Thus, if parents are not prevented from exercising free choice for reasons connected to their wealth, altruism or luck itself, there should be great social stability within the dynasty. Intrafamily transfers insure each member against the vagaries of fate or nature. Yet, there are limits to parental choice; problems of incentives, moral hazard and adverse selection cannot be avoided. In making their transfers, parents would like to be sure that their children really need them and will not rely on them to the extent of shirking responsibility for the rest of their lives (see Bruce and Waldman, 1990; Linbeck and Weibull, 1988; Cremer and Pestieau, 1993, 1996; Richter, 1992). But it is often argued that even though parents cannot forgo problems linked to asymmetric information, they are in a much better position than the government. This relative superiority of the parents is often viewed as a key argument against any public interference with private intergenerational transfers. Moreover, parents may not be able to transfer as much as they might wish. In this case, they will give priority to investments in human capital, where the return is greater than that on physical investments. The latter will thereby not be able to perform their role as buffers, and parent-child as well as child-child inequalities may subsist. Note that altruism in the neoclassical sense of the term is not to be confused with generosity or disinterest. Quite often, one makes a distinction between altruistic households, which leave positive (operative) bequests, and those which are constrained by the nonnegativity constraint on bequests (if they could, they would force their children into giving them resources) and thus do not leave any. One cannot say that the former are more altruistic than the latter. Paternalistic Bequests The paternalistic bequest shares the same bloodline as the altruistic (see Blinder, 1974, 1976a; Modigliani and Brumberg, 1954). Paternalistic parents also accumulate savings with the intention of transmitting them to their children. Yet, the amount and structure of the bequest are based not on their children’s preferences, but rather on their idea of what is good for their children, or uniquely on the pleasure they might derive from giving. One often refers to the bequest-as-consumption model because bequest appears in the parents’ utility function as any other consumption goods. Although it is

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possible for paternalistic and altruistic bequests to coincide, generally speaking, this is not the case. Paternalistic bequests might consist of assets that the heir does not really need, such as family possessions bequeathed inopportunely, that is, without the economic situation of the children being taken into account. A variant of the paternalistic bequest, put forward in particular by Modigliani (1986), assumes that the amount of the bequest does not depend on the absolute amount of the family’s resources, but rather on its relative value within the generation to which it belongs, the idea being that a family’s consumption needs tend to increase with economic growth from one generation to the next. Retrospective Bequests We now come to a category of models that share a number of common features: (i) the bequest is motivated by altruism that is labeled ad hoc relative to pure altruism à la Barro-Becker; (ii) information is limited and the forecast imperfect, so parents decide to leave their children a bequest commensurate to what they themselves received; (iii) the implicit rule ‘Do unto your children as you would have liked your parents to have done unto you’ is rooted in social norms of deferred reciprocity, as if bequests were made to one’s children in return for inheritance received from one’s parent. This social, or rather family, norm is related to what sociologists call habitus. Usually these models are cast in a three-generation setting and lead to social optimality if not the Golden Rule. However, this optimal equilibrium is not a market one but one that is based on a commitment to a perennial norm. Even though this commitment is Pareto optimal, one cannot exclude the possibility of rupture in the intergenerational social compact. Bevan (1979), Bevan and Stiglitz (1979), Cigno (1995), and Cox and Stark (1994) have developed models for this category of bequests. Bequests Based on Pure Exchange Intergenerational exchange was common in traditional societies. Parents took care of their children until they reached adulthood and promised to leave them an inheritance (often their work tools). In exchange, children promised to look after their parents once they reached old age, or even earlier in the event of failing health. This type of bequest, known as bequest-as-exchange, is still practiced in rural areas and is related to the old-age security hypothesis that is used to explain fertility. There are a wide variety of bequest-as-exchange models; they have in common that parents care about some service or action undertaken by their children especially to secure old-age needs, and that the education and bequests are the payment for this service or this action. They differ in the nature of what is exchanged, in the timing of the exchange and in the enforcement mechanism (courts, altruism, economic punishment or rewards). Why not always rely on the market? When the market option is rejected, it is primarily because of higher transaction costs. The family is capable of carrying out the tasks of

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middlemen or insurers much more cheaply than commercial companies. In addition, family members have more complete information on the risk of illness or death when financing retirement and on individual talents and motivations when financing education. In the traditional family, for instance, the weight of custom and geographic immobility helped ensure that these engagements were honored. In Kotlikoff and Spivak (1981), exchange leads to an annuity-type contract; in Cox (1987), one has an exchange of services; in Cox (1990), one finds a scheme of loans by parents that are mutually advantageous; Desai and Shah (1983) study the old-age security hypothesis within traditional families. In the same vein, Stark (1995), Becker (1993) and Cremer and Pestieau (1993) have introduced the idea of ‘preference shaping’ through education as a means to facilitate and secure exchange in general and support in particular. They consider a two-stage model. In the first stage, parents attempt to inculcate values in their children; in the second, when those values (guilt for misbehavior) have been imparted, children are ready to trade attention for bequests in terms that are quite favorable to their parents. The exchange-bequest models are most often cast in a setting implying efficient, if not fair, allocations between parents and children. Such a setting mimics that of a competitive market economy. In a quite distinct stream of literature, one finds the dissonant view of Buchanan (1983) who focuses on the rent-seeking aspect of inheritance. He argues that this represents a substantial source of wasteful investment and a significant economic inefficiency (this view is disputed by Anderson and Brown, 1985). Strategic Bequests In the modern family, it is easy and unfortunately common for children not to come to the aid of their elderly parents. However, filial ingratitude is hardly a new phenomenon. Two famous literary representations come to mind. The misfortunes of Shakespeare’s King Lear are well known, but Balzac’s Père Goriot experienced a hardly less tragic fate: ‘He had given his heart and soul for twenty years, his fortune in one day. When the lemon had been squeezed dry, his daughters dropped the peel at the corner of the street.’ These two works show why more than one parent has eschewed premature bequeathing. This leads us quite naturally to a particular type of bequest, the strategic bequest, which in many respects belongs to the bequest-as-exchange category. It is one of the ways of enforcing exchange within the family when there is a time lag between the giving and the receiving and there is no credible recourse to the legal power of the courts and the state (see Bernheim, Schleifer and Summers, 1985. There are other bequest-as-exchange models with strategic features, although less pronounced; see, for example, Cox, 1987.) The model poses in a family with two children. Each child wants to receive as large an inheritance as possible; at the same time, spending time with aging

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parents is costly (at least beyond a certain threshold) in terms of forgone leisure or earnings in the market. The game follows a precise chronology. First, the parents make a commitment as to the total amount of the bequest and to a rule whereby this amount will be divided up according to the level of attention provided by each child. For these promises to be credible, the commitment must be binding. Thereafter, the children do not cooperate with each other and each gives his parents the amount of attention he considers optimal given the inheritance he will derive from it. Following the death of both parents, the inheritance is divided as stipulated. It is clear that the trump card in this game is held by the parents. Operating according to the adage ‘divide and conquer’, they extract the maximum from each of their children under the threat of disinheriting them. 2.3 Capitalist Bequests The term capitalist, or entrepreneurial bequests evokes the image of the entrepreneur found in Ricardo (1817) and classical economists in general (see also Moore, 1979): an austere individual infused with the Weberian Protestant ethic, investing everything he earns and extending the influence of his decision making beyond his own existence. While accidental inheritance touches all classes of society, this type concerns only the well-to-do. (For an empirical test, see Arrondel and Lafferère, 1996, who distinguish the behavior of wealthy households from that of the ‘top-heavy’ ones.) The famous American billionaire Howard Hughes, who left behind a vast financial empire but no direct heir upon his death a couple of decades ago, comes to mind. This is the prototype of wealth so great that it may not be consumed in a single lifetime. It has an existence of its own that in a way exceeds its owner’s control. Even access to the annuity market and knowledge of one’s lifespan would not change the situation in the least. Parents in possession of such wealth, even those devoid of any concern for their family, have no choice but to bequeath it, most likely to their children in societies where the latter may not be disinherited. In any event, there will be an estate whether there are children or not. Such is the example of Alfred Nobel, who left his wealth not to his family but to the well-known Nobel Foundation. So far, we have focused on one factor: the very impossibility of spending an excessive amount of wealth in one generation (this applies to the 1 percent richest families, who, in most countries, possess nearly one-quarter of all wealth). There is another motivation in capitalist bequest: the desire to leave a perennial trace, a financial or industrial dynasty. One thus thinks of individuals such as John D. Rockefeller. Children and grandchildren are then needed not so much out of altruism, but as a necessary means of perpetuation. There is a formal analogy between this type of bequest and those left out of altruism in the Becker-Barro model.

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Lying behind these types of bequests is a whole range of behavior, all the way from pure altruism to selfish manipulation and absolute indifference to the children. From a normative point of view, many will prefer altruistic behavior, but in reality, one finds a little of everything (reality is not as schematic as our categories). What might the interest of this typology be? Is it important to know if certain types of behavior become more frequent and others less so in different times and places? (For the empirical evidence concerning the relative importance of these types of inheritance, see Arrondel, Masson and Pestieau, 1997, and Bernheim, 1991.) Might the likely shift in behavior in the direction of exchange and strategic attitudes be indicative of a change in values? This is not our most immediate concern. We are more interested in the different types of inheritance because each has specific implications for the desirability of adopting particular legal or fiscal regulation of giving and bequeathing. Taking an example from a purely economic viewpoint, taxing accidental bequests is harmless because it has no disincentive effect on that type of saving. The other types of bequests, on the other hand, can be badly affected by taxation. As stated, this is a purely economic viewpoint. One might object from another viewpoint that any inheritance taxation, regardless of the motivation, involves a repugnant confiscatory aspect. We now turn to this debate.

3. Taxing Bequests 3.1 Two Polar Views (for a presentation of these and other views, see Erreygers, 1997; Masson and Pestieau, 1994) Debate over inheritance and its legitimacy has often focused on whether it should be taxed. Quite often, among political scientists and philosophers more than economists, one finds two extreme positions. The first argues that taxing inheritance would allow society to move toward more equality, especially equality of starting conditions in life, without disrupting economic incentives, particularly those concerning work and saving. This position, which can be labeled as one of minimal liberty, assumes that a person has no right at all to decide what should happen with his or her property after his or her death; in this view, property rights do not include a natural right to bequest (see, for example, Haslett, 1994). The second position argues that taxing inheritance is not only illegitimate but destructive because it disrupts the delicate framework of incentives that regulate economic activities. This second position is notably advocated by Bracewell-Milnes (1989) and by the Public Choice school’s founders, James Buchanan and Gordon Tullock (see Buchanan, 1983, and Tullock, 1971). Tullock’s paper was followed by a number of interesting comments ( Greene, 1973; Koller, 1973; Ireland, 1973) and a reply by Tullock

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(1973). Following this view, every person has the right to decide what should happen with his or her property after his or her death. Accordingly, the right of bequest is a natural right. Quite clearly these two positions are fostered by different attitudes toward liberty and equality. They are concerned with basic principles and not with the actual implications for distributive justice and economic efficiency. Put another way, the first position postulates rather than demonstrates that a 100 percent tax on inheritance has no inefficiency effects and leads to a more equal distribution of wealth and eventually of income. The second position, on the contrary, finds any tax on bequests not only repugnant but inoperable as a means of redistributing wealth. The majority of thinkers, and particularly of economists, tend to take a middle position between the two extremes. 3.2 The Middle Position: A Trade-Off Between Equity and Efficiency The position generally taken on this issue of inheritance taxation is one of pragmatism. Making explicit the objectives of taxing authorities, inheritance taxation is deemed desirable if it can achieve some redistribution across and within generations without hurting production and growth. Actually, the extent of taxation will depend on the trade-off between equity and efficiency and this is an empirical and not an ideological matter. If, for example, it can be shown that equity can be achieved without much efficiency cost, then taxation of bequests and inter vivos gifts is desirable. The taxonomy of bequests above is very useful in coping with this issue. Indeed, wealth-transfer taxation will have allocative (efficiency) and redistributive (equity) implications that depend heavily on the type of bequest. We start with the redistributive implications. The clear dividing line on this matter is between (unconstrained) altruistic bequests and all others. In an altruistic world consisting of identical (dynastic) families, we should let the pater familias redistribute resources across and within generations. Estate taxation is then undesirable. However, if income differences are wider across families than within families, there arises a delicate trade-off between two types of redistribution: public and private. The case for estate taxation is enhanced if between-families inequality is higher than within-family inequality and if the efficiency cost of public redistribution is not much higher than that of private redistribution. This is true only of altruistic bequests. For all other types of bequests, estate taxation is always desirable on redistribution grounds. Let us now turn to efficiency considerations and analyze the allocative effects of a distortionary estate tax. We assume that the government runs a balanced budget and that the tax revenue is spent on public goods that enter agents’ utility in an additive way. In other words, we focus on just the uncompensated price effect of wealth-transfer taxation. In the altruistic model, when bequests are operative before and after the tax change, estate taxation

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discourages capital accumulation. (Bernheim and Bagwell, 1988 argue that, with pure altruism and marriage, we are all interconnected through bequests and this makes all taxes nondistortionary. They use this overall neutrality argument to emphasize the limits of altruism.) In the case of accidental bequests, estate taxation has no effect on saving. In the other models, bequest-as-consumption or bequest-as-exchange, taxing bequest is equivalent to taxing a particular type of future consumption. Does that mean that basically it is not desirable to tax wealth transfer ? Not at all. Even when such a tax has a depressive effect on the capital-labor ratio, it can still increase welfare, granted that the overall economy is dynamically inefficient - namely, there is too much capital. Further, even with dynamic efficiency, the desirability of a wealth-transfer tax is a general equilibrium matter that ought to be dealt with in the framework of optimal taxation theory. This section, as well as the current state of the literature on estate taxation, may leave the reader with the impression that the issue is so complicated that nothing can be said. Our own reading of the theoretical literature on inheritance taxation and of the empirical literature on the relative importance of alternative forms of bequests is that progressive inheritance taxation is desirable for both efficiency and equity reasons. The problem, if any, is one of compliance. In open economies with mobility of financial capital, the implementation of inheritance taxation is very difficult. All OECD countries collect less than 0.5 percent of their tax revenues through inheritance taxation in spite of rather high statutory rates.

4. Freedom of Bequeathing 4.1 Equal Division: Some Evidence The debate over the treatment of intergenerational transfer is not restricted to the issue of taxation; for taxation is only one way to restrict the freedom of bequeathing. In fact, one source of debate has been the opposition between the Anglo-Saxon view and the Napoleonic view of inheritance. The first implies freedom of bequests, the only restriction being estate taxation (the tax base is the total amount of the estate left by the deceased, and the tax liability is independent of the number or quality of heirs). Note that when there is no will, equal sharing is the rule. The latter implies equal sharing of the estate among children, but for a limited part that the deceased can allocate freely by writing a will. Within the framework, one has a so-called inheritance tax, whereby the tax base is the amount received by each heir and the rates depend on the degree of consanguinity. These different legal regimes can play an important rule in shaping wealth distribution. It is therefore interesting to see their actual implications by comparing the French and the American situations. Let us consider the US

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estates cases. Tomes (1981, 1988a and 1988b), whose work is based on heirs’ declarations, concludes that exact equality is achieved in one-fifth of the cases and ‘approximate’ equality in less than half. Other authors, who confine themselves to information contained in probate records, find a much greater incidence of equal sharing. In families with two children, for example, exact equality is observed in approximately 70 percent of the cases (63 percent in Menchik, 1980a; 87 percent in Menchik, 1988; 81 percent in Bennett, 1990; 63 percent in Jouflaian, 1993; 69 percent in Wilhem, 1996) versus only 22 percent in Tomes. Moreover, primogeniture represents less than 10 percent of the cases, and the frequency of equal sharing is higher among wealthy households. Finally, the transmission of an indivisible professional asset often leads to unequal sharing only if there is no other wealth that can compensate children left out of the professional bequest. There is thus hardly any doubt that equal sharing is the most frequent official practice in the US. Does that mean that making equal estate sharing mandatory in the US would not be binding for most households and would thus have no consequence? Not necessarily. As the strategic bequest model shows, what matters is the threat of disinheritance, even though the final outcome is equal sharing. In France, less than 8 percent of the estates are unequally divided (see Arrondel and Laferrère, 1992). These cases concern mainly the rich (contrary to the situation in the US) and the self-employed with many children and an illiquid or indivisible bequest (professional assets, real estate). Moreover, inheritance shares remain generally equal, the redistribution among siblings being achieved mainly through previous gifts (80 percent of the cases). It remains to determine whether unequal shares compensate the less-privileged child. There is some evidence in the US that girls, assumed to receive less education or to care more for parents, are slightly advantaged (Menchik, 1980a, 1980b; Bennett, 1990). Otherwise, evidence is mixed. Tomes (1981, 1988a, 1988b) finds significant compensatory effects, but other authors (Menchik, 1988; Wilhem, 1996) do not find any significant correlation between children’s observable characteristics and the relative amount of inheritance received. This ambiguous conclusion is also drawn for France by Arrondel and Lafferère (1992). Indeed, the French or American studies (apart from Tomes’s) can explain when unequal estate division occurs, but not the rationale underlying the distribution. 4.2 Inheritance Rules: Motivations and Implications Inheritance rules are not necessarily imposed by law. In this matter as in many others, tradition and custom are a much more effective way to regulate bequeathing. Bergstrom (1996), for example, refers to several anthropological studies that examine particular rules such as ‘partible patrilineal inheritance’ in central Tibet, whereby ‘in families that had male offspring, inheritance was

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in principle divided equally among them; in families that had no sons, inheritance was passed to a daughter’. Certainly there are many rules besides those of traditional equal division and (male) primogeniture. Each of them, enforced by law or by tradition, has or had a reasonable explanation and interesting implications. For example, as shown by Brenner (1985), the equal-division rule was imposed in the English Middle Ages during a rather short period characterized by ‘the mistreatment of both stepchildren by step-parents and younger children by their older brothers and sisters’ (p. 96). Cyrus Chu (1991) explains the practice of primogeniture in education in imperial China: the whole family pooled its money to subsidize just one child for his human capital investment in the hope he would move up the social ladder and bring honor and prestige to the family (see also Van de Gaer and Crisologo, 1999, who study inheritance rules in the Philippines). The economists are, however, much more interested in the implications than in the historical cause of alternative inheritance rules. A number of scholars (Stiglitz, 1969; Pryor, 1973; Blinder, 1973, 1976b; Atkinson, 1980; Davies, 1982; Laitner, 1988, 1991; Van de Gaer, 1997) have thus studied the expected effects of alternative inheritance rules combined with marriage patterns on the distribution of wealth. Not surprisingly, in these models, where compensatory bequests are assumed away, random marriage and equal division are strong factors of wealth equality. In all this investigation, fertility is assumed fixed. It is, however, interesting to note that fertility can be affected by inheritance rules. The French case is enlightening in that respect. Until the Revolution, each region had its own customs. As shown by Rosental (1991), fertility was much higher in regions subject to primogeniture than in regions subject to equal division. In the latter, the only way to avoid splitting a family’s property was to have at most two children. 4.3 Wills and Strategic Bequests Quite interesting in the debate over the freedom of bequests is the fact that the alternative positions range from one giving all the power to the parent-donor to one implying a confiscatory 100 percent inheritance tax. One can view the practice of many countries, that is, imposing an effectively small inheritance tax along with mandatory equal estate division among children, as an intermediate position that limits the discretionary power of parents. In a society where equal estate sharing is the rule, there is less risk of opportunism on the side of the testator. In fact, with such a rule, there is little room for wills. Empirically, there are fewer wills in countries such as France and Germany where the equal division rule applies, than in the US or the UK where there is full freedom of bequest. As pointed out by De Geest (1995) in reviewing literature on the economics of wills, ‘Much remains to be said about

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the forms of opportunism which testaments can prevent as well as create’ (p. 13). In the models of strategic bequests discussed above, the testator fully uses the possibility of opportunism that is given to him or to her by the legal practice of wills. Accordingly, the testament is not the outcome of a contract; it can be revoked at any time, and its content can even be kept secret. Not only the testament can be kept secret, but also the size of the estate. Note that in Bernheim, Schleifer and Summers (1985), the outcome is efficient even though the testator gets all the trade surplus. Yet, this only works if the inheritance rules and the size of the estate are known by the competing heirs. It would be an interesting avenue for future research to study the economics of wills through the alternative models of strategic and exchange bequests. When equal division is imposed, there is no room for strategic bequests and it is not even certain that the outcome is efficient. In a number of papers (Cremer and Pestieau, 1996), it appears clearly that the only way to induce children to perform and not to shirk responsibility while waiting for an inheritance is to allow their parents the possibility of disinheriting them. At equilibrium, there is no disinheriting but its threat is necessary. In these models, one sees that mandatory equal division is clearly a source of inefficiency or, to put it otherwise, that freedom of bequeathing is a factor of efficiency.

5. Conclusion In this chapter, we have presented a number of alternative models of inheritance and then discussed the implications of each of them for the desirability of inheritance taxation. It appears that the dividing line is clearly between models with altruistic bequests that are fully operative and all the other inheritance models. In a number of countries, the debate on inheritance taxation and on the freedom of bequeathing is lively. The practical problem inherent in inheritance taxation is that whatever the quality of arguments presented in favor of such a taxation, in the reality it brings little revenue to the state regardless of the statutory rates. In all OECD countries, inheritance and gifts taxation represents less than 1 percent of all public revenues. Yields are not only low, but often deemed unfair. After all, estate taxation is often called ‘the tax on sudden death’. The issue of whether bequeathing should be constrained is of a slightly different nature. It is interesting to remember that at one point in its history equal sharing was imposed in the UK because there were too many cases of unfair treatment of stepchildren (see, Brenner,1985). Equal sharing avoids that kind of inequity, but, at the same time, it prevents parents from compensating their children for unequal incomes or opportunities. One has the feeling that, in a number of countries, the trend is now in favor of increasing freedom of

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bequeathing. This hopefully implies an increasing trust in the judgment and the maturity of individuals in dealing with the intergenerational distribution of resources.

Acknowledgments I wish to thank Gerrit De Geest, Marty Crowe, and an anonymous referee for helpful comments and suggestions.

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or Do the Poor Get More?’, in Kessler, D. and Masson, A. (eds), Modelling the Accumulation and Distribution of Wealth, Oxford, Clarendon Press, 79-104. Tomes, Nigel (1988b), ‘The Intergenerational Transmission of Wealth and the Rise and Fall of Families’, in Kessler, D. and Masson, A. (eds), Modelling the Accumulation and Distribution of Wealth, Oxford, Clarendon Press, 147-165. Tullock, Gordon (1971), ‘Inheritance Justified’, 14 Journal of Law and Economics, 465-474. Tullock, Gordon (1973), ‘Inheritance Rejustified’, 16 Journal of Law and Economics, 425-428. Van de Gaer, D. (1997), ‘Remarks on Inheritance and Marriage’, KUL, unpublished manuscript. Van de Gaer, D. and Crisologo, L. (1999), ‘Population Growth and Customary Law on Land: The Case of Cordillera Villages in the Philippines’, Economic Development and Cultural Change, Forthcoming. Wilhem, M.O. (1996), ‘Bequest Behavior and the Effect of Heirs’ Earnings: Testing the Altruistic Model of Bequests’, 86 American Economic Review, 874-892.

5840 RENTING Werner Z. Hirsch Professor of Economics University of California, Los Angeles © Copyright 1999 Xerner Z. Hirsch

Abstract Landlord-tenant law can be grouped into three major classes - rent control, habitability, and anti-discrimination laws. At times, two or three such laws are in effect at the same time and even may be supplemented by some additional laws needed to assure their effectiveness. When that happens, as in the case where a jurisdiction has both rent control and habitability laws, landlords can find their financial future at risk. The reason is that virtually all landlord-tenant laws, intended to protect the interest of tenants, impose costs on landlords. The more such laws are enforced, the heavier the burdens on landlords, and the more limited the latters’ rights and opportunities to manage their enterprise. Moreover, both deductive and inductive studies suggest that some of the landlord-tenant laws, while burdening landlords, are of little, and at times no, help to tenants, though tenants may deserve protection. JEL classification: 619, 717, 722, 916, 917, 932, K11, K23 Keywords: Renting, Landlord-Tenant Relations, Rent Control, Habitability Laws, Housing Codes, Housing Discrimination Laws

1. Introduction Renting involves a temporary exchange of rights to occupy and make use of real property - unimproved and improved - in return for a fee, that is a rent payment. While the property may be used for agricultural, industrial, commercial or residential purposes, the law has taken special interest in residential property for a number of reasons. Housing provides shelter which is a necessity, and therefore has inelastic demand; it takes a long time to build new housing, and therefore it has inelastic short-run supply; it is one of the largest, if not the largest, budget item of most families; and it has many intangible characteristics which determine its quality, including spatial location and fixity, durability, age, size and appointments. This review, therefore, will focus on what law and economics has contributed to the understanding, regulation, and evaluation of landlord-tenant relations and particularly the laws’ side effects. 907

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Three classes of laws regulating landlord-tenant relations will be reviewed rent control laws and, in conjunction with them, vacancy decontrol, no-fault eviction and anti-conversion laws since they tend to be associated with rent control, habitability laws and anti-discrimination laws.

A. Economic Theory of Rental Housing Markets 2. Housing Market Theory Nowhere is housing a single market in the neoclassical sense. In fact it is a set of submarkets which differ in their location, housing type, tenure, quality and other aspects (Smith, et al., 1988, p. 30). They also differ in terms of the jurisdiction’s tenure strategy, that is, private versus public ownership of residential rental housing. This strategy is well documented for Australia, Germany, Holland, New Zealand, Sweden, Switzerland and the United Kingdom (Kemeny, 1995, pp. 75-129). Renting in a number of countries has also been discussed by Harloe (1985) and Emms (1990). Power (1993) has reviewed renting in five European countries. From these and other studies it is clear that the distinguishing characteristics of housing in general, and rental residential housing in particular, are many. Some are responsible for governments all over the world frequently interceding in the relations between landlords and tenants. For example, the fact that both the supply of and demand for rental housing tend to be inelastic can lead to sharp rent increases during market adjustments, which interested parties often proclaim to constitute rent gouging (a terms basically devoid of economic content). In order to analyze rental housing in general and the effects upon it of landlord-tenant laws in particular, economists have developed special methods of inquiry. One involves housing stock models and the other flow models which use hedonic price analysis (Kain and Quigley, 1970; Rosen, 1974; Barnett, 1979; Quigley, 1979). Hedonic price analysis also has been applied to estimate the effects of certain landlord-tenant laws (Hirsch, 1981; Hirsch and Law, 1979; Rydell et al., 1981; Marks, 1984) . Hedonic price analysis looks at housing as a complex commodity composed of a host of housing services flowing from the existing housing stock with the number of housing service units determining its quality. The housing services of a dwelling include location, heat, air conditioning, size, appointments, and so on, each valued and consumed by residents. Although the flow of housing services is not well-defined and its quantity hard to ascertain and to price, the monthly rent can be considered the product of the number of housing-service units times the unit’s price. The hedonic price approach supposes that the

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various housing characteristics of a dwelling have distinguishable values to residents. Thus, the hedonic housing price function estimates the marginal market prices consumers are willing to pay for each housing characteristic. Information from this function can be used to combine any set of measured characteristics into a one-dimensional measure of the value of the total flow of housing services from dwellings in a specific housing market. This approach has major beneficial applications to the analysis of landlord-tenant laws. It allows looking at rent as the product of the number of housing service units and the price of a unit, providing useful insight into the effect, for example, of a rent control law. Thus, even if rent control succeeds in reducing rent, hedonic housing price analysis permits the estimation of the percentage associated with lower housing service unit prices as well as that associated with the reduced number of housing service units. The latter testifies to the extent to which housing quality has diminished as a result of rent control (Rydell et al., 1981). In a similar manner, with the help of hedonic price methods, it becomes possible to determine what, if any, effect a habitability law has had on housing quality and the price of housing service units (Hirsch, Hirsch and Margolis, 1975).

3. Housing Market Models Economists have developed a number of specific rental housing models, which fall into the following categories: 1. Perfectly competitive static stock models which treat rental housing as a homogeneous commodity, thereby neglecting such characteristics as location, quality, size, and so on. 2. Perfectly competitive static flow models which assume the existence of an unobservable homogeneous commodity, that is, housing services (Muth, 1983 and Olsen, 1988). Rental housing has a variety of housing characteristics, each of which has quantitative and qualitative dimensions. This characteristics approach of Rosen (1974) involves a model of demand, supply and competitive market equilibrium. Each housing unit has a vector of n objectively measurable characteristics. A bundle of such characteristics constitutes a housing unit which has a price in the housing market. In a competitive market, such bundles and their prices indicate the implicit prices of characteristics, defined as hedonic prices. Multiple regression analysis can estimate these hedonic prices. Many of these models assume a group of households and firms to be confined to the rental market, ownership housing to be a substitute for rental housing with the price of ownership housing given, and rather static circumstances which do not identify how quality changes come about, that is, whether through maintenance, rehabilitation, conversion, and so on (Arnott, 1995).

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3. Perfectly competitive flow models with select dynamic features. For example, a housing model by Sweeney (1974b) incorporates a number of dynamic features and also explicitly allows quality differentiation. In this model a landlord owning a durable housing unit of a given quality makes, for instance, maintenance decisions. Based on information on rent-quality relationships and the rate at which the housing unit deteriorates subject to maintenance levels, the landlord selects the maintenance expenditure level which maximizes the discounted present value of net revenues from his housing unit. The model allows for construction and abandonment of housing, and a model by Arnott (1987) allows for demolition followed by construction of rentals. 4. Imperfectly competitive flow models which recognize imperfections due to location, heterogeneity of housing units, neighborhood effects, search costs and imperfections in capital markets. Two major classes of such models exist. One is a monopolistically competitive model derived from search-based matching models (Diamond, 1984). Tenants’ tastes guide the search for rentals. In an imperfect market, searchers finding the exact housing unit they desire can end up paying a rent above that commanded by rather similar rental units. Should landlords recognize this fact, they could charge a price above marginal cost. Yet, should there be free entry and exit, profits would decline, possibly to zero, and vacancies result. A second class of models can be referred to as contract models where market imperfections result from asymmetric information (Hubert, 1990). For example, there can be reliable and unreliable tenants, whose identity landlords discover only after occupancy has commenced. Unreliable tenants will move frequently and, in the absence of widespread information about their behavior, impose heavy costs on landlords. 5. Political-economic models theorize about the probability of a jurisdiction enacting landlord-tenant laws (Fallis, 1988). Such models take cognizance of the fact that landlord-tenant relations are significantly affected by the relative size, wealth, and political activity of the two groups to a bargain. Landlords in many communities tend to be richer but fewer in number than are tenants. But in addition to tenants, there are also homeowners. Whether their economic interest is more attuned to tenants or landlords is not altogether clear (Arnott, 1995). A model by Epple (1994) explicitly recognizes that a community has permanent and temporary residents, each with different interests. Neither group, however, knows the size of the other. Yet, homeowners are not incorporated into the model.

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B. Rent Control Laws 4. Legal Analysis In many countries governments have enacted laws that regulate the rents landlords may charge residential tenants for their property and services. The avowed purpose has been to protect tenants from unwarranted rent increases, particularly if they might force them to vacate the premises. Most of these controls were enacted in times of severe housing shortages, mainly during wartime and periods of hyperinflation. The relation between rent control and inflation has been explored by St. John (1996). Controls are of two types - first generation or hard controls, that is, virtual rent freezes, and second generation or soft controls which can allow for automatic rent increases (tied, for example, to the rate of inflation), cost passthroughs, vacancy decontrol, and so on. Rent freezes were imposed on many American and European cities during World War II. Some, including New York, retained these controls long into the post-war period. For example, in the United Kingdom, rent control was enacted by Parliament shortly after the outbreak of World War II (Hirsch, 1981) and Turner (1988). The Rent and Mortgage Interest Restrictions Act of 1939 applied to rent controls as well as to security of tenure. Rents were fixed at September 1939 levels. Also a number of major cities in developing countries have first generation types of rent controls, although they differ in detail and enforcement Malpezzi (1993). During runaway inflation of the 1970s, many local jurisdictions in the United States imposed rent control, including about 100 municipalities in the State of New Jersey alone. In California, when real estate prices skyrocketed in the late 1970s and the electorate passed a revenue limitation measure (Proposition 13), the measure’s sponsors promised to reduce rents. When rents were not lowered, a number of local jurisdictions (including the cities of Los Angeles, San Francisco, Oakland, Berkeley, and Santa Monica, and the County of Los Angeles) adopted rent control ordinances. Also, about one third of cities in California had rent control ordinances in effect on mobile home parks. Moreover in the mid 1970s all Canadian provinces introduced rent control, though only four have retained them (Arnott, 1995). In 1995, residential housing under rent control is estimated to fall between 10-15 percent (Arnott, 1995). In the United States, rent control has typically been justified by local government entities as an exercise of their police power. In the 1920s, the United States Supreme Court held that the use of state police power to enact rental controls was consistent with the due process clauses of the Fifth and Fourteenth Amendments of the United States Constitution only if utilized in response to a housing ‘emergency’ (Block v. Hirsch, 1921). In recent years,

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however, for some courts a crisis or extremely exigent circumstances are no longer required to justify rent control. For example, the California Supreme Court, in Birkenfeld v. City of Berkeley (1976, p. 129), declared that it ‘is now settled California law that legislation regulating prices or otherwise restricting contractual or property rights is within the police power if its operative provisions are reasonably related to the accomplishments of a legitimate governmental purpose.’ Thus, in the United States, the court’s inquiry in rent control cases is generally whether the ordinance reasonably relates to a legitimate purpose. The more important question of whether the measure will, in fact, achieve its stated objective of controlling rents is typically not reviewed by the courts. This is the traditional dichotomy between procedural and substantive due process, and it is this approach that ignores the value of economic analysis. The fact that rent controls may actually make a housing problem worse often appears irrelevant to a court’s view of a rent control ordinance. As long as the enacting body could reasonably conclude that the measure is related to a legitimate purpose, the measure is likely to be upheld, even if it is counterproductive (Palos Verdes Shores Mobile Estates, Ltd. v. City of Los Angeles, 1983). American courts have two further concerns. In order not to be confiscatory on its face, a rent control ordinance must permit the regulatory board to grant across-the-board increases based upon classification enumerated by the board or statute. Alternatively, the rent control ordinance must institute a unit-by-unit procedure that will operate without what the court considers to be an unreasonable delay. There is also a constitutional requirement for a ‘just and reasonable’ return, a difficult concept. A requirement of recent vintage and to be discussed below is the ‘nexus’ test. Rent control laws differ in stringency and tightness, depending on their coverage and pass-through provisions, the basis on which and manner in which permissible rent increases are calculated, the ease with which landlords can hope to get such increases, and whether the laws allow for vacancy decontrol, demolition of buildings, and use change. Stringent ordinances cover all premises, whereas the less stringent ones exempt single dwellings, luxury apartments, and apartment houses with fewer than four or three units. Also, the less stringent ordinances permit the cost for major repair and minor improvements to be passed on to tenants. Great differences also exist in the manner in which allowable rent increases are set and enforced. In the most extreme case, there can be rent freezes and even rollbacks to an earlier date. Most laws provide a formula by which annual ‘general adjustments’ are made: some stipulate a fixed annual percentage increase, while others tie increases to changes in the cost of living. Since rents are more in line with market rent under vacancy decontrol, total decontrol should be easier in its presence than in its absence. However, discrimination can result against groups of tenants that have low turnover rates (that is, senior citizens).

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Rent control is not unique to the United States. For example, in the United Kingdom, rent control has had a long history going back to 1939. The Rent Acts of 1965 and 1977 focused on ‘fair rents’ and allowed tenants to apply to a rent officer (with a right to appeal to a rent assessment committee) for determination of what is a fair rent for the relevant premises. In making the assessment, regard is to be had to the age, character, locality and state of repair of the premises, and also to the provision (if any) of furniture. This determination was to be made on the assumption that in the locality demand does not exceed supply, that is, the market is in equilibrium. While the legislation does not prescribe how this determination is to be made, the favored method had been to look for rents for equivalent premises in comparable jurisdictions. While possibly generating horizontal equally, the method does not assure that the rent is appropriate. This determination of fair rent has been costly to administer and has resulted in a large amount of litigation (Ogus, 1994). In recognizing its harmful effects in a White Paper of 1987, rent controls were abolished by the Housing Act of 1988. The end of fair rents in the United Kingdom has been examined by Davy (1992) and Lee (1992).

5. Economic Analysis: General Remarks Rent control laws have in common that they reduce the freedom of landlords to set rent levels and diminish the range of rents and property types that can feasibly be offered tenants. As a consequence, opportunities for mutually beneficial trades between landlords and tenants are reduced. Such laws amount to price control and result in distributional and efficiency consequences commonly associated with such controls. An exercise in positive economics reveals a host of effects on rental housing supply, property values, maintenance and housing quality, new construction and conversion, availability of rentals, potential mismatch of rental units to households and reduced housing mobility. Moreover, distributional effects occur, not only between landlords and tenants, but also among tenant groups with differing income, gender, race and age characteristics. It is helpful to recognize that rent control laws can apply to two major classes of property ownership. Rent control of apartments, unless they are furnished, involve single ownership, that is land as well as improvements are owned by one and the same party. The second class involves divided ownership which occurs when the improvements are owned by one party and the land on which they are placed are owned by another. Examples are housing condominiums and cooperatives as well as mobile home parks on leased land. In relation to an appraisal of effects of rent control, the two ownership patterns differ.

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Arnott recognizes, and our review confirms, that there are few empirical studies of first generation rent control in Europe at least in the English-language literature (Arnott, 1995, p. 102). Moreover, there are relatively few contributions that pertain to countries other than the United States. Exceptions are some papers on Canada (Arnott and Johnston, 1981; Smith and Tomlinson, 1981; Marks, 1984; Fallis and Smith, 1985); Germany (Börsch-Supan, 1986); Hong Kong (Cheung, 1975, 1979); Israel (Anas and Cho, 1988; Werczberger, 1988) and United Kingdom (Coleman, 1988; Ogus, 1994).

6. Economic Analysis: Rent Control of Single Ownership Property First-generation or hard rent control laws, that involve a virtual rent freeze, have usually been subjected to what Arnott (1995) refers to as ‘Textbook Analysis.’ This analysis makes use of the first model discussed earlier, that is, a perfectly competitive static stock model. It focuses on rent and availability of rental housing. When, for example, inflation raises the cost of providing rental housing, controls prevent landlords from passing on cost increases to tenants. Figure 1

Using a housing stock model in Figure 1 the two axes are rent (R) and number of dwellings (Q). Before the imposition of rent control on apartments, at equilibrium, the number of dwelling units was Q1 and the market-clearing rent was R1. As a result of, for example, increases in the price of input factors (whether repair and maintenance costs, utilities, or property taxes), the supply function shifts to the left (S2). Without a change in demand, a new equilibrium would be reached at Q2 and R2. Rent control would prohibit landlords from

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charging the rent that they would otherwise have sought; that is, their rent will be below R2. In the most extreme case where no rent increase is permitted, landlords would supply Q1 - Q3 fewer dwellings than would be demanded in the short run. In the long run, rent control is likely to have a chilling effect on investors and therefore curtail the supply of housing. Thus, cumulative declines in low-cost dwellings could be anticipated, accompanied by housing shortages. Empirical estimates of the long-run price elasticity of rental housing supply related to land prices in large US metropolitan areas suggest it to be about +0.20 (Hirsch, 1981). Thus, a 10 percent increase in the price of land per year would tend to increase rents by 6.5 percent. If no rent increases were permitted, supply would be reduced by 2.4 percent of low-cost housing units, and if only half of that increase were permitted, the shortage would be 1.2 percent. The effects of rent control can also be examined from the demand side, where the rental housing demand function shifts to the right. If we assume that, in the short run, the supply of low-cost housing rental units cannot change, a new equilibrium would be reached at a higher rent and number of dwelling units. Rent control does not permit this new price for housing units to be obtained, and a shortage of dwelling units will result. Landlords not permitted to raise rents may reduce repair and maintenance, and thereby the quality of housing. Or they may withdraw dwellings from the market by converting apartments into condominiums, convalescent homes, homes for the aged, or cooperatives. Some may even abandon their properties because of the artificial imbalance between costs and rent. The magnitude of the likely rental housing shortage can be estimated with the aid of income elasticities for low-cost rentals. An econometric study estimated it to be about +0.98 for 1974-75 (Hirsch, 1981, p. 293). In an uncontrolled rental market, in the presence of an annual per capita income increase of 8 percent, for example, and on the assumption that the short-run supply of low-cost housing does not increase, annual rent increases of about 8.0 percent could be expected. If rent control were to be imposed and were to permit no increase whatsoever, an 8.0 percent shortage of low-cost rental units would develop. If, on the other hand, rent increases were held to half the expected 8.0 percent, or 4.0 percent per annum, a shortage of about 4.0 percent would result. These shortages would be cumulative as long as income increases over time. The textbook analysis has been effectively summarized by Arnott (1995). Accordingly, when rents are capped below market-clearing levels, tenants in rent-controlled apartments benefit. The longer the occupancy, the greater the benefit. The below-market rents induce excess demand for housing and in turn a mismatch of apartments to households; reduced mobility of tenants and therefore the labor force; and grey- or black-market phenomena, for example, ‘key money’. Furthermore, landlords incur lower returns on their investment

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and a corresponding decline in property values. They tend to reduce repair and maintenance, convert to non-controlled land uses and desist from adding apartments. When the analysis applies the second model, that is, a perfectly competitive flow model, one can show that one effect of the reduced rents takes the form of a reduction in the number of housing service units, that is, quality of apartments provided. Empirical methods permit an estimation of the relative importance of changes in the number of housing service units provided, that is, quality of apartments, compared to housing service unit prices. If the main concern is with rent control’s effect on housing quality, a housing flow model, using hedonic housing price functions, is appropriate. A theoretical model by Frankena (1975) (the second type discussed earlier) separates the effect of rent control on the number of housing service units from that on the unit’s price. Frankena does so by examining the effect of rent control as a ceiling on rent (or, equivalently, revenue) per dwelling as opposed to a ceiling on price per housing service unit. His model leads to a kinked supply curve when rent control takes the form of a revenue constraint, as shown in Figure 2. Figure 2

The horizontal axis measures housing service units. Equilibrium price and quantity occur at p0 and q0, respectively, in the absence of controls. If rent control limits revenue per dwelling to price-quantity combinations along the rectangular hyperbola ASSR2, then the effective supply curve will become SASSR2. In this diagram, equilibrium occurs at a lower quality level (q1), but at a higher price per housing service unit (p1). Increased demand, then, will lead to even

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more deterioration of quality. Rydell et al. (1981) built a model that permits the estimation of both the price and the quality effects of rent control. They relied on the housing-services approach in which the variable of interest is a composite of the housing commodity’s desirable attributes. If landlords charge the market rent for a dwelling with a certain quantity of housing services, a reduction in rents means that the landlords are now not being paid for all the services they supply. For example, if the rent declines by 5 percent, the landlord will be receiving payment for only 95 percent of what he offers. The landlord then will be tempted to reduce the quantity of services to only those for which he is paid. This is done for the least cost through less maintenance resulting in deterioration, which, of course, is the result predicted by Frankena. It was projected that, after rent control had been in effect in Los Angeles for four years, the rents of controlled dwellings would be about 4 percent lower than they would have been if rent control had not been in force. Likewise, after four years, the price of rental housing services was estimated to be 3.2 percent lower than it would have been without rent control, and the quantity of rental housing service units was 1.5 percent lower (Rydell et al., 1981, p. VI). A 1991 paper projected the effect of rent control on housing service units and their prices for eight years (Rydell et al., 1991). It confirms that rent control of the sort enacted by Los Angeles in the late 1970s would confer its benefits early and extract its costs late. The early effects of rent control were exclusively housing service price reductions, whereas, as time passed, landlords reduced the level of rental housing services in line with the rent they were permitted to charge. Thus, controls would reduce benefits to renters and also reduce supply. If the rent-control ordinance were tightened, it would accelerate those reductions without providing proportionate increases in benefits to the renters. The long-term effect of rent control on rental housing quality was estimated by Mengle (1983). His study of eight large cities estimated that the presence of rent control was associated in 1974 with a 7.4 percent decrease in housing quality, while three years later it was associated with a 13.9 percent decrease. For indigent black tenants, the deterioration was 18.6 percent in 1974 and 26.6 percent in 1977. The deterioration was particularly serious for indigent aged tenants. Thus, in 1979 in the presence of rent control, the housing quality of all tenants had declined by 14.5 percent, of aged tenants 60 years and over by 17.3 percent, and of indigent tenants 60 years and over by 23.0 percent. Tenant gains and landlord losses that result from rent control have been compared by Rydell et al. (1991, p. 618). Gains are defined as net rent reductions after deterioration minus loss in consumer surplus due to reduced housing and rent control fees levied on tenants. Losses are the decrease in revenue due to rent reductions and decline in housing stock plus landlords’ rent control fees, minus reduced maintenance expenditures. The paper makes use

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of the Marshallian consumer surplus concept and assumes a constant elasticity aggregate demand function with an 0.7 price elasticity. It concludes that the present value of landlord losses exceeds the present value of tenant gains, pointing to two reasons - (1) housing benefit losses to tenants due to quality declines outstrip landlords’ savings from under-maintenance and (2) burden of rent control fees. In order to estimate the overall effect of rent control, a rent capitalization framework can be used. In it, the expected future flow of revenues from rental properties determines their values, which, in turn, depend on supply and demand conditions and their modification by a changing legal environment (Hirsch, 1987b). An econometric study of nine middle-sized cities in Los Angeles Country, California estimated that rent control was associated with an annualized decline in property values of between 7.3 percent and 11.9 percent, ceteris paribus. The effect of rent control was also examined by Albon and Stafford (1990). The third model, that is, a perfectly competitive flow model with dynamic features and explicit quality differentiation, also has been applied to a second-generation rent control analysis. In its simple form it has dynamic features, allows for quality differentiation and articulates specific provisions of rent control laws. A more complicated model by Sweeney (1974b) has been discussed before. It has been expanded to allow for rent control leading to demolition of existing buildings, followed by construction of new ones (Arnott, Davidson and Pines, 1983).

7. Economic Analysis: Rent Control of Divided Ownership Property Rent control under divided asset ownership has especially extensive effects. Here are some of the reasons: improvements, whether condominiums or mobile homes, are of no residential use without the land on which they are placed. Thus, land and improvements that jointly provide residential shelter are complementary goods. The tenant-owned condominium apartment or mobile home has a negative cross-price elasticity of demand for the stream of housing services associated with the stream emanating from the land on which the improvement is placed. Consequently, a decrease in rent for fee simple condominium or mobile home park land should increase the demand for condominium apartments or mobile homes, thus causing their prices to rise. In short, capping rents of land on which condominiums or mobile homes are placed will lead to an increase in their value, and thereby yield tenants a windfall profit which accrues in addition to benefits from reduced rents. Owners of condominium apartments and mobile homes benefit from unearned appreciated values of their assets.

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A capitalization model can be used to analyze, for example, the effect of changes in the rents for mobile home pads on mobile home values. Since the supply of mobile homes is assumed to be inelastic at any point in time, in this model prices are basically demand determined in the short run. P = f(U,V,W,C)

(1)

where P is the sales price of a mobile home or its assessed valuation; U is the flow of housing services derived from the home; V is the price per constant quality unit of pad services; W is the price per constant quality unit of alternative housing, mainly apartments; and C is the cost of transporting and installing the mobile home (Hirsch, 1988). The price of a mobile home unit is assumed to be inversely related to (C), the costs of transporting the home and installing it in a park. A home already located in a mobile home park should be relatively more expensive than a comparable one in a showroom, since for the former the costs of transportation and installation are absent. Mobile home prices should be positively related to the flow of housing services (U). The amount of housing services is an increasing function of a number of physical characteristics of mobile home units, including size, quality, and amenities contained in the coach. It is likely that consumers of mobile homes have a negative cross-price elasticity of demand for home services with respect to services of pads (V). Consequently, any decrease in the rent for pads should increase the demand for homes, causing their prices to rise. Two econometric studies have applied the capitalization model to estimate the effect of rent control on the value of mobile homes. One covers the State of California in 1984-86, where about 39 percent of all mobile homes were in rent control communities. Sales prices were on average about $8,800 or 32 percent higher in communities which had imposed rent control on mobile home park rents (Hirsch and Hirsch, 1988). A second econometric study pertains to a particular mobile home park in Ocean City, California in 1987-92. It found that during 1986-92, sales prices of mobile homes under rent control were $3,531 higher than those in uncontrolled markets (Hirsch, 1995). When under divided asset ownership income from one asset is capped, the landlord’s profit will be negatively affected in at least three ways - first, the annual rent savings benefiting tenants are losses incurred by landlords. Secondly, the lower rent adjustment resulting from rent control will be capitalized into lower prices potential buyers are willing to pay for the land on which the condominium or mobile home is placed. Thirdly, there is the damaging effect of rent control on risks perceived by potential buyers of the land. Because of heightened risks, potential park buyers will use a higher interest rate which they apply to capitalized expected rents into land values. The higher the risk, the lower the prices they are willing to pay for the land.

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8. Distributional Effects The issue of equity has been argued from two different points of view. One view holds that in a search for equity, macroeconomic instruments must be relied upon. It recognizes that while some equity in housing consumption is important, governments can pursue an income distribution policy which can make housing policies inefficient and even inequitable (Aaron and von Furstenberg, 1971; Kain, 1974). The second view distinguishes between general and specific egalitarianism, that is, the general fairness of the income distribution, and concern that all citizens have a minimum amount of essential commodities, including housing (Tobin, 1970). Specific egalitarianism requires an interest in the level of housing services accruing to indigents, minorities and the aged, even if an optimal income distribution were to prevail. An evaluation of equity aspects of landlord-tenant laws clearly is based on the specific egalitarian view, without necessarily determining an optimal housing service level. Whenever a government caps rents, distributional effects are likely to occur. In the case of single, undivided property ownership, forcing a landlord to charge rents which are below the market-clearing rent will cause his property to decline in value. The capitalization formula presented earlier gives expression to such an outcome. Inequities tend to occur also among tenants. For example, sitting tenants tend to benefit from reduced rents. As a result, there exist fewer rental opportunities for new tenants, who may be requiring apartments because of changes in their place of work, family circumstances, student status, and so on. The longer tenants stay after rent control is enacted, the more they benefit. In particular, gains accrue to senior citizens since they tend to stay put. Landlords whose rents are controlled tend, whenever possible, to seek new tenants who are good credit risks. In the case of apartments, landlords prefer small families, whose members are not destructive, for example, young professionals. As a consequence, tenants who are poor, have young children and have large families are less likely to gain access to vacated apartments. The long-term effects of rent control of apartments in Santa Monica, CA are well-documented in a California Court of Appeal ruling (Santa Monica Beach Ltd. v. The Superior Court of Los Angeles County, 1996, pp. 2155-2156). The following ten year effects of rent control found the City’s stock of rental housing units declined by nearly 5 percent and ... low-income rental units [by] 12 percent ... notwithstanding that, during the same period, the rental housing supply and the number of low-income rental units increased in all comparable non-rent-controlled Southern California cities. The City also lost 285 ‘very low-income’ rental units, the largest ‘exodus of economically disadvantaged renters’ from any comparable Southern California city. At the same time, the

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City experienced a 37 percent increase in the proportion of households with very high incomes (while the proportion of very high-income households dropped by more than 8 percent in Los Angeles County as a whole). ... In addition, rental housing in Santa Monica has become ‘increasingly unavailable’ to young families, with the number of family households with children declining by 1,299, a 6 percent drop during a period when no comparable non-rent-controlled Southern California city lost young family households. ... female-headed households with children under 18 in Santa Monica fell by more than 27 [percent], despite an increase in such households in Los Angeles County as a whole. ... Santa Monica’s elderly population ... declined by 1.7 [percent] [while] ... the elderly population of Los Angeles County rose by more than 15 [percent] over the same decade. The distributional effects of controls under divided property ownership are even more pronounced and widespread. With the help of the capitalization model it can be shown that the more onerous and continuous the rent control and therefore the greater the difference between the controlled and market clearing rent - the greater the home sales price appreciation. In addition to these distributional effects on landlords and tenants, certain tenant classes will be particularly effected. For example, the heightened resale prices of homes placed in parks and the absence of park spaces hurts young families and transient workers especially. At the same time, sitting tenants, many advanced in age, are prime beneficiaries.

9. Constitutionality - Is There a Taking? In the United States, the constitutionality of rent control, particularly of mobile home parks, has been of concern to the court in recent years. The issue involves The Takings Clause of the Fifth Amendment which provides: ‘[N]or shall private property be taken for public use, without just compensation.’ This Clause generally requires just compensation where the government authorizes a physical occupation of property. But where the Government merely regulates the property’s use, compensation is required only if considerations such as the regulations’ purpose or the extent to which it deprives the owner of the property’s economic use suggests that the regulation has unfairly singled out the property owner who bears a burden that should be borne by the public as a whole. The US Supreme Court has last ruled in 1992 on the constitutionality of rent control of property under undivided ownership. However, in 1996 a California Court of Appeal in Santa Monica Beach Ltd. v. Superior Court of Los Angeles County (1996) ruled rent control of apartments in Santa Monica, California unconstitutional. The alleged reason is that Santa Monica’s rent

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control law has failed to mitigate the effects of a growing shortage of housing units by assisting the poor, minorities, students, young families and senior citizens and, to the contrary, it has made things worse’. Thus, it did not meet the ‘nexus test’, to be discussed below. The US Supreme Court has ruled on the constitutionality of rent control of property under divided ownership. Some of the characteristics of mobile home rent control may make it particularly vulnerable to running foul of the Takings Clause. Courts have employed several tests in determining whether a government action or regulation effects an unconstitutional taking of property without just compensation, typically focusing their inquiry upon: (1) the character of the government action; (2) whether the property owner has been denied his or her reasonable investment expectations; (3) the economic impact of the action on the claimants; (4) whether the action gives rise to a permanent, physical occupation of the claimant’s property; and (5) whether the action substantially advances legitimate state interests. Until 1992, courts evaluating challenges to mobile home rent control ordinances typically focused on the fourth of these factors. Should mobile home park owners be able to characterize the intrusion created by an ordinance as a permanent physical occupation, their challenges could succeed. The leading case, adopting the position that mobile home rent control constitutes a permanent physical occupation and is, therefore, a taking, is Hall v. City of Santa Barbara (1986). Owners of a mobile home park challenged a mobile home park rent control ordinance by arguing that the ordinance transferred to each tenant a possessory interest in the land on which their mobile home was located. They claimed that the transfer was reflected in the facts that the prices for mobile homes in the park had shot up dramatically after the ordinance was enacted, and that many homes in the park were selling for above their bluebook value. A federal Court of Appeal citing, Loretto v. Teleprompter Manhattan CATV Corp. (1982), for the proposition that a permanent physical occupation of property is a government action of such a unique character that it is a taking without regard to the other factors that a court might ordinarily examine, concluded that the ordinance interfered with the park owner’s property rights as described in Loretto and therefore constituted a physical taking. Specifically, the court found that the ordinance directs the landlord to give tenants a lease, a recognized estate in land, lasting indefinitely. Moreover, the landlords’ residual rights in the property are largely at the mercy of his tenants: he loses practically all right to decide who occupies the property, and on what terms. If a tenant moves, the tenant alone decides who will be his successor by selecting the buyer for his rental unit; the landlord has no say as to who will live on the property, now or in the future. Moreover, because of the way the ordinance is alleged to operate, the tenant is able to derive an economic benefit from the statutory leasehold by capturing

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the rent control premium when he sells his mobile home. In effect, the tenant is given an economic interest in the land that he can use, sell or give away at his pleasure; this interest (or its monetary equivalent) is the tenant’s to keep or use, whether or not he continues to be a tenant. Moreover, the court is concerned that the ordinance has ‘eviscerated’ the property rights of the park owners, stating: as the Santa Barbara ordinance is alleged to operate, landlords are left with the right to collect rents while tenants have practically all other rights in the property they occupy. As we read the Supreme Court’s pronouncements, this oversteps the boundaries of mere regulation and shades into permanent occupation of the property for which compensation is due. (Hall v. City of Santa Barbara, 1986, pp. 2, 4)

Some state courts, particularly in California, have rejected the Hall position for two reasons: (1) mobile home rent control merely regulates the relationship between landlords and tenants, much like ordinary (apartment) rent control, and does not cause a permanent physical occupation of park owners’ property, and (2) the original price of the regulated pad was artificially high (as a result of monopolistic aspects of the market) so that resulting recalibration of the prices of both goods may be seen as a restoration of the equilibrium a free market would have reached. Such a restoration is not a taking. While it did not adopt the California courts’ approach, the US Supreme Court specifically rejected the Hall approach in Yee v. City of Escondido (1992), holding that a mobile home rent control ordinance without a vacancy decontrol provision did not effect a physical taking. The Court held unanimously that a physical taking can occur only when the government requires that the landowner submit to a physical occupation of his or her land. Yet the Escondido ordinance did not impose such a requirement, because a park owner could choose to evict all tenants and change the use of his or her land. It merely established the terms of the landlord-tenant relationship for those landowners who chose to devote their property to mobile home parks. Even as it rejected the argument that the Escondido mobile home rent control ordinance effected a physical taking, the Yee Court may have opened the door to challenges to mobile home rent control ordinances as regulatory takings. The Court implicitly invited such challenges by noting that the plaintiffs’ argument was ‘perhaps within the scope of our regulatory taking cases’ (Yee, 1992, p. 165). The Court also stated that rent controls ‘are analyzed by engaging in the “essentially ad hoc, factual inquiries” necessary to determine whether a regulatory taking has occurred’ (Yee, 1992, p. 166). Also, commenting on the plaintiffs’ argument that the Escondido ordinance transferred wealth from landlords to incumbent mobile home owners, the Court stated that:

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This effect might have some bearing on whether the ordinance causes a regulatory taking, as it may shed some light on whether there is a sufficient nexus between the effect of the ordinance and the objectives it is supposed to advance. See Nolan v. California Coastal Commission, supra, at 834-835, 97 L.Ed.2d 677, 107 S.Ct. 3141. But it has nothing to do with whether the ordinance causes a physical taking. (Yee, 1992, p. 167)

Finally, in response to plaintiffs’ argument that the Escondido ordinance effected a physical taking because it deprived landlords of the ability to choose their incoming tenants, the Court stated: This effect may be relevant to a regulatory taking argument, as it may be one factor a reviewing court would wish to consider in determining whether an ordinance unjustly imposes a burden on petitioners that should ‘be compensated by the government, rather than remaining disproportionately concentrated on a few persons.’ [Citation]. But it does not convert regulation into the unwanted physical occupation of land. (Yee, 1992, p. 167)

With each of these statements, the Court hinted that a regulatory takings challenge might succeed where the physical takings challenge failed. As the Yee Court suggested with its citation of Nollan v. California Coastal Commission (1987), a challenge to a mobile home rent control ordinance as a regulatory taking could be based on the fifth of the five Takings Clause factors: whether the ordinance substantially advances a legitimate state interest. As is set forth in Nollan, this test requires more than just a rational basis for the state’s action. For the action to pass constitutional muster, there must also be an essential nexus between the stated ends of the state action and the means employed. An argument that mobile home rent control is a regulatory taking could be based on the absence of a substantial nexus between mobile home rent control and the objectives it is supposed to advance. For example, if the objective of rent control is to alleviate a housing shortage and economic theory suggests, and empirical evidence confirms, such an outcome to be unlikely, a regulatory taking would have occurred. In a more recent decision, the US Supreme Court appears to have added a further requirement to the nexus test. In Dolan v. City of Tigard (1994) the Court added a ‘rough proportionality requirement’. It held that the city’s exactions for flood control purposes and a pedestrian bicycle path were unconstitutional. Although both were legitimate public purposes, and there was a significant nexus between these ends and the exactions required by the city, the degree of the required exactions was disproportionate to the impact that the planned land development would have on problems addressed by the exactions. In short, it failed the ‘rough proportionality’ test. There is still the question to

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what extent Dolan is applicable beyond the context of exactions required for permit approval, for example, rent control.

C. Laws Complementing Rent Control Rent control laws, particularly those of the first generation, often create conditions that appear to require follow-up legislation. They include vacancy decontrol, just-cause eviction laws and anti-conversion and anti-demolition laws.

10. Vacancy Decontrol Laws All over the world rent controls, once imposed, have been politically difficult to lift. Obstacles to terminating rent control are particularly formidable after controlled rents have fallen substantially below market levels. In order to avoid this situation, some jurisdictions allow vacancy decontrol of the following major types: once the tenant vacates the premises, the landlord can charge higher rents, for example, whatever rent the market will bear and (1) the premises remain decontrolled or (2) rent control is reconstituted at the higher rent. Some jurisdictions prescribe by how much rents can increase once premises have been vacated. Particularly the first type of decontrol would allow market forces to correct the disequilibrium created by rent control. The result would be particularly favorable under divided property ownership, for example, when the tenant sells the mobile home or condominium (Hirsch and Hirsch, 1988). Vacancy decontrol of mobile home parks, in particular, raises the question of who gains and who loses. While the unearned windfall profits of sitting tenants will clearly be reduced, the effect on new tenants requires analysis, specifically whether potential mobile home buyers will be better off with or without decontrol. Using a simple supply-demand housing stock model, controls can be shown to limit quantity supplied. With rent control, the supply curve moves up and prices increase. With vacancy decontrol, the supply curve shifts down. If vacancy decontrol results in an increased quantity, then the price will necessarily fall. While new purchasers clearly benefit in terms of lower initial prices, they are worse off due to pad rents starting at a higher level. This will lower the demand curve for mobile homes, but it would be hard to imagine a shift that lowered it enough to get a new equilibrium at a lower number of units. Sitting mobile home owners will generally be worse off due to the change. With permanent controls, they are free to sell the future rights to the controlled land rents, but lose this option with vacancy decontrol. They lose by

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the price decrease if they sell and by a lesser amount if they stay. For those planning to stay indefinitely, there is only a minor impact.

11. Just-Cause Eviction Laws In the presence of vacancy decontrol, landlords have a strong incentive to create circumstances conducive to tenants vacating their premises. To counteract these tendencies, jurisdictions often enact just-cause eviction laws, which enumerate the specific causes which allow eviction. Causes include among others, failure to pay rent, disorderly conduct, willful damage to premises, and so on (New Jersey Stat., 1974). Some states have attempted to apply such laws solely to senior citizens (California Assembly A.B.1202, 1974). The effect of a just-cause eviction law is to increase the security of tenancy. The demand function for apartments with just-cause eviction guarantees is higher, that is, further to the right, than that without such guarantees, ceteris paribus. Thus, the law by protecting tenants enhances their utility. But while just-cause eviction laws increase the welfare of tenants, they also impose costs on landlords. Specifically, such laws reduce landlords’ rights and thereby flexibility, and place greater risk upon them. Moreover, legal costs are likely to increase. As a consequence, the rental housing supply function shifts to the left in the presence of just-cause eviction laws, ceteris paribus. Depending on the relative shifts of the demand and supply functions, three different outcomes are possible. In the most likely case, the cost to the landlord of operating under a just-cause eviction law are higher than is the law’s value to tenants; the result can be fewer dwellings. In a second case, the cost to the landlord is smaller than the increased value to the tenant. The result usually will be more dwellings, however, at a higher rent. In a further case, law-induced benefit and cost increases are about equal with all parties left in the same welfare situation as before.

12. Anti-Conversion and Anti-Demolition Laws To protect tenants from landlords circumventing rent control laws, some jurisdictions have enacted anti-conversion and anti-demolition laws. The former prevent apartment house owners from converting properties into condominiums, cooperatives, or convalescence homes. While these laws protect tenants, they interfere with landlords’ rights to seek the most efficient and profitable use of their property. Thereby they can create inefficiencies as well as inequities, particulary when they prohibit ownership of residential rental property to go out of the housing business.

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D. Habitability Laws Habitability laws (or housing codes) compel landlords to make sure that a rental meets minimum standards of habitability, that is, is not substandard housing.

13. Legal Analysis Laws regulating landlord-tenant relations historically favored landlords over tenants. Specifically, the doctrine of caveat emptor was applied to relieve landlords of responsibility for warranting that a building rented for residential purposes was fit for that purpose at the inception of the tenancy. Landlords had no responsibility for a building to remain habitable during the term of tenancy. Repair of damage caused by ordinary wear and tear was considered the tenant’s responsibility. In 1826, the doctrine of constructive eviction was first recognized in the United States (Dyett v. Pendleton, 1826). Grounds for constructive eviction, which permitted the tenant to surrender possession and vacate premises, were the covenant of habitability and the covenant of quiet enjoyment. The covenant of habitability required the premises to be delivered in tenantable fit or suitable condition. Concerned that the only relief for tenants was to vacate the premises, some state statutes and court decisions in the post-World War II period modified the doctrine of constructive eviction. In so doing, the doctrine of caveat emptor was reinterpreted in relation to the rights and obligations of landlords and tenants. In light of the complexity of rental housing and the inequality of bargaining power in present-day society, a move towards the doctrine of caveat venditor occurred. As a result, an implied warranty of habitability in urban rental leases evolved (Markovits, 1976; Schwallie, 1990). In the mid-1970s two parallel developments occurred in the United Kingdom and the United States. In 1975 the Law Commission (Law Com. No. 67) handed to the Lord High Chancellor its proposed Codification of the Law of Landlord and Tenant. He in turn laid this Report on Obligations of Landlords and Tenants before Parliament Law Commissioners (1975). The Report proposes inter alia that particular obligations of landlords and tenants be divided into two classes - mandatory obligations that cannot be varied or excluded, and variable obligations that can be varied or excluded by agreement of the parties. The important mandatory obligations included the tenant’s right to exclusive possession of the premises and their quiet enjoyment; the tenant’s mandatory obligation was to pay rent, to protect the premises and to disclose his identity; as well as the landlord’s obligations to disclose his identity. The Law Commission also recommended that tenancy for a term of less than seven years be governed by an overriding covenant obliging the landlord

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to repair the structure and interior of a dwelling. In tenancies of a furnished dwelling for a term not exceeding 20 years there should be an implied, but variable, covenant by the landlord to keep the entirety of the premises in repair. In tenancies over 20 years and in the absence of expressed agreement, the entire responsibility for repairs of the premises should be imposed on the tenant. In 1976, the American Law Institute adopted Restatement of the Law: Property 2d - Landlord and Tenant (American Law Institute, 1976). According to the document’s section on habitability, a court could hold that a landlord had breached a covenant of habitability even though he had an agreement with a tenant on a month-to-month basis that clearly indicated that both landlord and tenant were fully aware of housing code violation. Remedies available to tenant include rescission, damages, rent abatement and rent withholding. Moreover, tenants are protected against retaliatory eviction. The United Kingdom has various laws providing for compulsory improvements and repair. For example, the Housing Act of 1974 in Part VIII provides powers to compel landlords to provide a bathroom and other standard amenities on request from a tenant (Haden, 1978). This requirement, which had existed since 1964, was intended by the 1974 Act to include repairs associated with the provision of standard amenities, and also to permit local authorities to act without a formal request from a tenant. In response to representation from a tenant, local authorities inform the owner and then inspect the premises and finally prepare a schedule of work and an estimate of costs. Under certain circumstances steps are initiated by the local authority as a result of house-to-house inspection. At any time within six weeks, the owner may appeal to the county court on the ground that the notice is invalid, for example that the expense involved is unreasonable or that the standard of repairs required is unreasonable in relation to the age, character and locality of the house. Once the notice has become operative, the owner has a further six months to decide whether or not to serve a purchase notice on the local authority. If no action of any kind has been taken by the owner on the expiration of the six month period, the local authority may then serve a formal reminder asking whether the owner intends to carry out the work. Should this not produce a satisfactory response, the local authority may then serve further notice stating that it intends to carry out the work in default and, after a further 21 days, may do so. Alternatively, it may wait until the full 12 months have expired and then act in default, though it must still give the owner 21 days notice of its intention to do so. In either instance, the cost of the work may then be recovered from the owner, subject to further provision of an appeal against the amount claimed. Procedures for compelling owners to carry out repairs on their property have been successfully instituted under the Public Health Act of 1936 and 1961. Large authorities are reported to issue hundreds or thousands of formal and informal notices per year under these statutes, compared to tens or hundreds

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under the Housing Act. Compulsory repair under the Public Health Act requires a finding of a statutory nuisance. As such it must either be prejudicial to the health of an occupier of the house in question, or a nuisance that is a danger or an annoyance to adjoining occupiers or other people in the area. It appears that the Public Health Act has been mainly used to require owners to remedy relatively inexpensive defects. By means of housing codes, many large American cities have shifted to the landlord the responsibility for repairing leased premises and maintaining them in habitable condition. Toward this end in the United States, for example, three remedies were developed - repair-and-deduct, rent withholding and receivership, with the first two often supplemented by retaliatory eviction laws, designed to protect tenants from eviction by former landlords for complaining about housing code violations. The implied warranty of habitability has been used as a defense in action of eviction, if the tenant is able to show that a ‘substantial’ violation of the housing code existed during the period rent was withheld. In addition, the tenant may take affirmative action against the landlord for breach of contract, though remaining liable for the reasonable value of the use of the premises. Of the three remedies listed, receivership is potentially the most costly to the landlord. It results in a complete stoppage of rental income to him, since all tenants in the building, not only aggrieved ones, pay rents into escrow. Moreover, the landlord loses control over his building altogether. Instead, control is temporarily transferred to a receiver, who may be enthusiastic about fixing up the building, possibly even above minimum standards established by housing codes. The repair decisions are thus made without due consideration of their potential profitability. Finally, contrary to most repair-and-deduct and withholding actions, receivership is usually initiated by government, which has vast resources behind it. It must be remembered that these laws were designed to protect tenants in view of their unequal bargaining power as well as their inability to effectively inspect a dwelling in the light of its structural and technological complexity. The unequal bargaining power issue affects mainly poor tenants and, in particular, members of minority groups. The great complexity of today’s rental housing is of concern to all tenants, though the rich can quite readily cope with complexity. In response to both conditions, courts have extended warranties of habitability to leases of rental housing. Concerning inequality in bargaining power, Judge Skelly Wright has argued in Javins v. First National Realty Corporation (1970, p. 1071) The inequality in bargaining power between landlord and tenant has been well documented. Tenants have very little leverage to enforce demands for better housing. Various impediments to competition in the rental housing market, such as

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racial and class discrimination and standardized form leases, mean that landlords place tenants in a take it or leave it situation. The increasingly severe shortage of adequate housing further increases the landlord’s bargaining power and escalates the need for maintaining and improving the existing stock. Finally, the findings by various studies of the social impact of bad housing has led to the realization that poor housing is detrimental to the whole society, not merely to the unlucky ones who must suffer the daily indignity of living in a slum.

In connection with the complexity of today’s dwellings which affects everybody, including the richest tenants, Judge Skelley Wright has stated in Javins v. First National Realty Corporation (1970, p. 1073): the increasing complexity of today’s dwellings renders them much more difficult to repair than the structures of earlier times. In a multiple dwelling repair may require access to equipment and areas in the control of the landlord. Low and middle income tenants, even if they were interested in making repairs, would be unable to obtain any financing for major repairs since they have no long-term interest in the property. ... The tenant must rely upon the skill and bona fides of his landlord at least as much as a car buyer must rely upon the car manufacturer. In dealing with major problems, such as heating, plumbing, electrical or structural defects, the tenant’s position corresponds precisely with the ‘ordinary consumer’ who cannot be expected to have the knowledge or capacity or even the opportunity to make adequate inspection of mechanical instrumentalities, like automobiles, and to decide for himself whether they are reasonably fit for the designed purposes.

14. Economic Analysis: Short-Term Welfare Effects By 1972 about half the states in the United States had a habitability law. Moreover, a number of local jurisdictions enacted such laws. An example is the City of Los Angeles with its Habitability Enforcement Program (Los Angeles City Ordinance 171074, 1996). While many legislators and judges are likely to agree that provision of habitable rental housing is a socially desirable goal, a crucial issue is whether enacting habitability laws is likely to have socially desirable effects, especially on indigent and minority tenants. The outcome depends to a large extent on whether landlords can pass on significant parts of their increased maintenance and repair costs to their tenants. In the early 1970s, this issue began to be researched, first by applying economic theory and later by carrying out econometric studies. Ackerman (1971, p. 1093) reasoned that ‘when code enforcement is seriously pursued, market forces will generally prevent landlords from passing on their increased

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costs through rent increases’. In opposition to this position, Komesar (1973, p. 475, 1187) argued that in many housing markets landlords were unlikely to be able to pass on their cost increases. An econometric study attempted to empirically estimate the effects of various habitability laws not only on cost but also on demand functions of rental housing (Hirsch, Hirsch and Margolis, 1975). In this manner an understanding of the welfare-effects of such laws became possible. Habitability laws have forced landlords to improve repair and maintenance of their dwellings and thereby improve the welfare of their tenants. It is clear that the cost to landlords increases in the presence of habitability laws. However, it is less clear on a priori grounds, whether and, if so, to what extent the well-being of tenants increases, let alone whether tenants’ welfare increases exceed landlords’ losses. One reason why tenants’ welfare may not increase relates to tenants’ preferences. There can be instances, admittedly not too many, where tenants prefer to live in substandard housing as long as their rent is commensurately low. Whether, on balance, the gains of tenants exceed the costs of landlords is affected by the relative importance of those tenants who are forced against their will to live in improved housing at higher cost. Some econometric studies have attempted to estimate the welfare effects of repair-and-deduct, rent-withholding, and receivership laws, respectively (Hirsch, Hirsch and Margolis, 1975). The econometric analysis uses hedonic price methods, and includes habitability laws among the explanatory variables in the rental housing demand and supply equations. The extent to which the demand and supply functions shift upward in the presence of a particular habitability law can be estimated, and so can the resulting change in consumers’ surplus. If such laws are enforced and lead to improved repair and maintenance, the tenants’ wellbeing will be enhanced and the demand function will shift upward. On the supply side, habitability laws can affect maintenance and repair decisions, and, as a result, they can increase landlords’ costs. In consequence, they can make the supply function shift upward. Welfare conclusions can be derived by comparing the magnitude of the vertical shifts of these demand and supply functions. Using a hedonic price approach, an econometric study found that, of the three types of habitability laws, in 1974-75 only receivership had a statistically significant effect on both the demanders and suppliers of low-cost rental housing in 34 large metropolitan areas with more than 1/4 of the United States population. Receivership laws were found to be associated with a statistically significant increase in rental expenditures incurred by indigent tenants, which, however, was not matched by benefits. Costs exceeded benefits by a factor of three and the consumer’s surplus declined by more than 10 percent (Hirsch, 1981, p. 272). Thus, although habitability laws were designed to improve the welfare of indigent tenants, in the sample studied they had failed to do so. Receivership laws may even have been counterproductive.

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An econometric analysis of black and aged indigent tenants, respectively, reveals that habitability laws affect them differently. For black indigents, again the vertical shift of the supply function related to a receivership law is more than three times that of the demand function and the difference again is statistically significant (Hirsch, 1983, p. 128). Yet, for aged indigents, the vertical shifts of the two functions are about of equal size. In short, for black indigents, receivership laws were counterproductive, while for aged indigents they were of no consequence. Why are habitability laws inconsequential or even counterproductive? One reason is that these regulations are not accompanied by an increase in the indigents’ purchasing power which should have permitted them to pay for improved housing. Without income transfers, habitability laws can be counterproductive. Schwallie (1990, p. 525) recently concluded that the implied warranty of habitability and habitability laws incorporating this warranty have often failed indigent tenants. The main reason is that ‘the warranty of habitability results in scarcer, more expensive housing for the poor. Moreover, the quality of low-rent housing is a consequence of inadequate demand due to the low incomes of renters...’. The effects of making the implied warranty of habitability compulsory on repairs, maintenance and safety and on equity have been discussed by Singer (1993, pp. 756-759).

15. Economic Analysis: Alternatives Consistent with the objectives of habitability laws, housing subsidy laws for rental housing meeting minimum standards have been enacted. When subsidies go directly to landlords, and only to those who meet minimum quality conditions, improved housing is assured. Moreover, the entire subsidy is then used for housing. In the United States, one such program is Sections 501 and 504 of the Housing and Urban Development Act of 1970, often referred to as a housing-allowance program. Under it, tenants who meet an income test are paid a rent subsidy as long as they do not live in substandard housing. The rent subsidy amounts to the difference between the rent payments and 25 percent of the tenant’s income. Such an earmarked subsidy is very different from a general welfare payment that can be used by recipients for whatever purpose they choose. Whenever the income elasticity of rental housing is smaller than one, and there exists evidence that this is the case for indigents, an earmarked subsidy is to be preferred (de Leeuw, 1971). As tenants receive such a rent subsidy, their housing demand function shifts to the right. Depending on the demand and supply elasticities and the nature of the demand function shift (that is, whether it is parallel or not), part, all, or none of the subsidy will be shifted

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to landlords in the form of rent changes.

16. Economic Analysis: Long-Term Welfare Effects Beyond short-run welfare effects of habitability laws, there exist also long-run effects, particularly in terms of housing stock deterioration. If such laws reduce dilapidation, upper income groups who by and large can assure themselves of habitable housing are little affected. The benefits to low and low-middle income groups are less clear. While the result is an increase in the supply of habitable rentals, their demand will also increase. There is some empirical evidence regarding the effectiveness of habitability laws in reducing substandard housing. An econometric study of the relation between habitability laws and two different measurements of dilapidation in the United States in 1960-75 produced the following results: among the different habitability laws receivership laws have the greatest effect on housing quality. In their presence, renter-occupied dilapidated and deteriorating housing units declined on average by 12.4 percent (Hirsch and Law, 1979). The law’s effect was even more pronounced if substandard housing is defined as housing lacking some or all plumbing facilities. By this measure, substandard housing declined by an average of 17.0 percent. It would be a mistake, however, to look upon a decline in substandard rental housing as an unmitigated gain. In fact, in the absence of substandard housing, options for indigent tenants are reduced. Some tenants are likely to end up in over-crowded standard units, or even homeless.

E. Laws Complementing Housing Codes Landlords may be tempted to evict tenants who invoke habitability laws. For such cases, anti-retaliatory eviction laws exist in some jurisdictions and they can be supplemented by anti-speedy eviction laws.

17. Anti-Retaliatory Eviction Laws Such laws, designed to protect tenants from being penalized by their landlords for complaining about housing code violations, can be looked upon as a means to assure tenants continued occupancy for a specified period. Already in the mid-1970s, about half the states in the US had such laws, usually with a 3-6 month rent freeze. Determination of the landlord’s motive is of critical importance.

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In terms of economic effects, anti-retaliatory eviction laws can be viewed as miniature, temporary rent control laws which preserve the existing rent status quo in the face of a changed buyer-seller relationship. The force of the rebuttable or conclusive presumption tends to deter landlords from raising rents for the statutory period, while operating and maintenance costs increase. The temporary and rather limited scope of retaliatory eviction laws is unlikely to cause many landlords to abandon their property. However, when the landlord feels legally ‘safe’ in raising rents, the increase may be larger than would have been the case otherwise.

18. Anti-Speedy Eviction Laws In the United States, for a long time the judicial process of ejecting a tenant was heavily burdened with procedural complexities and of slow pace. During the middle and end of the nineteenth century, legislation was enacted to provide a more efficient remedy through the institution of special summary proceedings for landlords seeking to evict tenants. The new proceedings were to prevent landlords from taking the law into their own hands through self-help. In the recent past, laws to rein in the use of summary proceedings and self-help have been enacted. Under a summary eviction law procedure, a basic pattern followed in most states is that upon a judgment for the landlord, in the absence of an appeal, a writ of restitution will be issued. Then, after a short period, the sheriff will execute the writ by evicting the tenant. However, in some states a concern for the wellbeing of the tenant and a desire to mitigate the harshness of an eviction has led to the adoption of legislation which permits a court to delay the enforcement of the writ of restitution. The major mitigating circumstance is that the tenant cannot find alternative housing. In many states, the courts recognize some variation of the common law right to self-help by landlords. The minimal conditions are a clear right to possession by the landlord without use of unreasonable force in retaking possession. Generally, peaceable entry in the absence of the tenant will be recognized as a legitimate exercise of the landlord’s authority. However, an increasing number of states have abrogated this common law right to self-help. They have recognized the existence of a tort claim by the tenant against the landlord who enters to retake the premises, even with reasonable force. One group of states permits a tenant a tort cause of action against the landlord for removal of the tenant without resort to judicial process, if the removal is against the will of the tenant. A second group expressly bars any use of self-held by the landlord, permitting the tenant a cause of action for the mere act of entry by the landlord in an attempt to remove the tenant. An example is

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California (Jordan v. Talbot, 1961). Analysis of the economic effects of anti-speedy eviction laws can be similar to that of habitability laws. Both types of speedy eviction impose burdens on tenants while benefiting landlords; laws modifying or negating them should result in upward shifts of the rental housing demand and supply functions. If the vertical shift of the demand function in the presence of anti-speedy eviction laws exceeds that of the supply function, and the difference is statistically significant, welfare is enhanced, and vice versa. An econometric study of black indigent tenants indicates that laws reining in landlords’ use of self-help measures may be socially desirable (Hirsch, 1983).

F. Anti-discrimination Laws Housing discrimination is said to exist when members of one or more groups, commonly defined by race, gender, age, religion, or family status, are denied housing that is available to other groups, regardless of formal qualifications. Not only does discrimination violate concepts of fairness, but it can also result in many social and economic side effects.

19. Racial Discrimination: Legal Analysis Countries have enacted a variety of laws to combat housing discrimination. Discrimination on the basis of race has played a major role in the history of the United States. A housing discrimination survey of 25 large metropolitan areas with central city populations in excess of 100,000 and where at least 12 and 7 percent of the population was black or Hispanic, respectively (Turner, 1991, pp. 3-17) produced the following findings. In the United States in 1989 black and Hispanic renters faced a 39 and 36 percent probability, respectively, of being denied information about housing availability, and a 17 and 16 percent probability, respectively, of being told that the advertised unit is no longer available even though it was available to comparable whites. For blacks and Hispanics the index of unfavorable treatment in completing the renting transaction was 44 and 42 percent, respectively. Since the end of the Civil War in the United States, a number of affirmative steps have been taken to combat discrimination. In terms of housing activities, Section 1982 of the Civil Rights Act of 1866 together with its interpretation by the US Supreme Court in Jones v. Alfred H. Mayer Co. (1968) was first. Next came the Fair Housing Act of 1968 and Fair Housing Amendments Act of 1988.

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For housing, one of the most important acts is that of 1968 which is often referred to as the ‘Fair Housing Act’. It prohibits discrimination based on race, color, religion, sex, and national origin in the sale or rental of most housing. While it covers a host of activities related to real estate and housing, it includes real estate brokers, apartment owners and extends to federally owned and operated dwellings and dwellings provided by federally insured loans and grants. Title VIII prohibits such discriminatory activities as refusal to rent a dwelling; terms, conditions, or privileges of renting dwellings; indicating preferences or limitations in advertising; and so on.

20. Racial Discrimination: Economic Analysis Racial housing discrimination appears to exist in many countries with racially diverse populations (Page, 1995). In many Western countries, especially the United States, such discrimination has been on the decline. Economists have been interested in the reasons responsible for housing discrimination and how anti-discrimination laws affect them, and welfare effects of anti-discrimination laws. A number of theories have been advanced to explain the existence of rental housing discrimination and the resulting segregation by race. They include the aversion theory (Muth, 1970), racial prejudice theory (Becker, 1957; Bailey, 1959), and amenity theory (Yinger, 1976). Effects of race discrimination which have been explored include segregation, employment opportunities, crime, drug use, homelessness, and so on (Sander, 1988). Laws prohibiting racial discrimination in rental housing impose on landlords costs which often can be sufficient to persuade them not to engage in this practice. If this is the case, these laws can do more than merely contribute to fairness. Since racial housing discrimination is inefficient, as it restricts the housing choices of minority families and their efficient access to housing, employment, and educational opportunities, these laws also enhance efficiency.

21. Age Discrimination: Legal Analysis In the United States until recently little attention was paid to housing discrimination of age groups. Even as late as 1971, the US Supreme Court in Graham v. Richardson (1971) included among ‘suspect’ categories requiring strict scrutiny only race, national origin and alienage. Recently, state legislatures and courts, as well as local governments, have shown concern about housing discrimination against families with children. By 1981 nine states and the District of Columbia had enacted laws dealing with age discrimination in

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housing, and many courts began to interpret discrimination laws to cover age. For example, the California Supreme Court, in Marina Point, Ltd. v. Wolfson (1982) interpreted the California Civil Rights Act as preventing housing discrimination against children. The court also found that the strongest basis for this position rested upon California’s Unruh Civil Rights Act (1982) which provides that ‘[a]ll persons ... are entitled to ... full and equal accommodations in all business establishments’. California courts have interpreted the phrase ‘business establishments’ to include housing. Comprehensive federal legislation only arrived with enactment of the Fair Housing Amendments Act of 1988. It prohibits landlords to refuse to rent or show a house or apartment to a family with children younger than 18, or to require such a family to pay higher rent, impose restrictions or create unfair barriers not required of someone without children. However, under some circumstances, families with children can be excluded, for example, in ‘housing for older persons’. There are two classes of such housing: (1) ‘62 or over housing’, if all tenants in the housing complex are 62 years or older, and (2) ‘55 or over housing’, if at least 80 percent of all units in the complex have at least one occupant 55 years or older and there exist significant facilities and services to meet the needs of older people. Major concerns have been voiced concerning the facilities and services requirement of ‘55 or over housing’, mainly its vagueness (California Senate Select Committee on Mobile Homes, 1989). Fear has been expressed about the potential for litigation and cost of providing appropriate facilities and services for senior citizens, particularly since approximately 60 percent of the more than 5,000 mobile home parks in California in 1988 had adult-only restrictions (California Senate ..., 1989, p. 13). Thus, age discrimination laws relating to housing have been directed mainly at tenants with children and at senior citizens. The interests of these two classes of tenants can be in serious conflict. Senior citizens favor a tranquil life which often becomes difficult with young children as close neighbors. Thus, some mobile home parks are dedicated to senior citizens. Young families, like all families, want to be free to live wherever they choose. Arguments in opposition to anti-age discrimination laws were advanced, for example, in Flowers v. John Burham & Co (1971) where a California appellate court determined that, because of children’s ‘independence, mischievousness, boisterousness and rowdyism’, age discrimination within housing was not arbitrary discrimination. Also, the dissent in Marina Point Ltd. v. Wolfson (1982) argued that regulations regarding children are reasonable and rationally related to the services performed by the landlord when it has been determined that the apartment complex has been constructed for all-adult housing and its facilities are ill-adapted for use by children. Thus, landlords are faced with two costs associated with the Wolfson decision: Not only will landlords be

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prohibited to choose tenants on the basis of whether or not they have children, but they will also be forced to incur expenses to alter their premises to accommodate children. Arguments in favor of such laws include the serious impact on family stability as well as a deep psychological effect on children. Moreover, since many minority families have many children, child discrimination might be disguised racial discrimination and no doubt contributes to such discrimination.

22. Age Discrimination: Economic Analysis The conflict that can arise when children and senior citizens are housed in great proximity can be looked upon as an externality problem. In the abstract, price discrimination can help solve this conflict. Depending on each market’s demand, either families with children or senior citizens would be forced to pay higher rents, which in some instances could be prohibitive. Clearly such a resolution of the conflict is likely to run into political opposition. Furthermore, traditional economic theory tends to indicate that landlords in highly competitive housing markets will seldom, if ever, refuse to rent to families with children. In such a setting, a landlord could satisfy his distaste for families with children at the expense of a higher vacancy rate. Therefore, housing markets with age discrimination probably contain elements of monopoly. The landlord has some locational monopoly as well as some market power due to any unique characteristics his building may have. More important, exclusionary maximum density zoning laws and slow growth policies of local governments, combined with a growing demand for housing rentals, have tended to widen the gap between the quantity of dwellings supplied and those demanded. While rents should have adjusted to this situation and helped to close these gaps, in reality price adjustment in the housing market has been slow. This result is due to institutional features, as well as the existence of long-term leases. Microeconomic analysis of welfare effects can utilize a demand and supply housing stock model. Since children impose costs on landlords, for example, for heightened repair and maintenance, the supply curve shifts upward as the number of children increases. With children affecting negatively the utility of some tenants, their demand function will shift downward. The welfare effect of such laws depends on the relative importance of tenants who enjoy children in their building compared to those who are ill-affected and if so by how much.

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G. Policy Implications 23. Policy Implications Many countries have a host of landlord-tenant laws and there exists an extensive legal, economic and law and economics literature on the subject. By far the greatest interest has been shown in rent control. Until recently virtually all appraisals of its effects on society were negative, perhaps for two reasons economists’ misgivings about any form of price control and excessive focus on first generation, hard rent controls analyzed by perfectly competitive, static economic housing models. A few voices have recently been heard claiming that analyses of second generation controls which recognize the imperfection of housing markets are much less conclusive. Arnott (1995, p. 118) concludes, ‘the case against second-generation rent control is so weak that economists should at least soften their opposition to them’. However, Arnott concedes that ‘[E]ven if the optimal rent control package would be beneficial, the actual ... package thrown up by the political process may be harmful’ (p. 109). Habitability laws are also common to many countries, although in only a few instances have their welfare implications been subjected to careful economic analysis. Some deductive and one econometric study in the United States raise serious doubts about their desirability. Anti-discrimination laws have also become common all over the world as society is seeking to free itself from race and age discrimination in rental housing. While society has good reason to oppose housing discrimination, and anti-race discrimination laws tend to be socially desirable, the efficacy of anti-age discrimination laws is less clear. The reason is that both young and old families have valid claims. The former lay claim to their right to live wherever they want, and the latter to the quiet enjoyment of their homes and surroundings. Additionally, and perhaps most importantly, law and economics should not look at the various laws in isolation. All too often jurisdictions have enacted a number of laws, for example, rent control laws with anti-conversion and anti-demolition provisions together with habitability laws. The former prevent landlords from using their best judgment in deciding on rent levels and on the best use of their property, thereby reducing their investment’s profitability and their ability to preserve housing quality. Yet, habitability laws compel them to provide tenants with habitable housing. In the extreme case, thus, landlords find themselves between a rock and a hard place. In conclusion, this review of renting confirms the judgement of Williamson (1996) that law and economics is a success story. This assessment is clearly correct in so far as Renting is concerned. Contributions to tools of economic analysis, legal thought and public policy have had a major impact and proved

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valuable.

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Singer, Joseph (1993), Property Law, Boston, MA, Little Brown. Skelley, Christine (1992), Rent Control and Complete Contract Equilibria, mimeo. Smith, Lawrence B. and Tomlinson, P. (1981), ‘Rent Controls in Ontario: Roofs or Ceilings?’, 9 American Real Estate and Urban Economics Association Journal, 93-114. Smith, Lawrence B., Tomlinson, P., Rosen, Kenneth T. and Fallis, George (1988a), ‘Recent Developments in Economic Models of Housing Markets’, 26 Journal of Economic Literature, 29-64. Smith, Lawrence B., Tomlinson, P., Rosen, Kenneth T. and Fallis, George (1988b), ‘An Economic Assessment of Rent Controls: The Ontario Experience’, 1 Journal of Real Estate Finance and Economics, 217-231. Smith, Richard A. (1989), ‘The Effects of Local Fair Housing Ordinances on Housing Segregation’, 48 American Journal of Economics and Sociology, 219-230. St. John, Michael (1996), ‘Inflation and Rent Control’, WMA Reporter, 27-32. Stake, Jeffrey E. (1988), ‘Toward an Economic Understanding of Touch and Concern’, Duke Law Journal, 925-974. Stegman, Michael (1988), Housing and Vacancy Report: New York City, 1987, New York (NY), City of New York Dept. of Housing Preservation and Development. Sternlieb, George (1976), Urban Housing Dilemma: The Dynamics of New York City’s Rent Controlled Housing, New Brunswick (NJ), Center for Urban Policy Research. Struyk, Raymond J. (1988), ‘The Distribution of Tenant Benefits from Rent Control in Urban Jordan’, 64 Land Economics, 125-134. Sweeney, James L. (1974a), ‘Quality, Commodity Hierarchies and Housing Markets’, 42 Econometrica, 147-167. Sweeney, James L. (1974b), ‘A Commodity Hierarchy Model of the Rental Housing Market’, 1 Journal of Urban Economics, 288-323. Symposium (1983), ‘Redistribution of Income Through Regulation in Housing’, 32 Emory Law Journal, 767-819. Symposium (1988), ‘Rent Control and the Theory of Efficient Regulation’, 54 Brooklyn Law Review, 729-739. Tobin, James (1970), ‘On Limiting the Domain of Inequality’, 13 Journal of Law and Economics, 263-277. Turner, Bengt (1988), ‘Economic and Political Aspects of Negotiated Rents in the Swedish Housing Market’, 1 Journal of Real Estate Finance and Economics, 257-276. Turner, Margery (1988), Rent Control and the Availability of Affordable Housing in the District of Columbia: A Delicate Balance, Report prepared for the District of Columbia’s Dept. of Consumer and Regulatory Affairs, Washington, DC, The Urban Institute. Turner, Margery (1991), Housing Discrimination Study - Synthesis, Washington, DC, U.S. Dept. of Housing and Urban Development. Vitaliano, Donald F. (1985), ‘The Short run Supply of Housing Services under Rent Control’, 22 Urban Studies, 535-542. Vitaliano, Donald F. (1986), ‘Measuring the Efficiency Cost of Rent Control’, 14(1) American Real Estate and Urban Economics Association Journal, 61-71. Weber, Shlomo and Weismeth, Hans (1987), ‘Contract Equilibrium in a Regulated Rental Housing Market’, 21 Journal of Urban Economics, 59-68. Weibull, Jürgen W. (1983), ‘A Dynamic Model of Trade Frictions and Disequilibrium in the Housing Market’, 85 Scandinavian Journal of Economics, 373-392.

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Weitzman, Phillip (1985), ‘Economics and Rent Regulation: A Call for a New Perspective’, 13 New York University Review of Law & Social Change, 975-988. Werczberger, Elia (1988), ‘The Experience with Rent Control in Israel: From Rental Housing to Condominiums’, 1 Journal of Real Estate Finance and Economics, 277-293. Wheaton, William (1990), ‘Vacancy, Search, and Prices in a Housing Market Matching Model’, 98 Journal of Political Economy, 1270-1292. Williamson, Oliver E. (1996), Revisiting Legal Realism: The Law, Economics and Organizational Perspective, Working Paper, Center for the Study of Law and Society, Berkeley, No. 95-12, 3. Willis, Kenneth G., Malpezzi, Stephen and Tipple, A. Graham (1990), ‘An Econometric and Cultural Analysis of Rent Control in Kumasi, Ghana’, 27 Urban Studies, 241-257. X (1988), ‘Note: Reassessing Rent Control: Its Economic Impact in a Gentrifying Housing Market’, 101 Harvard Law Review, 1835-1855. Yang, Chin Wei and Dennis, Enid (1984), ‘Elasticities and Rent Control Revisited’, 12(4) Atlantic Economic Journal, 59-61. Yinger, John (1976), ‘Racial Prejudice and Racial Residential Segregation in an Urban Model’, 3 Journal of Urban Economics, 383-406.

Cases and Legislation Age Discrimination Act of 1975, 42 U.S.C. §§6101-6107 (1976 and Supp. II 1978). American Law Institute (1976), Restatement of the Law: Property 2d-Landlord and Tenant. Birkenfeld v. City of Berkeley (1976), 17 Cal. 3d at 169-172, 550 P.2d at 1029-1032 Cal. Rptr. Block v. Hirsch (1921), 256 U.S. , 135-156. California Assembly (1973-1974 Regular Session), A.B. 1202 Dolan v. City of Tigard (1994), 512 U.S. 129 L.Ed. 304, 317, 114, S.Ct. 2309. Dyett v. Pendleton (1826 N.Y.), 8 Cow, 727. Fair Housing Amendments Act of 1988, Pub.L. No. 100-430, 102 Stat. 1625. Fair Housing Act, 42 U.S.C. §3601-3631 (1976 and Supp. II 1978). Fair Housing Act of 1968, 42 U.S.C.A. §3601 et. seq. Flowers v. John Burham & Co. (1971), 21 Cal. App. 3d 700, 98 Cal. Rptr. 644. Graham v. Richardson (1971), 403 U.S. 365. Hall v. City of Santa Barbara (1986), United States Court of Appeals, Ninth Circuit, No. 85-5838, August. Housing and Urban Development Act of 1970, Pub. L. No. 91-609, §§501, 504, 84 Stat. at 1784 and 1786 (1970). Housing: The Government’s Proposals, 1987 (Cm. 214). Javins v. First National Realty Corporation (1970), 428 F2d 1071, DC Cir. Jones v. Alfred H. Mayer Co. (1968), 392 U.S. 409. Jordan v. Talbot (1961), 55 C2d 597,12 Cal. Reptr. 488,361 P.2d 20. Law Commissioners, Codification of the Law Landlord and Tenant (1975), Law Com. No. 67. Los Angeles, Cal. (1996), Ordinance 171074 (March 6). Loretto v. Teleprompter Manhattan CATV Corp. (1982), 458 U.S. 419, 734, Ed. 2d 868, 102 S.Ct. 3164.

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Marina Point Ltd. v. Wolfson (1982), 30 Cal. 3d 721, 640 P.2d 114. 180 Cal. Rptr. 446, cert. Denied, 1035 S.Ct. 129. New Jersey Stat. Ann. (West Supp. 1974) §2A. 18-53. Nolan v. California Coastal Commision (1987), 483 U.S. 825, 834-837, 974, Ed. 2d 677, 107 S.Ct. 3141. Palos Verdes Shores Mobile Estates, Ltd. v. City of Los Angeles (1983), 142 Cal. App. 3d 362, 190 Cal. Rptr. 866. Rent Act 1965, s. 27 (I): Rent Act 1977, s. 70(I). Santa Monica Beach Ltd. v. The Superior Court of Los Angeles County (1996), 42 Cal. App. 4th 1228. Title VIII of the Civil Rights Act of 1968, 42 U.S.C. §3601-3631. Unruh Civil Rights Act (1982), Cal. Civ. §Code 51 West. Yee v. City of Escondido (1992), 503 U.S. 519, 522-523.

5850 REGULATION OF BANKING AND FINANCIAL MARKETS Dirk Heremans Professor of Monetary Economics at the Center for Economic Studies, and of Law and Economics at the Law School of the Catholic University of Leuven © Copyright 1999 Dirk Heremans

Abstract The dynamic evolution of the financial system is stirring up the regulatory debate. Recent theoretical insights in the role of financial intermediaries and banks shed new light on the role of financial regulation. Information asymmetries, adverse selection and moral hazard problems help to explain the need for investors’ protection and the occurrence of systemic crises that may endanger financial stability. Lender of last resort interventions and deposit insurance are to be complemented by incentive compatible capital adequacy rules in an efficient corporate governance perspective. The balance between market and government is shifting, replacing structural by prudential measures, eventually moving towards worldwide regulation. JEL classification: 310, 311, 312, 314, 430, 619 Keywords: Regulation, Banking, Insurance, Financial Markets, Financial Crisis, Corporate Governance

1. Introduction Recently no longer irresponsible macroeconomic policy of governments but rather excessive risk taking by financial intermediaries is becoming the major factor explaining the occurrence of financial crises. Hence, it is the regulation of banking and financial markets that is becoming the major challenge for public authorities as due to increased competition the borders between financial institutions are fading, financial innovations are multiplying off balance sheet activities, and internationalization is rendering control by national authorities more and more difficult. According to an International Monetary Fund study by Lindgren, Garcia and Saal (1996), since 1980 about 133 IMF member countries have experienced significant banking sector problems of which 36 countries had to face real financial crises.

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The major goal of regulation in economic life in general, however, traditionally consists in protecting the (uninformed) consumers against a variety of market imperfections. Problems of market failures also apply to the financial sector and the banking system in particular. The goal of banking regulation and supervision is often explicitly stated as to prevent banks from assuming unacceptably high risks which may endanger the interests of creditors, that is, deposit holders and savers in general. Government intervention may also aim at the advancement of other policy objectives: that is, to encourage particular activities in the industrial, the agricultural sector or in the social field. In the financial sector the government intervenes in credit markets to subsidize or guarantee lending for industry, agriculture, housing and other activities regarded as beneficial to the economy. Often specialized financial intermediaries are sponsored by governments to make home mortgages accessible to borrowers or to grant cheap investment credits to particular sectors of the economy. It may be observed all over the world that compared to other sectors of the economy a much more elaborate system of regulatory interventions has been set up in the financial sector. Hence, the question arises what is specific to the financial sector in order to warrant such extensive regulation and supervision. First, it is held that special protection has to be provided to the consumer due to the fiduciary nature of most financial products and services. Being in essence future markets, financial markets are unavoidably characterized by risk and uncertainty, what is also reflected in financial assets as the intertemporal assets traded in these markets. Consumers have to be protected from excessive prices and opportunistic behavior by the suppliers of financial services. Second, money, a special commodity with vital transaction functions in the economy, is at the core of the financial system. As a consequence monetary and financial stability has become even the overriding goal of financial regulation. Specific concern for the stability of the financial sector is warranted due to external effects. Financial markets and institutions are much more interconnected and characterized by ‘herd behavior’ than is the case in other sectors of the economy. Bankruptcy of one institution may easily spill over to others and endanger the whole financial system. The elaborate financial regulating system that has resulted in the aftermath of the economic depression of the 1930s, which was attributed to a financial crisis, has recently been questioned for various reasons. First, the traditional public interest view of regulation has been challenged by the public choice approach. The latter view observes that in reality regulation often fails to serve the public interest. Regulators are ‘captured’ by the regulated firms through lobbying in order to protect the business interests, often at the expense of the consumer. In particular, firms have an interest in limiting competition by restricting entry into their markets through regulatory

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barriers. It is observed that the ‘capture theory’ applies even more to the financial sector, where unbridled competition is seen as a major threat to the primary goal of stability of the financial system. Hence, according to Van Cayseele (1992), the emphasis has been more on stability than on efficiency by limiting competition. As a result the financial sector more than other sectors of the economy has been hit by the deregulation wave. Second, the regulation debate has recently received renewed interest in the economic literature by new insights from developments in the field of information economics. Financial markets in particular are seen as imperfect by definition characterized by asymmetric information, agency problems and moral hazard. Markets are powerful coordination mechanisms, yet they do not operate perfectly and cannot do so. However, government intervention does not provide better coordination and therefore need not replace market mechanisms. Government policies in the first instance have to create a framework for satisfactory market operation, and only in the second instance do they have to prevent and limit the consequences of some negative aspects of the operation of the market mechanism. Hence, a delicate balance has to be struck between the discipline of the market and coordination by government actions. Moreover, the dynamic evolution of the financial system constantly presents new challenges to the regulatory debate. Government measures to protect the consumer such as deposit insurance coverage have in turn created new moral hazard problems. They diminish the incentives for markets to discipline the banks and induce excessive risk taking as has been documented recently, for example in the widespread Savings and Loans crises in the US. Hence, in order to complement market discipline a regulatory dialectic has developed in which deposit insurance has become a major modern driving force behind the supervision and regulation of banks. In this evolutionary process there are no definite nor universal recipes to be found and the balance between market and government may shift over time. Rather than discussing ad hoc regulatory policies, it is important to specify the general principles that have to determine the right balance between market and government coordination. Therefore before moving into specific regulatory issues such as regulatory instruments and regulating authorities, a more fundamental analysis of the role and the nature of the financial system is in order.

2. The Nature of the Financial System According to economic analysis financial markets by definition are imperfect. Financial intermediaries find there origin precisely in these market

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imperfections.They may provide a market solution to the market failures and in this respect may be an alternative for government intervention. First, more than other economic activities financial operations are concerned with the future, and hence are characterized by risk and uncertainty. The key services of the financial system in the process of allocating funds between savers and borrowers consist in trading risk and liquidity. As a consequence, expectations play a major role in the pricing of financial assets. However, given the often limited amount of information available price developments are difficult to predict. As new information becomes available market parties adjust suddenly and collectively (so-called herd behavior) their price expectations. Together with low transaction costs in financial markets, it explains the high volatility and inherent instability of financial markets. Second, asymmetric information problems arise when market parties have different information. Hence, one party may not have enough information about the other party to make accurate decisions. It certainly applies to financial markets where one party often has superior information about the risk being transacted than the other party, for example an investor knows more about the riskiness of his investment than the money lender. Asymmetric information hampers the well-functioning of markets. It creates problems of adverse selection before the transaction is entered into, and of moral hazard after the transaction has taken place. Adverse selection arises as due to incomplete information the lender cannot accurately distinguish good risk applicants from bad-risk applicants before making an investment. Thereby a so-called ‘lemon-premium’ will increase the loan rate, so that only risky projects will be funded. Moral hazard costs, incurred by the lender in verifying that borrowers are using their funds as intended, further raise the loan rate. In the process financial intermediaries arise as they specialize in information on borrowers and solve these asymmetric information problems. The key services provided by financial institutions then consist in collecting and communicating information on debtors and on financial assets. The principal-agent relationship of creditors with financial institutions, however, involves similar information problems. How can the lender (the principal) make sure that the agent (the financial intermediary) acts in his interest? For example, depositors lack information regarding the riskiness of the bank’s portfolio. Should these financial intermediaries which provide market solutions to market imperfections, in turn not be subject to government regulation and supervision? Third, financial markets and financial institutions tend to be more interdependent than is the case for other sectors of the economy. Events in one financial market or institution may have important external affects on the rest of the financial system and on the whole economy. Together with the important potential for ‘herd behavior’ it explains the occurrence of so-called system risks.

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Finally, at the heart of the financial system lies a special commodity: money. The proper functioning of money depends upon price stability. As there is a link between prices and money in circulation, there is a need to keep money creation under control. Money creation, however, is profitable, so that it may not be taken for granted that an unregulated money supply will lead to a sufficient stable price level. As money is created by the banking sector a special need for controlling these specialized intermediaries may arise.

3. Information Failures and the Need for Financial Regulation Mainly due to information-asymmetries financial markets do not operate perfectly. In reallocating funds between market parties an agency problem arises between the lender (principal) and the borrower (agent), since the latter has private information about the potential return and risk of his investment project. Hence, optimal debt contracts typically include extra costs, a so-called external finance premium, that are incurred. They consist of costs incurred in screening loan applicants and monitoring the behavior of borrowers and include a premium for credit risk. These are dead-weight costs associated with the agency problem and are more particularly due to problems of adverse selection and moral hazard as explained before. Solutions for these information failures may be provided by the market itself, mainly by financial intermediation, or may require government intervention. Instead of individual investors having to perform a variety of screening and monitoring functions that are complex and time-consuming, financial intermediaries arise. They specialize in these information functions and may benefit thereby from scale economics, reducing the cost of production of information, that is the external financing costs. As is argued by several authors, for example Dewatripont and Tirole (1994), in the exercise of these information functions there may be a ‘natural monopoly’ in that their duplication by several parties is technically wasteful. However, the main reason for the existence of financial intermediaries depends on their ability to overcome free rider problems in the production of information, due to problems of non-appropriability of information. Information has public good characteristics in that information is often non-rivalrous, meaning that one person’s use of information does not diminish its availability for others to use. Moreover, because the transmission of information has become so cheap, it may be expensive to exclude some people from this information. The non-excludability of people who do not pay for it, creates a free rider problem. It prevents the market from producing enough information to eliminate all the asymmetric information. The undersupply of

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information in the market may require regulatory intervention by the government to disclose information. In financial markets large numbers of savers have little incentive to devote resources to screen and monitor investors. Financial intermediaries on the contrary will have an incentive to invest in information and to act as delegated monitors for many individual savers who deposit their funds with the intermediary, if they can obtain extra profits from the production of information, as is argued by Hubbard (1996, p. 203). Banks play a special role as financial intermediaries in this respect by reallocating funds from small uninformed savers to small and medium-size investors, whose creditworthiness is often difficult to evaluate. Individual savers are faced with difficult information problems as the use of their funds involves a lot of ‘private’ information. When banks give private loans, instead of buying market paper, they invest in information on credit risks. According to Mishkin (1997), banks are able to profit from the information they produce and to avoid the free rider problems by primarily making private loans. These loans are not traded, so that other investors cannot gain a free ride on the intermediary’s screening and monitoring efforts by observing what the bank is doing and bid up the loan’s price to the point where the bank receives no compensation for its production of information. Hence, banks generally benefit from higher intermediation margins compared to external finance premiums in financial markets. By giving private loans banks are also able to better discipline the behavior of investors and to avoid risks of moral hazard. This monitoring function proves to be more difficult in case of market financing, for example by the emission of corporate bonds. These distinctions lie at the heart of the controversy between the so-called banking financing model, that is predominant in continental Europe, versus the market financing model of business investments in the Anglo-Saxon world. It may help to explain differences in choices made by banking legislation among countries. The role of markets and financial intermediaries in the provision of information implies that the need for government intervention is essentially of a complementary nature. First, in financial markets regulation is needed to the extent that no solutions for information failures are provided by financial intermediaries. This is the domain of financial market regulation. Second, financial intermediaries alleviate information problems, but their operation creates in turn similar information and monitoring problems. This has to be solved by regulation and supervision of financial institutions. The case for government interventions in the operation of financial markets mainly rests upon asymmetric information problems that create risks of fraud, negligence, incompetence, and so on. Financial services in this respect are seen as credence goods whose quality it is difficult to establish. However,

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information problems may be alleviated by private production and selling of information. For example, rating agencies screen and monitor the creditworthiness of bond issuers in the financial market. Because of the public good nature of information and the free rider problem linked to it, financial intermediaries are not able to solve completely these information problems. Additional public policy is needed therefore, in particular in retail markets. Hence, traditionally the main motive for regulatory intervention is found in the need to protect the consumer against information related failures. Timely and accurate information disclosure is needed to enable market participants to make prudent financial decisions, for example regulation requires lenders to provide borrowers a meaningful disclosure of credit terms. Information disclosure rules may also aim at ensuring equal treatment for all financial customers. Financial institutions on the one hand help to alleviate information problems in financial markets. On the other hand a substantial part of financial assets issued by financial institutions are information intensive. This applies in particular to banks where depositors are not informed about the quality and risk of the asset portfolio. Information asymmetries create problems of moral hazard as financial institutions may take actions that are not in the interest of investors, for example banks may have incentives to make high yielding but very risky loans. Moreover a free rider problem arises as large numbers of investors have little incentive to devote resources to the monitoring of financial institutions. In particular, bank debt is primarily held by small unsophisticated depositors who have little incentive to perform various monitoring functions. However, these costs of moral hazard may also be reduced and financial institutions be disciplined by the nature of the debt claims they issue. By issuing short-term debt claims as the banks do, their behavior will be disciplined by the threats that savers may withdraw their funds on short notice. If, however, such short-term debt claims are insured, as is the case for deposit insurance, moral hazard problems may even increase. Only uninsured creditors who cannot run, as is the case when banks issue a certain amount of subordinated debt, will have incentives to monitor risk taking by banks. Government regulation and supervision is needed to provide additional ways to reduce the costs of moral hazard to individual savers. These failures in market discipline can be best counteracted by requiring that financial information should be disclosed promptly and be accurate. This can also be achieved by increasing incentives for responsible performance for bankers and bank shareholders, for example by augmenting their stake in the bank by capital adequacy rules requiring to invest more of their own funds.

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4. Financial Stability and the Need for Regulation Stability is traditionally an important concern in the financial sector. The characteristics of the financial sector are such that individual problems may easily spill over and endanger the whole financial system. Hence, failures in the operation of the financial sector not only have consequences for individual investors and savers but stock market crashes, bank failures and other financial disasters may endanger the health of the whole economy. Financial operations are characterized by risk and uncertainty. In particular information problems arise as explained before. As a result financial decision making depends heavily upon expectations. It is also characterized by herd behavior. Market parties adjust suddenly and collectively their expectations leading to high volatility in financial markets. Moreover, compared to other sectors of the economy, financial markets are much more interdependent. This is witnessed by very tight interconnections in the interbank market. Events in one financial market or institution may then have important effects on the rest of the financial system. Failure in one market or institution may create a financial panic and end up in a systemic crisis. Due to ever increasing international capital mobility it may become a worldwide financial crisis. Banks specifically are faced with a two-sided asymmetric information problem. On the asset side borrowers may fail on their repayment obligations. Depositors, however, cannot observe these credit risks. The quality of the loan portfolio is private information acquired while evaluating and monitoring borrowers. On the liabilities side savers and depositors may withdraw their funds on short notice. Banks, however, cannot observe the true liquidity needs of depositors. This is private information. A true liquidity risk arises when depositors collectively decide to withdraw more funds than the bank has immediately available. It will force the bank to liquidate relatively illiquid assets probably at a loss. A liquidity crisis may then endanger also the solvability of the bank and eventually lead to bankruptcy. As Dewatripont and Tirole (1994) observe, the providers of funds are not able to assess the value of the bank’s underlying assets. As a result bad news, whether true or false, may provoke a withdrawal of funds. Moreover, as deposits are repaid in full on a first-come-first-served basis until the liquid assets are exhausted, depositors have an incentive to act quickly. A ‘bank run’ may occur when enough savers lose confidence in the soundness of a bank. Moreover, bad news about one bank can snowball and have a contagion effect on other banks. A bank failure could eventually trigger a signal on the solvency of other banks. Even if these banks are financially healthy the information about the quality of the loan portfolio underlying the deposits is private, so that depositors may also lose confidence and withdraw their funds.

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As is documented by Paroush (1988) domino effects lead to a widespread loss of confidence in the banking system and create a ‘financial panic’. Financial market failures and instability eventually leading to a systemic crisis not only affect individual savers and depositors, but the health of the whole economy. Public policy intervention then is not only a microeconomic question of protecting individual savers and investors, but becomes a macroeconomic issue. Government concern about the health of the financial system is mainly motivated by the negative macroeconomic externalities from bank failures and financial panics. These impair the ability of the financial markets and intermediaries to provide the key services of risk sharing, liquidity and information when faced with economic disturbances. Financial crises undermine the efficiency with which resources in the economy are allocated as, for example, companies have difficulty raising capital for investment and job creation. The collapse of financial institutions in general may have important costs of debt deflation on effective aggregate demand in the economy, as is extensively documented by Hubbard (1991). Because of the banks’ importance it is in particular important to maintain the health of the banking industry. The severity of the Great Depression of the 1930s is often linked to the breakdown of the banking system’s ability to provide financial services. As explained before, banks are very important in reducing information costs in the economy. Insolvency of banks is costly because information on borrowers is then lost. It hurts in particular the ability of less well known borrowers to obtain loans. Moreover, banks play an essential role in the payments system and in the creation of money. As argued by Mishkin (1997) bank failures could cause large and uncontrollable fluctuations in the quantity of money in circulation. The negative impact of banking problems on economic growth, the government budgets, the balance of payments and foreign exchange rates are further documented in an IMF study by Lindgren, Garcia and Saal (1996). Systemic risks are more difficult to deal with than the previous individual risks for depositors and savers. Of course government intervention aiming at the protection of depositors and investors by reducing information costs will also stabilize their behavior and reduce the danger of major financial instability. Also at the international level the timely dissemination of accurate financial information may be in order. The question arises whether additional government intervention may be necessary. This applies especially to ex post interventions when a financial crisis has occurred. Liquidity crisis may be overcome by monetary authorities acting as a lender of last resort and providing additional liquidity. However, this may lead in turn to a moral hazard problem. Financial institutions anticipating the bail-out possibility by monetary authorities may behave in a riskier way. Hence, the

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lender of last resort certainly does not have to intervene for financial problems that do not contain the danger of leading to a systems crisis. For an international financial crisis the question arises as to the need of an international lender of last resort. Finally, ensuring a stable payments system has been a principal concern of public policy. Therefore financial regulation in a wider perspective contains also a whole framework for controlling the volume of money in circulation, that is a whole set of monetary policy instruments. Normally a stable and sound financial system is a condition for an efficient monetary policy. Therefore in financial law specific regulations determine for instance which institutions can offer deposit accounts. However, in the short run conflicts may also arise between money supply control and the provision of additional liquidity under the lender of last resort function.

5. Regulatory Instruments To maintain the health of the financial system governments have developed a whole range of regulatory instruments. They have placed different degrees of emphasis upon the various objectives at different times and have used different regulatory tools to achieve them. The different regulatory and policy measures are classified in Table 1 according to the following criteria. First, following Baltensperger (1990) public authorities may limit themselves to ex post interventions, offering protection to customers and financial intermediaries in the case of impending insolvency. They may also act in a preventive way by controlling the levels of risk assumed and reducing the probability of insolvency and illiquidity. Second, the safety and stability of the financial system may be enhanced by structural limitations of competition and market forces. Instead of these structural measures more weight is given to market efficiency by resorting to a whole set of prudential measures. Third, regulatory measures may focus on the macroeconomic concerns of systemic risk, or directly aim at microeconomic consumer protection. However, both are interrelated as the avoidance of consumer risks also limits systemic risks and vice-versa. Historically, the overriding reason for government intervention has been the desire to avoid systemic risk, mainly by ex post rescue operations of financial intermediaries. Preventive measures were mostly of a structural nature by limiting competition. The focus on market efficiency and individual consumer protection by deposit insurance and prudential measures is of a more recent date. Structural and prudential regulation often involve a whole set of different public regulatory measures which differ from country to country. They are

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stylized in Table 1 and further commented upon in the next sections. Protective interventions in the form of the lender of last resort and deposit insurance provisions do not involve such extensive regulation. Central banks can significantly limit the occurrence of systemic crises by their role as a ‘lender of last resort’. Central banks have been set up to control liquidity provision in the economy. They are the ultimate source of credit to which financial institutions can turn during a panic. By providing liquidity as a bankers’ bank they can stop the contagious transmission of financial problems among financial intermediaries. Table 1 Protective systems (ex post) Preventive measures (ex ante)

Lender of last resort Deposit insurance

Structural

Restrictions on entry and on business activities - product line restrictions - geographic restrictions Regulation of interest rates

Prudential

Portfolio restrictions and supervision - capital adequacy standards - asset restrictions and diversification rules - liquidity adequacy requirements Disclosure standards and reporting requirements Conduct and conflict rules Inspection and bank examination

As pointed out in Herring and Litan (1995, pp. 51-55), in some countries central banks under certain conditions also guarantee the settlements risk involved in the funds transfer system. By bearing the risk of non-payments by participants they take the systemic risk out of the payments system. The same role may also be taken up by private clearing houses, which have developed to

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handle larger value payments transactions. These clearing houses additionally use forms of private regulation such as capital standards, limits on the amount of debt and so on, to reduce default risk. The problem, however, is that these private intermediaries do not have sufficient means to cope with economy-wide shocks, for example serious disturbances that affect the members as a whole. There are several difficulties with the lender of last resort function. First, interventions must be carried out swiftly in a credible way. Credit should only be advanced to solvent financial intermediaries using the good, but illiquid, assets as collateral. They should not be used to bail out insolvent institutions, often at a high cost for taxpayers. However, it may not be easy in practice to distinguish between problems of liquidity and insolvency. Second, lender of last resort interventions may conflict with monetary policy objectives. In order to avoid a systemic crisis central banks may extend liquidity and fuel inflationary pressures. Inflation may structurally weaken the financial sector and its capacity to absorb shocks, thereby increasing the probability of a systemic crisis. In addition public authorities also intervene by guaranteeing some financial liabilities and by directly protecting investors through ‘deposit insurance’. Insurance arrangements contain the promise that if a financial institution fails, the investors will be reimbursed for the funds lost. They directly aim at individual investors protection, in particular the small depositors who are unable to determine the quality of the banks assets. Indirectly they also reduce the threat of a systemic crisis. This is achieved not by bailing out individual financial institutions, but by reducing incentives for bank runs by depositors and by containing the risk of contagion among financial institutions (see Diamond and Dybvig, 1983). Deposit insurance was already introduced in the 1930s in the US in order to stabilize the financial system in the aftermath of the Great Depression. Other countries have since followed, legislating a variety of deposit insurance schemes. Deposit insurance systems differ according to their public or private organization, compulsory or voluntary participation, fee structure, degree of coverage, funding provisions, etc. The question arises whether government intervention may not be limited to these protective policies. Why do public authorities resort to more extensive public regulation of the financial system? According to Herring and Litan (1995) further government regulation has to be explained by the potential high costs and moral hazard problems that these protective policies may entail. The lender of last resort prevents failures of financial institutions, in particular when they are considered to be ‘too big to fail’. In their IMF study Lindgren, Garcia and Saal (1996) document that the ‘too-big-to-fail’ doctrine has been prevalent in many countries, also in major industrial countries, for example recently in France and Japan, where it has prevented the closure of major commercial banks. Also in the US the practice in case of distress of merging

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banks rather than closing them relies upon this philosophy. When the government provides such a safety net it tempts financial institutions to pursue high risk investment strategies at the expense of the government. Also, when they are covered by deposit insurance, depositors have less incentive to monitor and discipline financial institutions. Hence, government safety nets help solve risk problems only by creating other problems. Instead of spending substantial amounts of GNP on rescuing ex post ailing financial institutions, preventive government interventions by regulation and supervision may be in order to counter ex ante these moral hazard effects.

6. Structural Regulation In order to limit the threat of systemic risks government intervention in the financial sector traditionally consisted in regulatory measures aiming at limiting competition and at restricting the operation of market forces. Unbridled competition was seen as a major threat to the stability of the financial sector. As listed in Table 1, structural regulation mainly involves restrictions on entry and on business activities, and often includes various measures of interest rate regulation. It was mainly in the aftermath of the Great Depression, which found its origin in a stock market crash, that it was deemed necessary to introduce structural restrictions on the scope of permissible activities of the different financial institutions. Before the crisis commercial banks acted as securities market financial institutions as well as depository institutions. They had an incentive to take on more risky activities in financial markets and earn investment banking fees, the risk being shifted in part to the depositors. In order to limit these risky activities and to reduce the risk of contagion within the financial system, after the crisis these activities were legally separated in many countries. In the US the separation of the banking and securities industries was legislated in the well-known Glass-Steagall Act. Besides bank investments in industrial firms, their real estate investments and insurance activities were also also often regulated. Frequently the ownership of financial institutions and non-financial firms was separated, and the investments of industrial firms in banks limited. However, these additional restrictions were aimed at limiting the concentration of power. For similar reasons also branching restrictions could be imposed. In the US in particular banks were geographically limited and were not allowed to open branches in other states and to engage in interstate banking. Since the 1970s the debate over retaining these restrictions has been reopened and limits have faded significantly. First, it was observed that some countries such as Germany had maintained a system of universal banking, in

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which banks were allowed to participate heavily in non-financial activities. Did this so-called bank intermediation model not present certain advantages for the economy? Giving a role to commercial banks in corporate finance may improve information gathering and the monitoring of loans, thereby reducing problems of adverse selection and moral hazard in core banking. Moreover, the restrictions also shielded the investment banking industry in many countries from competition. As a result of this recent debate, in its banking directives the European Community adopted the universal bank model. Second, the increased affiliation with commercial companies, however, remains a controversial issue. It may stretch the safety net meant only for bank depositors to protect other commercial operations, and induces more risky behavior. Also the risk of contagion increases as shocks in the industrial sector may more easily spread to financial institutions. Third, the combination of banking and insurance within the same financial institution has been permitted mainly in European countries. It raises, however, similar regulatory issues of conflicts of interests. Fourth, domestic branching restrictions by limiting the concentration of power may lower the cost of providing risk sharing, liquidity and information services. However, they increase the exposure of banks to credit risk by reducing their ability to diversify assets. In the meantime banks have spread worldwide so that it increasingly becomes difficult to maintain these restrictions. The European Community in its banking directives has resolutely opened up the opportunities for European-wide banking through the single bank license. Interest rates are important instruments of monetary policy. Hence, governments traditionally have intervened in the price formation in money and capital markets by regulating interest rates. Interest rate ceilings and other pricing rules, however, were also introduced to limit competition between banks and between banks and other financial institutions. Limiting price competition in financial markets would also reduce risk taking and moral hazard problems for financial institutions. Imposing interest rate ceilings such as regulation Q in the past in the US would then lower the cost of funds, enhance profits and reduce the likelihood of bank runs. Recently many of these anti-competitive regulatory measures have been removed. It was observed that they did not contribute to financial stability in the long run. They resulted in disintermediation as funds could be more profitably directly invested in and obtained from financial markets. Also many financial innovations were introduced to circumvent these restrictive regulations. In the trade-off between safety, stability and efficiency the present regulatory environment gives more weight to competition and efficiency. Instead of structurally limiting competition and the operation of market forces, regulation is taking more and more the form of prudential measures which may better serve the interest of the customers.

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7. Prudential Regulation Prudential control is exercised first at the market entry stage by ‘chartering’, that is the obligation to file an application for a charter. To obtain a license the owners have to supply sufficient equity capital. A minimum of capital is required as a cushion against losses. The chartering of new financial institutions is also subject to a screening of the proposed managers to prevent undesirable people from controlling them. According to Mishkin (1997) an adverse selection problem arises as financial activities may attract entrepreneurs wishing to engage in speculative activities. A central instrument of prudential control consists in capital adequacy rules. Equity capital provides the necessary cushion against losses, since shareholders may want to benefit from the leverage effect and to increase their return on equity by providing as little capital as necessary. Only in well capitalized institutions, however, do the shareholders have enough incentives to monitor their financial health. When financial institutions hold a large amount of equity capital, they have more to lose in case of failure so that they will pursue less risky activities. Capital requirements may take different forms. Traditionally they are calculated as a fixed percentage of the assets to limit the leverage ratio. Since these do not sufficiently reflect the differences in risk taking, default-risk-based capital requirements have been developed. Under the auspices of The Bank for International Settlements a risk-asset ratio, the so-called Cooke-ratio, that reflects ratios of capital to risk-weighted assets has been introduced. Recently additional risk-based capital requirements, so-called Capital Adequacy Directives, that take into account off-balance sheet activities and deal with market risk, have been devised. As is argued by Herring and Litan (1995, pp. 55-58) sound capital standards are important to offset the moral hazard created by government safety nets for depositors and other creditors. If capital regulation were perfect, no other regulatory interventions would be needed against the danger of moral hazard. Financial intermediaries could then be shut down and creditors reimbursed just before insolvency of the intermediary. In practice, however, regulators face delays in taking appropriate action, moreover the measuring of risk and the valuation of assets and capital proves to be difficult. Hence, other regulatory tools are necessary to backstop capital regulation. Besides structural interventions whereby financial institutions are not allowed to engage in certain activities, such as investments in common stocks by banks, the imposition of quantitative limits on certain asset holdings has more the character of prudential regulation. By ‘portfolio diversification rules’ such as limiting the amount of loans in particular categories or to individual borrowers the risk profile of banks can be reduced.

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Cash reserve requirements are often imposed as a measure to enhance liquidity adequacy. By providing the necessary liquidity for deposit withdrawals they increase confidence with depositors and reduce the threat of bank runs. In situations of collective withdrawals of deposits, however, they turned out to be largely insufficient to avoid a bank panic. Nowadays changes in required reserves have developed to an instrument that is used primarily for controlling the quantity of money and credit creation. By regular examination and inspection regulators may limit the moral hazard problems. They have to control whether the financial institutions are complying with the capital requirements and the restrictions on asset holding. A supervisory structure has to be set up in which bank examiners make periodic, but also unannounced visits to the financial intermediaries. Recent prudential measures such as ‘disclosure requirements’ tend to emphasize the disciplining of financial institutions by the market rather than by regulators. Generally, providing appropriate and timely disclosure of financial conditions of companies may help to reduce stock price volatility and excessive speculation. In particular, disclosure of financial conditions of financial institutions not only increases the ability but also gives incentives to investors to monitor the performance and the risk-profile of financial intermediaries. Recently the Basle Committee issued recommendations to banks to disclose their trading and derivatives activities. Also by discouraging shareholders and managers from excessive risk taking, public disclosure reduces the threat of systemic crises. Some degree of market discipline is also restored by recent developments such as market value accounting. Finally, many other regulatory measures are imposed that primarily aim at consumer protection. Consumers have to be protected against excessive prices from opportunistic behavior by producers of financial services and other participants in financial markets. In this respect regulation is no longer concerned with systemic stability, but with the integrity and efficiency of the financial markets. In the US traditionally antitrust regulation has been an important instrument to guarantee fair prices to consumers. With the advent of the European-wide financial market and the mergers it will entail, competition law may also play a larger role in Europe. Opportunistic behavior is often made possible by asymmetric information. In securities markets corporate officials and owners are better informed about the fortunes of their companies. Hence, other investors are protected by insider trading regulations. Certain financial products are sometimes very complicated such as insurance, pension plans and long-term securities. In order to avoid that some buyers of these products are misled standardized disclosure rules may be imposed, reporting requirements and supervision of these financial institutions by regulators may be in order.

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8. Regulatory Structure It follows from the previous discussion that the need for government intervention as well as the choice of regulatory instruments depend on the threat of the occurrence of systemic crises and on the need for individual investors’ protection. The occurrence of these risks may differ among financial institutions. Hence the need for regulating the different types of financial institutions depends on the specific activities they engage in. In particular the danger of systemic risk is seen as justifying a larger role for government. In this respect the activities of the different financial institutions may be compared according to three criteria: first the risks involved that may lead to their failure; second the interconnections among intermediaries determining the contagion affect; and finally their importance for the whole financial system and the real economy. According to these criteria, it is held by Mayer and Neven (1991) that deposit taking, which is the core of banking, has been found to be especially vulnerable to systemic risk. First, the maturity transformation sets the banks apart from other financial intermediaries. The mismatch between the maturities of their assets makes them vulnerable to decisions by depositors to withdraw their funds. As the liquidation value of their investments is often smaller this may amplify withdrawals to a bank run. Second, important interconnections in bank relations means that even healthy banks are exposed to failures elsewhere in the banking system. The externalities involved may lead to a contagious collapse of the whole banking system. Third, the costs to the economy of bank failures may be huge. Banks play a crucial role in the payments system and in refinancing other financial intermediaries. Failures have wider ramifications on the rest of the financial system and on the real economy. One may point also to the danger that a banking crisis causes large and uncontrollable fluctuations in the quantity of money and credit. Hence, the case for banking regulation not only arises from the need of depositors’ protection, but more urgently from the systemic risk of the collapse of the whole financial system. The question arises whether failures of other financial institutions present the same dangers of systemic crises. Also investment firms are subject to interconnections that can lead to a contagious loss of confidence. This is especially the case for market making functions. There are, however, according to Herring and Litan (1995, pp. 72-73), key distinctions between banks and investment firms that make a contagious transmission of shocks a less serious concern for systemic risk. First, the nature of customer relations, debt contracts and maturity of assets involve less liquidity risk. The funds of investors are kept in accounts that are segregated from the institutions own assets what is not the case in banking. Debt contracts by securities firms typically do not guarantee rates of return and are not redeemable at par, so that customers have little to gain from a run on

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securities firms that are in difficulty. The portfolio of investment firms also typically consists of marketable securities that can easily be evaluated and transferred in the event of a failure. Second, the role of securities houses in intermediating funds from savers to investors in many countries is much less crucial. Hence, their failure is much less likely to cause significant harms to the economy. Therefore the need for regulation of investment firms is less compelling. However, there remain sound reasons for regulation. The activities of investment firms involve information asymmetries and may require regulation to protect investors against fraud and incompetence. In this respect the regulation of portfolio managers has an affinity with the regulation of (free) professions. In addition capital requirements similar to those for banks may be imposed in order to avoid undermining confidence in the functioning of markets in the event of a steep decline in asset prices. In the insurance sector important interconnections exist through the important role of reinsurers. In principle an insurance crisis may emerge when many or all of the reinsurers simultaneously cut off reinsurance coverage, so that primary insurers eventually have to cut back on the availability of insurance. In practice major shocks in the insurance market have not entailed such a collapse. Even if this might be called a systemic insurance risk, insurance companies are not involved in payments and liquidity functions, so that the consequences for the whole financial system and the real economy would not be so dramatic as for a banking crisis. Protection of the individual consumer against asymmetric information problems, however, may be more compelling than in the rest of the financial sector. The reason is that those insurance contracts generally are complicated, and involve not only financial but also more technical actuarial risks. The elaborate financial regulatory system is continuously questioned at various levels.

9. Deregulation and the Regulatory Crisis In the last decades awareness has grown that regulation not only entails benefits, but also imposes substantial costs on the economy. In this respect the traditional public interest view of regulation has been challenged by the new public choice approach. It implies the need for an evaluation of the externalities and the incidence of regulatory measures. Structural regulation that limits market competition may eventually convey benefits to private financial institutions, by protecting them against outside competition and by promoting confidence in financial intermediaries. However, by restricting market entry it may involve substantial welfare costs to society. In this respect regulators may be ‘captured’ by the regulated firms through

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lobbying in order to protect their business interests at the expense of the consumer. Other types of regulation impose additional costs on the financial intermediaries when they have to adjust to the regulatory standards. The foregone earnings due to high capital requirements or to required cash reserves may be considered as a tax on financial institutions. By increasing the intermediation cost they lead to disintermediation. Financial institutions often respond by changing their activities and by introducing financial innovation in an attempt to circumvent the regulatory restrictions. In particular off-balance sheet transactions, which may be a multiple of traditional balance sheet activities have multiplied banking risks. Moreover, they also involve severe information problems as to measurement and valuation of these risks. As regulators respond by introducing new regulation it may leads to a regulatory dialectic. The dynamics of regulation boils down to a continuous tension between the desire for a stable financial system and an economic efficient system. The recent shift towards prudential regulatory measures is to be considered as an attempt to solve this tension. The discussion, however, remains as to the level of regulatory restrictions required. It pertains to the perception of the fragility of the financial system. Based upon empirical evidence Benston and Kaufman (1995) observe that the worries about contagion are often unfounded and that there is no reason to claim that banking is more fragile. Hence, a combination of minimum capital requirements with a system of structured early intervention would be sufficient to avoid a systemic crisis. The question, however, arises whether the empirical evidence is not biased by the high regulatory burden in the past? Will deregulation not give incentives for higher risk strategies and enhance systemic risk? In fact the debate boils down to finding the difficult balance between security and risk. As explained before, information asymmetries in financial markets create problems of moral hazard. Financial intermediaries may have incentives to take more risk than is in the interest of individual savers and depositors. Government regulation and intervention may be in order to reduce the costs of moral hazard to individual customers. When the government, however, provides a safety net through regulatory measures such as deposit insurance and the lender of last resort, it gives incentives to financial institutions to pursue high risk investment strategies. According to the free banking school these moral hazard problems are better solved by suitable private sector instruments of internal and external disciplining of bank management together with the promotion of competition of banks. Banks will be disciplined by markets as deposit-holders have incentives to monitor the behavior of banks. There is no need for independent supervisory authorities. Contrary to this view, however, a free rider problem

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arises in markets in case of a large number of investors who have little incentive to devote resources to the monitoring of financial institutions. Certain episodes such as the Savings and Loan Crisis in the last decade in the US teach that moral hazard remains a difficult regulatory concern. Taxpayers had to bear collectively the huge cost of the deposit insurance bail-out. Deposit insurance undermined the incentives for saving banks to pursue prudent policies as they reduce the need for individual savers to monitor bank management. In addition Hubbard (1996, p. 386) argues that the regulator’s incentives differed from those of tax payers. Regulatory supervision became lax at the first sign of trouble as regulators did not want troubled intermediaries to fail. These experiences are currently shaping the regulatory reform of financial institutions. Proposals have been launched to reform deposit insurance in various directions: from reducing the level of deposit insurance coverage and risk-based pricing of deposit insurance to private deposit insurance. The undesired risk incentives of the safety net has also to be reduced by supplementary prudential regulation such as capital adequacy and liquidity requirements.

10. The Changing Nature of Regulation Recently a debate has been launched about the regulatory structure. The rising tide for market solutions implies an increasing role for self-regulation and private regulatory bodies. Self-regulation will arise when clubs can be formed. Clubs are professional organizations which regulate the behavior of members. Self-regulation has the advantage of flexibility but the danger of capture by members. Also outside private agencies, such as rating agencies may discipline risk behavior as the rating of an intermediary affects its funding costs. However, private regulatory failures may occur due to a collective action problem. As a result of this debate, it is increasingly argued that the control of risks, remains in first instance the task of individual institutions or of clubs of institutions. The role of the government then has to be limited to supervising these private regulatory systems. In the same vein the traditional debate between rules versus discretion is taking a different direction. Whereas rules can be crude and not adapted to the situation at hand, discretion makes it a largely political matter. As argued by Horvitz (1995) the need for discretion may be reduced, while allowing for reasonably flexible regulation by a graduated system of interventions and controls. In the US it works through the operation of various trigger points as banks approach the critical area of balance sheet ratios. In this respect the

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recent Basle Agreements are being criticized as not providing such a graduated response. Moreover, the present system relying predominantly upon institutional regulation is being questioned. Banks, securities firms, insurance companies are being regulated and supervised by different regulatory bodies. In fact systemic stability is seen as requiring the application of different rules to different financial institutions. Institutional regulation becomes difficult to implement when the different financial intermediaries widen the scope of their financial activities, for example when universal banks engage in securities activities. Maintaining institutional regulation and subjecting universal banks to stricter capital requirements or providing a safety net also for their securities activities conflicts with competitive neutrality of regulation. Similar issues arise for financial conglomerates. A level playing field may be promoted and regulatory efficiency maintained by introducing a system of functional regulation. Regulation by function is likely to emerge and regulation by institution to decline in the future as the distinction between banks and other financial intermediaries is fading. More fundamentally the philosophy of regulation is analytically being reexamined in the new institutional economics literature. A strong analogy is pointed out between banking regulation and loan agreement covenants in ‘corporate governance’. By relying upon contract theory the analysis of financial regulation is becoming a true interdisciplinary law and economics endeavor. According to Richter (1990) the complex ongoing business relationships between savers, borrowers and financial institutions can be analyzed as a relational contract. By its nature it is an incomplete contract as analyzed by Hart (1994) that eventually may be in need of further regulation. In repeat business transactions one may relay upon private contract enforcing mechanisms such as reputation, for example. Individual monitoring in banking, however, suffers from a collective action problem. Dewatripont and Tirole (1994, pp. 117-118) argue that unsophisticated and small claimholders suffer from information asymmetries and have little incentive to invest in monitoring due to a free rider problem. Active representation of depositors must be provided by organizing ‘delegated’ monitoring. However, if no mechanism of private representation is or can be set up, regulation may be needed. It may take the form of private regulation by an independent supervisory or regulatory firm. Public regulation of banks is a very complex matter and therefore should limit itself to a complementary role by light-handed regulation. More specifically, regulation must focus upon altering incentives, for example for shareholders to discipline managers through higher capital requirements. It should not impose rigid regulatory schemes to all intermediaries, but introduce a number of options from which financial institutions should be allowed to make a selection. To summarize the

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arguments, financial regulation has to be devised within the framework of an efficient governance of financial intermediaries. The trend clearly is towards a more comprehensive approach to risk management, stressing the importance of internal governance and the role of market discipline.

11. The International Dimension The globalization of financial markets constitutes a major challenge to the regulation of financial activities and institutions which continues to be carried out by national governments. It creates several problems for which solutions are not easy to implement. First, due to the growing interdependence in international financial markets financial difficulties experienced in one country can easily spill over to other countries. A systemic crisis in one country and the failure of its authorities to deal with it appropriately may lead to a global banking crisis. Second, regulation can be considered as a tax and can have an impact on the international competitiveness of financial institutions. Different regulatory regimes may also create barriers for firms in cross-border trade in financial services. For instance, different capital requirements create an unlevel playing field between financial institutions of different countries. Third, financial institutions may attempt to avoid more stringent domestic regulation by locating abroad. Regulatory arbitrage impairs the effectiveness of regulation and the ability of different countries to maintain their own regulatory framework. Regulatory competition may eventually lead to a downward regulatory spiral. As is demonstrated in a game-theoretic framework by taking into account the special informational characteristics of financial products and the role of reputation in the banking industry (see Van Cayseele and Heremans, 1991) there may, however, be limits to this process. In particular in retail markets where financial integration is far less complete there remain upward regulatory pressures. Countries will be able to maintain regulatory measures as a signal of quality differentiation provided that they are valued by customers. The concern for the distortion of international competition certainly has been a major driving force behind attempts towards worldwide solutions for financial regulation. Recent international financial crises are increasing the urge for an international approach. International market integration also helps to explain the recent shift of emphasis from structural towards prudential regulation. Through efforts of international coordination an answer is sought for the questions of what should be the right of access to foreign markets, and whose rules should apply in international financial services. In this respect a tendency is observed to give branches and subsidiaries of foreign banks the same treatment as domestic banks. For cross-border transactions of financial

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intermediaries it is proposed (for example, by Hubbard, 1996, p. 426) that they should be monitored by the home country. Regulation and coordination can be limited as banks should be allowed to develop their own risk-assessment procedures which should only be subject to regulatory review. Taking into account the concern for the threat of complete deregulation, however, stronger forms of international harmonization are also being envisaged. The European Union has linked policies of mutual recognition and home country control rules with agreements on minimum standards of conduct. The Basel Committee on Banking Supervision has laid down common bank capital rules. These minimum standards, continue to be enforced by individual countries. They are, however, being criticized (for example by Herring and Litan, 1995) for their arbitrariness and potential inflexibility. In the face of the possibility of a worldwide systemic crisis the lender of last resort function still remains largely the endeavor of national central banks. Whether emergency liquidity assistance should be provided not only for banks but also for other financial intermediaries, and whether the lender of last resort function should be provided at the international level, remain heavily debated issues. Finally, faced with the increasing need for worldwide regulation, an agreement that extends beyond the Basle countries on a set of minimum capital standards, as Goldstein (1997) has argued for, may be eventually attained. But international cooperation beyond these minimal standards, remains a difficult issue. In particular, faced with the fragmented supervision by many agencies to be multiplied by the number of countries, the prospects for international cooperation to reinforce supervision remain bleak. These difficulties to agree on the international dimension of financial regulation and supervision are enhancing the overall trend towards greater emphasis on discipline by the market rather than by regulators.

Acknowledgements The author gratefully acknowledges the comments made by P. Van Cayseele, M. De Broeck, Y. Maes, P. Maenhout and an unknown referee. Helpful logistical support was provided by M. De Houwer and J. Janssens. All remaining errors are the responsibility of the author.

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Sevic, Zeljko (1994a), Komisioni Posao u Bankarskom Pravu (Undisclosed Agency Operations Commission Transactions in the Banking Law), Belgrade, Cigoja-stampa. Sevic, Zeljko (1994b), Pravni status Centralne Banke u Savremenoj Trzisnoj Privredi (Status of the Central Bank in a Contemporary Market Economy), Belgrade, Faculty of Law, University of Belgrade. Sevic, Zeljko (1995), ‘Svojinski Oblici i Efikasnost Funkcionisanja Bankarskog Sistema (Property Forms and the Banking System Efficiency)’, 9 Pravni zivot, 647-660. Sevic, Zeljko (1996a), ‘Odnos Centralne Banke i Izvrsne Vlasti (Relationship between the Central Bank and Executive Power)’, 1-2 Jugoslovensko Bankarstvo, 29-36. Sevic, Zeljko (1996b), Law and Economics I: Ekonomska Analiza Prava Svojine u Tranziciji (Law and Economics I: Economic Analysis of the Property Rights in Transition), Pravni zivot. Sevic, Zeljko (1996c), ‘Bankarstvo i Bankarsko Pravo: Neka Otvorena Pitanja Samostalnosti Bankarskog Prava (Banking and Banking Law: Some Open Questions on Banking Law Independence)’, 51(11-12) Finansije, 964-977. Sevic, Zeljko (1996d), Centralna Banka: Polozaj - Organizacija - Funkcije (Central Bank: Position - Organization - Functions), Belgrade, Cigoja-stampa. Sevic, Zeljko and Sevic, Aleksandar (1997), ‘Centralna Banka i Finansijska Trzista (Central Bank and Financial Markets)’, 27(1-2) Jugoslovensko Bankarstvo, 28-34. Shughart, William F., II (1988), ‘A Public Choice Perspective of the Banking Act of 1933', 7 Cato Journal, 595-613. Shull, Bernard (1983), ‘The Separation of Banking and Commerce: Origin, Development, and Implications for Antitrust’, 28 Antitrust Bulletin, 255-279. Skogh, Göran (1976), ‘Ett Alternativ till den Föreslagna Konsumentkreditlagen (An Alternative to the Proposed Consumer Credit Law)’, Svensk Juristtidning, 542-547. Smith, Bruce D. (1988), ‘Legal Restrictions, “Sunspots”, and Peel’s Bank Act: The Real Bills Doctrine Versus the Quantity Theory Reconsidered’, 96 Journal of Political Economy, 3-19. Smith, Vernon L. (1976), ‘The Borrower-Lender Relationship’, 66 American Economic Review, 406-407. Spierings, Renee (1990), ‘Reflections on the Regulation of Financial Intermediaries’, 43 Kyklos, 91-109. Stout, Lynn A. (1988), ‘The Unimportance of Being Efficient: An Economic Analysis of Stock Market Pricing and Securities Regulation’, 87 Michigan Law Review, 613-709. Stout, Lynn A. (1995a), ‘Agreeing to Disagree over Excessive Trading’, 81 Virginia Law Review, 751 ff. Stout, Lynn A. (1995b), ‘Betting the Bank: How Derivatives Trading Under Conditions of Uncertainty Can Increase Risks and Erode Returns in Financial Markets’, 21 Journal of Corporate Law, 53 ff. Stout, Lynn A. (1995c), ‘Are Stock Markets Costly Casinos? Disagreement, Market Failure, and Securities Regulation’, 81 Virginia Law Review, 611 ff. Stout, Lynn A. (1996), ‘Insurance or Gambling? Derivatives Trading in a World of Risk and Uncertainty’, 39 Brookings Review. Takigawa, Yoshio (1986), ‘Deregulation of Interest Rate and Bank Rate Policy’, 0(32) Kobe University Economics Review, 121-137. Terberger, Eva (1994), ‘Kommentar zu Picot, Arnold/Dietl, Helmut, Informations (de-)Regulierung am Kapitalmarkt aus Institutionenökonomischer Sicht (New Institutional Economics and the (De-)Regulation of Insider Trading)’, 13 Jahrbuch für Neue Politische Ökonomie, 143-148.

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Terberger, Eva (1995), ‘Bankenaufsicht (Regulation of Banks)’, in Gerke, Wolfgang and Steiner, Manfred (eds), Handwörterbuch des Finanz- und Bankwesens, Band 6, 2. Aufl., Stuttgart, 151-163. Thomson, James B. and Todd, Walker F. (1990), ‘Rethinking and Living with the Limits of Bank Regulation’, 9 Cato Journal, 579-600. Thurow, Lester C. (1985), ‘The Politics of Deregulation and Evolution of the Major Banks and the Financial Intermediaries in the U.S.A.’, 3 Review of the Economic Conditions in Italy, 353-362. Triantis, George G. (1986), ‘Allocation of Losses from Forged Indorsements on Checks and the Application of Section 3-405 of the Uniform Commercial Code’, 39 Oklahoma Law Review, 669-668. Tseng, Wang-Run (1996), ‘Capital Structure and the Regulation of Disclosure’, 25(4) National Taiwan University Law Journal, 279-317. Van Cayseele, Patrick (1992), ‘Regulation and Financial Market Integration’, in Steinherr, A. (ed.), The New European Financial Market Place, London and New York, Longman, 68-78. Van Cayseele, Patrick and Heremans, Dirk (1991), ‘Legal Principles of Financial Market Integration in 1992: An Economic Analysis’, 11 International Review of Law and Economics, 83-99. Van den Bergh, P. (1987), ‘Deregulering van de Internationale Financiële Stromen en Valutastelsel (Deregulation of the International Financial Flaws and Exchange System)’, XXX18de Vlaams Wetenschappelijk Economisch Congres, Brussel 8 en 9 mei 1987, Sociaal-economische Deregulering, 845-878. Varela, Oscar and Olson, Richard E. (1986), ‘A General Equilibrium Analysis of Financial Regulation’, 30 Journal of Public Economics, 329-340. Wall, Richard A. and Gort, Michael (1988), ‘Financial Markets and the Limits of Regulation’, 9(1) Managerial and Decision Economics, 65-73. Walz, W. Rainer (1993), ‘Ökonomische Regulierungstheorie vor den Toren des Bilanzrechts (Economic Theory of Regulation and Accounting Law)’,82 Zeitschrift für Betriebswirtschaftliche Forschung. Walz, W. Rainer (1996), ‘Rechtspolitik und Betriebswirtschaftslehre angesichts der Internationalisierung des Bilanzrechts (Legal Policy, Business Administration, and the Internationalization of Accounting Law)’, in Sadowski, D., Czap, H. and Wächter, H. (eds), Regulierung der Unternehmenspolitik. Methoden und Kritik der betriebswirtschaftlichen Rechtsanalyse, Wiesbaden, Gabler, 23-49. Wehrt, Klaus (1991), ‘Die BGH-Urteile zur Tilgungsverrechnung - Nur die Spitze des Eisbergs, Der korrekt abgerechnete Hypothekenbankkredit (The Judgements of the German Supreme Court Concerning the Reimbursement of Wrongly Calculated Interest Payments, a Critical Economic Review)’, 24 Betriebs-Berater, 1645-1655. Wehrt, Klaus (1994), ‘Zur Zinsfälligkeitsabrede, die eine Unterjährige Zahlungsverpflichtung Enthält, Anmerkung zum BGH-Urteil vom 5.10.93 - XI ZR 35/93 (An Interest Clause which Fixes the Periods for the Interest Payments, a Remark to a Judgement of the German Supreme Court)’, 3 Juristenzeitung, 155-157.

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Wehrt, Klaus (1994), ‘Die wettbewerbliche Funktion transparenter Zinsfälligkeitsabreden (The Competitive Function of Transparent Interest Clauses)’, 2 Zeitschrift für Bankrecht und Bankwirtschaft, 161-171. Wehrt, Klaus (1997), ‘Vorfälligkeitsentschädigung und Wettbewerb, Mögliche wettbewerbliche Auswirkungen der Rechtsprechung zur vorzeitigen Ablösung von Festzinsdarlehen (Possible Competitive Effects of the Jurisdiction According the Prepayment of Mortgages)’, 1 Zeitschrift für Bankrecht und Bankwirtschaft. Weisbrod, Steven R. (1988), ‘Regulation of International Banking: A Review Essay’, 22 Journal of Monetary Economics, 347-352. West, Richard R. (1973), ‘Bond Ratings, Bond Yields and Financial Regulation: Some Findings’, 16 Journal of Law and Economics, 159-168. White, Lawrence J. (1986), ‘The Partial Deregulation of Banks and Other Depository Institutions’, in Weiss, Leonard W. and Klass, Michael W. (eds), Regulatory Reform: What Actually Happened, Boston, Little Brown, 169-209. White, Lawrence J. (1990), ‘The S&L Debacle: How it Happened and Why Further Reforms are Needed’, 13(1) Regulation, 11-16. X (1985), ‘Note: Consumer Protection and Payment Systems: Policy for the Technological Era’, 98 Harvard Law Review, 1870-1889. Zdrahal, Peter (1991), ‘Comment (on Llewellyn, Capital Regulatory Convergence)’, in Weigel, Wolfgang (ed.), Economic Analysis of Law - A Collection of Applications, Vienna, Österreichischer Wirtschaftsverlag, 164-166.

Other References Heremans, Dirk (1981), ‘The Complementary Nature of Competition and Regulation in the Financial Sector’, in Verheirstraeten, A. (ed.), Competition and Regulation in Financial Markets, London, Macmillan, 32-34. Heremans, Dirk (1991), ‘Hervorming van de Beursmarkt in België. Kon het Niet Eenvoudiger en Efficiënter’, in Schrans, G. and Wymeersch, E. (eds), Financiële Herregulering in België (Reform of the Stock Market. Financial Regulation in Belgium), Antwerpen, Kluwer Rechtswetenschappen 171-182. Heremans, Dirk (1993), ‘Economic Aspects of the Second Banking Directive and of the Proposal for a Directive on Investment Services in the Securities Field’, in Stuyck, J. (ed.), Financial and Monetary Integration in the European Community. Legal, Institutional and Economic Aspects, Deventer, Kluwer, 37-55. Heremans, Dirk (1994), ‘Economic Aspects of the Banking and Investment Services Directive in a European Economic Area’, in Stuyck, J. and Looijestijn-Clearie, A. (eds), The European Economic Area EC-EFTA, Deventer, Kluwer, 105-117. Heremans, Dirk and Cousy, Herman (1996), Financial Markets and Insurance, Essays in Law and Economics III, Antwerpen, Maklu Publishers, 277 p.

5860 REGULATION OF THE LEGAL PROFESSION Frank H. Stephen and James H. Love University of Strathclyde, Glasgow, United Kingdom © Copyright 1999 Frank H. Stephan and James H. Love

Abstract This chapter reviews the contribution which economists, and others using economic modes of reasoning, have made to the analysis of the regulation of law firms. It particularly focuses on the analysis of self-regulation by the profession. The chapter begins by rehearsing the traditional cartel argument against self-regulation and its links with the modern private interest theory of regulation via capture theory. This is contrasted with the market failure view of regulation which in the context of the professions focuses on the information asymmetry between the professional and the client. There is then a brief discussion of the merits of self-regulation and inter-profession competition before turning to an examination of the instruments by which professional regulation is exercised: control of entry, control of advertising or other means of competition, control of fee levels, control of fee contracts and control of organisational form. In this context, prominence is given to recent empirical studies which test the effects of these regulatory controls or their removal. The focus throughout is on what the economics literature has had to say on the regulation of the practice of law. Thus more general treatments of the economics of the law firm are not discussed. JEL classification: L12, L43, L44, L84, L51, M37 Keywords: Legal Profession, Regulation, Advertising, Entry Restrictions, Fee Levels, Fee Contracts, Empirical Studies

1. Introduction In most jurisdictions one or more of the following is regulated in some manner: a. the provision of advice about the law for financial reward; b. the use of specific professional titles indicating expertise in legal matters; c. the right to appear on behalf of one of the parties before the courts. Whilst ultimately governed by statute and subject to oversight by some public official (judge, civil servant or politician) this regulation is frequently enforced and delimited by the profession itself (see further below). This article reviews the contribution which economists, and others using economic modes

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of reasoning, have made to the analysis of such regulatory regimes. We begin by rehearsing the traditional cartel argument against self-regulation and its links with the modern private interest theory of regulation via capture theory. This is contrasted with the market failure view of regulation which in the context of the professions focuses on the information asymmetry between the professional and the client. There is then a brief discussion of the merits of self-regulation and inter-profession competition before turning to an examination of the instruments by which professional regulation is exercised: control of entry, control of advertising or other means of competition, control of fee levels, control of fee contracts and control of organisational form. In this context we give prominence to recent empirical studies which test the effects of these regulatory controls or their removal. The focus throughout is on what the economics literature has had to say on the regulation of the practice of law. Thus more general treatments of the economics of the law firm are not discussed.

A. Regulation of Professions, Capture and Cartels 2. Economists’ Views Economists, traditionally, have been highly critical of many aspects of professional regulation and self-regulation in particular (see, for example, Arnauld, 1972; Arnauld and Friedland, 1977; Benham and Benham, 1975; Faure et al., 1993; Friedman and Kuznets, 1945; Kessel, 1958; Lees, 1966; Leffler, 1978). Self-regulation is characterised as, potentially, having the effect of a cartel: by controlling entry to the market and setting an agreed price above the competitive price, members of the profession earn economic rents. Restrictions on advertising and prohibitions on using fee-levels to attract business restrain competition from ‘breaking out’ between existing suppliers. It has been argued that restricting fee competition, particularly by publishing mandatory or recommended fee scales, reduces competition and innovation and is against the public interest (Arnauld, 1972; Arnauld and Friedland, 1977; Domberger and Sherr, 1989; Monopolies and Mergers Commission, 1970; Van den Bergh and Faure, 1991). Whilst the earlier literature was written from a price theory/industrial organisation perspective, more recently critics have adopted a capture theory or public choice perspective (Van den Bergh and Faure, 1991; Faure, 1993; Van den Bergh, 1993). This is not surprising since in the development of the private interest theory of regulation from capture theory Posner (1974) made a direct link with the theory of cartels. Indeed, self-regulation has been described as the ultimate form of regulatory capture (Kay, 1988). From this perspective the regulation of markets for professional services is seen to arise or at least is sustained because it is in the interests of

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the members of the profession. It legitimises or enforces their cartel-like behaviour.

3. Market Failure and Information Asymmetry An older, though nowadays less fashionable, view of regulation is that it arises from a public interest in remedying market failure (Noll, 1989). Notwithstanding the origins or motivations underlying regulation, many would argue that there is a potential market failure in many professional markets. The particular market failure that applies to professional markets in general, and the markets for legal services in particular, is that of information asymmetry. The asymmetry is between the professional on the one hand and the client on the other. For most clients legal services are credence goods (Darby and Karni, 1973) as opposed to search or experience goods. The client is usually less well informed about the nature of legal problems and their remedies than the lawyer and often relies on the lawyer to define the problem in the first place as well as recommending a course of action and implementing it (but see further below). Quinn (1982) distinguishes between two roles: the agency function (defining the client’s needs and selecting appropriate strategies) and the service function (using technical expertise to implement the chosen strategy). Normally in the legal context the lawyer performs both functions. Thus there is a potentially severe principal-agent problem (potentially encompassing supplier-induced demand). The lawyer as agent has a pecuniary interest in recommending expensive strategies which he/she will be paid to implement. This demands some protection for the (infrequent) consumer of personal professional services (see, for example, Arruñada, 1996; Dingwall and Fenn, 1987; Evans and Trebilcock, 1982; Faure, 1993; Faure et al., 1993; Federal Trade Commission, 1984; Helligman, 1993; Herrmann, 1993; Kritzer, 1990; Levmore, 1993; Matthews, 1991; Smith and Cox, 1985; Sykes, 1993; Wolfram, 1984). Under these conditions the market will fail to produce the socially optimum quantity of the professional service. Protection of consumers frequently takes the form of regulation of the profession and its markets. In certain circumstances, contingent fee contracts may mitigate or overcome some aspects of this problem (see further Part E below). It is important to recognise that the informational asymmetry identified here does not apply to all clients of lawyers. Many commercial clients are repeat purchasers in the market for legal services. Therefore they are able to acquire experience and knowledge of the market which reduces the asymmetry between lawyer and client. They are less in need of the agency function than infrequent purchasers. Furthermore in the case of repeat purchasers, lawyers must be aware of the loss of future business from behaving opportunistically. They must also be aware of reputational effects which may arise from social networks even

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where individual consumers are not repeat purchasers. Thus the information asymmetry argument does not carry over to all segments of the market for legal services (Hudec and Trebilcock, 1982; Trebilcock, 1982). It has its principal relevance in the market for private clients and small businesses. Thus although the information asymmetry argument is now well recognised its application must be sensitive to the circumstances of the market concerned. Recently, Emons (1997) has analysed a model of behaviour in a credence good market where, essentially, the service function cannot be provided separately from the agency function. He describes this as a situation of ‘profound economies of scope between diagnosis and treatment’. Consumers attempt to infer sellers incentives from observation of market data. The analysis demonstrates that market equilibria inducing non-fraudulent behaviour can exist. The information asymmetry between professional and client also gives rise to another potential source of market failure due to the client’s inability to judge, ex ante, the quality of the professional. In the extreme this can give rise to a ‘lemons’ problem (Akerlof, 1970). The use of licensing to avoid this problem is analysed in Leland (1979). The author concludes that the optimal supply of quality will not be produced in a market with asymmetry between client and supplier and that minimum quality standards may solve the problem. Clearly it will be in the interests of the profession to avoid a ‘lemons’ problem arising. However, Leland’s analysis suggests that if the setting of minimum standards is by the professional group itself it is likely to be set too high.

4. Professional Self-Regulation Dingwall and Fenn (1987) consider a number of possible responses to the information asymmetry problem. First, society could subsidise high quality suppliers to ensure that they remain in the market. Secondly, penalties could be imposed on those suppliers who do not meet some quality threshold. Thirdly, entry to the market could be restricted to those meeting some minimum standard. They consider the first implausible since it does not guarantee that the higher quality service will actually be supplied. The second and third response requires a regulatory agency which must avoid capture and be able to do what the individual client cannot: assess quality and signal it to potential consumers. Self-regulation can do the latter but runs the risk of being the ultimate form of regulatory capture. However, they argue that if self-regulation was so problematic why does it persist in most jurisdictions? If it were inefficient someone would benefit from its removal otherwise democracy itself would be inefficient. Dingwall and Fenn (1987) see self-regulation as arising from the social institution of trust: a social contract between society and the profession

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mitigates the moral hazard problem arising from the information asymmetry. However, they recognise that safeguards are required, particularly to ensure that the profession does not operate as a cartel. They also feel that the various professions will act as watchdogs on each other. The case for self-regulation has been examined in detail also in Ogus (1995). He points to a number of reasons why self-regulation might be preferred to regulation by some body external to the profession. In particular, self-regulation may reduce the cost of the regulator acquiring information and makes adjustments to regulations easier. These benefits need to be compared to the potential efficiency losses due to the potential for cartel-like behaviour. Curran (1993) reports J.C. Miller, Chairman of the Federal Trade Commission in the Reagan administration, making similar arguments for self-regulation (Miller, 1983). Even where regulation by a professional body is deemed an appropriate solution Ogus (1995) has argued that the public interest would be protected best by having a number of professional bodies in competition with each other. As implied in the foregoing, in many jurisdictions the regulation of a profession is in the hands of the members of the profession itself, either nationally or locally. This is usually the case with the legal profession (Arruñada, 1996; Curran, 1993; Dingwall and Fenn, 1987; Evans and Trebilcock, 1982; Faure, 1993; Federal Trade Commission, 1984; Finsinger, 1993; Helligman, 1993; Herrmann, 1993; Lees, 1966; Ogus, 1993; Pashigian, 1979; Stephen, 1994; Stephen and Love, 1996; Stephen, Love and Paterson, 1994; Van den Bergh, 1993). A more formal treatment of professional self-regulation is provided in Shaked and Sutton (1981a) which examines the effects on welfare of a self-regulating profession and also the effect on welfare of the existence of a lower quality para-profession. Shaked and Sutton (1982) focuses on the perceived quality of a profession and the availability of information. In particular, information available to consumers is related to the size of the profession: a larger profession increases the heterogeneity of information available to consumers and increases the demand at a given price. A small profession (whose quality is higher) will produce less information and reduce demand. Thus increased quality may be associated with lower price. In this work the motive force comes from the consumer side.

5. Alternatives to Self-Regulation Regulation may not be the only solution to the information asymmetry problem. Independent rating agencies have been suggested as a solution or the use of repeat purchasers to perform the agency function on behalf of infrequent purchasers (Stephen, Love and Paterson, 1994; Stephen and Love, 1996). Others suggest that competition will generate its own quality signals (Klein and

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Leffler, 1981; Leffler, 1978). Fama and Jensen (1983a, 1983b) and Carr and Mathewson (1990) suggest that the existence of partnerships with unlimited liability signals the quality of legal advice to consumers because each partner is willing to risk his/her wealth on the competence of the other partners (see further below for the development of this argument). Even if the information asymmetry problem is large its removal via professional self-regulation may introduce other, greater, distortions (Curran, 1993).

6. Deregulation of Professional Service Markets In both academic and policy discussion there has been a gradual shift against regulation, a shift which has quickened in pace in recent years. Markets for legal services have been the subject of varying degrees of deregulation in USA, Europe and elsewhere (see, for example, Bowles, 1994; Cox, 1989; Curran, 1993; Domberger and Sherr, 1987; Faure, 1993; Federal Trade Commission, 1984; Helligman, 1993; Herrman, 1993; Ogus, 1993; Paterson and Stephen, 1990; Shinnick, 1995; Stephen and Love, 1996; and Scottish Home and Health Department, 1989). In several jurisdictions there have been proposals by government to remove the general exemption of professions from anti-trust or restrictive practices legislation. However, not all such attempts have reached the statute book (for example England and Wales, Ireland, Scotland, Spain).

7. Instruments of Self-Regulation The current state of the discussion in the conceptual literature is such that although some authors recognise the potential problem arising from the asymmetry of information between client and professional, considerable scepticism remains on whether traditional self-regulation is a solution to the problem or a source of even greater welfare loss. The remainder of this paper considers that part of the literature which examines the instruments used by self-regulatory bodies for the legal profession to regulate the market. In particular, we emphasise empirical studies of regulation and de-regulation. The lack of discussion in the economics literature on some aspects of self-regulatory systems such as complaints procedures, controls on quality of training and requirements for continuing professional development and so on is reflected in their absence in what follows. Commentators (Cox, 1989; Curran, 1993; Domberger and Sherr, 1987, 1989; Evans and Trebilcock, 1982; Faure, 1993; Finsinger, 1993; Federal Trade Commission, 1984; Scottish Home and Health Department, 1989; Stephen, 1994; Stephen and Love, 1996; Stephen, Love and Paterson, 1994;

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Van den Bergh, 1993) have identified a number of instruments typically used by self-regulators of the legal profession which may work against the public interest: (i) restrictions on entry; (ii) restrictions on advertising and other means of promoting a competitive process within the profession; (iii) restrictions on fee competition; and (iv) restrictions on organisational form. A separate although connected literature has developed on restrictions on the nature of fee contracts between lawyers and clients. This particularly focuses on contingent fee contracts (see, for example, Clermont and Currivan, 1973; Dana and Spier, 1993; Danzon, 1983; Fisher, 1988; Gravelle and Waterson, 1993; Halpern and Turnbull, 1981; Hay, 1996; Kritzer, et al., 1984; Lynk, 1990; Miceli, 1994; Miceli and Segerson, 1991; Rickman, 1994; Rubinfeld and Scotchmer, 1993; Schwartz and Mitchell, 1970; Smith, 1992; Thomason, 1991; Watts, 1994). We now discuss each of these methods of self-regulatory control in turn.

B. Entry Restrictions 8. Entry to the Profession Economists (for example Friedman and Kuznets, 1945; Leffler, 1978) have criticised restrictions on entry to a profession or restrictions on providing a particular service by persons not recognised by a particular professional body. This can undoubtedly lead to supply shortages and hence the earning of substantial economic rents by members the profession. However, it not only requires a monopoly right for the profession over a particular service but also numerical restrictions on entry to the profession. Thus an excess demand for the services of the profession is maintained. The monopoly right ensures that an adjustment in supply from outside the profession cannot take place in response to the profession’s high incomes. In the most famous study, Friedman and Kuznets (1945) estimated economic rents of 15-110 percent being earned by professionals in the US during the 1929-36 period. This is the global effect of self-regulation and is not solely attributable to entry restrictions. Entry to the legal profession has continued to grow (for Europe see Bowles, 1994; Faure, 1993; Helligman, 1993; Herrmann, 1993; Ogus, 1993) for USA see Curran (1993) and Lueck, Olsen and Ransom (1995). Indeed as Curran (1993) points out the American Bar Association has been less successful than its medical counterpart in limiting the growth of the profession. It has not regulated the numbers qualifying to practice in the same way as the American Medical Association. Of course, established members of the profession may have an interest in encouraging an expansion of new entry to the lower reaches of the profession as this might reduce the salaries paid to new entrants due to excess supply. However, this argument only holds so long as the new entrants

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to the profession are unable to provide the basis for an increase in the number of law firms and thus compete away the rents earned by existing firms. However, the absence of severe restrictions on entry to the profession in general does not necessarily imply competition in specific service markets. Professional service markets, particularly of a personal nature, tend to be spatially localised. What may be important are geographical restrictions on movement which imply barriers to entry into specific service markets for existing members of the profession. In a number of jurisdictions lawyers may only appear before courts in the local area to whose bar they have been admitted (USA, Belgium, Germany, for example). In the case of legal advice, even when there are no formal restrictions on practising in a given locality, other restrictions on behaviour such as prohibiting advertising may raise the cost of entry (through an inability to quickly generate goodwill) and thus constitute a barrier to entering a specific spatial market. Alternatively prohibitions on ‘undercutting’ or ‘supplanting’ existing suppliers may reduce the incentive to enter a local market where rents are being earned. Thus, although there may be no formal barriers to entering a local market, such markets may not be contestable.

9. Empirical Studies of Entry to the Profession Economists’ empirical studies of the effects of such mobility restrictions for the legal profession are restricted to the USA. They find, for example, that lack of reciprocity between state bar associations leads lower numbers of practising lawyers and higher lawyer incomes (Holen, 1965; Kleiner, Gay and Green, 1982; Pashigian, 1977). However, a recent empirical study by Lueck, Olsen and Ransom (1995) finds little support for the view that licensing restrictions affect the price of legal services. Their evidence suggests that it is what they describe as ‘market forces’ which are most important. Licensing restrictions are proxied by requirements to pass a state bar exam, state bar exam pass rates, state residency requirements and requirement of an ABA recognised law school degree. Although they find that there is a relationship between state lawyer density, state bar exam pass rates and the requirement of an ABA recognised degree the effect is in the opposite direction to that hypothesised by the capture theory, that is, the lower the pass rate the higher is lawyer density, and the latter is higher in states requiring an ABA recognised degree. Although the authors argue that their evidence runs counter to the implications of the capture theory they do find that the higher are state bar exam pass rates the lower are lawyer fees.

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10. Professional ‘Monopoly Rights’ The preceding paragraphs have focused on controls on entry to the legal profession itself. Often, as discussed above, this has been accompanied by the exclusive rights given to the legal profession over certain services. Many writers commenting on the regulatory regimes governing the legal profession draw attention to ‘monopoly rights’ in certain areas of work and criticise this on a priori grounds. However, little empirical work has been done by economists to estimate the effects of professional monopoly rights and the existence of para-professions. This may be due, in part, to the absence of data sets which allow variations in such monopoly rights either over time or location to be studied. Even during the current deregulation wave there has been little empirical work estimating the effects of relaxing monopoly rights. Para-professions sometimes exist alongside professions with the right to provide services which overlap with some of those provided by a profession. There has been limited analysis of profession/para-profession interaction. Shaked and Sutton (1981a) examines the effects on welfare of the existence of a lower quality para-profession operating alongside a self-regulating profession. Shaked and Sutton (1981b) looks at the viability of a para-profession when there are consumers with different incomes but identical preferences. In this context the para-profession’s viability depends on the relative sizes of the two income groups of consumers. A series of studies of the deregulation of legal services in England and Wales between 1985 and 1992 which focuses on conveyancing (title transfer) services provides some limited insights on the relaxation of a profession’s monopoly rights and the impact of a para-profession. Until the mid-1980s solicitors had the exclusive right to provide conveyancing services for financial reward. This monopoly was revoked in 1985 and by 1987 the first licensed conveyancers (non-solicitors licensed to provide these services) were offering services in competition with solicitors in some areas of the country (Stephen and Love, 1996; Stephen, Love and Paterson, 1994). Paterson et al. (1988) report that solicitors surveyed in 1986 were reducing fees in anticipation of licensed conveyancer entry. Later surveys, however, provide a more complex picture of the effects of entry. Survey data for 1989 revealed solicitors’ conveyancing fees in a sample of locations where licensed conveyancers had entered as compared to those where there were no licensed conveyancers were lower (Love et al., 1992) and were less likely to involve price discrimination (Stephen et al., 1993). These results appear to support the conventional view that monopoly rights will operate to the disadvantage of clients of lawyers. A subsequent survey conducted in 1992 and covering the same locations as the earlier surveys produced results less conducive to the traditional economic view. Both the conveyancing fees of solicitors in markets where there were

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licensed conveyancers and those of licensed conveyancers had risen between 1989 and 1992 by more than those in markets where there were no licensed conveyancers; in addition licensed conveyancers’ feeing practices were more like those of solicitors than before (Stephen, Love and Paterson, 1994). There is the suggestion that the threat of entry is a more powerful restraint on solicitors’ behaviour than actual entry. Stephen and Love (1996) have sought to explain these results by the fact that licensed conveyancers produce a limited range of services and therefore have the same interest as lawyer conveyancers in maintaining high fees and also that the risks to licensed conveyancers are greater than those of solicitors. These results should caution against the assumption that multiple professional bodies will necessarily be to the benefit of consumers. However, the limited effects of removing a monopoly in a restricted field, as in this case, may not carry over to a more general removal of monopoly rights.

C. Restrictions on Advertising 11. Professional Advertising and Competition The second tool used by self-regulated professions has been the restriction or total ban on advertising by members of the profession. This has often been accompanied by restrictions on other aids to competition such as quoting of fees in advance of carrying out the work and so on (Cox, 1989; Curran, 1993; Domberger and Sherr, 1987, 1989; Evans and Trebilcock, 1982; Faure, 1993; Federal Trade Commission, 1984; Finsinger, 1993; Helligman, 1993; Herrman, 1993; Ogus, 1993; Paterson and Stephen, 1990; Scottish Home and Health Department, 1989; Shinnick, 1995; Stephen, 1994; Stephen and Love, 1996; Stephen, Love and Paterson, 1994). During the recent deregulation wave, restrictions on lawyer advertising have been relaxed to varying degrees in different jurisdictions. These deregulatory moves have been prompted by court decisions, consumer lobby pressure and activities of competition authorities. Economic analysis of restrictions on advertising by professionals has been carried out from an economics of information perspective based on the insights of Stigler’s (1961) analysis. Stigler argued that producer advertising was equivalent to a large amount of search by a large number of consumers. Consequently it reduced price dispersions and enhanced competition. Writers on the professions therefore argued that restrictions on advertising by professions imposed by self-regulatory bodies were designed to reduce competition by increasing the cost of consumer search (see for example, Benham and Benham, 1975). Removal of such restrictions would enhance competition and be in the interests of efficiency. In the 1960s and 1970s severe

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restrictions on advertising by lawyers was quite widespread (see for example, Federal Trade Commission, 1984; Cox, 1989; Monopolies and Mergers Commission, 1976; and contributions to Faure et al., 1993). Such severe restrictions still applied in Belgium and Germany until recently. (Faure, 1993; Herrmann, 1993). It is frequently asserted by critics of professional advertising that advertising will drive down the quality of services provided. Economists have examined the relationship between advertising and quality. Rogerson (1988) shows formally that even if price can communicate no information directly about quality, it can do so indirectly because price serves as a positive signal of quality when price advertising is allowed. Price advertising is therefore welfare enhancing because it improves consumer choice. A problem arises, however, if price advertising is undertaken exclusively, or at least principally, by low-price/low-quality suppliers. Price advertising therefore becomes an adverse signal on quality. This is a general argument, and does not depend on price being a clear signal on quality. Rizzo and Zeckhauser (1992) point out that consumers who are unable to assess quality ex ante (and possibly even ex post) and who observe a low price for a non-standardised service may assume that more knowledgeable purchasers have assessed the service as being of low quality. Professionals are keen to avoid such adverse signals on quality, and so Rizzo and Zeckhauser conclude that price advertising will be uncommon in most professions. Thus not only may advertising have an effect on quality, perceptions of quality may have an effect on the form of advertising chosen by professionals.

12. Empirical Studies of Lawyer Advertising An extensive empirical literature has developed on the restriction of advertising of professional services and what happens to fee levels when such restrictions are relaxed. A review of this literature is presented in Love and Stephen (1996). The general thrust of the evidence from this literature is that restrictions on advertising increase the fees charged for the profession’s services and that the more advertising there is the lower are fees. The one study contradicting this result is Rizzo and Zeckhauser (1992). Love and Stephen (1996) note a number of limitations to these studies. The empirical studies of advertising by members of the legal profession find that law firms which advertised charged, on the whole, lower fees than those that did not advertise (Cox, DeSerpa and Canby, 1982; Federal Trade Commission, 1984; Schroeter, Smith and Cox, 1987; Love et al., 1992; Stephen, 1994). Domberger and Sherr (1987, 1989) found that conveyancing fees in England and Wales had fallen since advertising and fee quoting had been permitted. Schroeter, Smith and Cox (1987), Love et al. (1992) and

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Stephen (1994) found that the more advertising by lawyers there was in a locality the lower were the fees charge by all lawyers in the locality (at least for certain transactions). Stephen et al. (1992) found that that price discrimination by solicitors was lower the more advertising there was in a market. However, Love et al. (1992) for England and Wales and Stephen (1994) for Scotland found that this result was only valid for some forms of lawyer advertising. The other studies did not distinguish between different forms of advertising. The hypothesis that non-price advertising will be much more common than price-advertising is supported by evidence from the legal profession in the UK and in the USA. Stephen, Love and Paterson (1994) show that within two years of advertising being permitted, the percentage of English solicitors’ firms which had advertised within the six months prior to an extensive survey was 46 percent; but only 2 percent of firms had advertised the price of any service. Six years later (in 1992), the proportion of advertising firms had risen to 59 percent, but price advertising was carried out by just 4 percent of firms. In Scotland, Stephen (1994) estimates that within three years of being permitted to do so, over half of Scottish solicitors’ firms engaged in advertising, but less than 3 per cent advertised the price of any service. The Federal Trade Commission (1984) study of attorney advertising found similar low levels of price advertising across US states. Empirical work on the quality of legal services in the presence of lawyer advertising does not present such a clear-cut view as that on fees. Love and Stephen (1996) point out that there are variations in how quality is measured in these studies. Muris and McChesney (1979) find that high advertising legal clinics provided better quality services than traditional legal firms for a sample transaction. However, since advertising only enters their analysis indirectly it is difficult to judge the implications for policy on advertising. Murdock and White (1985) conclude that advertisers are more likely to be low quality firms. Thomas (1985) argues that such a conclusion is not warranted by Murdock and White’s evidence. Cox, Schroeter and Smith (1986) find that quality is lower in those localities with greater lawyer advertising but find no statistically significant differences in the quality of work produced by advertisers and non-advertisers. Domberger and Sherr (1989) found that quality (measured by time taken) rose as a consequence of liberalisation of rules on advertising and competition in England and Wales.

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D. Regulation of Fees 13. Scale Fees The third weapon in the armoury of the self-regulating profession is the regulation of fees. Traditionally fees have been subject to control by the profession itself, by the courts or by the state through mandatory fee schedules. In some jurisdictions these mandatory scales have been transformed into recommendations. During the recent deregulation wave even these recommendations have been swept away and replaced by the market. Most self-regulatory bodies, however, have retained powers to punish those who charge ‘excessively’ low fees for bringing the profession into disrepute. In Germany fees are still determined by State regulation (Herrmann, 1993). In Belgium and the Netherlands a recommended fee schedule is produced by the profession and in Belgium there is a recommended minimum (Faure, 1993; Helligman, 1993). A recommended scale is still produced by the solicitors’ professional body in Ireland for conveyancing work (Shinnick, 1995) and one was in operation in Scotland until 1985 (Stephen and Love, 1996). The corresponding schedule was withdrawn in England and Wales in 1974, although Domberger and Sherr, 1992) argue that it still influenced feeing practices until the mid-1980s. Observers of professional self-regulation are highly critical of scale fees: In general, we regard a collective obligation not to compete in price, or a restriction collectively imposed which discourages such competition, as being one of the most effective restraints on competition. The introduction of price competition in the supply of a professional service where it is not at present permitted is likely to be the most effective single stimulant to greater efficiency and to innovation and variety of service and price that could be applied to that profession. (Monopolies and Mergers Commission, 1970, p. 78, see also Arnauld, 1972; Arnauld and Friedland, 1977, and Domberger and Sherr, 1989, 1992)

However, economists are generally sceptical about the ability of cartels to avoid their members selling output at prices below those agreed by the cartel. This practice has become known in the economics literature as ‘chiselling’ (see, for example, Cohen and Cyert, 1965, pp. 245-246). As has been pointed out many times (for example Stigler, 1966; Layard and Walters, 1978) the ability of a cartel to enforce its rules is inversely related to the number of members. Professional ‘cartels’ have many members. Scale fees are often ‘recommended’ (Monopolies and Mergers Commission, 1970, pp. 21, 22; Arnauld, 1972, p. 498; Shinnick, 1995) rather than

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mandatory or State-enforced charges. It is often argued that even where they are ‘mere’ recommendations they have the effect of raising fees: There appears to us to be little difference between so-called mandatory and recommended scales in their practical effect ... although disciplinary action could not be taken specifically for breach of a recommended scale, the fact that the fees charged were not in accordance with the scale might in some circumstances be quoted in support of a charge of breach of some other rule .... such that the established practitioner would not depart more readily from a ‘recommended’ scale than from a mandatory scale. (Monopolies and Mergers Commission, 1970, p. 22, see also Arnauld, 1972, p. 498)

14. Empirical Studies of Fee Schedules In contrast to the considerable empirical research on the role of advertising (as discussed above) there would appear to have been little on the impact or effectiveness of recommended fee scales. This is somewhat surprising given the conflicting a priori positions taken by commentators on professional regulation and the writers of general treatises on microeconomics. Arnauld and Friedland (1977) examined the relationship between the incomes of a sample of lawyers and (inter alia) the minimum fee recommended (where there was one) for a simple transaction for a sample of lawyers in California and Pennsylvania. They found that lawyer income rose as the recommended fee rose. It should be noted that the dependent variable here is lawyer income not the fee for the standard transaction. For this to imply that fees also rose, demand for the standard transaction must be inelastic. Arnauld and Friedland, however, argue that the influence of fee schedules on prices may be even greater than they demonstrate because high prices may induce entry which will moderate the effect on lawyer incomes. Strikingly, they also suggest that there may be widespread cheating on the fee schedule. There is some limited evidence that such ‘cheating’ on recommended fee schedules for lawyers does exist. Stephen (1993) reports evidence from a sample of solicitors’ conveyancing bills for 1984, when a scale of recommended fees was in force, that more than 40 percent of these solicitors charged conveyancing fees below that recommended by the Law Society of Scotland. Furthermore, statistically significant geographical patterns were identified in the determinants of these fees even although the fee schedule applied to all Scottish solicitors. However, this evidence must be qualified by the fact that large numbers of solicitors failed to co-operate in this study suggesting that the data analysed may not be representative of all solicitors.

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Stronger evidence of chiselling is presented in Shinnick (1995). This paper examines the conveyancing fees of a large sample of Irish solicitors. At the time at which the survey was carried out the Incorporated Law Society of Ireland, the self-regulatory body for solicitors in Ireland, published a recommended scale of fees for conveyancing which applied throughout the country. Considerable variation from the recommended fee was found. Econometric tests reject the hypothesis that a single fee is charged throughout Ireland, indicating that this variation was not random. The limited empirical evidence available suggests that the strong conclusions on scale fees arrived at on the basis of a priori reasoning by academic observers and competition authorities reported above may not have empirical support.

E. Restrictions on Fee Contracts 15. Contingency Fees In many jurisdictions lawyers’ fees are regulated by prohibiting certain forms of fee contract between lawyer and client. In particular, lawyers may be prohibited from entering into contingent-fee contracts with clients. Under such contracts the lawyer’s fee is contingent on the outcome of the case. The most common form of contingent fee contract is that used between lawyer and plaintiff in many civil cases in the United States. If the case is lost the lawyer receives no fee but if it is won the lawyer receives a percentage of the damage award to the client. Such contingent-fee contracts are prohibited in many European jurisdictions (see Faure, 1993; Helligman, 1993; Herrmann, 1993; Rickman, 1994) but changes are taking place (see, for example, Gravelle and Waterson, 1993; Rickman, 1994) and Lord Chancellor’s Department, 1998, on the introduction of conditional fees with a speculative mark-up in England and Wales). Lynk (1990) has argued that contingency fees are an interesting issue for two reasons: their economic characteristics and their public policy implications. Their economic characteristics have been studied to examine whether they encourage lawyers to invest more or fewer hours in a case; the incentive to settle out of court; and various aspects of the principal agent problem between client and lawyer. The public policy issues focus on whether contingent fees increase the volume of litigation and whether they improve access to justice by removing wealth barriers. Both sets of issues have featured in the literature. A number of authors have used the insight from the agency literature that tying the agent’s remuneration to the outcome is optimal to advocate the superiority of contingency fees in increasing the lawyer’s effort (Danzon, 1983; Halpern and Turnbull, 1981; Hay, 1996; Rickman, 1994; Schwartz and Mitchell, 1970).

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The incentive properties of contingent-fee contracts and hourly contracts more generally have been analyzed by many writers (Clermont and Currivan, 1973; Dana and Spier, 1993; Danzon, 1983; Fisher, 1988; Gravelle and Waterson, 1993; Halpern and Turnbull, 1981; Hay, 1996; Kritzer et al., 1985; Lynk, 1990; Miceli and Segerson, 1991; Rickman, 1994; Rubinfeld and Scotchmer, 1993; Schwartz and Mitchell, 1970; Smith, 1992; Swanson, 1991; Thomason, 1991).

16. Settlement Conflicts In many jurisdictions a fundamental argument put against contingency fees is that they conflict with the principle that lawyers should not have an interest in the cases which they handle (see for example, Rickman, 1994; Faure, 1993 and Helligman, 1993). Such a situation can produce a conflict of interest between client and lawyer over when to settle. In particular, whether the plaintiff in a tort case should accept an out of court settlement rather than go to court. This argument neglects the fact that such a conflict of interest can still exist under the conventional hourly-fee system; it is simply that the lawyer’s private interest is reversed. Under an hourly-fee system the lawyer earns more the greater the number of hours put into the case. It will thus be attractive to the lawyer to continue the case provided that the hourly rate is greater than the opportunity cost of the lawyer’s effort, that is, if super-normal profits are being made. Consequently, the lawyer has an interest in convincing the client to continue the case, ceteris paribus, rather than settle (Johnson, 1981). The opposite may be true under a contingency fee. Here the lawyer receives a predetermined share of any damages awarded but bears all costs incurred on behalf of the client. Thus when a pre-trial offer is made by the defendant to settle out of court the interests of the plaintiff and the plaintiff’s lawyer can conflict (Gravelle and Waterson, 1993; Johnson, 1981; Miller, 1987; Rickman, 1994; Schwartz and Mitchell, 1970; Swanson, 1991; Watts, 1994). Indeed, the higher the offer the more likely the interests of plaintiff and lawyer are to conflict under a contingent-fee system (Gravelle and Waterson, 1993). The foregoing analysis implicitly assumes that the client relies totally on the lawyer’s decision over settlement and that the lawyer is motivated by pure self-interest. Gravelle and Waterson (1993) allow for the variation of this assumption by incorporating a parameter in their model which varies as the client is better informed or as the lawyer is more altruistic. They find that the more informed the client is (or the more altruistic the lawyer is) the less likely a given offer will be accepted pre-trial under a contingency fee. Indeed, if the lawyer is more altruistic than selfish the probability of pre-trial settlement will be lower under a contingency fee than under an hourly fee. This result emphasises the crucial importance of the asymmetric information issue in

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determining the choice of fee contract. Well-informed clients are likely to prefer an hourly rate. Furthermore, the more imbued with a client service ethic lawyers are (the more altruistic) the more suitable is the hourly-fee contract to the client’s interest. There is some limited empirical evidence supporting this result in that Kritzer (1990) reports that for a sample of tort and contract cases where the plaintiff was an organisation 81 percent of the fee contracts were on an hourly basis whilst when the plaintiff was an individual 59 percent of the fee contracts were on a contingency basis. It is to be expected that organisations are more likely to be experienced litigants than individuals. Returning to the more standard setting where the lawyer is assumed to be self-interested, Gravelle and Waterson’s (1993) result is somewhat modified if the context is changed slightly and bargaining introduced to the model (Rickman, 1994; Swanson, 1991). Under these circumstances, it is argued that with the contingency fee contract the lawyer has a greater incentive to bargain hard. The lawyer’s behaviour may be affected in ways other than hours at a given effort level. Consequently even a relatively selfish lawyer settling out of court may improve the client’s award as against that attainable under an hourly fee contract where the incentive to bargain hard is less.

17. Volume of Litigation It is frequently argued by those supporting the ban on contingency fees in European jurisdictions that permitting contingency fees will increase the volume of litigation. The higher volume of litigation in the US where contingency fees are permitted is often cited in support of this view. However most of the economic modelling suggests the opposite conclusion (Clermont and Currivan, 1973; Dana and Spier, 1993; Danzon, 1983; Halpern and Turnbull, 1981; Miceli, 1994; Miceli and Segerson, 1991; Rubinfeld and Scotchmer, 1993). Miceli (1994) examines the impact of contingent fees on the pursuit of frivolous cases and finds no support for the view that contingent fees will encourage frivolous suits. Gravelle and Waterson (1993) develop a model in which both the probability of accident and the probability of settlement are endogenous. Thus they extend the model beyond the decision to litigate or settle given that an accident has occurred to one where the care taken by potential tortfeasors is influenced by the nature of contracts between potential victims and their lawyers and thus post-accident behavior. They find that the effect of a switch from hourly fee to a contingency fee has an ambiguous effect on the volume of litigation in this model and on welfare.

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18. Access to Justice A number of authors argue that a benefit of contingency fees is that risk averse or wealth-constrained victims of torts who under an hourly fee contract may be unwilling to pursue a claim will now do so because the risk is shifted to their lawyer. Some predict a consequent increase in the volume of litigation under contingency fees (Miceli and Segerson, 1991; Rubinfeld and Scotchmer, 1993) but Dana and Spier (1993) suggest that to the extent that victims may be overoptimistic about their chance of success contingency fees may actually reduce the number of suits. Neither of these views takes account of the deterrence (or otherwise) effects of a change from hourly to contingent contracts as predicted by Gravelle and Waterson (1993). However, it would seem that victims are likely to be better off one-way-or-another under contingency fees even although the overall welfare effects may be ambiguous.

F. Restrictions on Organizational Form 19. Choice of Organizational Form Thus far in this paper we have discussed the relationship between lawyer and client abstracting from the organisational form through which lawyers provide their services. We have focused on lawyer-client relations and relations between the profession as a whole and others in society. In most jurisdictions lawyers provide their services to the public through ‘firms’. However the nature and form of these law firms is regulated in many jurisdictions. Lawyers are not free in their choice of organizational form. Some organizational forms are prohibited. In this section we evaluate the economic rationale for such regulation of organizational form. We begin by considering the factors which might influence a lawyer’s choice of organizational form. Increases in firm size can be justified on a number of grounds. The most general of these is that economies of scale can be captured the greater the output of the firm. Every introductory textbook in economics lists sources of economies of scale. Principal among these are those emanating from specialization of labor and more efficient use of capital. The former of these may apply to legal services but the latter is more doubtful, at least where it is physical capital that is involved. The physical capital requirements of legal services are quite small and are likely to involve limited economies of scale. Legal services are essentially human (rather than physical) capital intensive. Provision of legal services through group practice allows specialization of lawyers in particular aspects of law, therefore, lowering the cost of providing

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services. Practices of lawyers with different specialties have the further benefit of risk spreading. Different specialties may face different business cycles and thus fluctuations in specialist income may be smoothed across the group. Furthermore, economies of scope may exist when a client has a range of legal service needs which can be serviced by specialists within the firm or when a legal problem has dimensions involving a range of specialties. Economies of scope are available to the sole practitioner but in the multi-lawyer firm they are combined with economies of specialization. The more complex the issues the more likely that specialists will dominate because the benefits of economies of specialization outweigh the economies of scope to the sole practitioner. Economies of scope or benefits from risk sharing in the multi-lawyer specialist firm will lead to multi-lawyer firms dominating. Similar arguments apply where the specialists involved are outside the legal profession in what is often referred to as multi-disciplinary practice (MDP). It has often been argued that clients would benefit from economies of scope where a professional firm included lawyers, accountants, surveyors and so on; so-called ‘one stop shopping’. We do not discuss this issue further here but a general discussion of the issue in a different context may be obtained from Smith and Hay (1997). Thus far we have only considered production costs. We have not considered agency costs which may arise from the asymmetry of information between client and lawyer. The analysis here may be helped by using Quinn’s (1982) distinction between the agency function and the service function discussed earlier in this paper. Earlier we pointed to the moral hazard problem that arises after a lawyer performs the agency function in diagnosing a client’s legal problem and recommending a course of action. This arises because it is assumed that the same lawyer will perform the consequent service function. The agency cost increases when it is recognized that there are economies of specialization. Many circumstances will arise under which the lawyer performing the agency function is not the least cost supplier of the service function required. This may be particularly so in the sole practitioner firm. In a multi-lawyer firm it is, perhaps, more likely that there will be a specialist within the firm who is the least-cost provider of the service function. The probability of this being so may increase the more lawyers there are in the firm. However, the fewer the number of partners and the more specialized the service function required the more likely that the firm will not be the least-cost supplier. This may even be the more so if the firm is an MDP. Nevertheless, it is likely that the lawyer performing the agency function will pass the client to a specialist within the firm: first, because the lawyer providing the agency function will share in the income of the firm generated from the provision of the specialized services; secondly, because recommending the client to another firm may mean that the client’s future business will also be lost.

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In many jurisdictions there are restrictions on the organisational forms which can be adopted by providers of legal services. Traditionally these restrictions appear to have been motivated by a desire to keep at arm’s length commercial or profit considerations on the part of lawyers, reflecting the agency problem which has been a central consideration throughout this paper. Thus for many years lawyers in most jurisdictions could only operate as sole practitioners or in partnerships with other lawyers and could not incorporate (see Bishop, 1989; Faure, 1993; Helligman, 1993; Herrmann, 1993; Ogus, 1993; Prichard, 1982, and Quinn, 1982). Furthermore, in the UK and Ireland providers of legal services are divided into two distinct professions with their own professional bodies and self-regulatory functions: solicitors and barristers (in Scotland known as advocates). Until 1990 in the UK only barristers (advocates) could appear before the higher courts and they could only take instructions from a solicitor and not directly from a client (see Bowles, 1994, and Ogus, 1993). There is a limited economic literature which examines such restrictions on organisational form. We first examine the issues surrounded the divided profession before moving on to the issue of firm size and organisational form.

20. A Divided Profession In England and Wales, Northern Ireland and Scotland (each of which is a separate legal jurisdiction) as well as the Republic of Ireland and certain states in Australia, what is elsewhere a single legal profession is split into two branches: solicitors and barristers (in Scotland, advocates). Solicitors provide legal advice to the public on the whole range of legal matters and have rights of audience in the lower courts. Barristers have rights of audience in the higher courts and provide consultancy services to solicitors. The rules governing each of the professions prohibits its members from practising as members of the other profession. Judges (as opposed to magistrates) are drawn almost exclusively from the ranks of barristers (advocates) (Bishop, 1989; Bowles, 1994; Ogus, 1993; Shinnick, 1995). Although rights of audience in the higher courts in Scotland and England and Wales have changed recently as a consequence of legislation to allow solicitors who meet certain tests of experience in advocacy in the lower courts to appear in the higher courts, there has been no move to fuse the professions. From an economic perspective the question is whether the division into two professions is efficiency enhancing or is a mere restrictive practice. It should be noted that specialisation in advocacy may exist within a fused profession. Within law firms some practitioners may specialise in court advocacy while others specialise in diagnosis and case management. Some firms may specialise in advocacy, particularly in the criminal field. Outside the criminal field in-house advocates may lack expertise in a particular area of law

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in spite of having enhanced advocacy skills. The issue then becomes whether or not any benefits from formally separating the roles outweigh the costs. Bishop (1989) analyses the separation into two professions as a prohibition on vertical integration between successive stages in a production process: the preparation of a case and its prosecution through advocacy in the courts. He argues along lines similar to those of Quinn (1982) that the conflict between the agency function and the service function is particularly severe due to the large benefits which accrue from specialisation in trial advocacy. The existence of a cadre of specialist consultants and litigators (barristers/advocates) removes the temptation to supply higher cost in-house advocacy. Not only this, it may provide competition in the downstream market. Thus one benefit of a divided profession is that the client gets higher quality advocacy than would be available from an in-house advocate. However, this benefit is not costless. Bishop argues that the cost will be the dead-weight loss to sophisticated buyers of legal services who do not require the intermediation of a solicitor. An additional cost might be the differential transaction costs associated with employing both solicitor and barrister rather than two solicitors within the same firm. This would be the case if economies of scope existed when the two legal advisors were from the same firm/office. An evaluation of the division in the profession cannot be resolved on these a priori arguments. It is a question of the relative magnitudes of the costs and benefits. However, their empirical measurement is fraught with difficulty. Ogus (1993) clearly doubts that the balance lies in favour of division but adduces additional points against division. If, he argues, division were efficient, why is it that when fusion is not prohibited we invariably observe fusion. Further, enforced division removes choice from informed consumers who might prefer lower quality but cheaper in-house advocacy to high quality but high price external advocacy. On the other hand Bishop points out that in some Australian states where there is fusion there is de facto separation as some specialist pleaders operate, in effect, as barristers. Bishop (1989) also discusses external effects which have a bearing on the division issue. The first of these is that the division into two specialist branches allows more effective policing of lawyer misbehaviour (particularly in the case of barristers) due to a ‘club’ effect. This reduction in dishonesty will benefit future honest litigants because it will reduce the cost of achieving justice. However the implication is that Bishop regards the division of the professions as an expensive means of achieving this benefit. The division may also allow the monitoring of the performance of the members of each profession by the members of the other. A further external effect is public capital formation through the production of high quality precedent. The existence of highly specialised and qualified advocates should produce better argued cases and more valuable precedent. Furthermore the recruitment of the judiciary from the

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ranks of the best of these specialist advocates, not only ensures that those recruited to the bench have proven their worth as trial lawyers but should further ensure high quality precedents. A final external effect identified by Bishop (1989) is a lowering of the cost of judicial administration. Here the main beneficiary is not the client but the trial judge. Poor advocacy places a burden on the trial judge to ensure that the decision reached is not influenced by inadequate advocacy. With highly specialised and skilled advocates this problem does not arise. Barristers also act as gatekeepers to the courts. They ensure that cases are sifted and well-prepared before reaching the court thus reducing the cost of adjudication. Similar external effects are adduced by Arruñada (1996) in his examination of Spanish Notaries. It is not easy to find empirical evidence to test propositions like those of Bishop. He cites the former Chief Justice of the United States, Warren Burger, in support of the higher quality of advocacy and the higher quality of the judiciary in England as compared to the US. However, Bishop does not regard this testimony as determinative. He then discusses at length the spontaneous evolution of barrister-like specialists in Australian states where there is de jure a fused profession. The final sources of evidence cited by Bishop are the extensive use of English precedents throughout the common-law world and the choice of London and English law to settle international legal issues. Both of these might be seen as suggesting a higher quality of legal services resulting from specialisation in the branches of the profession. Notwithstanding the above arguments Bishop does concede that it will only be where the stakes are high that the higher cost of specialisation may be worth incurring implying that rights of audience in lower courts should not be restricted to specialist advocates.

21. Sole Practitioners, Partnerships and Incorporation A more common organizational restriction in many jurisdiction is that providers of legal services must operate as independent providers or in partnership with other qualified lawyers. Even where incorporation is permitted restrictions are frequently imposed maintaining unlimited liability and that the directors of the firm must all be lawyers (see Bishop, 1989; Faure, 1993; Helligman, 1993; Herrmann, 1993; Ogus, 1993; Prichard, 1982, and Quinn, 1982). However, some US states permit incorporation under limited liability (Carr and Mathewson, 1988). Fama and Jensen (1983a, 1983b) have argued that professional partnership accompanied by unlimited liability is a solution to the moral hazard problem posed by the asymmetry between client and professional. The willingness of one professional to risk his or her wealth by entering into such a partnership with another professional signals to clients the trustworthiness of members of the

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partnership and provides a guarantee that there will be mutual monitoring among partners. Stephen and Gillanders (1993) present evidence that little mutual monitoring takes place within UK law firms and that ex ante screening of prospective partners is likely to dominate ex post monitoring. The persistence of sole practitioner firms in legal practice also seems to run counter to this signalling function of partnership: around 50 percent of law firms in the US are sole practitioners and around 40 percent of solicitors’ firms in England and Wales. However, Carr and Mathewson (1990) point out that the proportion of sole practitioner firms in the US has been declining for a number of years. Carr and Mathewson (1990) model the choice of organisational form for law firms in a competitive market subject to information asymmetries. They conclude that ‘partnerships dominate solo lawyers when client cases are large and the detection of chiselling is low’ (p. 328). They also point out that for large corporations it may pay to have in-house counsel to monitor legal services. However, they find that limited liability becomes attractive as it reduces the cost of capital to partnerships. In Carr and Mathewson (1988) they argue that the increased cost of capital when unlimited liability is small leads to inefficiently small law firms where complex cases are involved. They find empirical support for this conclusion from differences in law firm size across US states being related to whether or not limited liability is available. Their regressions support the view that law firm size rises where limited liability is permitted. Gilson (1991) suggests that the relationship runs in the opposite direction because of the tax advantages of incorporation: large firms derive a greater tax advantage from incorporation. Carr and Mathewson (1991) respond that their empirical results allow for a distinction between incorporation and limited liability since not all corporate law firms enjoy limited liability.

G. Conclusion 22. Summing Up This chapter has reviewed the extensive economic literature on the regulation of the legal profession. The case for regulation has been seen to be based on the moral hazard problem which arises from the information asymmetry between the lawyer and the infrequent user of legal services. The justification for self-regulation is seen to be based on reducing the costs of regulation. Nevertheless, much of the literature on self-regulation sees it working in the interests of the members of the profession by raising fees and professional incomes. A number of instruments through which self-regulation operates to restrict competition were identified. Theoretical work by economists tends to point to

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these working in the interests of the profession and against the interests of clients. The empirical literature testing such predictions is limited but produces mixed support for the theoretical predictions. For example, whilst there is some support from aggregate data for the view that restrictions on entry to the legal profession lead to higher incomes for lawyers, the microeconometric evidence on the effect of restrictions on fees runs counter to theory. The evidence from the removal of the conveyancing monopoly in England and Wales is at least ambiguous. Similarly, the limited empirical evidence on recommended scale fees for solicitors suggests significant deviations from these scales. The evidence on the effects of restrictions on advertising tends to support the theory, although it has been suggested that when different types of advertising are considered the evidence is less unambiguous. On the issues of contingent fees and restrictions on organisational form the empirical evidence is very limited. This survey of the literature suggests a need for more empirical studies. The theoretical literature, on the whole, suggests fairly strong recommendations to policymakers regarding self-regulation. On the other hand, the limited empirical evidence does not always support such strong theoretical predictions. More evidence would clarify whether the conflict arises from the limitations of the current evidence or from the theory.

Acknowledgements The authors would like to acknowledge constructive comments made by three referees and the editors on an earlier draft of this survey. We also benefited from comments made when aspects of this work were presented at Universidad de Valencia and the Lord Chancellor’s Department Economics Forum. The usual disclaimer applies.

Bibliography on Regulation of the Legal Profession (5860) Arnauld, R.J. (1972), ‘Pricing Professional Services: A Case Study of the Legal Services Industry’, 33 Southern Economic Journal. Arnauld, R.J. and Friedland, Thomas S. (1977), ‘The Effect of Fee Schedules on the Legal Services Industry’, XII Journal of Human Resources. Arruñada, Benito (1996), ‘The Economics of Notaries’, 3 European Journal of Law and Economics, 5-37. Benham, Lee and Benham, Alexandra (1975), ‘Regulating Through the Professions: A Perspective on Information Control’, 18 Journal of Law and Economics, 421-447. Bishop, William (1989), ‘Regulating the Market for Legal Services in England: Enforced Separation of Function and Restrictions on Forms of Enterprise’, 52 Modern Law Review, 326-351.

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Bowles, Roger A. (1994), ‘The Structure of the Legal Profession in England and Wales’, 10 Oxford Review of Economic Policy, 18-33. Bowles, Roger A. and Phillips, Jennifer (1977), ‘Solicitors’ Renumeration: A Critique of Recent Developments in Conveyancing’, 40 Modern Law Review, 639-650. Bowles, Roger A. and Skogh, Göran (1989), ‘Reputation, Monitoring and the Organisation of the Law Firm’, in Faure, Michael and Van den Bergh, Roger (eds), Essays in Law and Economics. Corporations, Accident Prevention and Compensation for Losses, Antwerpen, Maklu, 33-47. Calvani, Terry, Langenfeld, James and Shuford, Gordon (1988), ‘Attorney Advertising and Competition at the Bar’, 41 Vanderbilt Law Review, 761-788. Carr, Jack L. and Mathewson, G. Frank (1988), ‘Unlimited Liability as a Barrier to Entry’, 96 Journal of Political Economy, 766-784. Carr, Jack L. and Mathewson, G. Frank (1990), ‘The Economics of Law Firms: A Study in the Legal Organization of the Firm’, 33 Journal of Law and Economics, 307-330. Carr, Jack L. and Mathewson, G. Frank (1991), ‘Unlimited Liability and Law Firm Organization: Tax Factors and the Direction of Causation’, 99 Journal of Political Economy, 426-428. Charette, Frédérick (1992), ‘Libéraliser la Publicité des Avocats: Fondements et Conséquences (Liberalizing Lawyers’ Advertising: Foundations and Consequences)’, 71 Canadian Bar Review, 508-551. Clermont, K.N. and Currivan, J.D. (1973), ‘Improving on the Contingent Fee’, 63 Columbia Law Review, 529-639. Coffee, John C., Jr (1987), ‘The Regulation of Entrepreneurial Litigation: Balancing Fairness and Efficiency in the Large Class Action’, 54 University of Chicago Law Review, 877-937. Cox, Steven R. (1989), ‘Advertising Restrictions among Professionals: Bates v. State Bar of Arizona (1977)’, in Kwoka, J. and White, L. (eds), The Antitrust Revolution: The Role of Economics, Glenview, IIL, Scott Foresman. Cox, Steven R., DeSerpa, Allan C. and Canby, William C., Jr (1982), ‘Consumer Information and the Pricing of Legal Services’, 30 Journal of Industrial Economics, 305-318. Cox, Steven R., Schroeter, John R. and Smith, Scott L. (1986), ‘Attorney Advertising and the Quality of Routine Legal Services’, 2 Review of Industrial Organization, 340-354. Curran, Christopher (1993), ‘The American Experience with Self-Regulation in the Medical and Legal Professions’, in Faure, Michael, Finsinger, Jorg, Siegers, Jacques and Van den Bergh, Roger (eds), Regulation of Professions, Antwerpen, Maklu, 47-87. Dana, James D., Jr and Spier, Kathryn E. (1993), ‘Expertise and Contingent Fees: The Role of Asymmetric Information in Attorney Compensation’, 9 Journal of Law, Economics, and Organization, 349-367. Danzon, Patricia M. (1983), ‘Contingent Fees for Personal Injury Litigation’, 14 Bell Journal of Economics, 213-224. Darby, Michael R. and Karni, Edi (1973), ‘Free Competition and the Optimal Amount of Fraud’, 16 Journal of Law and Economics, 111-126. Dingwall, R. and Fenn, Paul T. (1987), ‘A Respectable Profession? Sociological and Economic Perspectives on the Regulation of Professional Services’, 7 International Review of Law and Economics, 51-64. Domberger, Simon and Sherr, Avrom (1981), ‘Economic Efficiency in the Provision of Legal Services: The Private Practitioner and the Law Centre’, 1 International Review of Law and Economics,

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29-49. Domberger, Simon and Sherr, Avrom (1987), ‘Competition in Conveyancing: An Analysis of Solicitors’ Charges 1983-85´, 8(3) Fiscal Studies, 17-28. Domberger, Simon and Sherr, Avrom (1989), ‘The Impact of Competition on Pricing and Quality of Legal Services’, 9 International Review of Law and Economics, 41-56. Domberger, Simon and Sherr, Avrom (1992), ‘Price Discrimination in Conveyancing: A Reply to Our Critics’, 13 International Review of Law and Economics, 103-107. Emons, Winand (1997), ‘Credence Goods and Fraudulent Experts’, 28 Rand Journal of Economics, 107-119. Evans, R.G. and Trebilcock, Michael J. (eds) (1982), Lawyers and the Consumer Interest: Regulating the Market for Legal Services, Toronto, Butterworths. Fama, Eugene F. and Jensen, Michael C. (1983a), ‘Separation of Ownership and Control’, 26 Journal of Law and Economics, 301-325. Fama, Eugene F. and Jensen, Michael C. (1983b), ‘Agency Problems and Residual Claims’, 26 Journal of Law and Economics, 327-349. Faure, Michael (1993), ‘Regulation of Attorneys in Belgium’, in Faure, Michael, Finsinger, Jorg, Siegers, Jacques and Van den Bergh, Roger (eds), Regulation of Professions, Antwerpen, Maklu. Faure, Michael, Finsinger, Jorg, Siegers, Jacques and Van den Bergh, Roger (eds) (1993), Regulation of Professions, Antwerpen, Maklu. Federal Trade Commission (1984), Improving Consumer Access to Legal Services, Report of Staff of the Federal Trade Commission, Cleveland, Nov. 1984. Finsinger, Jorg (1993), ‘Attorneys: Summary of the Cross National Comparison’, in Faure, Michael, Finsinger, Jorg, Siegers, Jacques and Van den Bergh, Roger (eds), Regulation of Professions, Antwerpen, Maklu. Fisher, Joseph M. (1988), ‘Contingent and Noncontingent Attorney’s Fees in Personal Injury Cases’, 6 Contemporary Policy Issues, 108-121. Friedman, Milton and Kuznets, S. (1945), Income from Independent Professional Practice, New York, National Bureau of Economic Research. Gilson, Ronald J. (1991), ‘Unlimited Liability and Law Firm Organization: Tax Factors and the Direction of Causation’, 99 Journal of Political Economy, 420-428. Gravelle, Hugh S.E. and Waterson, Michael (1993), ‘No Win, No Fee: Some Economics of Contingent Legal Fees’, 103(420) Economic Journal, 1205-1220. Gross, Leonard E. (1986), ‘Contractual Limitations on Attorney Malpractice Liability: An Economic Approach’, 75 Kentucky Law Journal, 793 ff. Halpern, Paul J. and Turnbull, Stuart M. (1981), ‘An Economic Analysis of Legal Fee Contracts’, in Evans, R.M. and Trebilcock, Michael J. (eds), Lawyers and the Consumer Interest, Toronto, Butterworths. Hay, Bruce L. (1996), ‘Contingent Fees and Agency Costs’, 25 Journal of Legal Studies, 503-533. Hazard, Geoffrey C., Jr, Pearce, Russell G. and Stempel, Jeffrey W. (1983), ‘Why Lawyers Should be Allowed to Advertise: A Market Analysis of Legal Services’, 58 New York University Law Review, 1084-1113. Helligman, K. (1993), ‘An Economic Analysis of the Regulation of Lawyers in the Netherlands’, in Faure, Michael, Finsinger, Jorg, Siegers, Jacques and Van den Bergh, Roger (eds), Regulation of Professions, Antwerpen, Maklu. Herrmann, H. (1993), ‘Regulation of Attorneys in Germany: Legal Framework and Actual Tendencies

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in Deregulation’, in Faure, Michael, Finsinger, Jorg, Siegers, Jacques and Van den Bergh, Roger (eds), Regulation of Professions, Antwerpen, Maklu. Holen, Arlene S. (1965), ‘Effects of Professional Licensing Arrangements on Interstate Labor Mobility and Resource Allocation’, 73 Journal of Political Economy, 492-498. Hudec, Albert J. and Trebilcock, Michael J. (1982), ‘Lawyer Advertising and the Supply of Information in the Market for Legal Services’, 20 University of Western Ontario Law Review, 53-99. Johnson, E. (1981), ‘Lawyer’s Choice: A Theoretical Appraisal of Litigation Investment Decisions’, 15 Law and Society Review. Julin, J.R. (1980), ‘The Legal Profession: Education and Entry’, in Blair, Roger D. and Rubin, Stephen (eds), Regulating the Professions: A Public-Policy Symposium, Lexington, MA, Lexington Books. Kaplow, Louis and Shavell, Steven (1989), ‘Legal Advice about Information to Present in Litigation: Its Effects and Social Desirability’, 102 Harvard Law Review, 565-615. Kaplow, Louis and Shavell, Steven (1992), ‘Private versus Socially Optimal Provision of Ex Ante Legal Advice’, 8 Journal of Law, Economics, and Organization, 306-320. Kay, John A. (1988), ‘The Forms of Regulation’, in Seldon, Arthur (ed), Financial Regulation - or Over-Regulation, Institute of Economic Affairs, 33-42. Kessel, Reuben A. (1958), ‘Price Discrimination in Medicine’, 1 Journal of Law and Economics, 20-53. Klein, Benjamin and Leffler, Keith B. (1981), ‘The Role of Market Forces in Assuring Contractual Performance’, 89 Journal of Political Economy, 615-641. Kleiner, Morris M., Gay, Robert S. and Greene, Karen (1982), ‘Barriers to Labor Migration: The Case of Occupational Licensing’, 12 Industrial Relations, 383-391. Kritzer, Herbert M. (1990), The Justice Broker: Lawyers and Ordinary Litigation, Oxford, Oxford University Press. Kritzer, Herbert M., Felstiner, William L.F., Saret, A. and Trubeck, David M. (1985), ‘The Impact of Fee Arrangement on Lawyer Effort’, 251 Law and Society Review. Kritzer, Herbert M., Sarat, Austin, Trubek, David, Bumiller, Kristin and McNichol, Elizabeth (1984), ‘Understanding the Cost of Litigation: The Case of the Hourly-Fee Lawyer’, 3 American Bar Foundation Research Journal, 559-604. Lees, D.S. (1966), The Economic Consequences of the Professions, London, Institute of Economic Affairs, 48 ff. Leffler, Keith B. (1978), ‘Physician Licensure: Competition and Monopoly in American Medicine’, 21 Journal of Law and Economics, 165-186. Leland, Hayne E. (1979), ‘Quacks, Lemons, and Licensing: A Theory of Minimum Quality Standards’, 87 Journal of Political Economy, 1325-1346. Levmore, Saul (1993), ‘Commissions and Conflicts in Agency Arrangements: Lawyers, Real Estate Brokers, Underwriters, and Other Agents’ Rewards’, 36 Journal of Law and Economics, 503-539. Lord Chancellor’s Department (1998), Access to Justice with Conditional Fees, London, Lord Chancellor’s Department. Love, James H. and Stephen, Frank H. (1996), ‘Advertising, Price and Quality in Self-regulating Professions: A Survey’, 3 International Journal of the Economics of Business, 227-247. Love, James H., Stephen, Frank H., Gillanders, Derek D. and Paterson, Alan A. (1992), ‘Spatial Aspects of Deregulation in the Market for Legal Services’, 26 Regional Studies, 127-147.

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Other References Akerlof, George (1970), ‘The Market for “Lemons”: Quality Uncertainty and the Market Mechanism’, 84 Journal of Political Economy, 488 - 500. Cohen, Kalman J. and Cyert, Richard M. (1965), Theory of the Firm: Resource Allocation in a Market Economy, Englewood Cliffs, Prentice Hall. Layard, P. Richard G. and Walters, Alan A. (1978), Micro-Economic Theory, Maidenhead, McGraw-Hill. Smith Howard and Hay, Donald A. (1997), ‘Competition in Retailing: One Stop Shopping’, 189 Applied Economics Discussion Paper Series, Institute of Economics and Statistics, University of Oxford. Stigler, George J. (1966), The Theory of Price, New York, Macmillan.

5870 THE REGULATION OF MEDICAL PROFESSIONS Reed Neil Olsen Department of Economics, Southwest Missouri State University © Copyright 1999 Reed Neil Olsen

Abstract This chapter reviews two areas of the medical regulation literature; the licensing of medical professionals and medical malpractice. The licensing literature draws upon a more general literature which explains the existence of regulation as reflecting the interests of either (1) the regulated profession, (2) the public, or (3) a combination of both the public and the profession. The major contribution of the licensing literature has been to empirically test these theories, finding mixed support for all three theories; its major weakness is the lack of empirical studies which explicitly test the third theory. The medical malpractice literature also draws upon a more general theory, hypothesizing that malpractice liability deters negligent treatment. The major contribution is empirical and focuses on two areas: (1) describing the recent existence and extent of the widely perceived medical malpractice ‘crisis’, which has led researchers to advocate diverse reforms of the system and (2) describing and estimating the effectiveness of actual malpractice reforms. The major weakness of the literature is the failure to consider, based upon historical antecedents, that no crisis might exist but that increased medical liability is simply an efficient response to changes in medical practice. JEL classifications: K13, I18 Keywords: Medical Licensing, Medical Malpractice, Malpractice Reform, Malpractice Crisis

1. Introduction This review on the regulation of medical professions discusses only two of the major areas where researchers have investigated, theoretically and empirically, the impact of regulation of the medical professions, the licensing of medical professions and medical malpractice law. Although not addressed in this review, a wide and diverse literature on other aspects of the regulation of medical professions certainly exists (for example, the impact of capital constraint, or Certificate of Need, regulation, see Joskow, 1981; for a general overview of the wider literature see Feldstein, 1988 and Phelps, 1992). Although the law and economics literature has made major contributions to 1018

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both of these two topics, there exists very little overlap between the two areas in either theoretical or empirical studies. The literature on professional licensing relies upon a wider literature, explaining the existence of regulation in general, for its theoretical base. From this literature, three explanations for professional licensure emerge: (1) the capture theory, which assumes that professionals ‘capture’ regulation and use it to deter entry and increase their incomes; (2) the public interest theory, which assumes that professional licensure is used in the public interest in order to insure the quality of professional services; and (3) the political economy theory, which assumes that both professional interests and public interests may simultaneously have an impact upon the existence and nature of licensing for health care professionals. The remainder of the professional licensing literature is focussed on attempts to empirically assess the validity of these three theories. Although most empirical researchers conclude that the data support the capture theory a careful reading of their findings actually reveals that such support is inconsistent at best. Thus, although medical licensure is sometimes found to deter entry and enhance the income of medical professionals, at other times it does not have such an impact. The inconsistent support for the capture theory, combined with a few studies which directly test both the public interest theory and the political economy theory, lend support to the political economy theory. The theoretical literature on medical malpractice is also based upon a wider literature dealing with tort law generally rather than medical malpractice specifically. This literature focusses on the impact that malpractice liability has upon the efforts, or precautions, that medical professionals take in order to avoid medical accidents which may result from their treatment of patients. As with tort law in general, the major aim of medical malpractice is, theoretically, to deter medical professionals from shirking on such precaution. In the section on medical malpractice, this general theoretical literature is discussed in more detail, as are the extensions of the literature for medical malpractice, specifically. Although the medical malpractice literature has made some original contributions to the theoretical literature, the main focus of the malpractice literature, similar to the professional licensing literature, has been on empirical studies. One of the main areas where the field of law and economics has contributed has been in studying, empirically, the medical malpractice ‘crisis’ which arose in the US and other developed nations in the past 20 to 30 years. As detailed below, during this time period the liability of medical professionals has increased dramatically and has led to the common conclusion that the malpractice system itself is inefficient and in need of reform. The review below critically assesses the validity of this common conclusion and suggests that some caution must be taken given the nature of the data to be found in the

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literature and, especially, the common lack of a historical perspective concerning malpractice liability. The final area of concern in the literature, also addressed below, is medical malpractice reform. Naturally, given the common assumption that a crisis exists in medical malpractice, much of the literature focusses on the need for reform of the malpractice system. Some of this literature is theoretical in nature, discussing the types of reforms that would be most likely to move the system away from the crisis and towards a more efficient system. Some, perhaps a majority, focus on detailing the actual reforms that have been enacted, mostly by the US and entirely at the state level, and estimating their effectiveness in reducing the malpractice liability of medical professionals.

A. The Licensing of Medical Professions 2. General Remark The literature on the licensing of medical professions fits into a larger literature on regulation in general and the licensing of all professionals in specific. These literatures have a common theoretical background which explains the existence, and persistence, of regulation. A brief summary of this theoretical literature is included below in order to provide a framework for the subsequent discussion of the empirical literature on licensing medical professions. Thus, the major contribution of the literature on medical licensure has not been theoretical but empirical. The extensive literature which investigates the impact of licensure upon markets for medical services is synthesized below. Finally, conclusions about findings gleaned from the empirical literature and directions for future research are given in the final section.

3. Theoretical Background Three general theories have been used to explain the existence of regulations limiting professional licensure of the medical professions: the capture theory, the public interest theory, and a more general, political economy theory. Although these theories are well known in the economics literature, a brief overview of each is included both for background and to clarify the testable hypotheses flowing from each theory. In its simplest form, the capture theory is a straightforward application of self-interest. Medical professionals ‘capture’ the regulations governing licensure and structure them to limit the supply of medical professionals and thereby increase their incomes (Coase, 1974; Friedman, 1962; Moore, 1961;

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Posner, 1974; and Stigler, 1971). As a result, the capture theory predicts that licensure should decrease the supply of medical professionals, increase the prices charged by medical professionals, and increase existing medical professionals’ incomes. Of course, regulatory capture may be attempted by coalitions of professionals within a given profession to the detriment of both the public and non-coalition professionals. For example, regulations may be structured to benefit physicians in certain specialties. In these cases, incomes of only coalition professionals would be expected to rise. In contrast, the public interest theory suggests that professional licensure occurs due to some market ‘failure’ and that its intent is to increase societal welfare. Unlike the capture theory, the public interest theory does not yield clear cut, tractable hypotheses that can be readily tested. For example, predictions from the public interest theory vary dependent upon the type of market failure. Thus, the first step is to accurately identify the relevant market failure being addressed. Researchers have commonly presumed that consumers of professional services, due to the complex nature of the service and uncertainty about the efficacy of competent service, lack complete information about the quality of such services (for example, Arrow, 1963). Hence, the public interest theory asserts that professional licensing corrects this market deficiency by ensuring that medical professionals are of a sufficiently high and standard quality. However, even if such informational asymmetries exist for professional services, the public interest theory still does not yield clean, testable hypotheses. For example, Leland (1979) shows that the impact of quality standards (that is, professional licensing) is dependent upon the cost function for quality. If higher quality applicants can meet the quality standard at lower cost, quality will rise as will market price and professional income. However, if higher quality applicants have a higher cost of meeting the standards, quality, prices and income will all fall. Thus, to be able to predict the impact of professional licensure one must also know its impact on quality. Unfortunately, data on quality are notoriously difficult to obtain. As a result, most researchers interpret the lack of anti-competitive effects as support for the public interest theory (for example, Holen, 1965; Maurizi, 1974; Shepard, 1978; and Noether, 1986). To be clear, anti-competitive effects are those which are predicted by the capture theory - decreased supply of professionals, higher prices, and higher incomes for professionals. In contrast to both capture and public interest theories, the political economy theory entertains the possibility that both the public and medical professionals have an impact on the existence and the form of medical professional licensure regulations (Becker, 1983; Peltzman, 1976, and Stigler, 1971). Thus, the political economy theory is basically a theory of checks and balances. Since all have an impact on the regulatory outcome, medical

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professionals cannot monolithically shape regulations merely to suit their self-interest, their ability to do so is tempered by the competing self-interest of the ‘public’. In fact, Becker (1983) demonstrates that regulators would have a predisposition to enact regulations that are in the public’s (society’s) interest. However, this predisposition is tempered by other factors such as the dispersion or concentration of the affected parties. Thus, the political economy theory predicts that medical professionals will sometimes, but not always, be able to use licensure to limit supply and increase prices and incomes.

4. Empirical Studies Before summarizing the empirical literature one must briefly discuss the nature of medical licensure regulation and how licensure is measured in the empirical studies. There are several common requirements for a medical professional to receive a license to practice. For example, it is common to require that professionals obtain a given education at an approved educational facility. Likewise, many medical professions require candidates for licensure to pass either state or national licensure exams. As can be seen below in the discussion of the empirical literature, the difficulty of the licensure exam as measured by its pass rate (or failure rate) in a given jurisdiction is commonly used to evaluate the impact of the exam requirement on market conditions. Educational and exam requirements are the most common licensure requirements. Some jurisdictions, however, waive educational and exam requirements for certain professionals, most commonly those who have obtained a license to practice in another jurisdiction. Some empirical studies estimate the impact that such rules, known as reciprocity, have on market conditions as well. Licensure requirements, of course, vary by jurisdiction and by profession. Though beyond the scope of this article, a full examination of the history of licensing for medical professionals can provide insight into the issues of primary concern to the literature discussed in this article. For example, licensing for health care professionals, as with many other professions, has most often either been proposed by the regulated professionals themselves or the licensing has had the support of the regulated professionals. In fact, physician licensure only became truly effective and widely applied jurisdictionally with the formation beginning in the late 1800s of effective national and state medical associations who could push for licensure (Shryock, 1967; Starr, 1982; Frech, 1996). Such an impetus for licensing, though most often combined with the regulated professionals publicly arguing that licensing served the public interest by protecting the public against low quality professionals, lends implicit support to the capture theory discussed above.

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For a summary of the history of licensure in the nursing profession see White (1980, 1983, 1987). The empirical literature also discusses current licensing regulations and the history of licensing regulations for other medical professions such as dentists (Shepard, 1978; Boulier, 1980), physicians (Kessel, 1958; Shryock, 1967; Leffler, 1978; Rizzo and Zeckhauser, 1990; Frech, 1974, 1996), optometrists (Benham and Benham, 1975) and physical therapists (Sass and Nichols, 1996). Other studies discuss licensing in general or for a number of different professions (Moore, 1961; Holen, 1965; Starr, 1982; Pashigian, 1979; Frech, 1996). A careful review of the literature yields no consistent picture of the impact that medical licensure has on income, prices, supply, or the quality of medical professionals. Early studies in this area focused on estimating the return to medical education under the assumption that higher than average returns to medical education, as opposed to other types of education, would be an indication of monopoly rents obtained through the capture of licensure. Friedman and Kuznets (1945), for example, compared the incomes of physicians to dentists, and found that physicians had average incomes 32.5 percent greater than dentists. According to their calculations only approximately half of this increased income could be a result of extra training requirements for physicians. As a result, they concluded that barriers to entry must explain the remainder of the differential returns. Early studies by Sloan (1970) and Fein and Weber (1971) also found higher than average returns to medical education and reached similar conclusions. However, Lindsay (1971, 1973) demonstrated that these empirical studies overestimated the returns to medical education. Lindsay noted that medical professionals were characterized not only by higher than average income but also by higher than average weekly hours worked. For example, during the period of the Fein and Weber (1971) study, 1966, physicians worked an average of 62 hours per week. As a result, estimates of the returns to medical education must be decreased to offset the disutility of working longer hours. Lindsay (1973) corrected for the hours worked bias for the time periods covered by all three of the earlier studies and found, as would be expected, much smaller differential returns to medical education. In some cases, he found negative differential returns, dependent upon the discount rate chosen, to medical education. Hence, Lindsay’s results seriously question the conclusions of earlier studies that entry barriers provided by, among other factors, medical licensure had led to higher than average returns. Leffler (1978) also noted that the differential returns to medical education were overestimated not only because of an hours worked bias but also because of the increased expected mortality of physicians, progressive income taxation, and ‘differential probabilities of conscription taxation’ (Leffler, 1978, p. 167). After adjusting for these factors, Leffler found much lower differential returns

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to medical education. Leffler did find positive differential returns, again dependent upon the discount rate, in some years, particularly the late 1960s and early 1970s. However, he attributed these returns to transitory demand shocks rather than entry barriers. Other studies have estimated hours adjusted rates of return to medical education with more recent data (Burstein and Cromwell, 1985; Marder and Willke, 1991) and have found positive differential rates of return. For example, Burstein and Cromwell (1985) found internal rates of return, hours adjusted, equalling about 12 percent for physicians and dentists from 1970 to 1980. Likewise, Marder and Willke (1991) found estimated internal rates of return, hours adjusted, by physician specialty in 1987 and found that such returns varied from a low of 1.5 percent for Pediatrics to a high of 58 percent for Pathology (where hours adjustment increased the rate of return) and 3.7 percent for General Practice. Thus, even though rates of return to medical education are not as high as estimated originally, substantial returns do exist especially for some medical specialties. In addition to studies which focused on estimating the differential return to medical education, other studies have estimated the impact that licensure has on the medical professional’s income directly. For example, early studies on professional licensure by Holen (1965), Benham, Maurizi and Reder (1968) and Maurizi (1974) suggested that licensure (as measured by licensure exam difficulty) was used to increase the incomes of professionals. The support for this conclusion was, however, mixed in these studies. For example, Benham, Maurizi and Reder found licensure to have a positive and significant impact on dentist’s income. Licensure, however, was found to have a negative, and sometimes significant, impact on physicians’ incomes. In addition, the studies used small samples of older aggregate data, rather than recent individual data. Further, neither Holen nor Maurizi attempted to control for the possibility that other demand or supply variables had a significant impact on professional income. Considerable overlap exists in many studies estimating the impact of professional licensure. Both Holen and Maurizi, for example, tested the impact of licensure regulations from multiple professions, including both medical and non-medical professions. Maurizi tested the impact of regulations from 18 different professions including eight medical professions (chiropodists, chiropractors, dentists, registered nurses, optometrists, osteopaths, pharmacists, and physicians). Additional studies of the impact of medical licensure on professional income also yielded mixed results. For example, Shepard (1978) found that lack of reciprocity between jurisdictions significantly limited the number of dentists and, as a result, increased average income for dentists. Shepard, however, used state level aggregate data for a single year (1970) which limits

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the validity of the results. White (1980) found that mandatory licensing for nurses had a small, but positive, impact on nurses’ incomes when first introduced in the 1950s. However in later years, after licensing had had more time to affect incomes, White found that mandatory licensing had no significant impact on nurses’ incomes. Pashigian (1980) found that licensing in a number of occupations, including physicians, dentists, optometrists, pharmacists, nurses and other allied health occupations, restricted the mobility of licensed professionals, all else being equal, but did not significantly raise incomes (for similar work, see Pashigian, 1979). Noether (1986) found that entry restrictions for foreign medical school graduates increased average physician income during the early 1960s. However, Noether’s data indicate that entry restrictions have not been effective since 1965 in increasing physicians’ incomes. She attributes this result to the increased ability of foreign medical school graduates to enter the US market. In a study of physical therapy licensure, Sass and Nichols (1996) found that licensure actually caused a decrease in professional wages and, presumably, in income as well. Licensure in the Sass and Nichols study is somewhat different than is measured in most other empirical studies of medical licensure. Rather than focussing on licensure conditions which limit the entry of professionals, Sass and Nichols focus on states with direct access laws (that is, laws which allow physical therapists to treat patients without referrals from physicians). Although physical therapists have lobbied in favor of direct access laws, Sass and Nichols found that direct access has the impact of lowering therapist wages and, presumably, income as well. Leffler (1978) found that physicians in states which rejected national physician licensure exams in favor of state licensure exams had higher average incomes. Leffler’s state level data comes from the 1960s and early 1970s. At that time, 41 states allowed physician candidates for licensure to take either a standardized national exam or an exam specific to the given state. Nine states, however, did not allow candidates the option of taking the national exam but required passage of the state exam for licensure. Requiring the state exam for licensure reduced the mobility of professionals from other states and, according to the capture theory, would be expected to increase physicians’ incomes. As a result, Leffler concluded that some evidence existed that local state coalitions of physicians used licensure in order to increase incomes. The fact that only nine of the 50 states required candidates to take the state exam indicates, however, that physician capture of licensure occurred only in a few states. Further, Leffler found direct evidence that states who accepted the national exams did so as a result of consumer, rather than physician, demand for licensure. Some evidence does exist indicating that medical licensure has a positive impact on prices charged by medical professionals. Kessel (1958) examined

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pricing of physician services and found evidence that suggested that physicians practiced price discrimination. More importantly, Kessel provided evidence that local medical societies, who controlled licensure, used licensure to force local physicians to keep prices high and comply with price discrimination practices. The major problem with Kessel’s study is his reliance upon ad hoc data. As a result, Kessel could only detail efforts by some local medical societies to force physicians to comply with local pricing rules. In fact, Kessel’s study focused on opposition by local medical societies to prepaid health plans and the physicians who contracted with such plans. He argued that opposition to prepaid plans resulted because they did not generally allow price discrimination by patient income. Kessel’s ad hoc empirical evidence, then, focused on demonstrating that local medical societies often denied licensure, or attempted to deny licensure, to physicians affiliated with such plans. Given the nature of Kessel’s ad hoc data, though, he could not estimate whether or not anti-competitive efforts by local medical societies were actually successful in raising prices or promoting price discrimination. In fact, the ad hoc data which Kessel used demonstrated that in some instances efforts to deny licenses to non-complying physicians failed. Studies by Benham and Benham (1975) and Haas-Wilson (1986) on eyeglasses and Shepard (1978) and Boulier (1980) on dental services provided some evidence that professional licensure increases prices. These studies do have some weaknesses. Only Haas-Wilson and Boulier used individual data. Haas-Wilson’s results were strong only when she considered the cumulative effects of several regulations. Boulier did not measure licensing restrictions directly but, rather, found state variations in individual fees which could not be explained by other variables included as controls in the regressions. The possibility of omitted variables limits the validity of his study. Shepard’s study is the most convincing but suffers because he looked at the impact that licensing has on average prices rather than individual dentist’s prices and because he uses only state aggregate, rather than individual, data. Next, consider the impact that medical licensure has on the quantity of professionals in a given market. As noted above, both Shepard (1978) and Noether (1986) found that licensure reduced the number of professionals in a market, Shepard with dentists and Noether with physicians. Noether found that entry restrictions significantly limited the ability of foreign medical school graduates to enter the US market which, in turn, positively affected physician incomes in the US However, she also found that the effectiveness of such entry restrictions have deteriorated over time to the point where their impact was largely non-existent by the early 1980s. White (1980), in his study of licensing for nurses, found that licensure either had a positive impact on employment of nurses, as it did in early years of licensure, or else had no significant impact on employment, as it did in later years. Svorny (1987), using aggregated state level data from 1965, found that licensure decreased the number of physicians per

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capita. Finally, consider the impact that professional licensure has on the quality of professional services. Studies of quality almost universally suffer from one overwhelming weakness; quality is difficult to measure. Regardless of this practical difficulty, several studies have attempted to estimate the impact that professional licensure has on the quality of professional services. Haas-Wilson (1986) generally found that regulations in optometry had no significant impact on quality as measured by the thoroughness of the eye exam. Carroll and Gaston (1981) found scattered support for their conclusion that licensure resulted in decreased quality for several professions. Their results were strongest for dentistry, although the variable they used to measure the quality of a dentist’s services - how long a patient must wait to receive an appointment rather than by a direct measure of the effectiveness of the dentist’s services - is questionable at best. In contrast, Feldman and Begun (1985) considered the impact of a number of different licensing regulations for optometry and found that regulation increased the quality of services as measured by the length of the eye exam and its thoroughness.

5. Conclusions The review of the empirical literature reveals that medical licensure does, for certain medical professions, in some jurisdictions, or during some periods of time, have the anti-competitive impacts predicted by the capture theory. At times and for certain professions, medical licensure limits the number of professionals in a market with resultant upward pressure upon prices of professional services and professional incomes. It is not surprising, then, that many of the empirical studies on medical licensure have concluded that their empirical results tend to support the capture theory. However, taking a broader overview of the entire empirical literature, one finds that at other times or for other medical professions, anti-competitive effects are not present. The same inconsistent picture holds when examining the impact that medical licensure has upon the quality of medical services. Sometimes, licensure increases quality, as predicted by the public interest theory, but at other times or for other medical professions it does not. The fact that no consistent picture of the impact that professional licensure has on supply, prices, income or quality of medical professionals emerges when reviewing the empirical literature seriously weakens support for both the capture theory and the public interest theory. The inconsistent impact of medical licensure actually lends support to the political economy theory of licensure where both medical professionals and the public are expected to have an impact on licensure. The political economy theory predicts, as noted above,

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that professionals will sometimes, but not always, have the ability to capture licensure to serve their own best interests. At other times, or for other professions, licensure will be used to serve the best interests of the public. Although most empirical studies of medical licensure conclude that their results support the capture theory, a few studies have taken an explicit look at the political economy theory. For example Leffler (1978), in his study of physician licensure, sets up a model to explicitly test the political economy theory. Leffler found evidence supporting consumer demand for physician licensure as well as significant pressure by physicians using licensure in an attempt to raise their incomes. Again, that neither physicians nor consumers are always successful in their attempts to use licensure gives support to the political economy theory of licensure. Likewise, Graddy (1991) found support for public interest and legislative forces, as well as interest group pressure in her study of state occupational regulations. Thus, the most serious failing of the medical licensure literature is the axiomatic approach of many researchers - assuming that the capture theory is correct and, not surprisingly, concluding that their own evidence, even though it is often only weakly supportive, supports the simple capture theory. As can be seen, a wealth of empirical studies have been done which look at the impact of licensure for a number of different medical professions. Only a few studies, though, have been done which seriously consider, or test for, the possibility that licensure has a more complex explanation. The major area where future research, mostly empirical, would be most profitable lies in testing these more complex explanations for medical licensure.

B. Medical Malpractice 6. General Remarks In the past 30 years, medical malpractice has consistently been of interest to a wide variety of groups, including but not limited to the law and economics literature. The intense interest in medical malpractice in the past three decades has been a result of the widespread perception that the malpractice system, previously working smoothly, experienced periodic crises beginning in the 1960s and extending into the 1970s and 1980s (for example, Danzon, 1985a, 1988; Sloan, Bovbjerg and Githens, 1991; Weiler, 1991). The perceived crisis in medical malpractice has generated an extensive literature in a number of diverse areas. The major areas where law and economics has contributed to the literature on medical malpractice are discussed in more detail in the following sections. For example, the law and economics literature has made a large contribution in developing the theoretical justification for the existence of

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medical malpractice law. However, empirical studies have been, perhaps, the most significant contribution of law and economics to the medical malpractice literature. These studies have focussed on two main areas. First, a number of studies detail the nature and extent of the ‘crisis’ in medical malpractice liability and the malpractice insurance market. Second, given the common conclusion that medical malpractice is in crisis, a number of studies focus on medical malpractice reform. Some of these studies are theoretical in nature, arguing for a particular type of reform as that best able to correct perceived deficiencies in the medical malpractice system. Others attempt to measure the impact that US legislative reforms passed at the state level have had upon the medical malpractice system. Most, although not all, of the focus in the literature has been on US medical malpractice law which leaves other malpractice systems as fruitful areas for future research.

7. The Theory of Medical Malpractice The theoretical justification for medical malpractice law fits into a larger law and economics literature discussing the existence and economic efficiency of tort law. In addition to this more general theoretical framework, the literature has also developed some theory specific to medical malpractice. Medical malpractice law, and tort law generally, hold health care providers to a court-determined legal standard of care which, if violated, establishes the negligence of the provider. Negligence will, in turn, establish the liability of the physician, or other health care provider, for any resultant injuries suffered by the patient (see Keeton, et al., 1989, for a complete discussion of the law of torts). Tort law, generally, and medical malpractice law, specifically, serves two primary purposes. First, they compensate injured parties for losses caused by negligent accidents. Second, the threat of liability for negligence induces potential injurers to take precaution against potential harm (Brown, 1973; Landes and Posner, 1980, 1984; Cooter and Ulen, 1986; and Posner, 1986a). The medical malpractice literature tends to focus on the incentives created by medical malpractice law, known as the deterrence effect, rather than upon the compensation of negligent accidents although, certainly, exceptions exist (for example, Shavell, 1978). The larger law and economics literature does address the issue of compensation as it is related to involuntary insurance against adverse outcomes. That is, higher average compensation levels will, all else being equal, induce potential injurers such as physicians to increase the price of their services to all patients. The increased compensation is, in effect, an implicit insurance contract against the risk of potential malpractice injuries. This larger literature generally argues that from the point of view of optimal

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insurance, which is defined to be that level of insurance which a fully informed consumer would choose to buy himself, full compensation levels lead to higher levels of implicit insurance than is optimal (see Epstein, 1980; Priest, 1985, 1987; Schwartz, 1988; and Viscusi, 1991). With respect to deterrence, the theoretical literature attempts to determine whether or not negligence, or other alternative liability rules, will lead to optimal or efficient deterrence. Optimal deterrence occurs when the liability rule gives each party (that is, both health care provider and patient) an incentive to take actions, or precautions, which minimize the total costs of the medical injuries, including the expected accident costs of the injuries themselves, the costs of preventing such injuries and the administration costs associated with the malpractice system (Calabresi, 1970). Brown (1973) and others (for example, Landes and Posner, 1980, 1984; Cooter and Ulen, 1986; and Posner, 1986a) have shown that tort liability rules can be used to force both parties (that is, in medical malpractice both provider and patient can take actions to avoid harm from treatment) to consider the full potential loss and, hence, to take the optimal level of precaution. Unfortunately this result is only valid under very limiting conditions; the courts and both parties must have full and costless information. When information is costly to obtain and, hence, incomplete, tort law does not necessarily result in optimal deterrence (Cooter and Ulen, 1986; Haddock and Curran, 1985; Kolstad, Ulen, and Johnson, 1990; Shavell, 1987; and White 1989). Even though the theoretical literature on medical malpractice draws upon the general theoretical background of tort law, described above, the medical malpractice literature goes beyond this general theoretical framework, although not always by using formal, mathematical models of deterrence. For example, a number of researchers have addressed the issue of which liability rule, out of all possible liability rules, results in optimal deterrence for cases of medical malpractice (for example, Shavell, 1978; Danzon, 1985c). Currently, as noted above, medical malpractice uses some form of the negligence liability rule where the courts establish a legal standard of precaution against which a provider’s actual precaution is measured in order to determine negligence and liability. Alternatives to a negligence liability rule, such as a strict liability rule or a no-fault rule, could be used to determine liability (see Shavell, 1978; Danzon, 1985c; Epstein, 1978, 1988; Weiler, 1991). In contrast to a negligence rule, a strict liability rule does not compare a defendant’s level of precaution to a legal standard. Rather, as long as the accident or injury was caused by the medical treatment, the defendant is found liable for the costs of such accidents. Theoretically, the major advantage of strict liability is that it reduces the costs of the legal system because only causation must be demonstrated rather than, as in the case of negligence rules, both causation and negligence. However, determining causation for medical

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injuries is problematic as adverse medical outcomes routinely happen because of prior medical conditions. In medical malpractice, unlike other torts, causation is often determined to exist when an adverse outcome occurs and the defendant is found negligent. Hence, a finding of negligence is often required to prove causation which obviates the cost advantages of strict liability. Similar problems exist relative to no-fault proposals for medical malpractice because no-fault rules generally require proof of causation as well (Shavell, 1978; Epstein, 1978, 1988; Danzon, 1985c). Thus, medical malpractice gives health care providers an incentive to avoid negligent injuries caused by medical treatment. Under ideal conditions, medical malpractice results in optimal deterrence. However, since conditions are not, realistically, ideal, some thought, as noted above, has been given to alternatives to the negligence standard set up by medical malpractice, such as strict liability and no-fault rules. However, there is another, useful, way to look at medical malpractice. For example, Posner (1986a, 1981) has proposed that the law, especially common law, can be best understood as a method of achieving societal efficiency (that is, maximizing the wealth of society). Under Posner’s efficiency theory of the law, legal rules do not necessarily result in perfectly optimal, or first-best, outcomes. Rather, the law is seen as a system for achieving the best possible, or second-best, outcomes given the constraints faced in the real world (for example, costly and, hence, incomplete information). Given the efficiency theory of the law, it is useful to look at medical malpractice as an efficient, albeit imperfect, system. Somewhat surprisingly few researchers have attempted to examine medical malpractice from this viewpoint, especially in any formal sense. A number of researchers have, though, loosely noted that medical malpractice may either be efficient or not as inefficient as its harshest critics have claimed (for example, Frech, 1978). Even so, a number of these researchers continue by proposing reforms that, they suggest, will improve the malpractice system implying, at the very least, that malpractice has not yet reached its second best optimum (for example, Danzon, 1985). Thus, one of the flaws in the theoretical literature on medical malpractice remains an insistence that medical malpractice law is inefficient. As shown in the next section, the persistence of the view that malpractice is inefficient can be, for the most part, traced to the widespread perception in the literature that the medical malpractice system is in ‘crisis’.

8. The Medical Malpractice Crisis Perhaps more than any other event, significant changes in the medical malpractice insurance market during the past few decades have prompted the view of a malpractice system in crisis. For example, available evidence

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indicates that during most of the 1950s the market for medical malpractice insurance was quite stable with malpractice insurance being so unimportant that insurance agents typically sold medical malpractice policies to physicians along with their home and auto insurance (Sloan Bovbjerg and Githens, 1991). Beginning in the 1960s, however, malpractice insurance premiums rose dramatically, over 500 percent in the 1960s (Sloan, Bovbjerg and Githens, 1991; Posner, 1986) and by the mid 1970s a full blown ‘crisis’ was thought to have developed (Danzon, 1985a,1985b; Sloan, Bovbjerg and Githens, 1991; Robinson, 1986a). Not only did insurance premiums rise dramatically but in some states, most notably New York and California, malpractice insurance was not available at any price as insurance carriers left the states. Increases in malpractice insurance premiums continued into the 1980s. By some estimates, premiums increased as much as 45 percent from 1982 to 1984 (US GAO, 1986). Of more importance, medical malpractice premiums, which in the 1950s represented less than 1 percent of a physician’s total costs (Sloan, Bovbjerg and Githens, 1991), had risen to 9 percent of their total costs by 1984 (US GAO, 1986). The empirical medical malpractice literature gives insight into why malpractice premiums rose at such dramatic rates during this time period. Essentially, as with all insurance premiums, the root cause of increased premiums can be traced to increased average benefits paid by insurers. Three variables affect the average benefits paid by medical malpractice insurers. The frequency of malpractice claims measures how often, usually on a per capita or per physician basis, malpractice claims are being filed. The probability of malpractice claims measures the likelihood, most often measured by the ratio of paid claims to total claims for a period, that the physician will lose a given malpractice case. Malpractice severity simply measures the average size of the awards paid by defendants and their insurance companies for cases they lose. As malpractice frequency, probability, or severity rise the cost of providing insurance coverage increases and companies react by increasing malpractice insurance premiums (Olsen, 1996). A good part of the empirical malpractice literature has focused on estimating these three variables. The literature demonstrates that, not surprisingly, during the same decades that malpractice insurance premiums rose dramatically so did malpractice frequency, probability and severity. For example, although claim frequency remained stable from the 1950s through the early 1960s (AMA, 1969), by 1968 claim frequency had risen 76 percent from its earlier level (Danzon, 1985a). From the mid 1960s to the mid to late 1980s, claim frequency rose on average 7 to 10 percent annually. In general, however, claim frequency showed modest increases in the 1960s, rapid increases in the early 1970s, a leveling off in the mid 1970s, and more modest increases in the late 1970s and early 1980s (Danzon, 1985; Olsen, 1996; US Department of Health and Human Services, 1987).

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The available evidence, although somewhat sparse, indicates that malpractice probability also increased during this same time period. For example, some researchers estimate that plaintiffs won only 24 percent of malpractice cases in the mid 1960s which increased to as much as 53 percent by the mid 1980s (Peterson, 1987). Although Peterson’s estimates of malpractice probability only used data gathered from a few metropolitan areas, other estimates agree that by the mid 1980s malpractice probability had risen to approximately 50 percent (US GAO, 1987; Weiler, 1991). One of the major areas of concern in the literature has been the large increases in the average size of paid malpractice claims (malpractice severity) over the past three decades. From 1960 to 1984, for example, average malpractice awards in some areas rose from 10 to 14 percent annually on average (Peterson, 1987; also see Weiler, 1991 and Danzon, 1985b). Although average awards grew at rates exceeding 10 percent annually, median awards grew at much more modest rates, as low as 4 to 5 percent annually (Peterson, 1987; Weiler, 1991; Danzon, 1985b). Lower growth rates for median, as compared to average, awards indicate that much of the increase in average awards is due to a small number of cases with extremely large awards while most cases had much more modest increases. In addition, briefly compare the changes in malpractice frequency, probability, and severity noted above to changes in other areas of personal injury litigation. For the most part only product liability consistently demonstrated increases in frequency, probability and severity comparable to those discussed above for malpractice. For example, the number of product liability cases rose 16 percent on an average annual basis from 1975 to 1989 (Viscusi, 1991). Though Viscusi’s data is expressed as the number of claims filed, rather than as a frequency, it still gives an indication that product liability claims rose at large rates during the 1970s and 1980s. In support of this view, Peterson’s (1987) data indicates that product liability cases, as a percent of total cases in two locales, Cook County, Illinois and San Francisco, rose from 3 to 5 percent annually from 1960-64 to 1980-84. During the same time period, malpractice cases as a percent of total cases rose from 2 to 5 percent. Other types of personal injury cases, actually fell relative to total cases (for example, work injury and auto injury cases). Danzon’s (1985a) data from the 1970s has comparable findings as well. Similar to the frequency of cases, Peterson (1987) finds that product liability severity is comparable to malpractice severity, rising at fairly large rates (6 -11 percent) annually from the mid 1960s to the mid 1980s while average severity for other types of personal injury cases were much more modest (for example, annual increases of 2-5 percent for work injury claims; 4 to 5 percent for auto injury claims). Peterson (1987) finds similar trends for probability for these other types of injury claims.

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The above empirical evidence is gathered from US data. The literature does, however, give evidence that similar trends for medical malpractice frequency, probability and severity exist in other developed countries. For example, Dewees, Trebilcock and Coyte (1991), compared the US to Canada and found a number of similarities. Just as with the US, Canada experienced relatively stable malpractice frequency and severity during the 1950s. Thereafter, malpractice frequency and severity rose at much higher rates. From 1971 to 1990 average annual growth rates in Canadian frequency and severity were 6.1 percent and 9.6 percent respectively. Although Canadian growth rates are similar to US growth rates, US malpractice frequency during these years was consistently 8-10 times as large as Canadian malpractice frequency (Dewees, Trebilcock and Coyte, 1991). However, the average size of malpractice awards were fairly similar during this time period in the two countries, with a few years where malpractice severity was actually higher in Canada than in the US (Dewees, Trebilcock and Coyte, 1991). Likewise, a similar trend was found in the United Kingdom where both severity and frequency rose at about 17 percent on average annually from the mid 1970s to the mid to late 1980s. Unfortunately, the United Kingdom data presented by Dewees, Trebilcock and Coyte only allow comparison to their US and Canadian data for growth rates, but not for levels, of malpractice frequency and severity. Danzon (1990b) had similar findings in her comparison of the US to Canada, Australia, and the United Kingdom. In fact, Danzon found that growth rates in malpractice severity were substantially higher, on an average annual basis, in the UK and Canada than in the US However, she found similar growth rates in malpractice frequency (averaging about 10 percent annually) in all three countries. However, US levels of malpractice frequency were 5 to 6 times that of Canadian malpractice frequency even though, similar to Dewees, Trebilcock and Coyte (1991), levels of average severity in the two countries were quite similar. She also found that UK levels of malpractice frequency were one fifth to two thirds of the US levels, dependent upon the region of the country. Thus, the widespread belief in the existence of a medical malpractice crisis hinges upon two crucial empirical observations. First, it hinges upon the view that prior to the 1960s, the medical malpractice system was working smoothly with few cases and, more importantly, no significant growth in the frequency, severity, or probability of medical malpractice (for example, Danzon, 1985a, p. 2). Second, the belief in the malpractice crisis also relies upon the wellestablished facts, as detailed above, that all of these measures increased dramatically after the mid 1960s and that such growth continued in the 1970s and 1980s. Although the latter view is well established empirically, the former is not. Olsen (1996) uses available historical data to demonstrate that medical malpractice cases were not rare events prior to the 1950s as has been assumed

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by most studies of medical malpractice. More importantly, Olsen (1996) demonstrates that growth rates in malpractice frequency and severity over most of the US history from 1820 on were comparable to more recent growth rates (see also DeVille, 1990; Sandor, 1957; Sadusk, 1956). Hence, these data suggest that if a medical malpractice crisis does exist, it has been an ongoing crisis for more than 150 years. Of course, the possibility exists that there is no malpractice crisis, but that the malpractice system is simply responding to changing variables in an efficient manner. Frech (1978) identified this as a possibility in his early commentary on medical malpractice. Few researchers, as noted in the previous section, take into account the possibility that the malpractice system is working efficiently. The failure to even consider, let alone investigate, this possibility is the most glaring deficiency in the medical malpractice literature. In recent work, Olsen (1997a, 1997b) has begun to address this deficiency, both by considering the possibility that the malpractice system is efficient and by empirical testing of that hypothesis. Similar to Grady (1988), Olsen posits that increased technology and, especially, the increased physician productivity (that is, an increased ability of physicians to avoid medical injuries) that has historically been linked with increased technology, explains much of the historical increases of medical malpractice liability. In fact, Olsen (1997a) finds that such increased physician productivity has historically been correlated with increased liability, as would be efficient according to standard tort models (according to the deterrence hypothesis discussed above, it is efficient to give more productive physicians, those who can have a larger impact on medical injuries, per unit of input, a correspondingly larger incentive to avoid shirking on the use of those inputs). Likewise, Olsen (1997b) formally tests this hypothesis, relying on data from the 1980s, and finds further support for the hypothesis that malpractice law is efficient, imposing higher malpractice liability for physicians who are more productive at avoiding medical injuries (for example; more experienced physicians, board certified physicians, and so on). Another possibility worthy of mention, though rarely considered in the literature, which might explain the medical malpractice ‘crisis’ is that the low levels of physician liability existing prior to the 1960s might actually have been too low, resulting from physician capture of licensure and the consequent use of licensure to deny expert witness testimony in malpractice cases. A number of researchers detail the emergence of this phenomenon (Kessel, 1958; Starr, 1982; DeVille, 1990), which made it much more difficult for plaintiffs to prove malpractice against physicians. However, beginning in the 1960s it became much easier to obtain expert witness testimony against plaintiff physicians, partially due to the erosion of the locality rule (which limited expert witnesses to the those practicing in the plaintiff physician’s locale, where local medical societies had more control over physicians) and partially due to erosions in the ability of local medical societies to discipline such ‘unethical’ practices as the

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offering of expert witnesses (see Danzon, 1985; Weiler, 1991 and Olsen, 1997a).

9. Medical Malpractice Reform Regardless of whether a malpractice crisis actually existed or not, the widespread perception of a crisis led to public policy pressure (which continues to the present) to reform medical malpractice law in the US (Sloan, Bovbjerg and Githens, 1991; US Congress Senate, 1969). Although a near consensus existed regarding the need for reform, no consensus existed on the appropriate nature of medical malpractice reform. For example, some in the law and economics literature have proposed a move toward a contractual basis for medical malpractice liability (Epstein, 1976, 1978, 1986; Robinson, 1986b; and Havighurst 1983, 1986). Others have suggested that medical malpractice should adopt a no-fault liability system similar to worker’s compensation or no-fault automobile insurance (Weiler, 1991; Abramson, 1990; Johnson, et al., 1989; AMA, 1987; Danzon, 1985). Siliciano (1991) has argued that malpractice law should be reformed so as to hold providers of care to the poor to a lower standard of negligence. Dewees, Trebilcock and Coyte (1991) presents evidence that suggests that increased medical malpractice frequency, severity, and probability in Canada are only partially explained by changes in the Canadian legal environment. As a result, they suggest that US type tort reforms are unlikely to have much of an impact on malpractice in Canada and recommend that a wider view of malpractice be taken where reduction in malpractice liability could be attained through amelioration of other factors which they claim have contributed more to the ‘crisis’ (for example, a general increase in the willingness to litigate, the impact that increased medical technology has on patients’ unrealistic perceptions of favorable outcomes, and so on). Grady (1988) argues that the medical malpractice crisis has been caused, not by changes in the legal environment per se, but by increased technology. Grady distinguishes between two types of precaution, durable and nondurable precaution. Durable precaution is defined as precaution which has a long life and, therefore, need not be used repetitively (for example, Grady’s example is that of a dialysis machine). Nondurable precaution, often used as complements with durable precaution, do not have a long life and must, therefore, be used repetitively (for example, the medical technician must check that the dialysis machine is properly connected and running correctly). Grady makes two points relative to durable and nondurable precaution. First, increased technology tends to increase the harm associated with failures to take nondurable precautions (not paying attention has more potential harm when driving a semi-truck than when driving a wagon). Second, courts hold

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defendants strictly liable for failures to use nondurable precaution even though this is not optimal due to the positive costs associated with remembering to use the nondurable precaution. These two aspects together, Grady claims, explain much of the medical malpractice crisis. Hence, in order to reform the malpractice system, one must change legal rules dealing with nondurable precaution where the standard of care is non-optimal rather than focussing on legal rules (such as the doctrine of informed consent and revision of the locality rule) which many commentators see as responsible for the malpractice crisis. Olsen (1997b) investigates the impact of various physician characteristics upon physician liability, measuring physician liability by the likelihood of the physician losing a malpractice suit (an estimate of malpractice probability) and the size of the judgement awarded for paid malpractice claims (an estimate of malpractice severity). Olsen finds that physician characteristics, such as board certification, which tend to increase the productivity of a physician’s time, also tend to increase physician liability, all else equal. To the extent that the increased physician productivity associated with such variables is associated with increased technology, Olsen’s findings tend to support Grady’s contention that technological innovations lie at the heart of the historical increases in physician malpractice liability (see Olsen, 1997a for further evidence supporting Grady’s claim). However, as noted above and in contrast to Grady, Olsen’s findings are supportive of the hypothesis that medical malpractice law is efficient. Obviously, if medical malpractice law is already working relatively efficiently, no need exists for medical malpractice reform. Regardless of the widespread prescriptions for malpractice reform, actual public policy towards malpractice reform either passed by US state legislatures or found in US state and federal courts’ common law precedents have, in general, either explicitly rejected or have not even considered the proposed reforms discussed above. For example, courts have actually limited the ability of the parties to freely contract out of current medical malpractice liability rules (see Tunkl v. Regents of the University of California, 383 P.2d 441, Cal. 1963). Only two states, Florida and Virginia, have replaced medical malpractice liability with a no-fault liability system and then only for infants who suffer neurological trauma during birth (Weiler, 1991; Epstein, 1988; Tedcastle and Dewar, 1988). Rather than wholesale changes in the medical malpractice system, US courts and legislatures have, instead, focussed on reforms whose apparent intent is to diminish the perceived crisis by reducing malpractice frequency, severity, and probability. A few of the more popular US reforms, for example, include limiting plaintiff attorney fees, shortening the statute of limitations for malpractice claims, offsetting malpractice awards when plaintiffs have insurance which pays for injuries (collateral source rule), payment limits on malpractice awards, periodic payment of awards, arbitration, sometimes mandatory, of claims, and pre-trial screening of malpractice claims to establish

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merit (Olsen, 1996; Weiler, 1991; AMA, 1989; Bovbjerg, 1989; Danzon, 1985b). Malpractice reform of this nature has been extensive in the US, although carried out solely, to date, at the state level. For example, by 1989 states had, on average, passed 5 of the 10 most common reforms (Olsen, 1996). Much of the empirical research in the literature attempts to measure the impact of such reforms on medical malpractice frequency, severity and probability. At the same time, such research also measures the impact that other legal, social, or demographic variables have upon medical malpractice. Some of the earliest work assessing the impact of US malpractice reforms was done by Danzon (1984, 1985, 1986). Using US state level data from the 1970s she found that only a few of the malpractice reforms, dollar limitations on awards and the mandatory offset of collateral benefits (for example., from health insurance) had a significant negative impact on medical malpractice severity (Danzon, 1984). None of the other malpractice reforms that she tested had a significant impact on either frequency or severity. Further, she found no significant impact from any of the reforms upon frequency. Danzon did, however, find other variables that had a significant impact upon the frequency and severity of medical malpractice claims. For example, she found that urbanization was the most powerful explanatory variable. Further, pro-plaintiff laws passed prior to the 1970s were found to have a significant positive impact on both frequency and severity. In contrast to Danzon, Sloan (1985) estimated the impact that various factors, including malpractice reforms, had upon malpractice insurance premiums (see also Viscusi and Born, 1995). Malpractice insurance premiums reflect, albeit imperfectly, increased malpractice frequency and severity through increased average benefits paid by insurers. Similar to Danzon, Sloan found that malpractice reforms generally had little impact upon malpractice insurance premiums. He found that only pre-trial screening panels had a significant and negative impact on premiums while reforms requiring binding arbitration had a significant positive impact on premiums. In contrast to Danzon, who found that increased lawyer density had no significant impact on either frequency or severity, Sloan found that lawyer density had a significant positive impact on malpractice premiums. Danzon (1986) attributes this discrepancy between the two studies to Sloan’s failure to include urbanization as a control variable in his study. As Danzon (1984, 1986) notes, urbanization is likely to capture a number of relevant factors besides lawyer density which may also have a positive impact on malpractice frequency and severity and, eventually, upon malpractice insurance premiums as well. Danzon (1986) updated her earlier study, which had only used data from the 1970s, incorporating data from 1975 to 1984. As she notes, one of the weaknesses of both Danzon (1984) and Sloan (1985) is that the data used in these two studies come only from the 1970s, Danzon’s from 1975 through 1978 and Sloan’s from 1974 to 1978. However, the majority of the malpractice

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reforms were either passed or became effective after 1975. Hence, much of the data from these studies came from periods before the reforms were effective. Of more importance, as Danzon (1986) notes, it is plausible that the impact of the reforms would only occur with some lag after implementation, especially when estimating the impact of such reforms upon malpractice insurance premiums. Danzon’s (1986) update of her earlier work, using an expanded data set to capture any lagged effect of the malpractice reforms, found both similarities and differences as compared to her previous empirical estimates. For example, similar to her earlier study, urbanization was positively related to both malpractice frequency and severity. However, urbanization was negatively related to the percentage of paid claims which Danzon interprets to mean that urban areas have a higher than average number of non-meritorious malpractice claims. Consistent with her earlier study, lawyer density was found to have no impact upon either malpractice frequency or severity. In contrast to the earlier study, Danzon (1986) found several malpractice reforms which tended to reduce malpractice frequency including decreases in the number of years before reaching the statute of limitations (that is, a reduction in the number of years during which claims can be filed) and mandatory collateral source rules. In contrast, laws permitting voluntary binding arbitration had the impact of increasing claim frequency. Similar to her earlier study, dollar limitations on malpractice awards and the mandatory offset of collateral benefits were found to reduce malpractice severity by approximately 23 percent for the former and 11-18 percent for the latter. The allowance of voluntary binding arbitration was also found to reduce average severity by about 20 percent. However, as noted above, since arbitration increased the frequency of malpractice cases, these two effects tend to offset each other. Besides their impact upon malpractice frequency and severity, malpractice reforms have also been found to affect the decisions that plaintiffs and/or defendants face, once a claim has been filed. A malpractice claim can, ultimately, be dropped by the plaintiff, settled (which is a decision made by both parties), or continue to trial. In fact, in some states the decision becomes more complex since voluntary binding arbitration is offered as a fourth possibility. To the extent that malpractice reforms affect these decisions, the reforms will have an indirect impact on malpractice although not upon malpractice frequency (because the decision to file a claim occurs prior to the time when these decisions are made). The earliest studies in this area, malpractice claim disposition, were also done by Danzon (Danzon, 1980; Danzon and Lillard, 1983). The major difference between these two studies is that the later study uses a more recent data set and a statistical technique which attempts to correct for potential selection bias. This later study (Danzon and Lillard, 1983) found that some malpractice reforms had a significant impact on the decisions to drop, settle,

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or go to trial and, also, upon the dollar amount of verdicts for those cases going to trial. For example, they found that limitations on attorney’s fees caused plaintiffs to drop 5 percent more cases and decrease the proportion of cases litigated all the way to a verdict by 1.5 percent. Likewise, for settled cases, attorney fee limitations reduced the settlement size by 9 percent. For cases going to verdict, a mandatory collateral source offset rule reduced dollar awards by 15 percent. The impact of a number of reforms intended to reduce awards, such as dollar limits on the award and periodic payment of the award, were considered together and found to lead to a 30 percent reduction in average awards at verdict. Hughes (1989), using data from the late 1970s, also corrected for potential selection bias and corrected the potential bias introduced by the inaccurate measurement of malpractice reforms used by earlier claim disposition studies. Such studies had measured malpractice reforms by whether a given state had adopted a reform and not whether the adopted reform applied to a given claim. Hughes correctly noted that only claims filed after adoption of a given reform were affected by the reform even though the earlier studies had assumed that all claims closed after the adoption of a given reform, regardless of the date of filing, were affected by the reform. Correcting for these problems, he found that most of the malpractice reforms had no significant impact on the probability of settling a malpractice claim. Only limitations on lawyer fees and a collateral source offset rule significantly increased the probability of settling the claim. Hughes found that malpractice reforms had a much stronger impact on the decision to drop a malpractice claim. In fact, five of the eight reforms he considered, including limitations on awards and periodic payment of awards, increased the probability that the plaintiff would drop the case. Although Hughes did not measure the impact that reforms had on average awards, an increase in the tendency to drop cases would be expected to reduce average awards, all else equal. Using more recent data from the 1980s in addition to data from the 1970s, Sloan, Mergenhagen and Githens (1989) also estimated the effectiveness of the malpractice reforms in reducing malpractice liability. Similar to Hughes (1989), they used claims level data and could not, as a result, estimate the impact of malpractice reforms on claim frequency. They did, however, estimate the impact of malpractice reforms on both malpractice probability (that is, the probability that a claim would be paid) and severity (that is, the size of the award for paid claims). Similar to other researchers, they also found that malpractice reforms had an inconsistent impact. For example, limitations on awards were found to significantly reduce severity, as found by earlier researchers. Likewise, mandatory collateral source offset rules tended to reduce severity as well. Few of the rest of the reforms considered had a significant impact on severity. The only malpractice reform found to have a statistically significant impact on probability was the statute of limitations, where an increase in the number of years a plaintiff was allowed to file a claim increased the probability of payment.

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Zuckerman, Koller and Bovbjerg (1990) estimated the impact that tort reforms had upon medical malpractice insurance premiums, frequency and severity. Again, they found that malpractice reforms had an inconsistent impact on malpractice insurance premiums. The only reforms which significantly lowered premiums were those which limited the size of awards or those which limited the statute of limitations (Viscusi and Born, 1995, had similar findings with respect to malpractice premiums). None of the malpractice reforms were found to decrease frequency. Similar to other studies, Zuckerman, Koller and Bovbjerg also found that limitations on awards, collateral source offset rules and limitations on attorney fees tended to reduce malpractice severity. Synthesizing the empirical work estimating the impact of malpractice reforms, it becomes clear that not all reforms have a consistent impact on provider liability or insurance premiums. Reforms such as limitations on awards, collateral source rules, and shortened statute of limitations have had the most consistent impact on such liability. Most other reforms have only occasionally been found to have an impact on the medical malpractice liability of health care providers. There are several public policy implications that may be gleaned from this empirical evidence. For example, if one takes the view that a crisis exists and needs amelioration, the empirical evidence highlights the types of reforms that would have the most probability of decreasing malpractice liability. Of course, as Hughes and Snyder (1989) illustrate, some care must be taken when making such public policy decisions. Care must be taken because the impact of the reforms is, theoretically, quite complex. For example, a reform may have the impact of decreasing severity, but changes in severity theoretically also have two competing impacts upon the frequency of claims. First, decreases in average awards give potential plaintiffs less incentive to file claims. However, decreases in average awards increases the incentive of potential defendants to be negligent which, in turn, increases the number of potential claims. As a result, predicting the impact of a given reform upon malpractice liability, ex ante, is problematic. Finally, given that neither malpractice cases nor large growth rates in malpractice liability are recent phenomena, as many in the literature assume to be the case, public policymakers must carefully consider whether the medical malpractice crisis is real or illusory. Most reforms, as outlined above, have little consistent impact on malpractice liability. One possible explanation for this is that the reforms, although intended to reduce liability, have not been well enough constructed to actually have that impact. Another possible explanation, though, is that the common law efficiently takes into account malpractice reform in the long run. That is, the law is flexible enough to overcome inefficient efforts to reduce malpractice liability. This area is, as noted above, one where much additional research must be done before being able to come to any firm conclusions. However, it is an area which must be investigated in

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order to ‘round out the circle’ of the medical malpractice literature (Calabresi, 1978).

10. Conclusions Theoretically, health care providers are found liable for negligence under medical malpractice law in order to optimally deter them from negligent treatment. Although the literature, as noted above, consistently assumes that medical malpractice fails to meet the goal of optimal deterrence because of imperfections in the legal system, it also consistently notes that such deterrence is a valid and necessary public policy goal. More than any other event, increased health care provider liability over the past three decades has resulted in the common perception that the medical malpractice system is both imperfect and in need of reform. Some care, however, must be taken in this conclusion as recent evidence indicates that, contrary to the common perception, substantial growth rates in health care provider liability for malpractice is not new phenomena nor limited to the US Much, if not most, of the literature on medical malpractice has focussed on either the need for, and the most efficient type of, malpractice reform or the impact that existing reforms have had on medical malpractice. Little of the literature has, however, seriously considered the possibility that malpractice reform is neither necessary nor optimal. Given the questionable basis for the common conclusion that malpractice reform is necessary, that a smoothly working malpractice system has suddenly gone into crisis, the possible efficiency of medical malpractice, at least on a second-best level, must be seriously evaluated by researchers. Common medical malpractice reforms in the US have had an inconsistent affect on medical malpractice liability. Some reforms, such as limitations on awards, collateral sources rules, and shortening the statute of limitations, have been found to have a fairly consistent impact on malpractice liability. Other reforms have been found, though, to either have no significant impact or an inconsistent impact on malpractice liability. As noted in the previous section, the inconsistent impact of reforms intended to reduce malpractice liability may mean, as some researchers have suggested, that more care should be paid to the nature of malpractice reform. However, it may also be the case that the reforms are ineffective because the law (for example, judges and juries) is flexible enough to obviate the reforms and still impose increased liability on health care providers. Again, this may be an efficient response to changes in medical relationships, leading one to again conclude that future research is needed which considers the possibility that current increased levels of liability are simply an efficient response to changing circumstances. Thus, a need exists for a better theoretical understanding of what changes would cause an efficient

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increase in malpractice liability for health care providers. One possible change which might efficiently lead to increased provider liability is the increased technological ability of medicine to provide efficacious treatment that has, especially, occurred in the last three decades simultaneous with the recent increase in malpractice liability (see Graddy, 1991 and Olsen, 1997a, 1997b for discussions on the impact of increased technology on medical malpractice).

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Frech, H. Edward III (ed.) (1991c), Health Economics Worldwide, Dordrecht, Kluwer Academic Publishers. Frech, H. Edward III (1992), ‘Review of Serious and Unstable Condition: Financing America’s Health Care, by Henry J. Aaron’, 30 Journal of Economic Literature, 2165-2166. Frech, H. Edward III (1993), ‘What Can Reform Achieve in Health Care Cost-Containment: Commentary’, in Helms, Robert B. (ed.), American Health Policy: Critical Issues for Reform, Wadhington, American Enterprise Institute, 298-302. Frech, H. Edward III (1993b), ‘Health Insurance: Designing Products to Reduce Costs’, in Duetsch, Larry L. and Cliffs, Englewood (eds), Indusrty Studies, New York, Prentice Hall, 307-323. Frech, H, Edward III (1993c), ‘Economie de la Santé’, 103(2) Revue d’Economie Politique, 609-611. Frech, H.E. III (1996), Competition and Monopoly in Medical Care, Washington, DC, The AEI Press, 191 p. Frech, H. Edward III and Ginsburg, Paul G. (1975), ‘Imposed Health Insurance in Monopolistic Markets, A Theoretical Analysis’, 13(1) Economic Inquiry, 55-70. Frech, H. Edward III and Ginsburg, Paul G. (1978a), Public Insurance in Private Medical Markets: Some Problems of National Health Insurance, Washington, American Enterprise Institute for Public Policy Research. Frech, H. Edward III and Ginsburg, Paul G. (1978b), ‘Competition Among Health Insurers’, in Greenberg, Warren (ed.), Competition in the Health Care Sector: Past, Presence and Future, Washington, Federal Trade Commission, 210-237. Reprinted by Aspen Systems, Germantown, MD. Frech, H. Edward III and Ginsburg, Paul G. (1980), ‘The Cost of Nursing Home Care in the United States: Government Financing, Ownership and Efficiency’, in Van Der Gaag, Jaques and Perlman, Mark (eds), Health, Economics and Health Economics: Proceedings of the World Congress on Health Economics, Amsterdam, North-Holland, 67-91. Frech, H. Edward III and Ginsburg, Paul G. (1981), ‘Property Rights and Competition in Health Insurance: Multiple Objectives for Nonprofit Firms’,3 Research in Law and Economics, 155-172. Frech, H. Edward III and Ginsburg, Paul G. (1988), ‘Competition Among Health Insurers, Revisited’, 13(2) Journal of Health Politics, Policy and Law, 279-291. Reprinted Greenberg, Warren, Competition in the Health Care Sector: Ten Years Later, Durham, NC, Duke University Press, pp. 57-70. Frech, H. Edward III and Mobley, Lee Rivers (1994), ‘Firm Growth and Failure in Increasingly Competitive Markets: Theory and Application to Hospital Markets’, 1(1) Journal of the Economics of Business, 77-94. Frech, H. Edward III and Mobley, Lee Rivers (1995), ‘Resolving the Impasse on Hospital Scale Economies: A New Approach’, 27 Applied Economics, 286-296. Frech, H. Edward III and Woolley, Michael J. (1989), ‘How Hospitals Compete: A Review of Literature’, 2 Journal of Law and Public Policy, 57-80. Frech, H. Edward III and Woolley, Michael J. (1992), ‘Consumer Information, Price and Nonprice Competition Among Hospitals’, in Frech, H.E., III and Zweifel, Peter (eds), Health Economics Worldwide: Proceeding of the Second World Congres on Health Economics, Dordrecht, Kluwer, 217-244.

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Frech, H. Edward III and Zweifel, Peter (1991), ‘Preface’, in Frech, H.E. III and Zweifel, Peter (eds), Health Economics Worldwide: Proceeding of the Second World Congres on Health Economics, Dordrecht, Kluwer, 7-8. Frech, H. Edward III, Borjas, George J. and Ginsburg, Paul B. (1983), ‘Property Rights and Wages: The Case of Nursing Homes’, 18(2) Journal of Human Resources, 231-246. Friedman, Milton (1962), ‘Occupational Licensure’ in Capitalism and Freedom, Chicago, University of Chicago Press. Friedman, Milton and Kuznets, S. (1945), Income from Independent Professional Practice, New York, National Bureau of Economic Research. Goldberg, Victor P. (1975), ‘Some Emerging Problems of Prepaid Health Plans in the Medi-Cal System’, 1 Policy Analysis, 55-68. Goldberg, Victor P. and Auger, Richard (1974), ‘Prepaid Health Plans and Moral Hazard’, 22 Public Policy, 353-397. Goldsmith, Art (1989), ‘Dental Hygienists’ Wages: The Role of Human Capital and Institutional Factors’, 29(2) Quarterly Review of Economics and Business, 56-67. Graddy, Elizabeth (1991), ‘Toward a General Theory of Occupational Regulation’, 72 Social Science Quarterly, 676-695. Grady, Mark F. (1988), ‘Why Are People Negligent?: Technology, Nondurable Precautions, and the Medical Malpractice Explosion’, 82 Northwestern University Law Review, 293 ff. Gravelle, Hugh S.E. (1990), ‘Medical Negligence: Evaluating Alternative Regimes’, 15 Geneva Papers on Risk and Insurance, 22-26. Haas-Wilson, Deborah (1986), ‘The Effect of Commercial Practice Restrictions: The Case of Optometry’, 29 Journal of Law and Economics, 165-186. Hall, Thomas D. and Lindsay, Cotton M. (1980), ‘Medical Schools: Producers of What? Sellers to Whom?’, 23 Journal of Law and Economics, 55-80. Havighurst, Clark C. (1983), ‘Decentralizing Decision Making: Private Contract versus Professional Norms’, in Meyer J. (ed.), Market Reforms in Health Care. Havighurst, Clark C. (1986), ‘Private Reform of Tort-Law Dogma: Market Opportunities and Legal Obstacles’, 49 Law and Contemporary Problems, 143 ff. Holen, Arlene S. (1965), ‘Effects of Professional Licensing Arrangements on Interstate Labor Mobility and Resource Allocation’, 73 Journal of Political Economy, 492-498. Hughes, James W. (1989), ‘The Effect of Medical Malpractice Reform Laws on Claim Disposition’, 9 International Review of Law and Economics, 57-78. Hughes, James W. and Savoca, Elizabeth (1997), ‘Measuring the Effect of Legal Reforms on the Longevity of Medical Malpractice Claims’, 17 International Review of Law and Economics, 261-273. Hughes, James W. and Snyder, Edward A. (1989a), ‘Evaluating Medical Malpractice Reforms’, 7(2) Contemporary Policy Issues, 83-498. Hughes, James W. and Snyder, Edward A. (1989b), ‘Policy Analysis of Medical Malpractice Reforms: What Can We Learn from Claims Data?’, 7 Journal of Business and Economic Statistics, 423-431. Hunsaker, Ann T. (1985), ‘The Federal Government’s Perspective on Litigation and Health Care Costs’, in Baily, Mary Ann and Cikins, Warren I. (eds), The Effects of Litigation on Health Care Costs, Washington, Brookings Institution, 11-21. Johnson, K., Phillips, C., Orentlicher, D. and Hatlie, M. (1989), ‘A Fault-Based Administrative Alternative for Resolving Medical Malpractice Claims’, 42 Vanderbilt Law Review, 1365 ff.

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Joskow, Paul L. (1981), Controlling Hospital Costs: The Role of Government Regulation, Cambridge, MIT Press, 211 p. Kendall, M.C. (1978), ‘Expectations, Imperfect Markets, and Medical Malpractice Insurance’, in Rottenberg, S. (ed.), The Economics of Medical Malpractice, Washington, American Enterprise Institute for Public Policy Research. Kessel, Reuben A. (1958), ‘Price Discrimination in Medicine’, 1 Journal of Law and Economics, 20-53. Kessel, Reuben A. (1970), ‘The A.M.A. and the Supply of Physicians’, 35 Law and Contemporary Problems, 267-283. Kessel, Reuben A. (1972), ‘Higher Education and the Nation’s Health: A Review of the Carnegie Commission Report on Medical Education’, 15 Journal of Law and Economics, 115-127. Leffler, Keith B. (1978), ‘Physician Licensure: Competition and Monopoly in American Medicine’, 21 Journal of Law and Economics, 165-186. Lindsay, Cotton M. (1971), ‘Measuring Human Capital Returns’, 79 Journal of Political Economy, 1195-1215. Lindsay, Cotton M. (1973), ‘Real Returns to Medical Education’, 8 Journal of Human Resources, 331-348. Lynk, William J. (1988), ‘Physician Price Fixing under the Sherman Act: An Indirect Test of the Maricopa Issues’, 7 Journal of Health Economics, 95-109. Marder, William D. and Willke, Richard J. (1991), ‘Comparisons of the Value of Physician Time by Specialty’, in Frech, H.E. (ed.), Regulating Doctors’ Fees: Competition, Benefits, and Controls under Medicare, Washington, DC, American Enterprise Institute. Maurizi, Alex R. (1974), ‘Occupational Licensing and the Public Interest’, 82 Journal of Political Economy, 399-413. McCoid, Allan H. (1959), ‘The Care Required of Medical Practitioners’, 12 Vanderbilt Law Review, 549-632. Mennemeyer, S.T. (1978), ‘Really Great Returns to Medical Education?’, 13 Journal of Human Resources, 75-90. Metzloff, Thomas B. (1988), ‘Researching Litigation: The Medical Malpractice Example’, 51(4) Law and Contemporary Problems, 199-241. Moore, Thomas G. (1961), ‘A Theory of Professional Licensing’, 4 Journal of Law and Economics, 93-117. Newhouse, Joseph P., Williams, Albert P., Bennett, Bruce W. and Schwartz, William B. (1982), ‘Does the Geographical Distribution of Physicians Reflect Market Failure?’, 13 Bell Journal of Economics, 493-505. Noether, Monica (1986), ‘The Effect of Government Policy Changes on the Supply of Physicians: Expansion of a Competitive Fringe’, 29 Journal of Law and Economics, 231-262. Olsen, Reed Neil (1996), ‘The Reform of Medical Malpractice Law: Historical Perspectives’, 55 The American Journal of Economics and Sociology, 257-275. Olsen, Reed Neil (1997a), ‘The Efficiency of Medical Malpractice Law: A New Appraisal’, 19 Research in Law and Economics. Olsen, Reed Neil (1997b), The Efficiency of Medical Malpractice: Theory and Empirical Evidence, Working Paper, Department of Economics, Southwest Missouri State University. Pashigian, B. Peter (1979), ‘Occupational Licensing and the Interstate Mobility of Professionals’, 22 Journal of Law and Economics, 1-25.

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Pashigian, B. Peter (1980), ‘Has Occupational Licensing Reduced Geographical Mobility and Raised Earnings?’, in Rottenberg, Simon (ed.), Occupational Licensure and Regulation, Washington, DC, American Enterprise Institute. Peterson, Michael (1987), Civil Juries in the 1980s: Trends in Jury Trials and Verdicts in California and Cook County, Illinois, The RAND Corporation, Report R-3466-ICJ. Phelps, Charles E. (1992), Health Economics, New York, HarperCollins Publishers, 559 p. Porter, John E. (1985), ‘The Effects of Litigation on Health Care Costs: A Congressional Perspective’, in Baily, Mary Ann and Cikins, Warren I. (eds), The Effects of Litigation on Health Care Costs, Washington, Brookings Institution, 36-42. Posner, James R. (1986a), ‘Trends in Medical Malpractice Insurance, 1970-1985', 49(2) Law and Contemporary Problems, 37-156. Psacharopoulos, G. (1975), Earnings and Education in OECD Countries, Paris, OECD. Quam, Lois (1990), ‘Comment: Medical Malpractice in Canada, 1971-1987', 15 Geneva Papers on Risk and Insurance, 81-83. Reder, M.W. (1976a), ‘Medical Malpractice: An Economist’s Viewpoint’, 2 American Bar Foundation Research Journal, 511-563. Reder, Melvin W. (1976b), ‘An Economic Analysis of Medical Malpractice’, 5 Journal of Legal Studies, 267-292. Resta, Giorgio (1996), ‘Scarsit… delle Risorse e Funzione Allocativa del Diritto: il Caso dei Trapianti d’Organo (Scarsity of Resources and Allocative Function of the Law: the Case of Organ Transplants)’, Rivista Critica del Diritto Privato, 111-159. Rizzo, John A. and Zeckhauser, Richard J. (1990), ‘Advertising and Entry: The Case of Physician Services’, 98 Journal of Political Economy, 476-500. Robinson, Glen O. (1986a), ‘The Medical Malpractice Crisis of the 1970's: A Retrospective’, 49(2) Law and Contemporary Problems, 5-35. Robinson, Glen O. (1986b), ‘Rethinking the Allocation of Medical Malpractice Risks between Patients and Providers’, 49(2) Law and Contemporary Problems, 173-199. Rottenberg, Simon (ed.) (1978), The Economics of Medical Malpractice, Washington, American Enterprise Institute for Public Policy Research, 293 p. Sass, Tim R. and Nichols, Mark W. (1996), ‘Scope-of-Practice Regulation: Physician Control and the Wages of Non-Physician Health-Care Professionals’, 9 Journal of Regulatory Economics, 61 ff. Schwartz, Gary T. (1991), ‘Products Liability and Medical Malpractice in Comparative Context’, in Huber, Peter W. and Litan, Robert E. (eds), Liability Maze: The Impact of Liability Law on Innovation and Safety, Washington, Brookings Institute, 28-80. Schwartz, Gary T. (1994), ‘A National Health Program: What its Effect would be on American Tort Law and Malpractice Law’, 79 Cornell Law Review, 1339-1381. Shavell, Steven (1978), ‘Theoretical Issues in Medical Malpractice’, in Rottenberg, Simon (ed.), The Economics of Medical Malpractice, Washington, American Enterprise Institute for Public Policy Research, 35-64. Shepard, Lawrence (1978), ‘Licensing Restrictions and the Cost of Dental Care’, 21 Journal of Law and Economics, 187-201. Siliciano, John A. (1991), ‘Wealth, Equity, and the Unitary Medical Malpractice Standard’, 77 Virginia Law Review, 439-487. Sloan, Frank A. (1970), ‘Lifetime Earnings and Physicians’ Choice of Specialty’, 24 Industrial and Labor Relations Review, 47-56. Sloan, Frank A. (1985), ‘State Responses to the Malpractice Insurance "Crisis" of the 1970s: An Empirical Assessment’, 9 Journal of Health Politics, Policy, and Law, 629 ff.

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Zuckerman, Stephen, Bovbjerg, Randall R. and Sloan, Frank A. (1990), ‘Effects of Tort Reforms and Other Factors on Medical Malpractice Insurance Premiums’, 27 Inquiry, 167-182. Zuckerman, Stephen, Koller, Christopher F. and Bovbjerg, Randall R. (1986), ‘Information on Malpractice: A Review of Empirical Research on Major Policy Issues’, 49(2) Law and Contemporary Problems, 85-111.

Other References American Medical Association (1969), Professional-Liability Survey Chicago: American Medical Association (1963), Reprinted in Medical Malpractice: The Patient vs. the Physician, US Congress, Senate, Washington, DC, Government Printing Office. American Medical Association (1987), Report of the Specialty Society Medical Liability Project. A Proposed Alternative to the Civil Justice System for Resolving Medical Liability Disputes: A Fault-Based, Administrative System, Chicago, American Medical Association. American Medical Association (1989), AMA Tort Reform Compendium, Chicago, American Medical Association. Becker, Gary (1983), ‘A Theory of Competition Among Pressure Groups for Political Influence’, 98 Quarterly Journal of Economics, 371 ff. Brown, John P. (1973), ‘Toward an Economic Theory of Liability’, 2 Journal of Legal Studies, 323 ff. Calabresi, Guido (1970), The Costs of Accidents: A Legal and Economic Analysis, New Haven, Yale University Press, 340 ff. Coase, Ronald (1974), ‘The Choice of the Institutional Framework: A Comment’, 17 The Journal of Law and Economics, 493 ff. Cooter, Robert and Ulen, Thomas (1986), ‘An Economic Case for Comparative Negligence’, 61 New York University Law Review, 1067 ff. DeVille, Kenneth A. (1990), Medical Malpractice in Nineteenth-Century America: Origins and Legacy, New York, New York University Press, 319 ff. Epstein, Richard (1980), Modern Products Liability Law, London, Quorum Books, 210 ff. Giesen, Dieter (1988), International Medical Malpractice Law: A Comparative Study of Civil Liability Arising from Medical Care, London, Martinus Nijhoff Publishers. Haddock, David and Curran, Christopher (1985), ‘An Economic Theory of Comparative Negligence’, 14 Journal of Legal Studies, 49 ff. Keeton, Page, Keeton, Robert E., Sargentich, Lewis D. and Steiner, Henry J. (1989), Cases and Materials on Tort and Accident Law, St. Paul, Minnesota, West Publishing Company, 1318 ff. Kolstad, Charles D., Ulen, Thomas S. and Johnson, Gary V.(1990), ‘Ex Post Liability for Harm vs. Ex Ante Safety Regulation: Substitutes or Complements?’, 80 American Economic Review, 888 ff. Landes, William and Posner, Richard (1980), ‘Joint and Multiple Tortfeasors: An Economic Analysis’, 9 Journal of Legal Studies, 517 ff. Landes, William and Posner, Richard (1984), ‘The Positive Economic Theory of Tort Law’, 15 Georgia Law Review, 851 ff. Leland, Hayne E. (1979), ‘Quacks, Lemons, and the Market Mechanism: A Theory of Minimum

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Quality Standards’, 87 Journal of Political Economy,1328-1346. Peltzman, Sam (1976), ‘Toward a More General Theory of Regulation’, 19 Journal of Law and Economics, 211-244. Posner, Richard (1974), ‘Theories of Economic Regulation’, 5 Bell Journal of Economics, 335-58. Posner, Richard (1981), ‘A Reply to Some Recent Criticisms of the Efficiency Theory of the Common Law’, 9 Hofstra Law Review, 775 ff. Posner, Richard (1986b), The Economic Analysis of Law, Boston, Little, Brown and Company, 666 ff. Priest, George L. (1985), ‘The Invention of Enterprise Liability’, 14 Journal of Legal Studies, 461 ff. Priest, George L. (1987), ‘The Current Insurance Crisis and Modern Tort Law’, 96 Yale Law Journal, 1521 ff. Sadusk, Joseph F. (1956), ‘Analysis of Professional Factors in Medical Malpractice Claims’, 161 Journal of the American Medical Association, 442-447. Sandor, Andrew A. (1957), ‘The History of Professional Liability Suits in the United States’, 163 Journal of the American Medical Association, 459-466. Sanger, E.F. (1879), ‘Report on Malpractice’, 100 Boston Medical and Surgical Journal, 41-50. Schwartz, Alan (1988), ‘Proposals for Products Liability Reform: A Theoretical Synthesis’, 97 Yale Law Journal, 353 ff. Shavell, Steven (1987), Economic Analysis of Accident Law, Cambridge, Massachusetts: Harvard University Press, 312 ff. Shryock, Richard H. (1967), Medical Licensing in America, 1650-1965, Baltimore, The Johns Hopkins Press. Starr, Paul (1982), The Social Transformation of American Medicine, New York, Basic Books, Inc., 514 ff. Stigler, George J. (1971), ‘The Theory of Economic Regulation’, 2 Bell Journal of Economics, Spring, 3-21. US Congress Senate (1969), Medical Malpractice, Patient vs. the Physician 91st Congress, 1st Session, Washington, DC, Government Printing Office. US Department of Health and Human Services (1987), Report of the Task Force on Medical Liability and Malpractice, Washington, DC, Government Printing Office. US General Accounting Office (1986), Medical Malpractice Insurance Costs Increased but Varied among Physicians and Hospitals, Washington, DC, US General Accounting Office. US General Accounting Office (1987), Medical Malpractice: Characteristics of Claims Closed in 1984, Washington, DC, US General Accounting Office. Viscusi, W. Kip (1991),Reforming Products Liability, Cambridge, Massachusetts, Harvard University Press, 270 ff. Werthman, Barbara (1984), Medical Malpractice: How Medicine is Changing the Law, Lexington, D.C. Heath and Company. White, Michelle (1989), ‘An Empirical Test of the Comparative and Contributory Negligence Rules in Accident Law’, 20 Rand Journal of Economic, 308 ff.

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5880 THE PHARMACEUTICAL INDUSTRY Patricia M. Danzon The Wharton School - University of Pennsylvania © Copyright 1999 Patricia M. Danzon

Abstract The pharmaceutical industry raises unique economic questions because of three related features. First, the high rate of R&D, technical change and importance of patent protection raise important positive and normative questions related to industry structure, prices, profits and public policy. Second, the industry is heavily regulated in all major functions. Early regulatory requirements focused on safety and efficacy. More recently, prices, promotion and expenditures are increasingly regulated, arising out of policy concerns to control spending under social insurance programs. Optimal policies must consider trade-offs between control of moral hazard, assuring access to medical care and preserving incentives for innovation. Third, major drugs are global products and the costs of R&D are global joint costs. This creates incentives for national free-rider strategies, whereas socially optimal policies should consider cross-national spillovers and optimal price differentials. Existing literature provides a framework and some empirical evidence on some of these issues, but many questions remain unanswered. JEL classification: L1, L4, L5, I11, L65, K32 Keywords: Pharmaceutical Industry, Regulation, Anti-trust, Health Care, R&D, Insurance

1. Introduction The pharmaceutical industry is of interest to the field of law and economics for two, related, reasons. First, the usual issues of structure, conduct and performance when applied to the pharmaceutical industry must take into account its unusually high rate of R&D, which implies a high rate of technical change, critical importance of patent protection, potential for market power and novel price and product competitive strategies. This raises interesting positive and normative issues related to prices, profits and public policy. Second, the industry is heavily regulated in all major functions. Much of the early regulation and early economic literature focused on regulation related to safety and efficacy. Because pharmaceuticals may entail 1055

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significant risks to health as well as potential benefits, all industrialized countries require that new drugs meet certain safety standards as a condition of market access. Since the 1960s some countries, including the US and the UK, also require evidence of efficacy; regulate the conduct of R&D; monitor manufacturing processes for quality; and restrict promotion and advertising, both to physicians and to consumers. In the 1980s and 1990s, the focus of most new regulation in most countries has been related to control of costs, through regulation of manufacturer prices, insurance reimbursement, and/or total expenditures. These policies arise out of concern to constrain health spending under public insurance schemes which pay for a large fraction of pharmaceutical expenditures. Insurance coverage tends to make demand less price-elastic, increasing consumption volume and use of more costly drugs. The controls adopted by public and private insurers have significant effects on both the demand and supply sides of the market and on the nature of competition. This in turn affects returns to and incentives for R&D and consumer welfare. A growing literature examines both positive and normative issues raised by these cost control regulations. This literature has certainly increased our understanding of these regulations but many questions remain unanswered. The effects of such regulation are profound and multi-dimensional even within a single country, affecting consumption patterns, productivity, R&D and hence the supply of future technologies. Moreover, research-based pharmaceuticals are global products that are diffused worldwide through licensing arrangements or, increasingly, through local subsidiaries of multinational corporations. The profitability of pharmaceutical R&D thus depends on worldwide sales and on policies adopted in many national markets. Each country faces an incentive to adopt the regulatory policies that best control its pharmaceutical budget in the short run, free-riding on others to pay for the joint costs of R&D, and ignoring cross-national spillovers of national regulatory policies through parallel trade and international price comparisons. But although policies remain national, the industry is global and market segmentation is breaking down. This requires a global perspective on both positive and normative analysis. The future structure of the industry, as it adapts to changing technology and regulation, is another interesting question with no certain answers. The emerging technologies of biotechnology and genomics are transforming the nature of R&D and comparative advantage within the industry. Small firms play an increasingly important role in the development of new drugs and new R&D technologies. Biotechnology and gene therapy have raised important safety and ethical issues for regulation. The alliances that link biotech firms with each other and with large pharmaceutical companies raise interesting questions related to agency and the nature of the firm.

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The primary focus of this survey is the recent literature on measurement of prices, profits, and cost of R&D, and on these new regulatory initiatives. A previous survey article on the political economy of the pharmaceutical industry (Comanor, 1986) reviewed the early literature on industry structure, pricing and effects of regulation, focusing almost exclusively on US regulations governing safety and efficacy in the 1960s and 1970s and related literature. Scherer (1993) focuses on issues related to pricing, profits and technical progress. Material covered in these earlier reviews is briefly reviewed here. The focus here is inevitably on US issues and evidence, given the dominance of US-based literature and firms in this industry. However, regulatory issues and evidence from other countries are included where possible. The focus on issues raised by regulation and policy is made without apology (for a contrary view, see Comanor, 1986). Regulation of safety, efficacy and quality fundamentally affect the industry’s cost structure and the nature of competition, while regulation of price, reimbursement and promotion affect demand and profitability. By any measure, regulation has been and remains a critical factor that shapes this industry and must be central to any realistic analysis of the industry.

2. Safety and Efficacy Regulation: Costs and Benefits Much of the early literature on the pharmaceutical industry grew out of the major regulatory initiatives adopted in the US in 1962. Under the 1938 Food, Drug and Cosmetics Act, any firm seeking to market a new chemical entity (NCE) was required to file a new drug application (NDA) to demonstrate that the drug was safe for use as suggested in proposed labeling. The Food and Drug Administration (FDA) had 180 days to reject the NDA. Congressional hearings on the industry were initiated in the late 1950s, arising out of concerns about prices, excess profits and promotion. Legislation was precipitated by the thalidomide tragedy. The drug thalidomide was still under review in the US but had been marketed in several countries of Europe, causing birth defects in hundreds of babies. The 1962 Kefauver-Harris Amendments to the 1938 Act strengthened safety requirements, extending FDA regulation to cover clinical testing and manufacturing facilities. More controversial, the Amendments also added the requirement that drugs show proof of efficacy, which usually requires double blind, randomized controlled trials of the drug relative to placebo; removed the time limit (previously 180 days) within which the FDA could reject an NDA; restricted manufacturers’ promotion to approved indications; and required that all promotional material must include a summary of side-effects and contraindications. The UK tightened safety regulations in 1964 and added efficacy requirements in 1971; some other countries

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followed suit. However others, such as France and Japan, retained much looser efficacy requirements (Thomas, 1996). The presumption underlying the requirements for proof of efficacy was that asymmetric information prevented physicians and consumers from making accurate evaluations, leading to wasted expenditures on ineffective drugs and enabling companies to use product innovation as an obstacle to price competition. However, the extent of the market failure was a matter of assumption, not evidence, and the added requirements clearly entailed additional costs. These costs include the real resource costs of larger and longer clinical trials and increased delay in bringing new drugs to market, which entail foregone benefits to consumers and foregone revenue to manufacturers. Higher fixed costs of R&D raise the threshold of the expected revenue needed to break even on developing a new drug, leading to higher break-even prices, ceteris paribus. Some drugs would be totally eliminated by the new, higher threshold, including some with potential positive net benefits to consumers (assuming some Type II errors by regulatory bodies), particularly for relatively rare diseases with small potential market size. The Orphan Drug Act of 1982 attempts to remedy the latter problem; however, this addresses only the smallest markets and by the imperfect means of granting market exclusivity. 2.1 Costs of Regulation An extensive literature has attempted to quantify the social and private costs and benefits of regulatory requirements for proof of efficacy, in particular, the 1962 US Amendments. Most research has focused on costs, in particular, the decline in the number of new drug introductions, longer delays for NCEs that ultimately do reach the market, higher input cost and capitalization cost per successful NCE due to larger and longer clinical trials, and shortened period of patent life - all of which coincided with the 1962 Amendments. Measurement of benefits has been even more elusive, because it requires comparing the actual rate of new drug introductions to the counterfactual rate that would have occurred, had the Amendments not been passed. Grabowski, Vernon and Thomas (1978) report that the number of NCEs fell from 233 in the five-year period 1957-1961 to 93 in 1962-1966 and 76 in 1967-1971. Some decline would be consistent with the intent of the legislation, if some of the prior introductions were ineffective. However, the percentage of total ethical drug sales accounted for by new NCEs declined roughly in proportion to the number of drugs, from 20.0 percentage in 1957-1961 to 5.5 percent in 1967-1971. This tends to refute the argument that only the most insignificant drugs were eliminated. Several studies (Baily, 1972; Peltzman, 1973; Wiggins, 1981) have attempted to estimate the contribution of the Amendments to this dramatic

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decline in new drug introductions. Bailey (1972) estimates a production function of new drugs and concludes that input costs per NCE increased more than three-fold after 1962. Peltzman estimates a demand pull model to predict new drugs for the post-1962 period based on pre-1962 relationships. He attributes all the difference between predicted and actual number of NCEs to regulation. However, this is an assumption rather than a tested proposition since he does not explicitly control for other possible contributing factors. Grabowski, Vernon and Thomas (1978) attempt to identify the marginal contribution of regulation, controlling for other possible contributing factors, including the depletion of new product opportunities; the thalidomide tragedy that may have made manufacturers and physicians more risk averse, hence reduced demand for new drugs; and pharmacological advances that may have raised R&D costs independent of regulation. Their strategy is to compare trends in NCE discoveries in the US relative to the UK, an appropriate comparator country because of its strong and successful research-based pharmaceutical industry. This provides a quasi-natural experiment because the UK did not adopt efficacy requirements until 1971 and its 1963 safety requirements were statistically unrelated to the flow of new discoveries. Grabowski et al. find that research productivity, defined as number of NCEs per (lagged) R&D expenditure, declined sixfold between 1960-61 and 1966-1970 in the US, compared to a threefold decline in the UK, and that the 1962 US Amendments increased the cost per new NCE by a factor of 2.3. They conclude that these differentials are plausibly attributable to regulation, since the UK would have been equally affected by exogenous changes in scientific opportunities and testing norms and by any thalidomide-related change in demand. Using the UK as a benchmark provides a conservative estimate because changes in the US, as the largest single pharmaceutical market, would influence incentives for innovative R&D for all firms, regardless of country of domicile, and hence could have contributed to the decline in discovery rates in the UK. Several studies have examined the role of regulation in increasing delay for drugs that ultimately do reach the market. Dranove and Meltzer (1994) estimate that the average time from a drug’s first worldwide patent application to its approval by the FDA rose from 3.5 years in the 1950s to almost 6 years in the 1960s and 14 years in the mid-1980. Wardell (1973) and Wardell and Lasagna (1975) report that the US lagged behind each major European country in new drug introductions for various new drugs sold in the US in the late 1960s. Comparing the US and Britain for the period 1962-1971, they find that more drugs were launched earlier in Britain than the US. The US had 59 product-years of prior availability compared to 120 in Britain. Of single country drugs, 77 were exclusive to Britain while

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21 were confined to the US. The authors attributed these differences to the increased stringency of FDA regulations. Other studies provide further support for the hypothesis that the 1962 Amendments delayed the introduction of new drugs into the US. Grabowski and Vernon (1978) compare introduction dates in the US and the UK for drugs discovered in the US between 1960 and 1974. The proportion of drugs introduced first in the US declined significantly between the periods 1960-1962 and 1972-1974, while the proportion introduced later in the US increasing significantly. The authors conclude that increased regulatory scrutiny in the US caused multinational companies to introduce new products abroad before their US launch. Similarly, Grabowski (1980) finds that many more drugs were introduced first in Europe despite most being discovered in US research laboratories or by US-based firms, with the lag increasing over time. Wiggins (1981) extends the evidence by using differences in average FDA approval times across therapeutic categories. He finds large and significant effects of the 1962 Amendments, particularly on R&D cost per new product introduced, with some additional depressing effect on research expenditures and significant variation across therapeutic categories. However, in a study of new product introductions between 1956 and 1976, by therapeutic category, he finds that the overall decline is dominated by a few therapeutic classes for which regulatory stringency appears to be less important than other, non-regulatory factors in the decline in new product introductions. The cost in foregone consumer welfare from delay or elimination of new drugs remains a current issue for different reasons in different countries. In the US, concern has focused on regulatory delay in approval of promising therapies for life-threatening diseases and other conditions that lack effective alternative therapies, such as AIDS. The economic argument is that the costs of delay are higher, hence the optimal risk-benefit trade-off is different if no alternative therapy exists. Since the mid-1970s the FDA has attempted to accelerate approval of such critical drugs, under pressure from Congress, consumer groups and the pharmaceutical industry. Early studies (by, for example, Wiggins, 1981) concluded that the drug lag for ‘important therapeutic advances’ was similar to that for all new chemical entities. More recently, Dranove and Meltzer (1994) conclude that, beginning in the 1950s, more important drugs - especially drugs that proved to be successful in the marketplace - have been developed and approved more rapidly than less important drugs. This differential appears to reflect actions of drug companies as much as regulatory priority setting. Moreover, for their period 1950-1986 the trend towards longer average development and approval times implied that even drugs two standard deviations above the mean level of importance took longer to reach the market. One interesting feature of the

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Dranove and Meltzer study is the use of a comprehensive set of ex post measures of drug importance, including citations in medical textbooks, in medical journals, and in subsequent patent applications; the extent of worldwide introduction; and US sales. To the extent that these ex post measures of importance are noisy measures of ex ante forecasts of importance, their estimates of differential delay are understated. These findings that, since the 1962 Amendments, delay in approval for important drugs has increased less than for more minor drugs, and that firm strategies can significantly influence delay, implies that estimates of the average drug lag due to the 1962 Amendments may overestimate the social costs of the regulation-induced delay. On the other hand, if it is costly for firms to accelerate approval, then the measure of total social costs should include these added expenditures as well as the pure delay-induced costs. The fact that approval time continued to lengthen through the 1980s and that this is not confined to the US suggests either that other countries have experienced similar regulatory factors or that other factors such as common clinical factors may play an important role. Recent evidence suggests some convergence. Although Dranove and Meltzer (1994) find that approval times have lengthened in the US, their data indicate some narrowing of the gap between the US and other countries at the end of their period. Schweitzer, Schweitzer and Guellec (1996), using a sample of drugs approved in the US between 1970 and 1988, conclude that there were no significant differences in approval between the US and the G-7 countries, but that Switzerland was consistently quicker. These different findings may reflect differences in time period, methodology or sample. They may also reflect real changes in firms’ optimal timing of launch in different countries. In particular, with increasing interdependence between markets, due to parallel trade and regulatory use of international price comparisons, the incentive of firms is to delay launch in countries with relatively low prices that may become a ceiling for prices in other countries. More on this below. 2.2 Benefits of Regulation Of course, regulatory control may also benefit consumers, by reducing the risk that harmful or useless drugs are admitted to the market. The production of safety and efficacy information is a public good which may be underprovided by the market. For safety, liability may provide an alternative corrective to regulation. For efficacy, the market may acquire information over time, but learning by experience may entail a welfare loss. The optimal regulatory policy would set safety and efficacy standards to achieve the optimal balance between costs and benefits. The only study that has attempted to estimate both the benefits and costs of efficacy regulation is Peltzman’s (1973) study of the effects of the 1962

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US Amendments. Peltzman attempts to estimate the benefits of regulation by examining the rate of growth of market shares of new drugs before and after the Amendments. He concludes that the benefits were minimal and were far outweighed by the costs, which he estimates as foregone consumer surplus due to the reduced flow of NCEs which he attributes entirely to regulation. These conclusions depend critically on the methods for estimating costs and benefits, which have been questioned (for example, Temin, 1980). In particular, if consumer learning is slower or less accurate than assumed, Peltzman’s estimates understate the benefits of regulation. Conversely, Peltzman’s estimates of costs may be overstated by ascribing the decline in NCEs solely to the regulation. Nevertheless, this is an important study because it offers a theoretical and empirical framework for evaluating the overall net benefits of efficacy requirements in a particular country. The more numerous studies of cross-national differences in regulatory approval times and number of drugs admitted cannot provide the basis for policy implications because cross-national comparisons can only meaningfully be made for drugs that are approved in all comparison countries, which is a relatively small fraction of all drugs; because delay may reflect corporate strategies in additional to regulatory constraints; and because the delay may yield benefits in risk reduction or reduced wasteful expenditure on ineffective drugs. Thus delay and other regulatory costs cannot alone define the optimal extent and form of regulatory control, which remains an unresolved issue. Nevertheless, recent efforts to harmonize regulatory requirements across countries should reduce the expense and delay of new drug approval and yield net social benefits. The information generated by conduct of clinical trials is a public good, as is regulatory review of the evidence assuming similar standards. In 1995 the European Union established the European Medicines Evaluation Agency (EMEA) as the required approval route for biotech products and as an optional route for other innovative products. The EMEA’s goal is to review submissions within 365 days. An alternative is single country approval under the same rules, with reciprocity to other EU countries subject to objection. Competition between these alternative routes may stimulate efficiency. National systems remain for products that seek approval in only a single country. Harmonization between Europe, the US and Japan has been achieved on some issues but remaining differences still require country-specific trials and approval. 2.3 R&D Cost per New Chemical Entity The research-based pharmaceutical industry invests a higher percentage of sales in R&D than most other industries (US CBO, 1994). The R&D/sales ratio for the US research-based industry has increased from 11.9 percent in

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1980 to 21.2 percent in 1997 (PhRMA, 1997). However, because of the long lag between R&D and sales, a point-in-time R&D/sales ratio is downward biased as an estimate of the fraction of total costs that is accounted for by R&D. The sales in the denominator pertain to several cohorts of drugs currently on the market, whose R&D occurred many years earlier; conversely, the R&D expenditure in the numerator aggregates the one-year expenditures for several different cohorts that will generate sales over several future decades. To estimate R&D as a fraction of total cost, the stream of costs over the life cycle of a drug, from discovery through launch and sales, must be expressed in discounted present value at a common date. Applying this calculation to the date of launch, R&D accounts for roughly 30 percent of total costs (Danzon, 1997). The appropriate methodology for measuring the R&D cost per new drug approved was pioneered by Hansen (1979), using company-specific data for a cohort of drugs. DiMasi et al. (1991) extend this approach to estimate R&D costs for drugs introduced from 1980 through 1984. The average successful NCE incurred $73m. of preclinical testing expense and $53m during clinical testing, excluding amortization of failures and cost of capital. These out-of-pocket expenses have increased over time, partly due to increasingly stringent regulation and increased targeting of chronic conditions that require longer trials. Since only 23 percent of the drugs entering human trials reached market launch, the costs of the failures (‘dry holes’) must be amortized across the successful compounds to yield the out-of-pocket cost per successful new drug. Grabowski, Vernon and Thomas (1978) report that the success rate of drugs entering clinical trials declined from one in three in the 1950s to less than one in ten after 1962. The final adjustment is to add the cost of foregone interest on capital between the time of investment outlay and market launch, which is approximately twelve years. This includes ten years from beginning trials to filing for an NDA and an additional two or more years for regulatory review. Assuming a 9 percent real cost of capital, this foregone interest accounts for roughly half of the total estimated pre-tax cost per successful NCE of $231m. in 1987 dollars (DiMasi et al.,1991). The US Congress OTA (1993) updated this to $359m before tax in 1993 dollars. Di Masi et al. (1991) estimate that a one year reduction in NDA review time would reduce the total cost by 19 percent. This large effect reflects the high capitalization cost of delay added after all investments has been incurred. Note that this measure of delay cost does not include the foregone revenue to the originator firm because delay shortens effective patent life. An alternative, not mutually exclusive view of the rise in R&D cost per new drug is the dramatic decrease in productivity of R&D expenditures over time. Henderson and Cockburn (1996) report that in 1971, member firms of the US Pharmaceutical Manufacturers’ Association spent about $360m on

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R&D, compared to $8.9 billion in 1991, an increase of over 2300 percent in constant 1991 dollars. Over the same period, the output of important patents (those granted in two of the three major world markets, the US, Europe and Japan) fell, while the number of drugs discovered per year remained approximately constant. They conclude that this increase in cost cannot be explained by shifts in the distribution of R&D across therapeutic categories. The possibility of bias due to shifts in the location of R&D - as foreign firms shift a larger share of the R&D to the US - is not explored. These estimates of costs per new drug and regulation-induced delay must be viewed as ex post averages that reflect the endogenous decisions made by firms, given the constraints imposed by regulation, technology and market opportunities. Firms can influence the out-of-pocket costs and duration of R&D by their selection of drug candidates, rejection rates on questionable leads, and development strategies. For example, pursuing certain trials simultaneously rather than in sequence saves time but entails out-of-pocket expense that could have been averted by a sequential strategy. Size of clinical trials may be influenced by the tolerance for risk of finding statistically insignificant effects. Thus the observed average cost per NCE presumably reflects the subset of drug candidates and strategies that were expected to yield revenues sufficient to cover costs. The striking rise in real R&D expenditures in the 1970s and 1980s is consistent with rational behavior in the face of rising out-of-pocket and delay costs only if technological and market opportunities were also expanding. More recently, manufacturers have become more aggressive at screening out less promising candidates early in the development process, as regulation and competition have reduced expected revenues in recent years and possibly reduced expected prices of late arrivals in a therapeutic class. Thus changes in cost per NCE reflect firms’ optimizing responses to changes in market opportunities, as well as technological and regulatory shifts. Henderson and Cockburn (1996) point out that if R&D entails wasteful, competitive investments as firms race against each other in substantially similar research, then the reported average cost per drug overstates the true R&D expense required in a more ideal competitive environment. On the other hand, if there are significant spillovers across projects within and between firms, then the average observed cost understates the resource requirement for a single firm to develop a new drug. Using detailed data from individual firms, they conclude that the evidence is more consistent with the spillover hypothesis and find no evidence to support the racing hypothesis. This is consistent with qualitative evidence that R&D spending and employment changes slowly, driven by heterogeneous firm capabilities and the evolution of scientific opportunities. However, as the authors note, these conclusions are tentative because they depend on the use of patents as

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a measure of innovative output. Moreover, the assumed lag structure permits testing of only one specific model of racing behavior. On the other hand, their study makes no attempt to measure potential benefits to consumers that should be offset against any additional cost of duplicative R&D, if the existence of competing drugs on the market lowers prices. More on this below. The evidence from Dranove and Meltzer (1994) provides further support for the proposition that R&D costs and delay are at least partly endogenous. Their conclusion that pharmaceutical manufacturers, rather than the FDA, are more responsible for relative acceleration of important drugs rests upon evidence that acceleration is observed during the 1950s, before the lengthy approval process was initiated and accelerated development is a worldwide phenomenon. Once market importance is controlled for, scientific importance does not appear to be associated with accelerated review, which might suggest no independent role for regulation, after controlling for the role of manufacturers. However, in reality, interaction of manufacturers and regulators is important but difficult to separate empirically. Future studies may find a greater contribution by the FDA, at least for drugs to treat highly visible, life-threatening diseases such as AIDs. For countries other than the US there are no methodologically comparable estimates of R&D cost per successful NCE, correctly calculated to include the amortized cost of dry holes and capitalization cost. However, even if a cross-national comparison of R&D cost per NCE using comparable methodology were available, causal inference would be difficult for several reasons. First, with the harmonization of regulatory requirements firms increasingly conduct multi-national trials for global drugs. If country-specific studies reflect only the costs incurred in each country, all cost estimates are likely to be downward biased and relative costs will be upward biased in the countries where a disproportionate share of R&D is undertaken, particularly the US. Second, cross-national comparisons of R&D costs may be subject to sample selection bias because the mix of drugs that is approved differs greatly across countries. This reflects not only differences in regulatory stringency but also medical norms, local supply characteristics, pricing environments and other factors that affect costs and expected revenues and hence influence the portfolio of drugs that firms submit for approval. For example, a country with less stringent efficacy requirements might have a lower ratio of dry holes to successful NCEs, ceteris paribus, hence lower total cost per new drug approved. However, this would reflect differences in drug characteristics, in addition to the pure differential cost for a standardized cohort of drugs.

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2.4 Cost of Capital Several studies have attempted to estimate the pharmaceutical industry’s cost of capital, as a critical input in estimates of the cost and profitability of R&D. The cost of capital determines the interest cost on R&D funds invested and the discounted present value of life-time revenue flows. Using standard finance models such as the capital asset pricing model (CAPM), the conclusion is generally that the pharmaceutical industry is of average risk, with a beta approximately equal to one, a nominal cost of capital of roughly 15 percent or 10 percent in real terms in 1990 (for example, Grabowski and Vernon, 1993; Myers and Shyam-Sunder, 1996 and references cited therein). Although the industry is often perceived as highly risky because the success of any individual drug candidate is highly uncertain, such risks are readily diversifiable. However, Myers and Shyam-Sundar (1996) point out the sequential nature of investment in R&D amplifies risk. Investing in R&D is equivalent to investing in compound lotteries and compound call options. Both beta and the opportunity cost of capital are higher for early stage R&D projects than for later stages. By implication, the average cost of capital is higher for small companies, that have several early-stage projects but no final products, than for large companies that have a diversified portfolio of products at various stages of the life cycle of development and commercialization.

3. Patents The purpose of patent protection is to grant the originator firm a period market exclusivity that provides an opportunity to charge a price above marginal cost in order to recover the investment in R&D. In theory, the socially optimal patent term is defined by trading off the marginal utility gain from stimulating the development of innovative products against the loss from suboptimal consumption that results if patents lead to prices in excess of marginal cost. The optimal patent term may thus differ between countries. In pharmaceuticals, as in other industries, the period of effective market exclusivity may be much less than the nominal patent term because of entry of slightly differentiated products that are close substitutes. However, patent protection does block entry of generically equivalent imitator versions of the same compound until patent expiration. For pharmaceuticals, the value of patent protection is further constrained by two factors. First, the effective patent life is truncated by the delay between patent filing and product launch, which is particularly long for pharmaceuticals due to the lengthy process of drug development and regulatory approval described earlier. For example, with a nominal patent

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term of 20 years, the mean duration of 12 years from discovery research to product launch would leave an effective patent life of only eight years. In the US, the 1984 Patent Term Restoration and Competition Act grants to innovator firms an extension of patent term for up to five years, to offset the loss due to regulatory delay. However, as a quid pro quo, the 1984 Act expedited post-patent entry by generic manufacturers, by granting them access to the active ingredient before the actual patent expiry, and by regulating market access with an Accelerated New Drug Application (ANDA) that requires only a showing of bioequivalence to the originator product, without new trials. This 1984 Act has greatly accelerated generic entry after patent expiry in the US. Similar measures have been proposed for the EU but so far have not been adopted. The extent of generic penetration and the speed of generic erosion of originator market share differ significantly across countries and over time, depending on policies adopted by regulators and third party payers. Studies of generic penetration and effects on brand pricing strategies are discussed below. Second, in most countries drugs are reimbursed by publicly financed health or social insurance schemes. Insurance coverage tends to reduce demand elasticity, which could increase market power, ceteris paribus. Offsetting this, most public and private insurers have adopted controls on price, reimbursement, volume or total expenditures on drugs, in order to constrain manufacturers’ exploitation of this inelastic demand and to constrain insurance-induced overuse (moral hazard) on the part of patients and of providers, who may use prescription drugs to enhance demand for their own services (Danzon and Liu, 1996). Regulation designed to control costs can significantly limit and even nullify the value of patents to originator firms. Weak patent protection and associated copying of innovator drugs by local firms, particularly in developing countries, has been an important issue in international trade negotiations. In the Uruguay round of GATT, participating countries agreed to a 20 year patent life from date of application. However, because drugs already in the pipeline were exempted from the new rules, this provision would not grant patent protection to new drugs reaching the market for several years in countries that newly granted intellectual property protection. Differences between countries in patent protection would matter less if markets were fully separable, such that the effect of weak patent protection in one country affected only that country. However for pharmaceuticals there are important market spillovers for two reasons. First, pharmaceutical R&D is a global joint cost of serving all countries in which a drug is marketed. The incentives for investment in global products thus depends on total global revenues. This gives each country an incentive to free-ride, waiting

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for others to pay the joint costs. Second, the ability of producers of global drugs to segment markets along national lines and charge different prices, is breaking down as a result of parallel trade and regulatory use of foreign prices to set domestic prices. The EU Court of Justice, in Merck v. PrimeCrown (1996) upheld the right of parallel importers to import pharmaceuticals from one EU member state in which a product had no patent protection to another EU country in which the product was under patent protection. With parallel trade, the weak patent protection in one country effectively spills over to other countries, undermining the ability of the manufacturer to realize the value of the patent in countries that respect patents. The same effect occurs if the government in a country with patents regulates domestic prices based on prices in other countries that do not recognize intellectual property. The theory of Ramsey pricing (Ramsey, 1927) provides the theoretically optimal set of price differentials for pricing to cover joint costs when consumers differ in their ability or willingness to pay. The use of Ramsey pricing to set optimal cross-national differences in prices is discussed in (Danzon, 1997a, 1997b). However, Ramsey pricing sets optimal price differentials, taking demand elasticities as given. But demand elasticities for individual products depend on patent structure. Thus in a full social optimum, the differentials in both patent terms and prices would be simultaneously determined. This simultaneous determination of cross-national differences in patent terms and prices for global products such as pharmaceuticals is an interesting issue for future work.

4. Pricing: Competition and Regulation The pharmaceutical industry is structurally competitive, with low overall concentration. Although concentration within specific therapeutic categories is greater, the market is contestable in the long run, however, since there are no barriers to entering the process of research and discovery by established or new firms, as evidenced by the large number and high rate of turnover of start-up companies. It is incorrect to infer that entry would take 12 years (the mean time from discovery to approval for new drugs). Competitive entry is initiated long before a promising innovative compound for a new indication or with a new mode action reaches the market. Competitor firms can obtain information on the drug candidates under development by other firms in the industry, from patent filings and regulatory filings with the FDA. The techniques of rational drug design make it increasingly easy for competitors to develop similar but chemically distinct compounds to a promising new compound under development. Thus the pioneer may not necessarily be the first to reach the market and even if it is, follower compounds that are close

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therapeutic substitutes now enter the market within months. The SSRIs (selective seratonin reuptake inhibitors) and statins (HMG CoAse Reductase inhibitors) illustrate the rapid speed of imitative entry. To the extent that market power exists, it results largely from legal restrictions and other institutional factors. The role of patents in intentionally restricting competition has already been described. In addition, in most industrialized countries the demand for ethical drugs is channeled by legislation through physicians and other licensed professionals who are authorized to prescribe drugs. This separation of decision maker from payer makes demand less elastic, if physicians are uninformed about drug prices or, even if informed, are imperfect agents for patients. Insurance coverage further reduces price sensitivity. Traditional insurance that reimburses for the price of the drug, net of a fixed co-payment fee per script or a small co-insurance percentage, reduces demand elasticity in familiar ways. To offset this, both private and public insurers increasingly use strategies designed to make physicians more cost-conscious with respect to price and volume of prescriptions. Since most insurers outside the US are public or quasi-public bodies, these cost control strategies have the effect of regulation. An important consequence of this vital role of physicians and insurance coverage in influencing demand for drugs is that demand conditions differ across countries and over time, as medical reimbursement and insurance systems change. Thus any analysis of the form and extent of competition in the pharmaceutical industry is context-dependent and must take into account institutional arrangements in the local medical and insurance markets. 4.1 Pricing and Competition in Unregulated Markets The early literature provides interesting evidence on competition in relatively free markets because insurance coverage and regulatory controls were less widespread. In the 1960s and 1970s, US patients paid directly out-of-pocket for most outpatient drugs, with minimal insurance coverage. Nevertheless, opinion in the economic and policy literature was divided on the competitive effect of closely substitutable drugs and hence on the effects of the 1962 Amendments. Some view the development of closely substitutable ‘me-too’ products as waste that is costly to consumers, on the theory that the rapid introduction of new products, protected by patents, leads to increased product differentiation and higher prices (see, for example, Comanor, 1964 and Temin, 1980). This theory predicts that the 1962 Amendments, by requiring proof of efficacy and restricting drug advertising, should increase price competition. The alternative view is that the extent of price competition depends positively on the number of close therapeutic substitutes, in which case the existence of close substitutes may benefit consumers. To assess the impact of the 1962 US Amendments on prices, Peltzman (1973) examines average price changes in a time series

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analysis from 1952 to 1962 and a cross sectional analysis for the three years preceding the 1962 regulations. He finds no evidence that the number of NCEs had any net inflationary impact on drug prices, even under the strong assumption that innovation offers no net therapeutic benefit. He concludes that, if anything, the 1962 Amendments accelerated the rate of drug price inflation and added to the annual cost of drugs to consumers. Several subsequent studies tend to confirm that the development of new, closely substitutable drugs does not limit price competition. In a study of launch prices of new drugs introduced between 1958 and 1975, Reekie (1978) found that new drugs that offer significant therapeutic advance were priced above existing drugs but tended to lower price over time, whereas imitators were priced lower initially but tended to increase prices. This pattern, of a skimming strategy for innovative drugs and a penetration strategy for imitators was confirmed by Lu and Comanor (1998) using data for 144 new drugs launched in the US between 1978 and 1987. The penetration strategy is consistent with a multiperiod model with interrelated demand and imperfectly informed buyers, in which sellers offer a low initial price to encourage use and build reputation. Imitative products optimally set even lower initial launch prices and raise prices over time (Schmalensee, 1982). Most of these studies predate the application of managed care principles to pharmacy benefits in the US in the 1980s and 1990s, which has significantly affected demand for pharmaceuticals. Pharmacy benefit managers (PBMs) typically establish formularies of preferred drugs, which are selected on the basis of price and cost-effectiveness. Incentives and other inducements are offered to patients, physicians and pharmacists to use preferred drugs. Such strategies increase the cross-price elasticity of demand between therapeutic substitutes and are particularly powerful between generic equivalents (see below). For therapeutic substitutes, the use of formularies, physician monitoring and other strategies enables PBMs to shift market share between therapeutically similar, single source drugs, thereby increasing the demand elasticity facing manufacturers of on-patent drugs. Because of their ability to shift market share and hence make demand more elastic, PBMs have been able to negotiate discounts averaging 20-25 percent off the list price that is charged to the unmanaged, retail pharmacy sector (Boston Consulting Group, 1993). Evidence that new drugs are being launched at lower list prices than established drugs in the same product class and that the discount is greater, the greater the number of existing drugs in the product class (Boston Consulting Group, 1993) suggests that price sensitivity is spilling over to the unmanaged market.

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The future form of discounting and related competitive strategies in the US is uncertain because of litigation and growing legislative constraints initiated by retail pharmacists, who have not been offered discounts for patented drugs on the same terms as PBMs because individual retail pharmacists cannot - and arguably should not attempt to - shift market share between therapeutic substitutes (Danzon, 1997a). Pharmacists countrywide filed a massive series of antitrust claims against drug manufacturers, alleging collusive pricing and price discrimination (Scherer, 1996). This litigation explicitly excluded off-patent, multisource drugs, for which pharmacists do receive discounts because their legal authorization to substitute generic equivalents enables them to shift market share between multisource drugs. The recent partial settlement of this litigation and the pharmacists’ success in obtaining passage of anti-discount pricing legislation in several states, may reduce the practice of discounting and possibly reduce price competition more generally. The effect on profitability is theoretically ambiguous: while individual firms presumably perceived discounting to be in their short-run interests, the long-run effects, once discounting became an industry-wide strategy, could have been negative. However, since managed care has irreversibly changed the price-sensitivity and sophistication of purchasers, legal impediments to discounting will not simply return the status quo ante. Drug manufacturers are developing innovative competitive strategies, including risk-sharing contracts, but it is too soon to predict future developments. 4.2 Generics Generic substitution programs are used by HMOs and most pharmacy benefit managers in the US and in some other countries, notably the UK, Canada, Germany and other countries that use reference price reimbursement (see below). The main strategy is to limit reimbursement for multisource drugs to the price of a low or moderately priced generic. The patient must pay the difference if a higher priced drug, usually the originator brand, is dispensed. In the US most states have overturned their anti-substitution legislation and now authorize pharmacists to dispense a generic of their choice unless the physician explicitly notes that the brand is required. Since pharmacists capture the difference between the reimbursement price and the acquisition cost, pharmacists have strong incentives to select a relatively cheap generic, rather than a more expensive generic or brand. Thus for the manufacturer of multisource products, the primary customer is the pharmacist whose demand is highly price elastic. The cost and delay for generics entering the market was greatly reduced in the US by the 1984 Drug Price Competition and Patent Term Restoration Act, which reduced testing requirements and granted earlier access to essential data for generics, in return for extended patent life of originator drugs to compensate for time lost due to regulatory approval requirements.

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Several studies have examined the effects of the 1984 Act on generic entry and, more generally, the effect of generics on prices, promotional activity and market shares of brand drugs. The differences between the studies probably reflects changes in market conditions, as more states relaxed their anti-substitution laws in the 1970s and 1980s, the 1984 Act, and the growth of managed care in the 1980s and 1990s. Frank and Salkever (1992) provide a formal derivation of the conditions under which generic entry can lead to price increases for brand name drugs. Drawing on the observation made in several studies, that the prescription drug market consists of at least two segments, price-sensitive consumers and brand loyal consumers who are less price sensitive, they show that one plausible condition under which entry may increase brand prices is that entry makes the reduced form demand for the originator (after taking into account response of generics) less elastic. Viewing promotion and price as simultaneous choice variables, they also develop the conditions under which brand advertising may decrease while brand prices increase. Caves, Whinston and Hurwitz (1991) analyze post-patent pricing and promotion for 30 drugs whose patents expired between 1976 and 1987. They find small decreases in brand price following generic entry, with slightly greater effects in the hospital market than in the retail sector, as expected given the wider prevalence of formularies in hospitals at that time. However, their empirical specification includes therapeutic class-specific time effects, in addition to linear and quadratic time variables, which may capture some of the patent expiration effects. Caves, Whinston and Hurwitz (1991) also find significant reduction in brand promotion even before patent expiration. The net effect of less promotion and lower generic prices is that quantity sold does not increase significantly after patent expiration, implying ambiguous welfare effects. They conclude that a significant component of promotion of branded drugs is of the ‘market expansion’ variety, which reduces the extent to which these activities can be viewed as limiting generic competitors. Grabowski and Vernon (1992), using data on patent expirations that spanned the 1984 Act, find that some brand prices increased after generic entry and that generic prices were significantly inversely related to number of generic competitors. A safe conclusion is that none of these studies find strong brand price reductions following generic entry, whereas number of generic entrants has strong downward pressure on generic price. All of these studies underestimate generic penetration in the 1990s, which has greatly accelerated due to the growth of managed care and, possibly, patent expirations for more significant drugs with larger potential markets. For recent patent expirations, the brand drug typically loses over

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half the market in less than a year, compared to five years or more found in previous studies. Thus the ability of brand advertising to build brand loyalty (for example, Caves, Whinston and Hurwitz, 1991) has apparently diminished significantly. This experience underscores the point that conclusions on competition are context-specific, depending on the time period, insurance arrangements and resulting incentives for physicians, pharmacists and patients, which interact to determine demand elasticities and hence optimal manufacturer pricing strategies. None of these studies formally examine the role of pharmacists in drug demand and generic switching. Masson and Steiner (1985) show that for a sample of 37 multisource drugs in 1980, pharmacists obtained the generic at an average price 45 percent lower than the brand, but the difference at retail was only 24.3 percent, because the pharmacist retained a higher average absolute margin on the generics. Similarly, Grabowski and Vernon (1996) show that for 15 drugs whose patents expired between 1984 and 1987, the average absolute margin was roughly 40 percent higher on the generic. Caves, Whinston and Hurwitz (1991) find that pharmacists were quite conservative in exercising their right to substitute a generic, even where authorized. However, the recent gain in market share of generics suggests that this has changed as a result of the growth of managed pharmacy benefits and the associated pressure on pharmacy margins and reimbursement incentives that are designed to make pharmacists highly price sensitive in their choice between drugs. Alexander, Flynn and Linkins (1994) attempt to estimate aggregate demand elasticities using country-level data for seven countries pooled over the period 1980-1987. They use a two-stage procedure. Price is treated as endogenous and estimated in the first stage, with a labor cost index included as an identifying variable. The second stage equation regresses Quantity on this predicted price variable and measures of income, physicians per capita, fixed country effects and a time trend. The resulting elasticity estimate of !2.8 is implausibly large, since it implies even higher product-specific elasticities. It is probably upward biased (in absolute value) due to spurious negative correlation induced by imputing quantity by dividing total expenditures by an estimate of average price that is at best very rough. Since labor cost is presumably highly correlated with income per capita, it is unclear whether the system is identified. Finally, since prices were regulated in five of the seven countries, the assumption that prices are endogenously determined by manufacturers is questionable. Other studies have generally estimated much lower aggregate demand elasticities (less than !1.0 in absolute value). These studies are reviewed in Anessi (1997).

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4.3 Price Change The pharmaceutical industry has been under considerable attack in the US for rates of price increase in the late 1980s that appeared to exceed general inflation. Accurate measurement of price levels and intertemporal price change is particularly problematic, however, in industries with rapid technological change, including pharmaceuticals. Suslow (1996) uses hedonic methods to estimate a quality-adjusted measure of price change for anti-ulcerants. She concludes that unadjusted price indexes that fail to adjust for quality improvements are upward biased. Griliches and Cockburn (1994) demonstrate the upward bias in the official US producer price index for pharmaceuticals that results from treating generics as new drugs, rather than as new versions of old drugs. Berndt, Griliches and Rosett (1993) show that lags in updating the market basket used in official price indexes led to official estimates of price growth being upward biased by as much as 50 percent in the US. Danzon and Kim (1996), using data from seven countries for the period 1981-1992, show that biases differ across countries, depending on the form and effects of regulation, the role of generics and the structure of the official index (fixed or chained weights). For example, the upward bias from treating generics as new drugs rather than modifications of old drugs is greatest in the US, where generics have a relatively large market share, relatively low prices and negative price change over time. 4.4 Regulation of Prices, Reimbursement and Expenditures As noted earlier, to the extent that market power exists in the pharmaceutical industry, it derives partly from the legal grant of monopoly through patent protection. The inelastic nature of demand may be exacerbated by comprehensive insurance coverage, which has provided a rationale for regulation of prices, volumes and/or expenditures in most countries with public and social insurance systems. An extensive literature has addressed the general question of optimal insurance coverage under conditions of moral hazard. Because insurance tends to undermine cost-consciousness of patients and providers in their use of medical services, including drugs, optimal insurance policies include some contractual terms to control insurance-induced overuse (moral hazard). Although early insurance theory typically focuses on consumer co-payment (for example, Pauly, 1968; Zeckhauser, 1971), in the case of medical insurance the optimal trade-off between control of moral hazard and financial protection may yield co-payments that are optimally too low to provide much incentive. Forms of provider cost-sharing may therefore be preferred (Ellis and McGuire, 1991). In the case of drugs, optimal insurance coverage should also take into account the effects of current prices and volumes on incentives for R&D.

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In practice, the cost control strategies applied to drugs by private and public insurers differ across countries and continually evolve over time. A limited literature addresses the positive issue of measuring the effects of different insurance and regulatory structures on prices, drug expenditures and drug use. Harder to measure - and an important topic for future research - are effects of regulatory strategies on health benefits for current patients, on manufacturers’ incentives to invest in innovative R&D, and hence effects on future patients. Under direct price regulatory schemes, such as France and Italy, the manufacturer must obtain approval of the price of a new drug before it can be reimbursed by the social insurance system. Subsequent price changes must also be approved and price decreases may be mandated. The criteria used for setting prices include cost, comparison with existing drugs and international price comparisons. The 1989 EU Transparency Directive requires that such criteria be ‘transparent’ and neutral with respect to country of origin, but interpretation inevitably permits significant discretion. In practice, such systems are widely alleged to be used to pursue industrial policy goals, granting higher prices for products that are locally produced. Danzon and Percy (1996) develop a model showing that such biased regulation creates incentives for manufacturers to distort production efficiency and incur excessively high costs - for example, construction of an excessive number of production plants - in order to obtain higher prices. Other countries, including Germany, the Netherlands and New Zealand have established reference price systems that limit the reimbursement price for drugs in designated groups. Manufacturers remain free to charge more than the reference price; however, since the patient must pay the difference, demand is highly elastic above the reference price, leading most manufacturers to drop their prices to the reference price. Zweifel and Crivelli (1996) analyse reference pricing using a duopoly model; Danzon and Liu (1996) develop a model with physicians as imperfect agents and monopolistic competition between suppliers. The empirical analysis shows that reference pricing significantly reduced price levels and the rate of price increase, which is consistent with independent rather than collusive pricing by manufacturers. Branded drugs suffered a loss in market share despite a reduction in relative price under reference pricing. Prices of non-reference priced drugs increased, as predicted by an optimal life-cycle pricing strategy with reduced economic life and possibly with market segmentation (Danzon and Liu, 1996). The effect of reference price systems on the quality of care for patients and on R&D incentives for manufacturers depends critically on the criteria used to cluster drugs, since reference pricing induces competition primarily between drugs in the same cluster. In particular, if on-patent drugs are

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clustered with older drugs for which patents have expired, reference pricing tends to undermine the ability of innovator firms to recoup the costs of R&D while under patent protection. At the limit, if a new drug is reimbursed at a reference price rate determined by the supply price of a generic version of an old molecule and this price reflects the marginal cost of production, the incentive for innovative R&D would be seriously undermined. In theory, of course, since reference price limits apply only to reimbursement, patients should be willing to pay the differential if the new drug truly offers greater therapeutic benefits. However, physicians may be reluctant to take the time to explain the options, risks and benefits. In the case of Germany, the legal requirement that physicians explain to the patient why a more expensive drug is needed would impose a time cost on physicians that is not reimbursable but has a significant opportunity cost. Thus physician response plausibly contributes to the observed high demand elasticity at prices above the reference price. Price controls alone do not control drug expenditure growth, which is driven largely by the introduction of new, higher priced drugs that are or are perceived to be more effective. In 1993, therefore, Germany adopted a global limit on drug spending, with physicians at risk for the first DM280m of any overrun and the pharmaceutical industry at risk for the next DM280m overrun. This strategy dramatically reduced expenditures (Munnich and Sullivan, 1994). Danzon and Liu (1996) provide a theoretical and empirical analysis that distinguishes effects of reference pricing and drug budgets, using data from the period 1986-1994. They show that if physicians were perfect agents for patients, drug budgets should have no effect. In fact, the sharp spending cut reflected a reduction in number of prescriptions and substitution of older, cheaper drugs for newer, more expensive drugs that can only be plausibly explained by physicians’ concern for their own income. In response to the 1993 drug budgets, manufacturers cut prices of on-patent drugs by more than the mandatory 5 percent price roll-back, consistent with a significant drop in demand and increase in demand elasticity. Schulenburg et al. (1994) report that the referrals to specialists and hospitals increased in response to the drug budgets, plausibly because inpatient drugs were not included. Thus the net budget saving was much less than the saving in outpatient drug costs. Under the UK Prescription Price Regulation Scheme (PPRS), manufacturers are permitted to set prices of patented drugs, subject to the constraint that the rate of return on capital invested in the UK fall within a range, currently 17-21 percent. Each company negotiates with the government for a company-specific return of rate that depends on such factors as contribution to the economy. Prices of off-patent drugs are regulated. Standard theory predicts that pure rate of return regulation induces excessive capital investments and lower productivity (Averch and

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Johnson, 1962). However, in an empirical study of the effects of such biased regulatory schemes in the UK, France and Italy on labor and total factor productivity, Danzon and Percy (1996) find that although the rate of growth of capital and labor in the UK pharmaceutical industry has been high, relative to other UK industry and relative to pharmaceuticals in other countries, it has not been biased towards capital relative to labor, possibly because the permitted rate of return may depend on employment growth. Moreover, the UK has experience relatively high productivity growth, compared to other regulated and unregulated countries. Price regulation in most countries has been effective in controlling prices but not expenditures. Several cross-national price comparisons show that drug prices are significantly lower in France and Italy, which have strict price regulation, than in the US or Germany (for example, BEUC, 1989; Farmindustria, 1993). However, Danzon and Kim (1998) show that the measured differentials can vary significantly, depending on the sample of drugs used, the index number methodology used, including unit for measuring price and weights. Most international comparisons have been undertaken for regulatory purposes, have been biased by use of very small, non-random samples including only branded drugs, and have not adhered to standard index number methods (for example, GAO, 1992, 1994). For example, the exclusive focus on branded drugs tends to bias comparisons in favor of countries with strict price regulation. Regulation and competition are to some degree substitutes: less regulated markets tend to have higher brand prices but larger generic market shares and lower priced generics, plausibly because substantial brand mark-ups and cross-price elasticity of demand are necessary conditions to attract significant generic entry. The increasing use of international price comparisons, particularly for comparing prices across countries of the EU, imply that these methodological issues are of prime policy importance. The failure of price controls to constrain expenditure growth has prompted several countries to adopt controls on volume or expenditures. Germany’s national drug budget, described above, has evolved in 1997 into physician-specific drug spending targets with financial penalties for significant overruns. The UK has indicative drug budgets for general practitioners that, so far, are merely advisory and lack direct financial consequences (except for fundholding physicians who voluntarily assume financial risk for a broad range of services including drugs). France negotiates revenue caps with individual companies; prices are rolled back if volume and hence total revenue exceed the target level. Many issues related to costs and benefits of these evolving regulatory strategies require further analysis. The evidence from Germany shows that placing physicians at financial risk is a potent weapon to limit drug

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spending. However, it is a blunt weapon because physician budgets cannot be perfectly risk-adjusted to reflect differences in patient characteristics. Such caps therefore create incentives for cream skimming and/or service restrictions for sick patients. Limits confined to drug spending create no incentive for efficient substitution between drugs and other medical services, outpatient versus inpatient care, and so on. Cost-effective substitution between services is essential to achieve the maximum value from total health expenditures, but physicians cannot be expected to have the information or time required to evaluate alternative treatment regimens for specific patient conditions. In addition, in the longer run, regulatory systems that penalize physicians for prescribing costly new drugs could significantly reduce incentives for R&D. In response to the cost-increasing effects of new technologies, there is a growing interest by governments and other payers in the use of technology assessment, including cost-effectiveness analysis, to evaluate new drugs. Although so far no country requires evidence of cost-effectiveness for registration, an increasing number of countries consider economic factors as a condition of reimbursement. Australia and the province of Ontario in Canada were the first require data on cost-effectiveness in reimbursement decisions. France and the UK encourage the provisions of such data, as do many private insurers in the US (Elixhauser, Luce and Steiner, 1995). Since the conclusions from a cost-effectiveness study are highly sensitive to - and only as good as - the methodology and data employed in the study, there have been several attempts to establish guidelines for such studies (Drummond, 1994, 1996). Thus whereas the key research issue of the 1960s and 1970s was the design of market access controls, to appropriately balance reduction in risks to health and safety against delay in market access, the key issue in the 1990s is the design of price regulatory strategies that provide an optimal trade-off between control of drug spending, access for patients to new, more advanced therapies, incentives for optimal use of drugs relative to other medical services and long-run incentives for manufacturers to develop new drugs for the future.

5. Profitability and Rates of Return The pharmaceutical industry has been under frequent attack for apparently high profits. (The term ‘profit’ is used to denote a return in excess of a normal return on capital invested.) Accurate measurement of profits is not easy in any industry. It is particularly problematic in the case of pharmaceuticals because of the length of product life and because of the importance of investments in intangible R&D and promotional capital. Both

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of these investment flows are expensed on accounting statements but, from an economic perspective, are more correctly viewed as investments with a multi-year payout over the market life of a drug. Several approaches have been used to measure profitability. The Lerner index of price relative to marginal production cost suggests high profitability. The ratio of the price of originator drugs relative to generic price several years after patent expiration (a rough measure of marginal cost) is roughly 5 (Caves, Whinston and Hurwitz, 1991). However, this probably overstated the Lerner index at earlier points of the life cycle for this cohort of drugs, since the price of originator drugs tended to rise in real terms with age in the US in the 1980s (Danzon and Kim, 1996). More fundamentally, a Lerner index based on short-run marginal production cost at a single point in time in one country is not a good indicator of the conceptually correct measure, which compares the discounted present value of global revenues over the full life cycle, relative to total costs including investments in R&D and promotion. A second approach to profitability measurement attempts to adjust reported rates of return on book value of capital to take account of intangible capital of R&D and promotion. Standard accounting practices treat investments in R&D and promotion as current expenses rather than as investments in intangible capital, leading to systematic upward bias in accounting rates of return for industries with relatively high intangible investments. Clarkson (1996) illustrates the effects of these adjustments for firms in fourteen industries for the period 1980-1993. Before adjustment, the average accounting rate of return on equity for the fourteen industries is 12.3 percent; the pharmaceutical industry has the highest return of 24.4 percent. After adjustment for intangible capital, the average is 10.2 percent compared to 13.3 percent for pharmaceuticals, which is less than the adjusted return for petroleum, computer software and foods. The most reliable approach to measuring the rate of return to investment in a cohort of drugs uses discounted cash flow estimates of the costs and returns for that cohort. Grabowski and Vernon (1990, 1996) estimate the returns on R&D for new drugs introduced in the 1970s and in 1980-1984, respectively. The cost estimates include dry holes and interest cost of funds, based on data gathered from individual firms. Market sales data for the US are used to project a sales profile over an economic life of over 20 years. Foreign sales are estimated using a foreign sales multiplier. Applying a contribution margin to net out direct costs then yields a life-cycle profile for net revenue, which is discounted to present value using a 10.0-10.5 percent real cost of capital. Grabowski and Vernon conclude that drug introductions in the 1970s on average earned a return roughly equal to their cost of capital. The later cohort on average yielded a positive net present value of $22.2m, or an internal rate of return of 11.1 percent, compared to the 10.5

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percent cost of capital. Given the margin of error in estimating several of the key parameters, the hypothesis of a normal rate of return cannot be rejected. The returns distribution across drugs is highly skewed, such that only the top 30 percent of drugs cover the average R&D cost. Grabowski and Vernon (1996) use simulation analysis to show that an important implication of this skewed distribution of returns is that regulatory strategies that target these ‘blockbuster’ drugs could significantly reduce expected average returns and hence reduce incentives for R&D. By contrast, a competitive strategy that permits high prices for patented drugs but then promotes generic competition after patent expiry has a much less negative effect on incentives for R&D, because a given loss in sales revenue is more heavily discounted if it occurs late rather than early in the product life cycle. While the basic point is important and correct, the magnitude of the revenue loss from targeting blockbuster drugs may be sensitive to the assumption that R&D cost per drugs is uniform whereas the distribution of revenues is highly skewed. To the extent that firms can anticipate the different market potential of different drugs and incur higher R&D costs for drug candidates with potentially greater returns, the cost distribution may roughly mirror the returns distribution, such that the distribution of net revenues is less skewed than the distribution of gross revenues. Using similar methodology, a smaller sample (1981-1983 drug introductions) and different parameter values, the US OTA (1993) concluded that the average NCE in this period earned excess returns of $36m over the average R&D cost. Again, no confidence interval is reported and conclusions are sensitive to several important assumptions. Moreover, even if the drugs introduced in the 1980s did earn abnormal returns, the experience of the 1990s cohort of drugs is likely to be less favorable, because of the growth of managed care in the US, increased regulatory stringency in many foreign markets, and more rapid generic erosion of post-patent market shares in several major markets, including the US, Germany and the UK. Although the rapid growth in R&D investment - indeed any investment - by the pharmaceutical industry in the 1980s implies that at least normal and possibly above-normal returns were anticipated, such growth would also be consistent with expanding technological possibilities. Although this cohort rate-of-return approach is the only valid approach to measuring profitability, it is vulnerable to the fundamental objection that, if estimated returns either exceed or fall short of normal levels, this reflects either measurement error on the part of researchers or market disequilibrium that is probably already being corrected by competitive entry, such that the analyst’s estimate is obsolete before it is made. Since there are no significant barriers to entry to research activities, if pharmaceutical R&D were to generate persistently excessive returns, competitive entry would occur as

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long as expected profits exceed the cost of capital. Dissipation of excess profits could take the form of price competition but could also include undertaking more or riskier R&D that targets new therapeutic areas with little prior experience. This competitive adjustment process may not be smooth or instantaneous, because market and regulatory conditions, including insurance reimbursement systems, are continually changing; market entry through new R&D may take time and the actual realization of returns may be different from that anticipated when an R&D investment is initiated. In general, a reasonable assumption is that competitive entry to exploit R&D opportunities will tend to restore expected profitability to normal levels if anticipated profits are above normal. The more important policy question is whether the resulting rate of introduction of new drugs and mix of innovative vs. imitative drugs is socially optimal. In other words, changes in the regulatory and reimbursement environment may affect profitability in the short run. But in the long run, the rate and mix of R&D adjusts such that normal returns are realized on average. Whether the resulting R&D expenditures entail significant duplicative investment is an important issue. Henderson and Cockburn (1996) provide some evidence against this idea, but not a definitive rejection. The current trend of payers to demand evidence of cost-effectiveness relative to existing drugs as a condition for reimbursement above existing drugs, reinforces incentives for manufacturers to target R&D towards innovative therapies and away from imitative drugs. Of course, the great uncertainty ex ante as to the ultimate therapeutic value of new drugs and the speed of approval implies that ex post realizations may still yield some me-too drugs. Even the optimal number of me-toos is uncertain, given their value as a competitive constraint and sometimes as a source of significant improvements for some subsets of patients.

6. Industry Structure and Productivity: Regulation or Technology? Government regulation has had a significant impact on industry structure. In the US, the 1938 Federal Food, Drug, and Cosmetic Act restricted the sale of some drugs to prescription, leaving only less potent drugs available for direct over-the-counter (OTC) demand by consumers. The fact that insurance coverage is restricted in many countries to prescription drugs and that physician agency is an issue only for prescription drugs has distinguished the prescription sector from the OTC sector. The 1962 Amendments, enacted to promote safety and efficacy, further differentiated the research-based industry. Several studies have examined the effects of regulation and other factors on industry structure and economies of scale in R&D. Temin (1980)

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examines the impact of regulatory and technological change on the structure of the US pharmaceutical industry using firm level data from 1948 to 1973. Major technological advances in the postwar period dramatically increased the number and therapeutic potential of new drugs. Temin finds that the size of drug firms increased dramatically during this period with much of the growth concentrated in large rather than small firms. Grabowski and Vernon (1976, 1977) suggest that regulation-induced increases in cost and risks of R&D create scale economies that result in the concentration of innovation in large firms. They also hypothesize that this concentration would lead to higher market shares and higher prices for drugs that do obtain FDA approval, due to the reduction in the number of close competitors. Their empirical findings support the first hypothesis, showing an increasing proportion of innovations concentrated in large firms and increasing concentration ratios of innovational output. However, they find no evidence to support the second hypothesis: concentration of sales in the industry did not increase and competition from generic and non-patented products prevented prices from rising. The relationship between research productivity and firm size is further examined by Thomas (1990). Despite the decline in the annual number of NCE introductions following the 1962 Amendments, levels of real R&D expenditures rose each year from 1960 to 1980. Thomas shows that the decline in NCE introductions around 1962 was concentrated in the smallest firms, many of which dropped out of innovation. Using productivity trends in the UK as a control to isolate the effects of regulation in the US, Thomas estimates the ‘direct effects’ of regulation on individual firms and the ‘indirect effects’ resulting from the asymmetric impact of the regulation on small and large firms. In contrast to Grabowski and Vernon, he concludes that the sales gains due to reduced competition from smaller firms more than offset the reduction in research productivity for large firms. Thomas (1996) extends the argument that strict safety and efficacy regulation in the US and UK led to a shakeout of smaller, less innovative firms and concentration of innovative effort in larger firms. This, together with relatively free pricing policies, may have contributed to the preeminence of these two countries in developing innovative products, by forcing the development of the necessary skills. Thomas argues that the much less stringent efficacy regulation in France and Japan has sheltered weak domestic firms and hence contributed to the failure of these countries to develop skills necessary to compete in the global pharmaceutical marketplace. The price regulatory systems in these two countries, which depress prices over the life of a drug, create incentives for firms to focus R&D efforts on a large number of new drugs in order to get frequent price increases, rather than invest in fewer, truly innovative drugs that achieve global penetration (Danzon, 1997).

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More recently, the structure of the pharmaceutical industry has been undergoing fundamental change. Horizontal mergers have combined some of the largest firms, ostensibly to further exploit potential economies of scale, scope and risk-pooling. Other large firms have integrated forward into distribution, with the acquisition of pharmacy benefit management companies. The stated rationale for this strategy is to gain access to information and possibly leverage to gain sales advantage. The long-term value of both the horizontal and vertical integration strategies remains to be determined, compared to the alternative of devoting the same resources to R&D. It is also plausible that the optimal strategy is different for different firms, depending on their other assets and capabilities. At the same time, the biotechnology revolution has dramatically increased the importance of small firms in discovery research and related development of new tools for enhancing R&D productivity, for example, through rational drug design. In the 1980s a very small number of successful biotech firms developed their functional scope to become fully integrated pharmaceutical companies, similar in structure to the traditional chemical-based firms. However, theory and evidence for the 1990s indicate a higher degree of specialization and mutual dependence between small and large firms. Most small firms now specialize in discovery, relying on large firms for development and marketing expertise where regulatory interactions and economies of scale play a greater role. Conversely, although large firms still have in-house R&D activities, they also draw extensively on discoveries - tools and target compounds - that are in-licensed from smaller firms. The extent and form of alliances between small firms, particularly biotech, and large firms varies, in part reflecting the particular expertise of large firms. However there is virtually universal recognition that small firms have a key role to play and that most large firms cannot compete effectively in the R&D race without taking advantage of the developments offered by small firms. An important implication of this mutual dependence is that it is now almost impossible - and perhaps a meaningless task - to attempt to estimate returns to scale in R&D productivity. Since all firms draw on technologies developed by other firms through licensure and other sharing arrangements, any attempt to allocate specific new drugs to specific firms in order to count the number of new drugs per firm is at risk of error because most drug innovation employs inputs developed by several other firms, in addition to the firm that ultimately takes it through the regulatory process.

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7. Promotion and Advertising 7.1 Information or Persuasion? The pharmaceutical industry’s large expenditures on advertising and promotion have been controversial in both the economic literature and the policy debate, with concern over both magnitude and form. Critics question the social value of these large promotional expenditures and charge that they lead to increased market power and higher prices. The alternative view is that promotion provides information to physicians and consumers which is necessary for the effective use of the products. Considerable research has focused on determining the competitive effect of promotional expenditures in the pharmaceutical industry. An early proponent of the anti-competitive hypothesis, Walker (1971) argues that large promotion expenditures raise entry barriers and increase market power, by requiring new entrants to make large outlays in order to attract attention to new products. The alternative view is that advertising may enhance competition by facilitating the introduction of new products and new firms. Schwartzman (1975) finds that more innovative firms spend larger sums on promotion. Telser (1975) finds that the extent of new entry into a therapeutic class is positively related to promotional intensity. However, this positive correlation between research and selling intensity, at the level of either the firm or the therapeutic class, does not prove that the effect of advertising is to enhance competition. Clearly the two may be simultaneously determined and both causally related to such unobservable factors as technological advance and market potential. Leffler (1981) estimates a model across therapeutic categories with selling effort as the dependent variable and the number of new products introduced as the primary explanatory variable. He finds a significant positive effect which he interprets as suggesting that informative advertising of pharmaceuticals may be substantial. He also finds evidence, however, that advertising of established pharmaceutical products accomplishes ‘reminder’ and ‘habit-formation’ purposes by finding significant coefficients on variables which indicate therapeutic categories in which he hypothesizes that the returns from noninformative, repetitive advertising are relatively high. These results suggest that the impact of advertising is multidimensional and that the net effect on competition may differ, depending on the circumstances. The distinction drawn by Leffler between the ‘persuasion’ and ‘information’ roles of pharmaceutical promotion is extended by Hurwitz and Caves (1988) in a study of promotional expenditures for a sample of drugs that went off-patent and their generic competitors. Their interest is in the scope of rent-seeking in manufacturers’ promotion outlays. They note that

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the social costs generated by rent-seeking behavior must be weighed against the efficiency advantages of sellers as suppliers of product information demanded by buyers. Their results indicate that the leader’s (the original patent holder) market share increases significantly with its own sales promotion, independent of the amount of goodwill generated before it went off-patent, although these past investments are also important. In addition, the leader’s share diminishes with generic outlays. The leader’s price premium significantly increases the generics’ share of advertising, although the implied sensitivity is small in the short run. They conclude that there are both information and rent-seeking functions of pharmaceutical promotion. Beales (1996) uses the FDA policy restricting manufacturer advertising of unapproved indications as a natural experiment to test the importance of pharmaceutical marketing as a source of information for physicians. He analyzes the impact of promotional activity following FDA approval of second indications for existing drugs on the share of patients treated with the newly approved product, the total fraction of patients treated with drug therapy, and the average price level. He finds some evidence that seller-provided information after approval results in increased market share for the new indication as well as lower average price per prescription of other products in the market, suggesting an increase in consumer benefits from increased manufacturer-provided information. However, it is difficult to differentiate between the impact of FDA approval itself and the impact of promotional expenditures in this study. 7.2 Regulation of Promotion and Advertising Several countries have adopted regulations designed to discourage promotion. The UK PPRS limits the promotional expenditure that can be deducted as a cost in calculating the net rate of return. The provisions of the German global drug budgets, that place the pharmaceutical industry at financial risk for budget overruns (after the share paid by physicians), are designed to discourage promotional effort. Similarly, the French revenue caps for individual pharmaceutical firms severely reduce the incentive for incremental promotional effort that would lead to a budget overrun for the firm. In the US, since 1962 the FDA has imposed strict limits on content of promotional material to physicians and consumers. More recently, the growth of managed care has fundamentally changed the nature of marketing of pharmaceuticals. The autonomy of the physician has been reduced, with power shifting to payers or their agents, in the form of pharmacy benefit managers or pharmaceutical and therapeutics committees that make formulary decisions. This shift in the primary ‘customer’ from the physician to a cost-conscious decision maker has been accompanied by a dramatic

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increase in the importance of cost-effectiveness analysis, to demonstrate that a particular drug is more cost-effective than the alternatives. The available evidence on use of cost-effectiveness analysis by managed care organizations is summarized in Elixhauser, Luce and Steiner (1995). In response to this trend, the FDA has proposed regulations that would require that a pharmaceutical firm’s cost-effectiveness claims be supported by ‘sound’ analysis. If this requirement is defined as requiring a double blind, randomized clinical trial between the two drugs under comparison, it raises many of the same issues that were debated at the time of the 1962 efficacy requirements. In particular, are the gains from reducing the risk of misleading claims outweighed by the costs of the added regulatory requirements? These costs would include higher out-of-pocket costs for firms that would ultimately be passed on to consumers; delay and foregone benefits to consumers if the diffusion of new drugs is delayed; and a reduction in the number of drugs that are worth developing. Again, some might argue that elimination of me-too drugs would, on balance, benefit consumers but, as discussed earlier, both theory and evidence on this point remain inconclusive. However, it seems likely that as purchasers are increasingly either a managed care regime in the US or sophisticated, cost-conscious institutional buyers in other countries, that firms will face strong incentives to eliminate drugs that are clearly going to be pure me-toos at an early stage in the R&D process. The case for a regulatory requirement for randomized controlled trials (RCTs) before cost-effectiveness claims can be made seems weaker than the case for RCTs for efficacy. The information on both costs and effects produced from RCTs is of dubious value as evidence of cost-effectiveness in practice because trials do not mirror actual practice. Strict protocols are applied to the selection of participating patients, to assure compliance and follow up all questionable outcomes. The result is that neither costs nor effects of controlled trials reflect those that would be realized in actual practice by a particular patient, group of patients or health plan. Moreover, the evidence (Elixhauser, Luce and Steiner, 1995) suggests that managed care plans are quite skeptical of cost-effectiveness claims made by manufacturers. Similar conclusions surely apply to government regulators that review such claims for public insurances. Nevertheless, there appears to be a strong case for encouraging competition in the provision of information on cost-effectiveness of pharmaceuticals, including the development of guidelines for the conduct of such studies.

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8. Conclusions The economics literature on the pharmaceutical industry has made many valuable contributions, in framing some of the important issues and providing useful - although rarely definitive - empirical evidence. Nevertheless, we still lack complete answers to some of the basic questions raised by policymakers and academics. If the moral hazard effects of insurance justify some forms of control, which forms provide the best trade-offs between reasonable control of costs, access for patients, incentives for efficient mix of medical services and incentives for innovative R&D? Is there a case for separate regulation of promotional activity for pharmaceuticals, distinct from that applied to other consumer products? If so, what forms of regulation of promotional activities yield the greatest net social benefits, and how does this differ between prescription and over-the-counter medications? These are only some of the interesting questions that remain to be explored.

Bibliography on The Pharmaceutical Industry (5880) Alexander, Donald, Flynn, Joseph E. and Linkins, Linda A. (1994), ‘Estimates of the Demand for Ethical Pharmaceutical Drugs Across Countries and Time’, 26 Applied Economics, 821-826. Anessi Pessina, Eugenio (1997), The Effect of User Charges on the Utilization of Prescription Medicines in the Italian National Health Service, Unpublished Doctoral Dissertation, Philadelphia, The Wharton School, University of Pennsylvania. Averch, Harvey and Johnson, Leyland (1962), ‘Behavior of the Firm under Regulatory Constraint’, 52 American Economic Review, 1052-1069 Baily, Martin N. (1972), ‘Research and Development Costs and Returns: The U.S. Pharmaceutical Industry’, 80 Journal of Political Economy, 70-85. Beales, J. Howard, III (1996), ‘New Uses for Old Drugs’, in Helms, Robert B. (ed.), Competitive Strategies in the Pharmaceutical Industry, Washington, DC, The American Enterprise Institute Press 281-305. Berndt, Ernst R. and Greenberg, Paul (1996), ‘Price Growth of Prescription Pharmaceutical Preparations: An Update and Explanation’, in Helms, Robert B. (ed.), Competitive Strategies in the Pharmaceutical Industry, Washington, DC, The American Enterprise Institute Press, 35-48. Berndt, Ernst R., Griliches, Zvi and Rosett, Joshua G. (1993), ‘Auditing the Producer Price Index: Micro Evidence from Prescription Pharmaceutical Preparations’, 11 Journal of Business and Economic Statistics, 251-264. BEUC (1989), Drug Prices and Drug Legislation in Europe, Brussels. Boston Consulting Group (1993), The Changing Environment for U.S. Pharmaceuticals. Caves, Richard E., Whinston, Michael D. and Hurwitz, Mark A. (1991), ‘Patent Expiration, Entry, and Competition in the U.S. Pharmaceutical Industry’, Brookings Papers on Economic Activity: Microeconomics, 1-66.

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Clarkson, Kenneth W. (1996), ‘The Effects of Research and Promotion on Rates of Return’, in Helms, Robert B. (ed.), Competitive Strategies in the Pharmaceutical Industry, Washington, DC, American Enterprise Institute Press, 238-268. Comanor, William S. (1964), ‘Research and Competitive Product Differentiation in the Pharmaceutical Industry in the United States’, 31 Economica, 372-384. Comanor, William S. (1986), ‘The Political Economy of the Pharmaceutical Industry’, 24 Journal of Economic Literature, 1178-1217. Danzon, Patricia M. (1996), ‘The Uses and Abuses of International Price Comparisons’, in Robert B. (ed.), Competitive Strategies in the Pharmaceutical Industry, Washington, DC, The American Enterprise Institute Press, 85-106. Danzon, Patricia M. (1997a), Price Regulation in the Pharmaceutical Industry: National vs. Global Interests, Washington, DC, The American Enterprise Institute Press. Danzon, Patricia M. (1997b), ‘Price Discrimination for Pharmaceuticals: Welfare Effects in the US and the EU’, 4 International Journal of the Economics of Business, 301-322. Danzon, Patricia M. (1998), ‘The Economics of Parallel Trade’, 13(3) PharmacoEconomics, 1-12. Danzon, Patricia M. and Kim, Jeong (1996), ‘International Price Comparisons for Pharmaceuticals’, Working Paper, Philadelphia, University of Pennsylvania, The Wharton School. Danzon, Patricia M. and Liu, Hong (1996), ‘Reference Pricing and Physician Drug Budgets: The German Experience in Controlling Pharmaceutical Expenditures’, Working Paper, Philadelphia, University of Pennsylvania, The Wharton School. Danzon, Patricia M. and Percy, Allison (1996), ‘The Effects of Price Regulation on Productivity in Pharmaceuticals’, in Robert Lipsey (ed.), Studies in Income and Wealth, National Bureau of Economic Research, forthcoming. DiMasi, Joseph A., Bryant, N.R. and Lasagna, Louis (1991), ‘New Drug Development in the United States from 1963 to 1990’, 50(5) Clinical Pharmacology and Therapeutics. DiMasi, Joseph A., Hansen, Ronald W., Grabowski, Henry G. and Lasagna, Louis (1991), ‘The Cost of Innovation in the Pharmaceutical Industry’, 10 Journal of Health Economics, 107-142. Dranove, David and Meltzer, David (1994), ‘Do Important Drugs Reach the Market Sooner?’ 25 Rand Journal of Economics, 402-423. Drummond, Michael F. (1994), ‘Guidelines for Pharmaoeconomic Studies: The Way Forward’, 6 Pharmacoeconomics, 493-497. Drummond, Michael F. (1996), Experimental versus Observational Data in the Economic Evaluation of Health Care Technologies, University of North Carolina. Elixhauser, Anne, Luce, Bryan R. and Steiner, Claudia A. (1995), Cost Effectiveness Analysis, Medical Technology Assessment, and Managed Care Organizations, Bethesda, MD, MEDTAP International Inc.. Ellis, Randall and McGuire, Thomas (1991), ‘Optimal Payment Systems for Health Services’, 10 Journal of Health Economics. Farmindustria (1993), Indicatori Farmaceutici, Rome, Farmindustria. Frank, Richard G. and Salkever, David S. (1992), ‘Pricing, Patent Loss and the Market for Pharmaceuticals’, Southern Economic Journal, 165-79. Grabowski, Henry G. (1980), Drug Regulation and Innovation.

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Grabowski, Henry G., Vernon, John M. and Thomas, Lacy G., II (1978), ‘Estimating the Effects of Regulation on Innovation: An International Comparative Analysis of the Pharmaceutical Industry’, 21 Journal of Law and Economics, 133-163. Grabowski, Henry G. and Vernon, John M. (1976). ‘Structural Effects of Regulation on Innovation in the Ethical Drug Industry’, in Masson, R.T. and Qualls, P.D. (eds), Essays on Industrial Organization in Honor of Joe S. Bain, Cambridge, MA, Lippincott, Ballinger 181-205. Grabowski, Henry G. and Vernon, John M. (1977). ‘Consumer Protection Regulation in Ethical Drugs’, 67 American Economic Review, 359-64. Grabowski, Henry G., Vernon, John M. and Thomas, Lacy Glenn (1978), ‘Estimating the Effects of Regulation on Innovation: An International Comparative Analysis of the Pharmaceutical Industry’, 21 Journal of Law and Economics, 133-163. Grabowski, Henry G. and Vernon, John M. (1990), ‘A New Look at the Returns and Risks to Pharmaceutical R&D’, 36 Management Science, 804-821. Grabowski, Henry G. and Vernon, John M. (1992), ‘Brand Loyalty, Entry and Price Competition in Pharmaceuticals after the 1984 Act’, 35 Journal of Law and Economics, 331-350. Grabowski, Henry G. and Vernon, John M. (1993), ‘Returns to R&D on New Drug Introductions in the 1980's’, in Helms, Robert B. (ed.), Conference on Competitive Strategies in the Pharmaceutical Industry, Washington, DC, The American Enterprise Institute Press. Grabowski, Henry G. and Vernon, John M. (1996), ‘Prospects for Returns to Pharmaceutical R&D under Health Care Reform’, in Helms, Robert B. (ed.), Competitive Strategies in the Pharmaceutical Industry, Washington, DC, The American Enterprise Institute Press194-207. Griliches, Zvi and Cockburn, Iain (1994), ‘Generics and New Goods in Pharmaceutical Price Indexes’, 84 American Economic Review, 1213-1232. Hansen, Ronald W. (1979), ‘The Pharmaceutical Development Process: Estimates of Current Development Costs and Times and the Effects of Regulatory Changes’, in Chien, R.I. (ed.), Issues in Pharmaceutical Economics, Lexington, MA, Lexington Books. 151-187. Henderson, Rebecca and Cockburn, Iain (1996), ‘The Determinants of Research Productivity in Ethical Drug Discovery’, in Helms, Robert B. (ed.), Competitive Strategies in the Pharmaceutical Industry, Washington, DC, The American Enterprise Institute Press, 167-193. Hurwitz, Mark A. and Caves, Richard E. (1988), ‘Persuasion or Information? Promotion and the Shares of Brand Name and Generic Pharmaceuticals’, 31 Journal of Law and Economics, 299-320. Leffler, Keith B. (1981), ‘Persuasion or Information? The Economics of Prescription Drug Advertising’, 24 Journal of Law and Economics, 45-74. Lu, John and Comanor, William (1998), ‘Strategic Pricing of Pharmaceuticals’, Review of Economics and Statistics, forthcoming. Masson, Alison and Steiner, Robert L. (1985), Generic Substitution and Prescription Drug Prices: Economic Effects of State Drug Product Selection Laws, Washington, DC, Bureau of Economics, Federal Trade Commission. Munnich, Frank E. and Sullivan, K. (1994), ‘The Impact of Recent Legislative Change on Germany’, 6(Suppl.1) PharmacoEconomics, 11-16.

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Myers, Steward C. and Shyam-Sunder, Lakshmi (1996), ‘Measuring Pharmaceutical Industry Risk and the Cost of Capital’, in Helms, Robert B. (ed.), Competitive Strategies in the Pharmaceutical Industry, Washington, DC, The American Enterprise Institute Press, 208-237. Pauly, Mark V. (1968). ‘The Economics of Moral Hazard’, 58 American Economic Review, 231-237. Peltzman, Sam (1973), ‘An Evaluation of Consumer Protection Legislation: The 1962 Drug Amendments’, 8 Journal of Political Economy, 1049-1091. Pharmaceutical Research and Manufacturers of America (PhRMA) (1997), 1997 Industry Profile, Washington, DC. Ramsey, Frank P. (1927), ‘A Contribution to the Theory of Taxation', 37 Economic Journal’, 47-61. Reekie, W. Duncan (1978), ‘Price and Quality Competition in the United States Drug Industry’, 26 Journal of Industrial Economics, 223-237. Scherer, Frederic M. (1993), ‘Pricing, Profits and Technological Progress in the Pharmaceutical Industry’, 7 Journal of Economic Perspectives, 97-115. Scherer, Frederic M. (1996), ‘How U.S. Antitrust Can Go Astray: The Brand Name Prescription Drug Litigation’, 4 International Journal of the Economics of Business, 239-256. Schmalensee, Richard (1982), ‘Product Differentiation Advantages of Pioneering Brands’, 72 American Economic Review, 349-365. Schulenburg, Mathias V.D. and Schöffski, O. (1993), Implications of the Structural Reform of Healthcare Act on the Referral and Hospital Admission Practices of Primary Care Physicians, Hanover, University of Hanover, Institute of Insurance Science. Schulenburg, J. Matthias Graf Von Der and Schöffski, Oliver (1994), ‘Transformation des Gesundheitswesens im Spannungsfeld zwischen Kostendämpfung und Freiheit, Eine ökonomische Analyse des veränderten Überweisungs- und Einweisungsverhaltens nach den Arzneimittelregulierungen des GSG (Transformation of the Health Care System, An Economic Analysis of the Changes in Referrals and Hospital Admissions after the Drug Budget of the Health Care Reform Act of 1992)’, in Oberender, P. (ed.), Probleme der Transformation im Gesundheitswesen, Baden-Baden, Nomos, 45-81. Schwartzman, David (1975), The Expected Return from Pharmaceutical Research, Washington, DC, The American Enterprise Institute Press. Schweitzer, Stuart O., Schweitzer, Maurice E. and Guellec, Marie S. (1996), ‘Is There a U.S. Drug Lag? The Timing of New Pharmaceutical Approvals in the G-7 Countries and Switzerland’, 53 Medical Care Research and Review, 162-178. Suslow, Valerie Y. (1996), ‘Measuring Quality Change in the Market for Anti-Ulcer Drugs’, in Helms, Robert B. (ed.), Competitive Strategies in the Pharmaceutical Industry, Washington, DC, The American Enterprise Institute Press, 49-72. Telser, Lester (1975), ‘The Theory of Supply with Applications to the Ethical Pharmaceutical Industry’, 18 Journal of Law and Economics, 449-478. Temin, Peter (1980), Taking Your Medicine: Drug Regulation in the United States, Cambridge, MA, Harvard University Press. Thomas, Lacy Glenn, II (1990), ‘Regulation and Firm Size: FDA Impacts on Innovation’, 21 RAND Journal of Economics, 497-517.

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Thomas, Lacy Glenn, II (1996), ‘Industrial Policy and International Competitiveness in the Pharmaceutical Industry’, in Robert B. Helms (ed.), Competitive Strategies in the Pharmaceutical Industry, Washington, DC, The American Enterprise Institute Press, 107-129. US Congress, Office of Technology Assessment (OTA) (1993), Pharmaceutical R&D: Costs, Risks and Rewards, Washington, DC, Government Printing Office. US Congressional Budget Office (CBO) (1994), An Analysis of the Administration’s Health Proposal, Washington, DC, Government Printing Office. US General Accounting Office (GAO) (1992), Prescription Drugs: Companies Typically Charge More in the United States than in Canada, Washington, DC, Government Printing Office. US General Accounting Office (GAO) (1994), Prescription Drugs: Companies Typically Charge More in the United States than in the UK, Washington, DC, Government Printing Office. Walker, Hugh E. (1971), Market Power and Price Levels in the Ethical Drug Industry, Bloomington, University of Indiana Press. Wardell, William M. (1973), ‘Introduction of New Therapeutic Drugs in the United States and Great Britain: An International Comparison’, 14 Clinical Pharmacology Therapeutics, 773-790. Wardell, William M. and Lasagna, Louis (1975), Regulation and Drug Development, Washington, DC, American Enterprise Institute Press. Wiggins, Steven N. (1981), ‘Product Quality Regulation and New Drug Introductions: Some New Evidence from the 1970s’, 63 Review of Economics and Statistics, 615-619. Zeckhauser, Richard (1971), ‘Medical Insurance: A Case Study of the Trade-Off Between Risk Spreading and Appropriate Incentives’, 2 JET, 10-26. Zweifel, Peter and Crivelli, Lucien (1996), ‘Price Regulation: Lessons from Germany’, 9 Journal of Regulatory Economics.

5890 FRANCHISE CONTRACTS Antony W. Dnes The Nottingham Trent University © Copyright 1999 Antony W. Dnes

Abstract Theoretical and empirical work on franchising has developed from agency theory and from ideas about asset specificity and opportunism associated with transactions-cost analysis. I begin by considering some traditional arguments about the capital-structure function of franchising. Next, I consider agency and transaction-cost theoretical explanations of franchising. An interesting special case is where the franchisor also runs company stores. Econometric work supports the view that franchise contracts protect against reciprocal opportunism. I also examine several arguments concerning the possible nature of ‘hostages’ in franchise contracts. JEL classification: K23, L22 Keywords: Franchising, Agency, Search Theory, Hostages

1. Introduction Franchising is an organizational form lying between markets and hierarchies, and can follow either a business-format or a simpler dealership model. It is a symbiotic relationship between businesses (Schanze, 1991). Business-format franchising, in which the franchisor supplies a brand name and also a model business for the franchisee to copy, is the growing sector of franchising and covers businesses like vehicle rental and fast-food restaurants. Many of the differences between business-format franchising and dealerships (for example, cars or petroleum) are disappearing over time as manufacturers provide a wide range of support for their dealers. Theoretical and empirical work on franchising has developed from agency theory and from ideas about asset specificity and opportunism associated with transaction-cost analysis. I begin by considering some traditional arguments about the capital-structure function of franchising. Next, I consider agency and transaction-cost theoretical explanations of franchising. An interesting special case is where the franchisor also runs company stores. Econometric work supports the view that franchise contracts protect against reciprocal opportunism. I also examine several arguments concerning the possible nature of ‘hostages’ in franchise contracts.

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2. Franchising as a Method of Raising Capital An early argument is that firms franchise to raise capital for expansion (Caves and Murphy, 1975). Rubin (1978) argues that this makes no sense unless we assume that the franchisor is more risk averse than the franchisee, which is implausible. Even if franchisors could not use normal capital markets, they could sell shares in a portfolio of all outlets. The shares would diversify risk for the buyers but impose no costs on the franchisor. Franchisees would pay less for undiversified investments if they are risk averse, which implies smaller returns for franchisors. Any capital-market advantages from franchising must come from shifting risk to the franchisee, which only makes sense if the franchisor is the more risk averse. Rubin’s argument that capital raising does not explain franchising depends upon an assumption of zero transaction costs. Franchising can be a capital issue under less restrictive assumptions. However, empirical work generally supports organizational costs rather than capital-market influences as the driving force behind franchising. Lafontaine (1992) discovered that increases in the capital cost of opening stores reduced the proportion of franchised outlets, which is contrary to the capital-raising story.

3. Franchising as a Problem of Monitoring and Control Rubin explains the features of franchising in terms of solving monitoring problems. In retail networks where the satellite business is remote from the head office monitoring is difficult and it pays to develop an incentive system that encourages the avoidance of shirking. A profit-sharing agreement gives the franchisee sufficient residual profits to make shirking too costly. The franchise chain will show more total profit if shirking is controlled. Franchisors will not pay any more profit to franchisees than is necessary to remove the incentive to shirk. A competitive supply of prospective franchisees should be willing to pay lump sums equal to the difference between franchise profits and what they could earn as managers in similar occupations. We do not usually observe franchise contracts of this kind. Instead franchisees pay a lump-sum initial fee, and a continuing royalty payment related to sales, in return for residual profits. The most plausible explanation is that the franchisee requires protection against poor post-contract performance by the franchisor. The franchisor’s duties cover such things as providing managerial support and the monitoring of standards of operation throughout the franchise system. Monitoring of the system is necessary to control a classic externality problem: if one franchisee allows quality to deteriorate, he benefits by the full amount of the savings from reduced quality but incurs only part of

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the costs as other franchisees will suffer some of the loss of business. This type of externality is described by Mathewson and Winter (1985) as horizontal free riding. The theory generates several predictions. Increasing the geographical density of outlets should make operating company stores more attractive. Also, franchisors should buy back their outlets as their chains become more mature, the density of outlets increases, and distance-related monitoring costs become lower per outlet. Buy-backs are observed in mature chains. Much econometric work supports the importance of geographical density in explaining franchising (Lafontaine, 1992; Brickley and Dark, 1987; Norton, 1988). Lafontaine also finds evidence that increases in the importance of the franchisor’s inputs increase the royalty, which supports the view that franchise contracts are partly constructed to control the franchisor’s opportunism.

4. Modelling Franchising as an Agency Relationship Mathewson and Winter (1985) argue that horizontal externalities are not necessary to explain franchise contracts. Monitoring difficulties arise for the franchisor even when there is only one territory. However, vertical externality (chiselling on the franchisor’s standards) is an ever-present problem. Risk aversion on the part of the franchisee is also not a sufficient condition for the emergence of a franchise contract. The franchisor could impose a large penalty if the franchisee were caught cheating, making the franchisee’s income the same across different demand conditions and giving a pure risk-sharing contract with no profit-sharing. However, the penalty may be infeasible owing to wealth constraints affecting the franchisee and this gives profit sharing. In their model local demand at a franchised outlet is subject to uncertainty and may take a high or low state. The franchisor cannot costlessly identify any ruling state of demand. The franchisee has better local information and may attempt to reduce the quality of his effort in high demand states and try to pass off the resulting low output as due to a low demand state, reflecting a problem of franchisee moral hazard. The franchise contract specifies the franchise fee schedule (lump sum plus royalty) plus the quality of the franchisee’s input in good and bad demand states. Mathewson and Winter agree with Rubin that the first-best contract between franchisor and franchisee would lease the brand name in return for a lump-sum payment. The franchisor would be encouraged by the incentive of maximizing the fee to find the joint-profit-maximizing monitoring arrangements. Each franchisee would pay a fee conditional on the value of the brand name and therefore dependent on the optimal amount of monitoring, and could enforce the contract ex post.

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If it is infeasible to cover all aspects of the franchise relationship in an explicit contract, profit-sharing emerges. In their basic model, Mathewson and Winter attribute this to a constraint on the wealth of franchisees that prevents them from sinking large investments into franchises. This empirically relevant constraint makes franchisors rely on rewards rather than the penalty of termination to maintain franchisees’ standards. An incentive-compatibility constraint in their model ensures that the profit accruing to the franchisee from correctly declaring the better demand state and applying the correct effort level exceeds the profit from wrongly declaring the poor state and adjusting effort downward. A participation constraint ensures that the contract gives sufficient profit for the franchisee to pay a royalty fee. Mathewson and Winter derive the franchise fees, franchise effort in each state, the level of brand-name investment by the franchisor (including advertising) and the frequency of monitoring. The removal of the wealth constraint from the model opens up the possibility that franchisees could post bonds to guarantee good performance. Mathewson and Winter agree with Rubin that bond posting is problematic as the franchisor might behave opportunistically. The expected value of the lump sum must be less than the profits accruing to the franchisor from the proper delivery of services. Otherwise, there will be an incentive for the franchisor to abscond with the lump sum, possibly by contriving some reason for contract termination. The royalty, or its equivalent, is always the engine for rent extraction.

5. The Organizational Mix ‘Dual distribution’ is an important phenomenon. Gallini and Lutz’s (1992) model shows that both dual distribution and the use of a sales royalty may be methods by which a new franchisor signals the profitability of the franchise chain by making franchisor returns dependent on the revenues of company stores. Consider the case where a franchisor with a fixed number of outlets knows that demand is favourable so that stores should be unusually profitable. The problem is to convey this information in a credible manner to prospective franchisees. The high-profit franchisor chooses the proportion of company stores, the lump sum and the royalty to establish a separating equilibrium defining a contract that a low-profit franchisor would never offer. A separation constraint ensures that a low quality franchisor will always make more profit from truthfully declaring quality and franchising all stores, compared with emulating the dual-distribution strategy of the high-profit franchisor. A number of predictions may be made on the basis of signalling theory, but they are not supported by empirical work. To take one as an example, the high profitability of some franchises would be recognized over time and there would be no need for franchisors to operate company stores as a signal. We should see

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mature franchise chains concentrating on franchising, rather than the operation of company stores. Whilst there is possibly some support for this hypothesis, for example Martin (1988) observes that older units are often franchised, economists often observe a buy-back phenomenon (Thompson, 1994) as the chain matures. Lafontaine (1993) reports econometric results showing no support for a range of hypotheses suggesting that franchisors use their organizational mix as a method of signalling.

6. A Search Theory of Franchising Minkler (1992) has suggested that franchising is a device through which the franchisor gathers and uses local information. The theory is Austrian in character and emphasizes the key role played by information in the competitive process. There is a dark side to franchising in Minkler’s approach: franchisees are useful temporary tools, rather as in some of the small-business literature (Hoy, 1994; Bates, 1995). According to agency-based theories of franchising distance of the satellite business from the mother company, which makes monitoring more difficult, should be associated with an increased reliance on franchising. However, Minkler cites examples where franchised and company stores operate in close proximity to each other. For example, in Sacramento, California, 34 Taco Bell restaurants covered a 30-mile radius, of which seven were company owned. Minkler argues that franchisors draw on the local knowledge of franchisees, which concerns local tastes and market conditions. The franchisor might be unable to direct the satellite business, even if monitoring costs were zero, because of ignorance. Franchising allows the use of the trade mark to be exchanged for the franchisee’s local entrepreneurship, which is defined as noticing and acting upon opportunities. The franchisee’s local entrepreneurship reduces the cost of search for new business. How reasonable is the search-cost theory? Empirical work by Minkler shows that older outlets are more likely to be franchised than newer ones, which is consistent with the theory and with Martin’s (1988) results, although it is not consistent with Thompson (1994). A problem is that the buy-back phenomenon is consistent with many theories: for example older stores may be easier to monitor owing to experience effects unconnected with distance. It is difficult to imagine an empirical test to distinguish Minkler’s theory from others.

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7. Vertical Restrictions and Franchising Within the mainstream industrial-organization literature there are papers which show that a firm with monopoly power supplying an intermediate product into a competitive industry has an incentive to exercise vertical control if downstream input substitution is possible. Vertical restrictions principally comprise refusal to supply, tied-in sales, and exclusive-dealing contracts. The arguments of several economists that there are efficiency reasons for all of these practices are reflected in the specialist economic analysis of franchising, and in the benign view taken by European competition law towards franchising (Dnes, 1991c). For example, against simple claims that a monopolist could foreclose a downstream market by refusing to supply unless buyers were tied into a restrictive contract, it may be argued that it is profitable to allow access to inputs at monopoly prices to more efficient downstream firms. Although, to be fair, some recent analysis has revealed conditions under which refusal to supply (Bolton and Whinston, 1993) is a credible policy committing a firm to compete aggressively in the downstream market and deterring entry. Analyses of franchising based on monopoly-power explanations of vertical restrictions are typically less general than theories based on the economics of organization. As a very simple example of lack of generality, note that monopoly-power theories of vertical restrictions usually deal with product franchises, when most business-format franchises are based on services, and would seem to have relevance only for brand-and-trade-name franchising. The relevance of the market-power approach is further questioned by a lack of supporting empirical evidence: for example Lafontaine (1992) found that the proportion of franchised outlets decreased as franchisor input sales increased. Blair and Kaserman (1982) formulate a two-period model that does represent the franchise contract as a mixture of vertical controls. The model predicts use of both a lump sum and a royalty whenever the franchisor’s and franchisee’s discount factors diverge (reflecting perceptions of uncertainty). Blair and Kaserman avoid regarding individual controls like resale price maintenance (RPM) and franchise fees as perfect substitutes for one another. In general, franchising firms use a mix of contractual devices and cannot be indifferent between them. Blair and Kaserman suggest there may be complementarity between monopoly-power and organizational explanations of common features of franchised businesses. A franchisor with the relatively lower discount factor would not be able to extract all the expected downstream rent from the franchisee. Thus, post-contract tensions would arise as the franchisor saw franchisees enjoying super-normal profits. If franchisor uncertainty over forecasts fell over time, mature franchise chains would open more company stores. Blair and Kaserman also suggest that the franchisor can practice

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post-contract opportunism. The franchisor must promise the franchisee a normal return on investment. Afterwards, however, the franchisor may be able to increase his share of sales revenue without provoking the franchisee to close down (if there were worse losses from closing). The franchisor may use strategies like forcing, where quotas push sales past the point of profit maximization for the franchisee. Blair and Kaserman share some of the concerns over franchisor and franchisee incentive compatibility shown in the organizational literature and are not solely motivated by traditional market-power issues. Efficiency-based explanations of vertical restrictions are descended from Telser’s (1960) analysis of RPM. A retailer could provide service levels like advice and product demonstrations only to find that consumers made use of these and then bought the product at a low price from a no-frills retailer. There is a free-rider problem among retailers implying that no retailer would provide services. If service levels matter in promoting sales for the manufacturing and retailing industries combined, and are not separable, a means like RPM must be found to defeat free riding. Marvel (1982) explains exclusive dealing, which is a common feature of franchising, in a similar fashion. When a manufacturer with a valuable brand supplies an outlet it endorses the retailer’s business and centralized advertising may promote the retailer’s sales more generally. Marvel argues that exclusive dealing prevents retailers from diverting business to other brands and wasting advertising. Klein and Saft (1985) examine tied-in sales and argue that franchisors use these either to control the quality of the final service, or to measure the sales of franchisees. Where the franchisee cannot substitute away from the input, a mark-up on a tie-in is equivalent to a fixed percentage sales royalty if price is predictable. Tie-ins may also develop where the franchisor wishes to ensure that franchisees use inputs of specific quality. Rather than monitoring the required technical properties of more generic inputs, the franchisor has the much simpler problem of ascertaining whether anything else was used.

8. Hostages in Franchise Contracts Transaction-cost analysis shows that franchise contractual provisions that are often regarded as unfair in the law have important implications for efficiency (Klein, 1995). Fully contingent, costlessly enforceable, explicit contracts are not usually feasible. Uncertainty implies a large number of possible contingencies and some aspects of contractual performance are difficult to measure. Individuals have an incentive to renege on agreements and hold-up any contracting partner who has made specific investments by taking advantage of unspecified or unenforceable aspects of contracts. Full vertical integration

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between trading partners will not always be observed: for example integration of human capital is outlawed by the prohibition of slavery. One method of safeguarding performance is for a potential cheater to post a bond (a ‘hostage’) possibly in an implicit form if the cheater is required to make an investment in a highly specific form with a very low salvageable value. In both cases, the same purpose is served. Franchise contracts typically require franchisees to pay lump-sum fees to franchisors and to make highly specific investments in equipment. The franchisor usually takes the right to terminate the contract at will if the franchisee is not maintaining quality standards. For any hostage to be effective it must set the franchisee’s expected gain from cheating equal to zero. This implies that hostages will be worth much more than the actual gain when monitoring costs are positive. Cheating by the franchisor is controlled by possible increases in operating costs. A franchisor known to appropriate hostages opportunistically would lose franchisees and find it hard to recruit new ones, forcing him to use more costly organizational forms. As long as the franchisee’s bond is greater than the franchisee’s expected gain from cheating and is less than the cost penalty imposed on the franchisor on moving to some other organizational form, a hostage can support their relationship. The hostage is a low-cost substitute for costly monitoring and enforcement devices. Of particular interest is Klein’s argument that the franchisor’s contractual right to terminate the contract at will (for good cause) supports a number of hostages. Given termination at will, the common requirement that franchisees lease their properties from the franchisor can be explained. The franchisee could be forced to move premises and sacrifice valuable leasehold improvements, which would revert to the franchisor as lessor. This gives the franchisor a hostage with which to control franchisee behaviour and enables monitoring to be reduced with an associated cost saving. In recent years Klein has moved to the view that the rents attached to the non-salvageable investment should be the focus in valuing the franchisee’s potential loss, at least in cases where there are no binding legal constraints on the franchisor’s behaviour. It is important to recognize the rich variety of devices used to support contracts. The use of restrictive covenants in franchise agreements can also be explained in terms of hostages. Covenants usually prevent a franchisee from competing in a market area for some period after leaving the franchise system, implying that the non-availability of an alternative rent stream is used to constrain the franchisee’s behaviour: that is, he cannot cheat and leave for better pastures. A new franchisee’s future level of skill is not known but if he becomes highly adept at his business, he might be tempted to set up on his own. A covenant prevents the franchisee from simply removing the franchisor’s investment in his training. Also, termination by the franchisor can cause the loss of the hostage.

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Williamson (1985) makes some suggestions concerning likely hostage selection. Implicit hostages are less vulnerable to opportunistic appropriation by trading partners compared with pecuniary hostages. A hostage can be selected to be unattractive to its holder. An ideal hostage is like an ‘ugly princess’: the medieval king with two equally cherished daughters would be wiser posting the ugly one as a hostage, as she is less likely to be appropriated by the captor. A number of common observations emerge from studying franchisees’ contracts (Dnes, 1993d). Franchising increases the specificity of investment for the satellite business, compared with independent operation, for example leasehold improvements are trademarked and hard to adapt to other uses. Also, lump-sum fees are typically small in relation to sunk investment for the franchisee and appear to be linked to the franchisor’s costs of establishing the franchisee (training and launch advertising). The implicit aspects of contracts are important and show adjustments that favour the interests of both franchisees and franchisors. The feasibility of placing disciplinary hostages with franchisors is qualified by the explicit and implicit details of franchise contracts, which often set out conditions under which the franchisor must buy-back assets in the event of termination. Statute law in some countries, like the USA, also makes it difficult to call in a hostage for disciplinary reasons. Principles of common law, such as the prohibition against penal damages for breach of contract, may also make disciplinary hostages illegal in an Anglo-American setting. It is not surprising that franchisees are careful to avoid hostage penalties in their contracts: investments in such things as leasehold improvements are not ugly princesses but are of potential direct value to the franchisor. There are several questions about the real-world feasibility of disciplinary hostages, regardless of whether these are measured as rent streams or as the book value of sunk investments. Sunk investment by the franchisee may well have mainly a screening function, serving to demonstrate confidence in his own competence.

9. Conclusions The last decade has witnessed progress in the scientific understanding of franchising. Several theories have been constructed to explain franchising, most of which emphasize savings of monitoring costs in an agency framework. Details of the theories show how opportunism on the part of both franchisors and franchisees may be controlled. In separate developments, writers have argued that franchisors recruit franchisees to reduce information-search costs, or that they signal franchise quality by running company stores.

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Empirical studies tend to support theories emphasizing opportunism on the part of franchisors and franchisees. Thus, elements of both agency approaches and transaction-cost analysis receive support. The most robust finding is that franchising is encouraged by factors like geographical dispersion of units, which increases monitoring costs. Other key findings are that small units and measures of the importance of the franchisee’s input encourage franchising, whereas increasing the importance of the franchisor’s centralized role encourages the use of company stores. In many key respects, in result although not in principle, transaction-cost analysis and agency analysis are just two different languages describing the same franchising phenomena.

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Lee, Tenpao, Kim, Tae Kyun and Baumel, C. Phillip (1988), ‘Impact of Deregulation on the Financial Performance of the Class I Railroads: Heuristic Models of Pooled Time Series and Cross Sectional Data’, 24 Logistics and Transportation Review, 281-296. Lee, Tenpao, Kim, Tae Kyun and Baumel, C. Phillip (1989), ‘Impact of Deregulation on the Financial Performance of the Class I Railroads: Errata’, 25 Logistics and Transportation Review, 91-94. Levine, Michael E. (1975), ‘Regulating Airmail Transportation’, 18 Journal of Law and Economics, 317-359. Levine, Michael E. (1981), ‘Revisionism Revised? Airline Deregulation and the Public Interest’, 44(1) Law and Contemporary Problems, 179-195. Levine, Michael E. (1987), ‘Airline Competition in Deregulated Markets: Theory, Firm Strategy, and Public Policy’, 4 Yale Journal on Regulation, 393-494. Lewisch, Peter (1989), Erwerbsfreiheit und Bedarfsprüfung (The Freedom to Earn One’s Living as Subjected to Regulations Concerning Needs), Vienna, Marktwirtschaftliche Schriften des Carl Menger Institutes, 47 p. Lewisch, Peter (1991), ‘The Political Economy of Barriers to Entry: The Example of the Amendment for Taxicab Regulation in Austria’, in Weigel, Wolfgang (ed.), Economic Analysis of Law - A Collection of Applications, Vienna, Österreichischer Wirtschaftsverlag, 222-234. MacDonald, James M. (1989), ‘Railroad Deregulation, Innovation, and Competition: Effects of the Staggers Act on Grain Transportation’, 32 Journal of Law and Economics, 63-95. McCarthy, Patrick S. and Oesterle, William (1987), ‘The Deterrent Effects of Stiffer DUI Laws: An Empirical Study’, 23 Logistics and Transportation Review, 353-371. McFarland, Henry (1987), ‘Did Railroad Deregulation Lead to Monopoly Pricing? An Application of q*’, 60 Journal of Business, 385-400. McGowan, Francis and Seabright, Paul (1989), ‘Deregulating European Airlines’, 0(9) Economic Policy: A European Forum, 283-344. McKenzie, Richard B. and Shughart, William F., II (1987), ‘Deregulation and Air Travel Safety’, 11(3-4) Regulation, 42-47. McMullen, B. Starr and Stanley, Linda R. (1988), ‘The Impact of Deregulation on the Production Structure of the Motor Carrier Industry’, 26 Economic Inquiry, 299-316. McShan, Scott and Windle, Robert J. (1989), ‘The Implications of Hub and Spoke Routing for Airline Costs and Competitiveness’, 25 Logistics and Transportation Review, 209-230. Meyer, John R. and Oster, Clinton V., Jr (eds) (1981), Airline Deregulation: The Early Experience, Boston, Auburn House. Meyer, John R., Oster, Clinton V., Jr and Strong, John S. (1987), ‘The U.S. Experience with Airline Deregulation: The Effect on Travelers: Fares and Service’, in Meyer, John R. and Oster, Clinton V., Jr (eds), Deregulation and the Future of Intercity Passengers, Cambridge, MA, MIT Press, 109-124. Michel, Allen and Shaked, Israel (1987), ‘Trucking Deregulation and Motor Carrier Performance: The Shareholders’ Perspective’, 22 Financial Review, 295-311. Migué, Jean-Luc, Bélanger, Gérard and Boucher, Michel (1978), Le prix du transport au Québec (The Cost of Transport in Quebec), Québec, Éditeur officiel du Quebec. Miller, James C., III (1979), ‘Airline Market Shares vs. Capacity Shares and the Possibility of Short-Run Loss Equilibria’, 1 Research in Law and Economics, 81-96.

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Mitchell, Mark L. and Maloney, Michael T. (1989), ‘Crisis in the Cockpit? the Role of Market Forces in Promoting Air Travel Safety’, 32 Journal of Law and Economics, 329-355. Moore, Thomas G. (1976), Trucking Regulation. Lessons from Europe, Washington, American Enterprise Institute for Public Policy Research, 148 p. Moore, Thomas G. (1978), ‘The Beneficiaries of Trucking Regulation’, 21 Journal of Law and Economics, 327-343. Moore, Thomas G. (1986), ‘U.S. Airline Deregulation: Its Effects on Passengers, Capital, and Labor’, 29 Journal of Law and Economics, 1-28. Moore, Thomas G. (1988), ‘Transportation Policy’, 12(3) Regulation, 57-62. Morrison, Steven A. and Winston, Clifford (1986), The Economic Effects of Airline Deregulation, Washington, Brookings Institution, 84 p. Morrison, Steven A. and Winston, Clifford (1990), ‘The Dynamics of Airline Pricing and Competition’, 80 American Economic Review. Papers and Proceedings, 389-393. Moses, Leon N. and Savage, Ian (eds) (1989), Transportation Safety in an Age of Deregulation, Oxford, Oxford University Press, 368 p. Nelson, James C. (1987), ‘Politics and Economics in Transport Regulation and Deregulation: A Century Perspective of the ICC’s Role’, 23 Logistics and Transportation Review, 5-32. Netter, Jeffry M., Poulsen, Annette B. and Hersch, Philip L. (1988), ‘Insider Trading: The Law, the Theory, the Evidence’, 6(3) Contemporary Policy Issues, 1-13. Olson, C. Vincent and Trapani, John M. II (1981), ‘Who Has Benefited from Regulation of the Airline Industry?’, 24 Journal of Law and Economics, 75-93. Oum, Tae Hoon and Tretheway, Michael W. (1984), ‘Reforming Canadian Airline Regulation’, 20 Logistics and Transportation Review, 261-284. Oum, Tae Hoon and Zhang, Yimin (1991), ‘Utilisation of Quasi-Fixed Inputs and Estimation of Cost Functions: An Application to Airline Costs’, 25 Journal of Transport Economics and Policy, 121-134. Oum, Tae Hoon, Stanbury, W.T. and Tretheway, Michael W. (1990), ‘Airline Deregulation in Canada and its Economic Effects’, in Hayashi, T. (ed.), New Dimensions for Public Utilities, Osaka, Osaka University Press. Panzar, John C. (1983), ‘Regulatory Theory and the U.S. Airline Experience’, 139 Journal of Institutional and Theoretical Economics, 490-505. Pastor, Santos (1982), ‘La Construcción Naval Española Veinte Años Después (The Shipbuilding Industry Twenty Years After: Dynamics and Regulation)’, in Raga, José T. (ed.), Homenaje al Profesor Lucas Beltrán, Madrid, IEF. Pastor, Santos (1982), ‘El Mercado de Transporte Marítimo en los Primeros Ochenta (The Maritime Transport in the Eighties: Problems and Policies)’, 2 Anuario de Derecho Marítimo. Pastor, Santos (1984), ‘Política Marítima Española: Valoración e Implicaciones de Futuro (The Regulation of the Shipping Industry)’, in X (ed.), El Libro Transporte Marítimo y Política Económica, Madrid, IETC-Ministerio de Transportes. Peeters, Ch., Verbeke, A. and Winkelmans, W. (1987), ‘Een Geïntegreerd Overheidsbeleid voor de Belgische Binnenvaartsector (An Integrated Governmental Policy for the Belgian Inland Shipping)’, 32 Tijdschrift voor Economie en Management, 19-37. Peltzman, Sam (1963), ‘CAB: Freedom from Competition’, New Individualist Review.

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Peltzman, Sam (1975), ‘Effects of CAB Regulation’, in U.S. Senate, Subcommittee on Administrative Practice and Procedures, Committee on Judiciary, Oversight of CAB Practices and Procedures. Pera, Alberto (1989), ‘Deregulation and Privatisation in an Economy Wide Context’, 0(12) OECD Economic Studies, 159-204. Peterson, Rodney (1984), ‘SYMPOSIUM: An Economic Analysis of Statutory Changes in Rail Carrier Entry and Exit’, 13 Transport Law Journal, 189 ff. Phillips, Karen Borlaug and Phillips, Laurence T. (1984), ‘Research, Politics, and the Dynamics of Policy Development: A Case Study of Motor Carrier Regulatory Reform’, 17 Policy Sciences, 367-384. Phillips, Laurence T. (1992), ‘Contractual Relationships in the Deregulated Transportation Marketplace’, 34 Journal of Law and Economics, 535-564. Plourde, André (1987), ‘On the Role and Status of Canadian Natural Gas Carriers under Deregulation’, 13(1) Journal of Energy and Development, 1-25. Ponzanelli, Giulio (1991), ‘Limitazione di Responsabilitá., Analisi Economica e Giudizio di Costituzionalit. (Limitation of Liability, Economic Analysis and Constitutional Judgement)’, I Il Foro Italiano, 643-647. Prager, Robin A. (1989), ‘Using Stock Price Data to Measure the Effects of Regulation: The Interstate Commerce Act and the Railroad Industry’, 20 Rand Journal of Economics, 280-290. Priest, George L. (1975), ‘The History of the Postal Monopoly in the United States’, 18 Journal of Law and Economics, 33-80. Pustay, Michael W. (1989), ‘Liberalization of U.S. International Aviation Policy: A Preliminary Assessment’, 29(2) Quarterly Review of Economics and Business, 15-26. Rakowski, James P. (1988), ‘Marketing Economics and the Results of Trucking Deregulation in the Less-Than-Truckload Sector’, 27 Transportation Journal, 11-22. Reiss, Peter C. and Spiller, Pablo T. (1989), ‘Competition and Entry in Small Airline Markets’, 32(S) Journal of Law and Economics, 179-202. Rose, Nancy L. (1985), ‘The Incidence of Regulatory Rents in the Motor Carrier Industry’, 16 Rand Journal of Economics, 299-318. Rose, Nancy L. (1987), ‘Labor Rent Sharing and Regulation: Evidence from the Trucking Industry’, 95 Journal of Political Economy, 1146-1178. Sacasas, Rene and Glaskowsky, Nicholas A., Jr (1990), ‘Motor Carrier Deregulation: A Decade of Legal and Economic Conflict’, 18 Transport Law Journal, 189 ff. Samuels, George E. (1990), ‘Airline Deregulation: Its Effects and the Competitive Environment’, 17 International Journal of Transport Economics, 131-146. Sarwar, Ghulam and Anderson, Dale G. (1989), ‘Railroad Rate Deregulation and Uncertainty of Farm Level Prices for Corn’, 71 American Journal of Agricultural Economics, 883-891. Schipper, Katherine, Thompson, Rex and Weil, Roman L. (1987), ‘Disentangling Interrelated Effects of Regulatory Changes on Shareholders Wealth: The Case of Motor Carrier Deregulation’, 30 Journal of Law and Economics, 67-100. Sickles, Robin C., Good, David H. and Johnson, Richard L. (1986), ‘Allocative Distortions and the Regulatory Transition of the U.S. Airline Industry’, 33 Journal of Econometrics, 143-163. Spiller, Pablo T. (1983), ‘The Differential Impact of Airline Regulation on Individual Firms and Markets: An Empirical Analysis’, 26 Journal of Law and Economics, 655-689.

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Stanbury, W.T. and Tretheway, Michael W. (1986), ‘Airline Deregulation: A Bibliography’, 22 Logistics and Transportation Review, 449-489. Talley, Wayne K. and Schwarz Miller, Ann (1988), ‘The Demand for Air Services Provided by Air Passenger Cargo Carriers in a Deregulated Environment’, 15 International Journal of Transport Economics, 159-168. Taylor, D. Wayne (1989), ‘The Economic Effects of the Direct Regulation of the Taxicab Industry in Metropolitan Toronto’, 25 Logistics and Transportation Review, 169-182. Tehranian, Hassan and Bruning, Edward R. (1984), ‘Deregulation and Investor Perception of Motor Carrier Securities’, 20 Logistics and Transportation Review, 165-186. Thomas, Janet M. and Callan, Scott J. (1989), ‘Constant Returns to Scale in the Post Deregulatory Period and the Case of Specialized Motor Carriers’, 25 Logistics and Transportation Review, 271-288. Tretheway, Michael W. (1986), ‘Airline Deregulation: Introduction’,22 Logistics and Transportation Review, 293-296. Tucci, Gianrocco (1985), ‘Regulation and “Contestability” in Formulating an Air Transport Policy for the European Community’, 76 Rivista di Politica Economica, 219-239. Tullock, Gordon (1986), ‘The Case of Dutch Inland Shipping: Comment’, 6 International Review of Law and Economics, 139-140. Tye, William B. (1983), ‘The Postal Service: Economics Made Simplistic’, 3 Journal of Policy Analysis and Management, 62-73. Tye, William B. (1987), Encouraging Cooperation among Competitors: The Case of Motor Carrier Deregulation and Collective Ratemaking, New York, Greenwood Press, 202 p. Van Scyoc, Lee J. (1989), ‘Effects of Airline Deregulation on Profitability’, 25 Logistics and Transportation Review, 39-251. Vetsuypens, Michael R. and Helmuth, John A. (1988), ‘Airline Deregulation: Additional Evidence from the Capital Markets’, 27(2) Quarterly Journal of Business and Economics, 117-138. White, Evan D. (1989), ‘Economic Regulation of Oregon Intrastate Trucking: A Policy Evaluation’, 17 Transport Law Journal, 179 ff. Williams, George (1990), ‘Achieving a Competitive Environment for Europe’s Airline Industry’, National Westminster Bank Quarterly Review, 2-14. Willig, Robert D. and Baumol, William J. (1987), ‘Using Competition as a Guide’, 11(1) Regulation, 28-35. Woodbury, John R., Besen, Stanley M. and Fournier, Gary M. (1983), ‘The Determinants of Network Television Program Prices: Implicit Contracts, Regulation, and Bargaining Power’, 14 Bell Journal of Economics, 351-365. Ying, John S. (1990), ‘The Inefficiency of Regulating a Competitive Industry: Productivity Gains in Trucking Following Reform’, 72 Review of Economics and Statistics, 191-201. Ying, John S. (1990), ‘Regulatory Reform and Technical Change: New Evidence of Scale Economies in Trucking’, 56 Southern Economic Journal, 996-1009. Zimmerman, Martin B. (1979), ‘Rent and Regulation in Unit-Train Rate Determination’, 10 Bell Journal of Economics, 271-281.

5910 INTERNATIONAL TRADE Alan O. Sykes University of Chicago, School of Law © Copyright 1999 Alan O. Syles

Abstract This chapter provides a survey of the law and economics literature on international trade topics. It includes an overview of the legal system, and a general discussion of normative and positive economic approaches to the analysis of the legal rules on trade. Particular issues discussed subsequently include antidumping and subsidies rules, the escape clause for troubled industries, non-discrimination obligations in international trade, technical barriers to trade, and international dispute resolution in the trade field. JEL classification: K33 Keywords: International Trade, Dumping, Subsidies, Nontariff Barriers, Most-Favored-Nation, International Dispute Resolution

1. Introduction The instruments of international trade policy, such as border taxes (tariffs) and quantitative restrictions on the volume of imports or exports (quotas) are, in one fashion or another, laws. Economic scholars have studied the impact and wisdom of these laws for centuries, creating a branch of international economics devoted to these matters of ‘commercial policy’. It is no stretch to characterize all of the work in this field as ‘law and economics’. Were I to define the field in that fashion, however, the bibliography accompanying this chapter would by itself fill this volume. To reduce the undertaking to manageable proportions, I have restricted attention primarily to the work of economically-oriented scholars with legal backgrounds, to work with considerable legal as well as economic content, and to work that has been published in law and economics journals. I have also omitted attention to various ‘trade and’ issues, such as trade and the environment, trade and labor standards, and trade and competition policy, on the premise that they are better addressed elsewhere (see Bhagwati and Hudec, 1996). Finally, I have included a selective set of references to the mainstream international economics literature, intended to provide readers with a place to start should they desire to learn more about the basic economics of international trade. The work of many prominent figures in international economics is nevertheless 1114

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unrepresented or underrepresented, and to them I apologize in advance.

2. The Legal Landscape Until modern times, most nations maintained substantial tariffs or restrictive quotas on a wide array of goods. Accordingly, much of the early work in international economics focused on the wisdom of these conventional instruments of international trade policy. Scholars soon developed the economic case for free trade, which holds that (with some qualifications) nations can increase their national economic welfare through a unilateral reduction in their import restrictions. The logic of this proposition, which involves a demonstration that trade liberalization benefits consumers more than it costs producers or the government treasury, may be found in virtually any international economics textbook. The years since the end of World War II have changed the legal landscape profoundly, with equally important implications for the research agenda. From the Bretton Woods conference of 1944 emerged the General Agreement on Tariffs and Trade (GATT), concluded in 1947. Although the central objective of GATT was to foster a reduction in tariffs and quotas, its drafters recognized from the outset that bare commitments to lower tariffs and quotas were but a small part of what would be necessary to an effective trade liberalizing agreement. The restrictive effects of a tariff could easily be recreated by a domestic regulatory measure that disadvantaged imported goods, by a domestic subsidy, by a state-franchised monopsonist with the sole right to import from abroad, by a cumbersome bureaucracy for import processing, or in a number of other ways. The drafters had to plug such ‘loopholes’, and also had to decide whether reductions in trade impediments could be implemented on a discriminatory basis, and whether subgroups within the GATT membership would be allowed to negotiate separate trade agreements. They had to accommodate demands by signatories for the right to address certain ‘unfair’ trade practices unilaterally. They also had to anticipate the possibility of contingencies that might make some terms of the bargain politically unpalatable, and incorporate mechanisms to permit modification of the bargain under appropriate circumstances. Finally, they had to confront the question of how to respond to breach (or alleged breach) of promise by a signatory. As a result of attention to these and other issues, the GATT emerged as a lengthy and elaborate document, with provisions governing not only tariffs and quotas but, inter alia, various domestic taxes and domestic regulatory policies, the conduct of state controlled entities, methods of customs valuation, unfair practices such as dumping and subsidization, rules governing discrimination in trade, procedures for adjusting and renegotiating the bargain, and a dispute settlement mechanism.

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After 1947, the GATT continued to expand its scope and coverage. In the late 1970s, additional agreements were entered on such matters as technical standards and regulations, subsidies, antidumping, and government procurement. Various regional arrangements also emerged (such as the European Union and the NAFTA) that afforded preferential trade benefits to their members pursuant to an exception to the non-discrimination obligations of GATT allowing for customs unions and free trade areas. These regional arrangements have their own legal foundation, often more complex and far reaching than that of the GATT itself (Jackson, 1989). During the most recent round of negotiations under GATT auspices (the ‘Uruguay Round’), a new institution was created to absorb the GATT and its various side agreements - the World Trade Organization (WTO). The WTO treaty elaborated many prior GATT obligations, added a new dispute resolution system with considerably greater credibility and authority, and for the first time extended the coverage of the GATT system to services industries, such as banking, securities, telecommunications and insurance. This service sector liberalization has proven even more complicated than liberalization in the goods sector due to the mix of licensing, prudential, and other regulations that are in play. The effects of international trade agreements on national regulatory policies has thus become considerably more significant, and will likely continue to grow. Current discussions in the WTO and the OECD further contemplate possible linkages between trade policy on the one hand and competition policy, environmental policy and labor market standards on the other. The WTO already extends its umbrella to the substantive rules of intellectual property law. Nations that are parties to the WTO (over 120 at this writing) or to various regional arrangements must implement their international obligations at the national level. Usually, the implementation process requires a host of domestic statutes or their equivalent, replacing or modifying preexisting domestic law in a number of areas, and creating new domestic law in a number of others. Title 19 of the United States Code, for example, a massive volume, is closely connected to and shaped by the international law of the WTO and NAFTA. For a general introduction to the scope of international and national law in the trade area, the reader may wish to consult Jackson, Davey and Sykes (1995).

3. The Framework for Law and Economics Research Although I have said little about economics to this point, the reader should already appreciate the potential scope of law and economics research in the area. Each of the topics addressed by the WTO agreement, the various regional agreements, and national laws relating thereto raises a range of normative and positive questions. In this section, I sketch a framework for thinking about and

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identifying these questions in general terms. The succeeding sections delve into the literature on particular topics. Normative Perspectives Much of the research in international economics has a normative cast. Early writers such as Adam Smith and David Ricardo were responding to the misguided Mercantilist instinct that national wealth was measured by the size of the gold reserve rather than the standard of living of the citizenry, urging governments to open their markets. The more modern articulation of the case for free trade grounded in the theory of comparative advantage, with various technical caveats and qualifiers, is also plainly normative in tone, resting either on Kaldor-Hicks conceptions of welfare as a basis for policy making or, in the alternative, the claim that other policy instruments can better address distributive concerns. It is also conventionally argued that trade policy is an inferior policy instrument for addressing various market failures including production externalities, labor market imperfections and the like. Better to tax the pollution output of a domestic polluter directly, for example, than to tax its imported input products - a tax on pollution will correct the externality without distorting the choice of inputs and sacrificing the least cost method of production (see Bhagwati and Srinivasan, 1983; Dixit and Norman, 1980; Kenen, 1985, and Krugman and Obstfeld, 1994). Normative discussion of international trade policy often must distinguish between national welfare and global welfare (or now regional welfare) for many purposes. For example, perhaps the best known caveat to the case for free trade - the opportunity for importing nations with the power to influence their terms of trade (that is, a degree of monopsony power) to use tariffs to extract rents from foreigners - suggests how some nations can increase their own welfare at the expense of global welfare (see Bhagwati and Srinivasan, 1983; Dixit and Norman, 1980). The modern literature on strategic trade policy, which suggests among other things how nations can increase their welfare by subsidizing or protecting certain industries with increasing returns to scale, affords yet another example of the importance of the choice between national and global objective functions (see Krugman, 1987). The same welfare economic framework can be brought to bear on the broader range of topics implicated by modern international trade law. Whether the problem concerns the discipline of national government subsidies that may distort trade, ‘dumping’ by foreign firms (explained below), the question whether nations should discriminate between trading partners in their tariff policies, the consequences of harmonizing regulations for the international marketing of prescription drugs, the procedures for certifying that imported foodstuffs are sanitary, or the wisdom of protecting declining industries to facilitate ‘orderly contraction’ or alleviate unemployment, the normative

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questions to be asked are much the same. The Kaldor-Hicks benchmark can be used to evaluate the available alternatives. Sometimes, but not always, global and national welfare will point in different directions. One can inquire as to what policy is optimal by the appropriate criterion in the abstract, or ask the related question whether some existing legal rule at the global, regional or national level is optimal from among the set of politically feasible choices. An alternative normative framework rests not on conventional economic measures of welfare, but on democratic legitimacy and international consensus as the underlying value. Here, the question becomes one of how national governments should faithfully implement their international obligations, or perhaps how courts and administrative agencies with discretion should exercise it to promote the international or national goals implicit in the texts of treaties and statutes. Sometimes, though not always, an interpretation of a text intended to provide it with economic coherence may be helpful in this context, much as economic scholars have helped shape the interpretation of laws such as the US Sherman Antitrust Act or sections of the Uniform Commercial Code. Positive Perspectives Although international economists have long described themselves as engaged in positive as well as normative inquiry, the distinction between the two has been muddled for much of the history of the discipline. Part of the muddle owes to the naiveté of much economic writing (particularly older writings), in which governments are ‘assumed’ to maximize national welfare. Normative analysis using the national welfare criterion then becomes positive analysis as well, with the national welfare optimum serving as a predictor of how governments will behave. That predictor has proven a poor one, however, on many fronts. Most obviously, national governments would engage in far less trade protectionism than they do in practice if the economists’ familiar measure of national welfare were the touchstone of policy making. To improve the quality of positive theory, it has been necessary for international economics to embrace the insights of public choice theory. The emergent ‘political economy’ of trade policy recognizes that different interest groups have different degrees of influence on political actors. The weakness of consumer interest groups, for example, can explain why tariffs emerge in the first instance despite their generally adverse impact on national economic welfare (see Baldwin, 1982; Dougan, 1984). Public choice has also proven successful at explaining a number of more narrow policy decisions in the trade field (see Gerber, 1976) such as the politics of partivular qutas, as well as the pattern of votes cast in elections where trade was a key issue (see Irwin, 1994). Public choice insights further help to explain why international agreements such as the GATT tend to liberalize trade despite the absence of much consumer participation - they allow producer groups comprised of exporters to

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reward their political representatives for securing access to foreign markets (see Baldwin, 1987). This example once again suggests the importance for analysis of the distinction between the national and global perspectives - the interest groups in play (or at least their stakes in the outcome) may change importantly as we move from an environment in which nations act noncooperatively to an environment in which nations act cooperatively. The positive analysis of international agreements also draws on another line of economic analysis - the economics of contracts. An international agreement is, after all, a contract between or among nations. It can be honored or breached, breach can be efficient or inefficient (from the perspective of the self-interested officials who enter the agreement), moral hazards and hold-up opportunities may arise, the agreement may be self enforcing or not, enforcement may rely on reputation, self help, third party coercion, and so forth. Insights from the theory of contracts about how parties design agreements to facilitate valuable adjustments of the bargain while discouraging opportunism thus have much to contribute to the understanding of international agreements generally, and international trade agreements in particular. With this background, I now turn to the literature on particular legal topics. The concluding section contains some thoughts about further research. A compact survey of many of these issues may be found in the recent volume by Trebilcock and Howse (1994). Another useful selection of writings may be found in Bhandari and Sykes (1998).

4. Antidumping Law Aside from the study of conventional tariffs and quotas, perhaps no topic in the law and economics of international trade has a longer history than the study of dumping. The term ‘dumping’ has meant different things through the years, but in modern parlance it refers to pricing behavior by an exporting firm that results in (a) an F.O.B. price to the export market that is below the F.O.B. price to the home market for the same goods; (b) an F.O.B. price to the export market that is below the F.O.B. price to some third market; or (c) an F.O.B. price to the export market that is below the fully allocated cost of production for the good in question (including an allocation of fixed costs, general selling and administrative expenses, and so on). Prior to the formation of GATT, some nations (including the United States) unilaterally condemned dumping and had statutes in place to sanction it. The GATT (now WTO) authorizes such sanctions but constrains them - an importing nation can counteract dumping with an ‘antidumping duty’ equal to the magnitude of dumping (the difference between the export price and the relevant benchmark above), but only if the dumping is causing material injury to a competing domestic industry.

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The early view of antidumping law in the economics profession was favorable. A distinguished University of Chicago economist, Jacob Viner, devoted an entire volume to dumping, arguing that it is harmful to the importing country. He reasoned that low prices attributable to dumping are transitory, and impose adjustment costs on the importing nation that exceed the benefits of temporarily cheaper imports (Viner, 1923). The basis for Viner’s analysis, however, was shaky. Dumping need not be transitory (as when different markets have different demand elasticities), and even when it is, nothing in Viner’s work (or since) demonstrates that temporarily cheap imports necessarily impose adjustment costs that exceed the welfare gains to the importing country from temporarily cheaper imports. Not surprisingly, therefore, scholars eventually began to question the wisdom of antidumping policy. Various possible justifications in addition to Viner’s have been considered, including the notion that dumping is somehow symptomatic of predatory pricing, and by and large rejected (see Barcelo, 1979; Ordover, Sykes and Willig, 1983; Knoll, 1987; Messerlin, 1990; Therakan, 1990; Cass, 1993). It is also clear that the administration of the antidumping laws often biases the system in favor of a finding of dumping through peculiar accounting and averaging practices (Boltuck and Litan, 1991; McGee, 1993; Dick, 1991). To be sure, an antidumping duty may by chance benefit a nation with the ability to influence its terms of trade. Or it may protect an industry with increasing returns or positive externalities, and thereby yield the sorts of benefits that are the focus of the strategic trade policy literature (see Dick, 1991). But these benefits of antidumping duties have nothing to do with the existence or nonexistence of dumping, only with the special circumstances in which protectionist measures may have utility to the importing nation for other reasons. It is thus fair to say that an academic consensus now holds antidumping law to be welfare-reducing in general. Interestingly, the national welfare effects are often worse than the global welfare effects, because the importing nation is generally harmed, ceteris paribus, when it deprives itself of cheaper imports. From the global perspective, however, if antidumping policy reduces the incidence of imperfect price discrimination, the welfare effects can be favorable (see Ordover, Sykes and Willig, 1983). Cass and Boltuck (1996) also consider various ‘fairness’ justifications for antidumping law, and for the most part reject them. Although the normative analysis of antidumping law is well developed and has probably hit diminishing returns, strikingly little has been done from the positive perspective. If antidumping policy is so foolish, why is it also so survivable, particularly in the WTO environment where nations have mutually agreed to forego economically foolish policies on a number of other fronts?

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5. Subsidies and Countervailing Measures Attention to the problem of subsidies in international trade, and to the legal regime that constrains them or allows nations to respond to them, also has a rich history in law and economics. Economists have long distrusted government subsidy programs, recognizing that although subsidies may in principle correct certain forms of market failure, they may also cause distortions in resource allocation. The latter concern has become increasingly prevalent with the rise of public choice. In an ideal world, governments would limit subsidies to their constructive uses and eschew unproductive uses. Suppose that this goal is doubly difficult to achieve in a noncooperative environment because governments find themselves in a race to the bottom of sorts (farmers in country A can demand subsidies to level the playing field with the subsidized farmers in country B, for example). Or suppose that subsidies are being used to protect domestic industries against foreign competition, much like tariffs. If so, international trade law might usefully incorporate a covenant to forego certain types of subsidies - indeed, such an evolving covenant has been present in the GATT system since its inception. The question of what an ideal anti-subsidy compact might look like was the focus of Schwartz and Harper (1972). In the end, however, they concluded that the problem was immense and perhaps insoluble, suggesting, among other things, that Kaldor-Hicks efficiency is not easy to identify in practice, and that is hardly clear that the Kaldor-Hicks benchmark is the proper one in any event. Related to the policies imposing multilateral constraints on subsidies are those facilitating a unilateral response to imports of subsidized goods. Subsidized competition is often labeled ‘unfair’, and the GATT system has since its inception permitted signatories to counteract the effects of subsidization at the border through the use of ‘countervailing duties’. These duties may be employed in many instances even when the foreign subsidy practice at issue is perfectly legal under international law. As in the case of antidumping duties, however, countervailing duties are only permitted when subsidized imports are causing injury to competing firms. The wisdom of unilateral countervailing measures has been questioned. Subsidized imports are cheaper than unsubsidized imports, ceteris paribus, and cheaper imports tend to enhance the welfare of the importing nation regardless of the reason for their cheapness. It is by no means clear why an importing nation should not respond to subsidized imports with, in the words of Paul Krugman, ‘a thank-you note to the embassy’. Although Barcelo (1977) viewed unilateral countervailing measures as a useful adjunct to efforts to discipline wasteful government subsidy practices, Schwartz (1978) initiates a more skeptical line of discussion. Sykes (1989) argues that under virtually any

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assumption about market structure or possible market imperfections, countervailing duties are an imprudent policy from the perspective of the importing country, and dubious as well from the global welfare perspective (see also Trebilcock, 1990). Another strand of literature questions the ability of existing countervailing duty law to achieve its own posited objectives (granting the possibility that those posited objectives may not be welfare enhancing). In particular, if one assumes that the goal of countervailing duty law is to counteract the effects of the subsidy on the prices charged for imported goods, it is essential for those who administer the law to identify that price effect in deciding what duty to impose. Likewise, if countervailing measures are only allowable if a subsidy is causing injury abroad, it is necessary to identify the price effect to decide whether the subsidy is indeed causing material injury. The effect of the subsidy on price will depend, in turn, and inter alia, on how the subsidy affects marginal costs for subsidized firms. Yet, existing law pays little attention to that issue (to see its importance, consider one example - farm programs that pay farmers to reduce acreage will not lower their export prices). Goetz, Granet and Schwartz (1986) made these points, which led Diamond (1989, 1990a) to suggest some specific reforms designed to make countervailing duties a more accurate device for counteracting the cross border effects of subsidies. Sykes (1990a) is critical of these proposals on grounds of administrative cost, coupled with some uncertainty as to whether they will have any welfare payoff. Cass (1990) also has a mixed reaction. As in the case of antidumping law, far less has been done with the positive side of subsidies and countervailing measures than with the normative side. The effects of duties in the presence of downstream integration have been examined (Benson et al., 1994), but the political economy of national and international rules regarding subsidies has received little attention.

6. Injury Analysis in Antidumping and Countervailing Duty Cases As noted, WTO law prohibits antidumping and countervailing duties unless the importing nation first establishes that the unfair imports in question are causing or threatening ‘material injury’ to domestic competitors. The task of determining what impact an unfair practice has on the domestic industry lends itself readily to economic analysis, and much has been written on the subject. Initial work focused on the lack of economic coherence in the analysis of the US International Trade Commission (ITC), the agency charged with administering the injury test under US law. The pertinent statute requires the ITC to determine whether dumped or subsidized imports, as the case may be, have caused or threaten to cause ‘material injury’ to domestic producers of like

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products. If the task of the ITC is thus to ascertain what effect the dumping or subsidization has had on domestic producers (a proposition that is not uncontroversial as a legal matter), it has often relied on information that is misleading. For example, it has tended to look for a correlation between rising imports and deterioration in the condition of domestic producers, but that correlation may be spurious. It has also emphasized price comparisons between imported and domestic goods, even though price differentials may reflect quality differentials that have nothing to do with the impact of any unfair practice. These and other criticisms have been leveled by a number of writers, most notably Knoll (1989a, 1989b). He and others have suggested that the tools of price theory be employed to construct quantitative models that would allow the ITC more accurately to measure the impact of dumping or subsidies. Proponents of this economic approach include Boltuck and Kaplan (see Therakan, 1990, as well as Rousslang, 1988; see also Morkre and Kelly, 1993). In Wood (1989), the emphasis is rather different - she argues that antidumping and countervailing duties should not be sued to protect supracompetitive rates of return to a domestic industry, and urges that lost monopoly profits not ‘count’ in the injury analysis. Other writers have wondered whether the apparent economic incoherence in the analysis of the ITC has a political economy explanation. Cass and Schwartz (1990) address the issue, and conclude that it probably does not. Sykes (1996) disagrees to an extent, offering some conjectures as to why ITC practice may serve the joint political interests of the United States and its trading partners. He further questions whether a more economic approach to injury analysis would have any welfare benefits. Finally, efforts have been made to ascertain whether injury findings reflect political factors (such as the interests of the constituencies of key Senators and Congressmen), or instead reflect judgments about the ‘merits’ of each case. Finger, Hall and Nelson (1982) hold the former view, while Anderson (1993) concludes that ITC decisions are not well explained by such political variables.

7. Safeguards Measures and the ‘Escape Clause’ Article XIX of the GATT (the ‘escape clause’) permits signatories to withdraw trade concessions temporarily when increased imports cause or threaten to cause ‘serious injury’ to a domestic competing industry. US law further provides that these ‘safeguards measures’ shall not be taken when some cause other than increased imports is a more important source of injury. Several writers have undertaken to give economic content to this inquiry. Grossman (1986) analyzes the causes of injury to the US steel industry in the early 1980s, while Pindyck and Rotemberg (1987) consider the copper industry.

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In these papers, the authors set forth a framework within which to think about the causal contribution of increased imports to industrial decline (no trivial task since import quantity is usually viewed as an endogenous variable by economists), as well as the causal contribution of other factors such as recession. Kelly (1988, 1989) also addresses these issues. Other writers have inquired into the wisdom of safeguards measures. Lawrence and Litan (1986) find efficiency and fairness arguments unpersuasive as a justification for protecting industries impaired by import competition, although in the end they favor the use of escape clause measures as a ‘safety valve’ against protectionist pressures that might produce an even worse outcome if left unchecked. Trebilcock, Chandler and Howse (1990) are agnostic about the possible utility of temporary protection to facilitate adjustment, although skeptical of government policies in practice. Sykes (1990c) suggests some possible reforms in the injury analysis aimed at limiting relief to plausible cases of labor market imperfections. On the positive side, Sykes (1991) offers a public choice explanation for the existence of GATT Article XIX. He suggests that declining firms will rationally expend greater resources to secure protection than growing firms, and that the escape clause may facilitate the politically ‘efficient breach’ of GATT obligations.

8. The Most-Favored Nation Obligation and Exceptions Article I of the GATT agreement is a general prohibition on discrimination in tariff policy, creating a so-called ‘most-favored nation’ obligation. Article XI creates a similar obligation relating to the use of quotas. But the GATT system also contains a number of exceptions to these obligations. The most important is Article XXIV, which permits the formation of customs unions and free trade areas (such as the European Union and NAFTA) that grant trade preferences to members. Other exceptions include the authority to use discriminatory safeguards measures under certain conditions, and the authority to grant preferences to developing countries. The normative economics of trade discrimination has been studied extensively. Other things being equal, discrimination in protectionist policies (such as the use of different tariffs for different trading partners) produces greater deadweight losses than nondiscriminatory policy. The reason is that discrimination produces ‘trade diversion’ - inefficient investment and production in higher cost countries that benefit from trade preferences. Other things may not be equal, however, because discriminatory trade liberalization may be better than none at all - in the parlance of the profession, ‘trade creation’ can dominate trade diversion (see Lipsey, 1960; Bhagwati and

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Srinivasan, 1983). Thus, the theoretical view of discrimination is agnostic, and it becomes a difficult empirical question whether a particular discriminatory arrangement is welfare reducing or welfare enhancing. The question is all the more difficult because the answer turns on a counterfactual - what would the world look like without the discrimination in question? The prevailing view seems to be, however, that most of the existing preferential arrangements have tended to be welfare enhancing, and that regional arrangements such as the EU and NAFTA are ‘building blocks’ rather than ‘stumbling blocks’ on the road toward a more open trading system (see Lawrence, 1996). Schwartz and Sykes (1996) examine the GATT rules on trade discrimination from a positive perspective. They argue that nondiscrimination rules tend to maximize political surplus for officials in signatory nations, other things being equal, by increasing the sum of producer surplus and government revenue (both assumed to count heavily in the political welfare functions of politicians). But exceptions exist - for example, the most-favored nation obligation may at times create a free rider problem in bargaining that makes it difficult for nations to exhaust all politically valuable deals. Schwartz and Sykes use these observations to offer an explanation for some of the exceptions to the most-favored nation obligation under GATT, including Article XXIV.

9. Technical Barriers to Trade Recent negotiations under WTO auspices have produced two agreements concerning ‘technical barriers’ to trade, which result from divergent product standards and regulations in the international economy. The agreement on sanitary and phytosanitary measures is aimed at food safety issues and related problems in the agricultural sector. The agreement on technical barriers to trade covers other product markets. These agreements contain their own commitments regarding nondiscrimination, least-restrictive means tests, covenants to rely on international standards where feasible, and many other matters. Sykes (1995) provides a survey of the economic issues involved in the technical barriers area, a review of the different legal approaches to policing technical barriers around the world, and an economic explanation for many of the legal rules that are in place. Leebron (1996) discusses in a general way the case for harmonizing national regulatory policies (see also Davidson et al., 1989).

10. Dispute Settlement, Self Help and Unilateralism International trade agreements have no central enforcement authority with the power to compel nations to adhere to them. It is also exceedingly unlikely that

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any nation would unilaterally go to war to vindicate its rights under these agreements. Yet, these agreements seem to hold together fairly well, and it is apparent that some mixture of reputational concerns and implicit threats of unilateral retaliation on matters of commercial policy go a long way toward making trade agreements viable. But unilateral ‘retaliation’ in the trade arena may also be opportunistic, and may be employed against nations that have done nothing wrong under international law. This concern has been expressed widely with respect to Section 301 of the 1974 US Trade Act, which permits the United States to retaliate for all manner of ‘unfair’ practices. Many prominent economists have been critical of the ‘aggressive unilateralism’ of the United States under this statute. Bhagwati (1988) is illustrative. Sykes (1990b) takes the other side of the debate, arguing that Section 301 was a potentially sensible ‘self help’ measure in the face of imperfections in the GATT dispute resolution system. Sykes (1992) argues further that Section 301 might play a constructive role in addressing trade impediments outside the coverage of GATT obligations, and that Section 301 had been fairly successful from the US point of view in opening up foreign markets without the need for any retaliatory measures in most cases. New developments in the WTO dispute resolution system moot many of the arguments in this debate, as it can no longer be argued that unilateral action is necessary to create meaningful commercial policy sanctions for breach of promise - the new Dispute Resolution Understanding ensures that WTO-authorized sanctions can be imposed on nations found to be in violation. Likewise, the number of matters still outside the explicit or implicit coverage of the WTO/GATT system has diminished greatly. Perhaps the next step in the economic literature on dispute resolution within trade agreements will be to explain the recent changes in the WTO system, including the details of procedures and sanctions, and in time to assess their efficacy.

11. A Concluding Note on the Research Agenda The expanding scope and detail of international trade law affords law and economics scholars an exceptionally broad range of research opportunities. Although the welfare economics of conventional tariffs and quotas is quite well developed, normatively inclined scholars should find much to occupy them in the treatment of nontariff issues of various sorts. Issues relating to regulatory divergence and harmonization, for example, will be central for many years in both goods and services markets. I suspect that much of the best work will be focused reasonably narrowly on particular problems, from the marketing of prescription medications to the harmonization of telecommunications standards

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to the opening of insurance and securities markets. Much work also remains to be done on understanding the economic consequences of regional trading arrangements, and on the question of how the WTO ought police their emergence and operation. Opportunities for normative, comparative analysis are also widespread, as the world witnesses a proliferation of sophisticated legal arrangements that must all contend with essentially similar problems. The ‘trade and’ issues that I have neglected in this chapter - trade and the environment, trade and competition policy, and so on - will also afford fruitful subjects for research as the wisdom of harmonizing policies across nations increasingly becomes a subject of topical debate. The opportunities for positive analysis are equally great, if not greater. The political economy of much of the WTO/GATT system remains unexplored, from the provisions on ‘unfair’ trade practices to the treatment of developing countries to the rules for accession, voting, renegotiation and dispute settlement to the sector specific arrangements such as the Agreement on Agriculture. Fundamental questions relating to the expansion and evolution of the GATT system, both in scope and timing, have hardly been posed, let alone answered. The same may be said about the details of regional arrangements - even the most basic questions, such as who joins a regional arrangement, when, and why, remain little touched. In short, much like other subject areas under the rubric of international law, law and economics has only begun to make a dent in the set of potential topics in the trade area. The rapid rate of change in international trade law simply adds to the possibilities for interesting new research. Mainstream economists can, of course, be expected to continue to invest considerable energy in the field, but scholars with legal training as well will retain a comparative advantage in work addressed to many of the concrete positive and normative problems raised by modern legal developments.

Bibliography on International Trade (5910) Anderson, Keith B. (1993), ‘Agency Discretion or Statutory Direction: Decision Making at the U.S. International Trade Commission’, 36 Journal of Law and Economics, 915-935. Anderson, Terry L. and McChesney, Fred S. (1994), ‘Raid or Trade? An Economic Model of Indian White Relations’, 37 Journal of Law and Economics, 39-74. Baldwin, Robert E. (1982), ‘The Political Economy of Protectionism’, in Bhagwati, Jagdish (ed.), Import Competition and Response, Chicago, University of Chicago Press. Baldwin, Robert E. (1987), Trade Policy in a Changing World Economy, Chicago, University of Chicago. Barcelo, John J. (1977), ‘Subsidies and Countervailing Duties - Analysis and Proposal’, 9 Law and Policy in International Business, 779 ff. Barcelo, John J. (1979), ‘The Antidumping Law: Repeal it or Revise it’, in Jackson, John H. (ed.),

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Antidumping Law: Policy and Implementation, Ann Arbor, University of Michigan. Benson, Bruce L. and Hartigan, James C. (1983), ‘Tariff Restrictions Which Lower Price in the Restricting Country: An Analysis of Spatial Markets’, 14 Journal of International Economics, 117-133. Benson, Bruce L. and Hartigan, James C. (1984), ‘Tariffs and Quotas in a Spatial Duopoly’, 50 Southern Economic Journal, 965-978. Benson, Bruce L. and Hartigan, James C. (1987), ‘Tariffs, and Location Specific Income Redistribution’, 17 Regional Science and Urban Economics, 223-243. Benson, Bruce L., Faminow, Merle D., Marquis, Milton H. and Sauer, Douglas G. (1994), ‘Intra-National Effects of a Countervailing Duty on the U.S./Canadian Hog Market’, 16 Review of Agricultural Economics, 187-201. Bermann, George A. (1993), ‘Regulatory Cooperation with Counterpart Agencies Abroad: The FAA’s Aircraft Certification Experience’, 24 Law and Policy in International Buiness, 669-781. Bhagwati, Jagdish N. (1988), Protectionism, Cambridge, MA, MIT Press. Bhagwati, Jagdish N. and Hudec, Robert E. (1996), Fair Trade and Harmonization: Prerequisites to Free Trade?, Cambridge, MA, MIT Press. Bhagwati, Jagdish N. and Srinivasan, T.N. (1983), Lectures in International Trade, Cambridge, MIT Press. Bhandari, J.S. and Sykes, Alan O. (1998), Economic Dimensions in International Law, Cambridge, Cambridge University Press. Boltuck, Richard and Litan, Robert E. (1991), Down in the Dumps: Administration of Unfair Trade Laws, Washington, Brookings. Cass, Ronald A. (1990), ‘Trade Subsidy Law: Can a Foolish Inconsistency be Good Enough for Government Work?’, 21 Law and Policy in International Business, 609-661. Cass, Ronald A. (1993), ‘Price Administration and Predation Analysis in Antitrust and International Trade: A Comment’, 61 University of Cincinnati Law Review, 877 ff. Cass, Ronald A. and Boltuck, Richard D. (1996), ‘Antidumping and Countervailing Duty Law: The Mirage of Equitable International Competition’, in Bhagwati, Jagdish and Hudec, Robert E. (eds), Fair Trade and Harmonization: Prerequisites to Free Trade?, Cambridge, MA, MIT Press. Cass, Ronald A. and Schwartz, Warren F. (1990), ‘Coherence and Transparency in the Implementation of International Trade Laws’, in Trebilcock, Michael J. and York, Robert C. (eds), Fair Exchange: Reforming Trade Remedy Laws, Toronto, C.D. Howe Institute. Centner, Terence J. (1993), ‘The U.S.’s Organic Foods Production Act: Does the Small-Farmer Exception Breach the U.S.’s Obligations Under GATT?’, 28 Tulsa Law Journal, 715-722. Centner, Terence J. (1995), ‘Organically-Produced Food Products: Regulations from the European Union and the United States Set the Stage for Imports’, 7 Journal of International Food and Agribusiness Marketing, 41-58. Centner, Terence J. and Lathrop, K.W. (1996), ‘Differentiating Food Products: Organic Labeling Provisions Facilitate Consumer Choice’, 1 Drake Agricultural Law Review, 30-50. Cohen, Mark A. and Rubin, Paul H. (1992), ‘Politically Imposed Entry Barriers’, 18 Eastern Economic Journal, 333-344.

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Crocker, Keith J. and Lyon, Thomas P. (1994), ‘What do Facilitating Practices Facilitate? An Empirical Investigation of Most Favored Nation Clauses in Natural Gas Contracts’, 37 Journal of Law and Economics, 297-322. Davidson, Russell et al. (1989), ‘On the Welfare Effects of Anti-discrimination Regulations in the EC Car Market’, 7 International Journal of Industrial Organization, 205-230. Diamond, Richard (1989), ‘Economic Foundations of Countervailing Duty Law’, 29 Virginia Journal of International Law, 767 ff. Diamond, Richard (1990a), ‘A Search for Economic and Financial Principles in the Administration of United States Countervailing Duty Law’, 21 Law and Policy in International Business, 507-607. Diamond, Richard (1990b), ‘Changes in the Game: Understanding the Relationship between Section 301 and US Trade Strategies’, 8 Boston University International Law Journal, 351-361. Dick, Andrew (1991), ‘Learning by Doing and Dumping in the Semiconductor Industry’, 34 Journal of Law and Economics, 133-159. Dixit, Avanish K. and Norman, Victor D. (1980), Theory of International Trade, Cambridge, Cambridge University Press. Dougan, William R. (1984), ‘Tariffs and the Economic Theory of Regulation’, 6 Research in Law and Economics, 187-210. Espinosa, M.P. and Macho-Stadler, I. (1989), ‘Coordinación de Política Industrial en el Marco de la CEE (Industrial Policy Coordination in the EEC)’, 2 De Economía Pública, 61-77. Farran, Andrew (1986), ‘The Interplay of Law and Economics in International Trade Regulation’, in Snape, R.H. (ed.), Issues in World Trade Policy: GATT at the Crossroads. Papers presented at a confernce of the Centre of Policy Studies, Monash University, Australia, New York, St. Martin’s Press, 193-217. Finger, J. Michael, Hall, H. Keith and Nelson, Douglas R. (1982), ‘The Political Economy of Administered Protection’, 72 American Economic Review. Frey, Bruno S. (1988), ‘Regulations by Consensus: The Practice of International Investment Agreements: Comment’, 144 Journal of Institutional and Theoretical Economics, 176-179. Garcimartin, Alférez and Francisco, Javier (1995), ‘El Régimen Normativo de las Transacciones Privadas Internacionales: una Aproximación Económica (The Regulation of International Private Transactions: an Economic Approach)’, 2 Revista Española de Derecho Internacional, 99-111. Garcimartin, Alférez and Francisco, Javier (1996), ‘El Coste de la ley Helms-Burton para las Empresas Españolas (The Costs of Helms-Burton Rule for Spanish Companies)’, Revista Derecho de los Negocios. Gerber, David J. (1976), ‘The United States Sugar Quota Program: A Study in the Direct Congressional Control of Imports’, 19 Journal of Law and Economics, 103-147. Godek, Paul E. (1985), ‘Industry Structure and Redistribution through Trade Restrictions’, 28 Journal of Law and Economics, 687-703. Goetz, Charles, Granet, Lloyd and Schwartz, Warren (1986), A Search for Economic and Financial Principles in the Administration of U.S. Countervailing Duty Law, 6 International Review of Law and Economics 17 ff. Grossman, Eugene (1986), ‘Imports as a Cause of Injury: The Case of the US Steel Industry’, 16 Journal of Industrial Economics.

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Haucap, Justus and Wey, Christian (1997), ‘Location Choice as a Signal of Product Quality: The Economics of “Made in Germany”’, 153 Journal of Institutional and Theoretical Economics. Heywood, John S. (1991), ‘Imports and Domestic Wages: Is the Relationship Consistent with Expense Preference Behavior?’, 7 Journal of Law, Economics, and Organization, 355-372. Inman, Robert P. and Rubinfeld, Daniel L. (1994), ‘The EMU and Fiscal Policy in the New European Community: An Issue for Economic Federalism’,14 International Review of Law and Economics, 147-161. Irwin, Douglas A. (1994), ‘The Political Economy of Free Trade: Voting in the British General Election of 1906', 37 Journal of Law and Economics, 75-108. Jackson, John H. (1989), The World Trading System, Cambridge, MA, MIT Press. Jackson, John H., Davey, William J. and Sykes, Alan O. (1995), Legal Problems of International Economic Relations (3rd edn), Minneapolis, West Publishing. Kalt, Joseph P. (1989), ‘Exhaustible Resource Price Policy, International Trade, and Intertemporal Welfare’, 17 Journal of Environmental Economics and Management, 109-126. Kalt, Joseph P. (1991), ‘Using the Gas Industry as a Guide to Reconstituting the Electricity Industry: Comment’, 13 Research in Law and Economics, 57-61. Kelly, Kenneth (1988), ‘The Analysis of Causality in Escape Clause Cases’, Journal of Industrial Economics. Kelly, Kenneth (1989), ‘Can Imports Injure a Domestic Industry When They Decline?’, 12 Research in Law and Economics, 119-129. Kenen, Peter (1985), The International Economy, Englewood Cliffs, NJ, Prentice Hall. Knoll, Michael S. (1987), ‘United States Antidumping Law: The Case for Reconsideration’, 22 Texas International Law Journal, 265 ff. Knoll, Michael S. (1989a), ‘Legal and Economic Framework for the Analysis of Injury by the U.S. International Trade Commission’, 23 Journal of World Trade, 95-107. Knoll, Michael S. (1989b), ‘An Economic Approach to the Determination of Injury Under United States Antidumping and Countervailing Duty Law’, 22 New York University Journal of International Law and Politics, 37 ff. Kornhauser, Lewis A. and Benoit, J.-P. (1992), ‘Unsafe Havens’, 59 University of Chicago Law Review, 1421 ff. Krauss, Melvyn B. (1978), The New Protectionism. The Welfare State and International Trade, New York, New York University Press, 179 p. Krugman, Paul R. (1987), ‘Is Free Trade Passe?’, 1 Journal of Economic Perspectives, 131 ff. Krugman, Paul R. and Obstfeld, Maurice (1994), International Economics: Theory and Policy (3rd edn), Cambridge, MA, MIT Press. Lawrence, Robert (1996), Regionalism, Multilateralsim and Deeper Integration, Washington, Brookings. Lawrence, Robert and Litan Robert (1986), Saving Free Trade, Washington, Brookings. Leebron, David W. (1996), ‘Lying Down with Procrustes: An Analysis of Harmonization Claims’, in Bhagwati, Jagdish and Hudec, Robert E. (eds), Fair Trade and Harmonization: Prerequisites for Free Trade?, Cambridge, MA, MIT Press. Lipsey, Richard (1960), ‘The Theory of Customs Unions: A General Survey’, 70 Economic Journal, 496 ff.

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McGee, Robert W. (1993), ‘An Economic Analysis of Protectionism in the US With Implications for International Trade in Europe’, 26 George Washington Journal of International Law and Economics, 539-573. McGee, Robert W. (1994), A Trade Policy for Free Societies: The Case Against Protectionism, Westport, Quorum Books, 197 p. Messerlin, Patrick A. (1990), ‘The Antidumping Regulations of the European Community: The Privatisation of Administered Protectection’, in Trebilcock, Michael J. and York, Robert C. (eds), Fair Exchange: Reforming Trade Remedy Laws, Toronto, C.D. Howe Institute. Mock, William B.T. (1992), ‘Game Theory Signaling and International Legal Relations’, 25 George Washington Journal of International Law and Economics, 33-66. Morkre, Morris E. and Kelly, Kenneth (1993), ‘Perspectives on the Effects of Unfair Imports of Domestic Industries’, 61 University of Cincinnati Law Review, 919 ff. Navarro, Peter (1989), ‘Creating and Destroying Comparative Advantage: The Role of Regulation in International Trade’, 13 Journal of Comparative Economics, 205-226. Niskanen, William A. (1988), ‘U.S. Trade Policy’, 12 Regulation, 34-42. Ordover, Janusz, Sykes, Alan and Willig Robert (1983), ‘International Trade Practices’, 15 New York University Journal of International Law and Politcs. Phegan, Colin (1986), ‘The Interplay of Law and Economics in International Trade Regulation: Comment’, in Snape, R.H. (ed.), Issues in World Trade Policy: GATT at the Crossroads. Papers presented at a Conference of the Centre of Policy Studies, Monash University, Australia, New York, St. Martin’s Press, 218-221. Pindyck, Robert S. and Rotemberg, Julio J. (1987), ‘Are Imports to Blame? Attribution of Injury under the 1974 Trade Act’, 30 Journal of Law and Economics, 101-122. Rousslang, Donald J. (1988), ‘Import Injury in U.S. Trade Law: An Economic View’, 8 International Review of Law and Economics, 117-122. Schanze, Erich (1986), Investitionsverträge im Internationalen Wirtschaftsrecht (Investment Contracts in International Economic), Frankfurt, Metzner, 305 p. Schanze, Erich (1986), ‘Untemehmensrechtliche Koordination von Staat und Wirtschaft bei internationalen Gro Projekten in Entwicklungsländern (Corporate Coordination of State and Economy Concerning Project Investment in Developing Countries)’, 6 Jahrbuch für Neue Politische Ökonomie, 269-287. Schwartz, Warren F. and Harper, Eugene W. (1972), ‘The Regulation of Subsidies Affecting International Trade’, 70 Michigan Law Review, 831 ff. Schwartz, Warren F. (1978), Zenith Radio Corp. vs. United States: Countervailing Duties and the Regulation of International Trade, 1978 Supreme Court Review 297. Schwartz, Warren F. and Sykes, Alan O. (1996), ‘Toward a Positive Theory of the Most Favored Nation Obligation and its Exceptions in the WTO/GATT System’, 16 International Review of Law and Economics, 27-52. Solomon, Lewis D. and Dicker, Howard B. (1988), ‘The Crash of 1987: A Legal and Public Policy Analysis’, 57 Fordham Law Review, 191 ff. Spier, Kathryn E. and Weinsteinn, David E. (1995), ‘Retaliatory Mechanisms for Eliminating Trade Barriers: Aggressive Unilateralism vs GATT Cooperation’, in Chang, Winston W. and Katayama, Seiichi (eds), Imperfect Competition in International Trade, Boston, Kluwer Academic Publishers. Sykes, Alan O. (1989), ‘Countervailing Duty Law: An Economic Perspective’, 89 Colombia Law Review, 199-263.

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Sykes, Alan O. (1990a), ‘“Mandatory” Retaliation for Breach of Trade Agreements: Some Thoughts on the Strategic Design of Section 301’, 8 Boston University International Law Journal, 301-324. Sykes, Alan O. (1990b), ‘Second Best Countervailing Duty Policy: A Critique of the Entitlement Approach’, 21 Law and Policy in International Business, 699-721. Sykes, Alan O. (1990c), ‘GATT Safeguards Reform: The Injury Test’, in Trebilcock, Michael J. and York, Robert C. (eds), Fair Exchange: Reforming Trade Remedy Laws, Toronto, C.D. Howe Institute. Sykes, Alan O. (1991), ‘Protectionism as a ‘Safeguard’: A Positive Analysis of the GATT ‘Escape Clause’ with Normative Speculations’, 58 University of Chicago Law Review, 255-305. Sykes, Alan O. (1992), ‘Constructive Unilateral Threats in International Commercial Relations: The Limited Case for Section 301', 23 Law and Policy in International Business, 263-330. Sykes, Alan O. (1995), Product Standards for the Internationally Integrated Goods Markets, Washington, Brookings. Sykes, Alan O. (1996), ‘The Economics of Injury in Antidumping and Countervailing Duty Cases’, 16 International Review of Law and Economics, 5-26. Therakan, P.K.M. (1990), Policy Implications of Antidumping Measures, Amsterdam, North Holland. Thygesen, Niels (1994), ‘Why is Economic and Monetary Union an Important Objective for Europe?’, 14 International Review of Law and Economics, 133-145. Trebilcock, Michael J. (1990), ‘Throwing Deep: Trade Remedy Laws in a First-Best World’, in Trebilcock, Michael J. and York, Robert C. (eds), Fair Exchange: Reforming Trade Remedy Laws, Toronto, C.D. Howe Institute. Trebilcock, Michael J. and Howse, Robert (1994), The Regulation of International Trade, New York, Routledge. Trebilcock, Michael J., Chandler, Marsha and Howse, Robert (1990), Trade and Transitions, London, Routledge. Viner, Jacob (1923), Dumping: A Problem in International Trade, Chicago, University of Chicago Press. Vousden, Neil (1990), The Economics of Trade Protection, Cambridge, Cambridge University Press, 305 p. Wils, Wouter P.J. (1993), ‘The Search for the Rule in Article 30 EEC: Much Ado About Nothing?’, 18 European Law Review, 475-492. Wils, Wouter P.J. (1994), ‘Subsidiarity and EC Environmental Policy: Taking People’s Concerns Seriously’, 6 Journal of Environmental Law, 81-91. Wood, Diane P. (1989), ‘’Unfair’ Trade Injury: A Competition Based Approach’, 41 Stanford Law Review, 1153 ff.

5920 LAND AND LIVESTOCK CONTRACTING IN AGRICULTURE: A PRINCIPAL-AGENT PERSPECTIVE Charles R. Knoeber Professor, North Carolina State University © Copyright 1999 Charles R. Knoeber

Abstract The seemingly disparate literatures on land tenancy and on the contract production of livestock actually have much in common. Here, they are examined together within a simple principal-agent framework. The core of this framework and a central issue in much writing on these agricultural contracts is the trade-off between smaller risk-bearing costs and better incentives for farmer effort, for the revelation of information and for innovation. The relative importance of risk and incentive in explaining the design and use of land tenancy and livestock production contracts remains a key topic for research. JEL classification: L14, Q12, Q15 Keywords: Land, Livestock, Contracts, Agriculture

1. Introduction Contractual arrangements in agriculture have attracted research interest along several different lines. One primary focus is land tenancy. The causes and consequences of sharecropping, land rental, and owner-operator farming inform a long, active, and widely-known stream of research (surveys include Newberry and Stiglitz, 1979; Binswanger and Rosenzweig, 1984; Otsuka and Hayami, 1989; Singh, 1989; and Otsuka, Hiroyuki and Hayami, 1992). A second important focus is more recent and less widely-known, arising out of the changing organization of livestock production in the United States (Shelden, 1996 provides an overview). Traditionally, livestock producers have bred and raised animals for sale in auction markets. Beginning with broiler chickens in the 1950s, followed by turkeys, and now spreading to swine, a new form of contract production has come to dominate (see Knoeber, 1989 and Menard, 1996 for a description of broilers; and Martin, 1994 for swine). Increasingly, ‘growers’ raise animals under contract for large ‘integrator’ firms. Under this new arrangement, an integrator firm provides young animals (chicks, poults, feeder pigs), feed, medicine and 1133

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advice to contract growers. Growers provide housing, utilities, labor and management. Animals are kept by growers until maturity, but are owned by the integrator firm. At maturity, animals are collected by the integrator and transported to slaughter and processing plants. For broilers and turkeys, the breeding of chicks (poults), mixing of feed, and slaughtering and processing are all typically done by the integrator firm. For swine, integrators mix feed but only sometimes breed pigs and only rarely operate packing plants. These contracts share some features with contracts that have been used for several decades to organize the production of fruits and vegetables for processing (see Reimund, Martin and Moore, 1981; Knoeber, 1983). Reasons for the advent of contract production and the nature of its effects are important emerging research topics. The issues in land tenancy and in contract production are similar. Examining these two related research streams is the purpose of this survey. A simple principal-agent framework is used to organize the discussion, and the primary focus is choice of contract form. This approach narrows the range of issues discussed. An abstract setting in which a single principal contracts with a single agent and in which only the agent’s actions are of concern provides the background for much of the survey. Attention is paid to situations where a single principal contracts with multiple agents, but the possibility that the actions of the principal (as well as those of the agent) matter is generally ignored (Reid, 1977; Eswaran and Kotwal, 1985; Allen and Lueck, 1993; Battacharyya and Lafontaine, 1995 all examine this double moral hazard case). Collective contracts which unite farmers into cooperatives are also ignored. Finally, the effects that varying institutions (largely governmental) have on contract choice receive scant attention. This is appropriate for the discussion of livestock contracting which is largely restricted to activity in the United States, but is a defect in the discussion of land contracting which, while emphasizing the United States experience, is intended to be substantially broader.

2. Framework 2.1 Overview All contracts are formed because the parties involved expect to benefit. In the agricultural context, a focus is often the source of these benefits. One strain of literature emphasizes the stochastic nature of prices and production outcomes facing farmers and views contracts as a vehicle to shift (or share) risk. In this strain, the important benefit of contract production and marketing, as well as sharecropping or other land tenure arrangements, is the reduction in risk-bearing costs. Another strain emphasizes efficiencies in the organization of production. Here, the important benefit of contracts is

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the reduction of transaction and production costs afforded by specialization and the incentives that contracts provide for effort, revelation of information, and innovation. The literature emphasizing the benefits from shifting risk presumes impediments to trading risks directly, as in insurance markets, which limit risk-shifting opportunities for participants in agriculture. Agricultural contracting offers a second-best technique to reallocate the risks of farming and processing. In this literature, the effects of contract design on behavior, except those that follow directly from changing the riskiness of producer or buyer profit functions, are often ignored. But shifting the risk of production outcomes to others also reduces the incentive to achieve better outcomes, since (part of) the gain to better outcomes inures to others. Indeed, if all risk is shifted, as when a farmer is simply paid a wage unrelated to his effort, the farmer is left with no incentive to work hard or to make good, but difficult, decisions. The reason is that the costs of such actions are borne by the farmer and all gains go to the employer. Where these incentive effects are recognized, they are treated as a cost which limits the extent to which agricultural contracts can be used to shift risk. The literature emphasizing production efficiencies takes the opposite approach. Here, agricultural contracts are often analyzed presuming risk neutrality, explicitly ignoring any risk-bearing effects that they may have. The focus is how contract design affects the incentives of farmers (and processors) and so ultimately the costs of production. Where risk is considered, it is treated as a cost of providing better incentives. For example, tying a farmer’s income more closely to production outcomes provides incentive to improve these production outcomes but also forces him to bear more risk. Here, the farmer’s aversion to risk limits the extent to which incentives can be improved. While these two strains of literature differ in emphasis, they overlap in their attention to the trade-off between the reduction in the costs of risk bearing and the provision of better incentives. This trade-off is the core of the principal-agent problem and provides a useful framework from which to view the literature on agricultural contracting. 2.2 Principal-Agent Formulation Consider a farmer (agent) acting for a landlord (principal). The farmer provides an input, effort, that contributes to output. Denote effort as a and output as X, where X(a) and X' > 0. The farmer’s income, I, depends upon the contract that he faces and in general form is written I = αX + ßa + δ, where α and ß are rewards to greater output and effort respectively. Here, the farmer’s income depends upon output, his effort, and the parameter, δ, which is a fixed payment and can be thought of as a non-contingent wage. If

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both α = 0 and ß = 0, the farmer’s income is unrelated to his behavior and so he has no incentive to provide effort. To induce effort, the contract can provide either α > 0, ß > 0 or both. If α = 0 and ß > 0, the farmer is rewarded on the basis of his effort only. This is an incentive wage payment. If α > 0 and ß = 0, the farmer is rewarded on the basis of his output only. This is a cropshare or piece rate payment. If α = 1, ß = 0, and δ < 0, the farmer receives all output and has a negative fixed payment. This is a land rental contract. Why might one form of contract be preferred to others? If providing incentive to the farmer is all that matters, any level of effort can be induced using a positive α, a positive ß, or a combination of the two. None seems to have an advantage over others. Differences arise when the costs of using X or a to reward the farmer are considered. These costs take two forms. One is risk-bearing cost; the other is monitoring cost. Monitoring costs arise because it is necessary to measure. If the farmer’s reward is based on output, X must be measured. If the farmer’s reward is based on effort (input), a must be measured. In many circumstances, monitoring costs will be less when reward is based on output for two reasons. First, the physical nature of output often allows easier measurement. This will be the case where output is less subject to variation in quality and has fewer dimensions than effort. Second, it will typically be true that output must be measured for purposes of sale whether or not it is the basis for farmer reward. If so, and if no additional measurement is necessary to reward the farmer (additional measurement would be required if, for example, the crop was not of uniform quality and the farmer’s reward was a portion of the crop itself), the relevant monitoring cost is zero when output is used as the basis for farmer payment. The high cost of measuring effort also makes it likely that an imperfect measure will be used. So, measuring effort likely will be both more costly than measuring output and less precise. The degree of imprecision depends upon the cost of refining measurement. As a consequence, we can think (roughly) of the choice of how to reward a farmer as that between a precise measure of output, X and an imprecise estimator of effort, â. Since â is an estimator of a, it measures effort with error. Importantly, this introduces risk into the farmer’s reward. Using â as the basis for rewarding a farmer, then, entails two disadvantages relative to using X. Measurement costs are greater and the farmer is forced to bear the risk of errors in the measure of his effort. For this, a risk-averse farmer must be compensated. It seems that rewards based on output will provide incentive more cheaply than rewards based on effort. But, so far, the important cost of reward based on output has been ignored. Output, while increasing in effort, has a large random component. Weather, pest infestations, and many other exogenous forces have marked effects on X. Rewards based on output may be quite risky, and bearing this

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risk is costly. The relative cost of rewards based on output depends upon the size of these risk-bearing costs (costs of measuring output are presumed to be zero) compared to the sum of monitoring costs and smaller risk-bearing costs associated with rewards based upon an estimator of effort, â. To see how this affects the form of contract used, consider several extreme cases. First, if the farmer is risk neutral (so, risk-bearing costs are zero) and measuring effort is costly, incentive can be provided most cheaply by rewards based on X. A land rent contract with α = 1, ß = 0, and δ < 0 seems optimal. Second, if the farmer is risk averse and monitoring costs are zero (effort can be measured without error at no cost), incentive can be provided most cheaply by rewards based on effort. An incentive wage contract with α = 0 and ß > 0 seems optimal. Third, if the farmer is risk neutral and monitoring costs are zero, a land rent contract, an incentive wage contract, and combinations of cropshare and incentive wage contracts (where 0 < α < 1 and ß > 0) all work equally well. Finally, the most interesting case is that where the farmer is risk averse (so risk costs matter) and monitoring costs are positive. Here, there is a trade-off. Effort can be maintained by increasing α and decreasing ß or the reverse. Optimality requires raising α until the additional risk-bearing costs just offset the savings in monitoring costs from the corresponding reduction in ß. Models focusing on this trade-off between incentive and risk costs include Stiglitz (1974) and Warr (1978).

3. Risk Shifting as the Motivation for Contracts 3.1 Sharecropping Drawing especially on early work by Johnson (1950), Cheung (1968, 1969) characterizes sharecropping as motivated by gains from risk shifting. Johnson notes that an exogenously imposed sharecropping contract (0 < α < 1 and ß = 0) provides too little incentive for the farmer to provide effort since he receives only a fraction (α) of the gain and incurs all of the cost, but Johnson also argues that competition works to eliminate insufficient effort. Landlord and tenant will contract not only over the share of output each receives but also over the required effort of the tenant. If effort is insufficient, the lease will not be renewed. Essentially, a is assumed to be easily observable (monitoring cost is zero), so a minimum level of a can be written into the contract. Recently, Banerji and Rashid (1996) have argued that tournaments in which a tenant farmer’s output is compared to that of other tenants provide one mechanism for the landlord to deduce the farmer’s effort. With effort observable, competition forces the farmer to provide the contractual minimum. Cheung (1968) extends Johnson’s argument by explicitly assuming that transaction costs are zero. With this assumption,

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any contract (cropshare, lease, wage) provides appropriate incentive for effort. Cheung argues that sharecropping is used because it provides for risk sharing. Apland, Barnes and Justice (1984) and Petersson and Andersson (1996) adopt this framework and, ignoring any incentive effects, attempt to estimate the risk-sharing benefits from cropshare contracts for sample farms in the United States and Sweden respectively. A difficulty with Cheung’s argument, however, is that sharecropping is not universal. If sharecropping is equivalent to other contracts in incentive and superior in risk sharing, why are other contracts also used? Cheung’s (1969) answer is that transaction (monitoring and contracting) costs are not always zero. This allows a trade-off between risk sharing and incentive, a trade-off that may be unfavorable to cropshare contracts. Stiglitz (1974) and Newberry (1977) also treat risk sharing as the motivation for cropshare contracts and develop conditions under which these contracts provide efficient incentives. In addition, both authors along with Reid (1976) show that where monitoring is costless and risk enters through stochastic output, sharecropping is unnecessary to shift risk. A mixture of rental and wage contracts can duplicate the risk shifting effected by a cropshare contract. These results and a general unwillingness to accept that monitoring costs are zero, has led to substantial criticism of risk sharing as the primary motivation for sharecropping (see especially Jaynes, 1984). In an interesting twist, Reid (1973, 1976) argues that risk considerations motivate sharecropping, but through risk reduction not risk sharing. Cropshare contracts provide superior incentives to adapt to post contractual changes in the environment and so to dampen the effect of nature on output, reducing risk itself. 3.2 Livestock Contracts Even more so than cropshare contracts, livestock production contracts are viewed as motivated by risk sharing. Kliebenstein and Lawrence (1995, p. 1215) state that ‘the primary reason (that growers enter swine production contracts) is risk reduction’. Similarly, Johnson and Foster (1994) ignore any incentive effects and evaluate the desirability of swine production contracts to growers in terms of the risks that growers must bear. Knoeber and Thurman (1995), while not arguing that risk sharing necessarily motivates contracting in broilers, estimate the extent of risk shifting afforded by contract production. This is substantial. Martin (1994) makes similar estimates for swine production. But here, the extent of risk shifting is not as pronounced. Although livestock production contracts do provide considerable risk shifting, and although observers and participants claim that this is the most important motivation for such contracts, no studies have tested for a link between risk and the incidence of such contracts. A number of tests have

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been conducted for cropshare contracts. If risk shifting is important, cropshare contracts should be observed where yields are most uncertain. Higgs (1973) finds weak evidence consistent with this implication for corn and cotton in the early twentieth century in the southern United States. Rao (1971) finds opposing evidence for Indian farms. More recently, Allen and Lueck (1992b, 1996), for farms, and Leffler and Rucker (1991), for timberland, find no relation between risk and the nature of contracts chosen.

4. Incentive as the Motivation for Contracts 4.1 Sharecropping Focusing on Cheung’s (1969) assertion that transactions costs (monitoring and contracting costs) are important in explaining the incidence of contracts, another stream of literature emphasizes incentives to explain sharecropping. Higgs (1974), Alston and Higgs (1982) and Alston, Datta and Nugent (1984), while not denying the potential importance of risk sharing, argue that differences in supervision costs (costs of measuring a) help explain variation in the extent of sharecropping for crops that have similar yield variability. Where it is more costly to measure a, sharecropping, or basing farmer rewards on X, becomes more likely. All three papers find evidence consistent with this prediction using historical data for the southern United States. Evidence for India is presented in Datta, O’Hara and Nugent (1986). Bell and Zusman (1976) and Stiglitz (1988) also emphasize difficulties in monitoring farmer effort as a rationale for sharecropping. Where measuring effort is expensive (so minimum a cannot be fixed by contract), a share contract, with " > 0, provides incentive but only by imposing risk on the farmer. Trading off the loss from too little incentive against that from too great risk bearing defines the optimal share contract. If capital as well as labor is allowed as an argument in the production function, and if these inputs are complementary, introducing a link to credit into a cropshare contract may be desirable. Providing subsidized credit to a sharecropper will induce greater use of capital and so greater labor productivity and hence more effort (this may not be true if tenants also work off the farm; see Subramanian, 1995). So, the common occurrence of interlinked credit and cropshare contracts may have its origin in the difficulty of providing incentives for effort (see Braverman and Stiglitz, 1982, 1986; Mitra, 1983). Murrell (1983), Eswaran and Kotwal (1985), and Chew (1991) all ignore risk costs and focus on contracting costs to explain sharecropping, but the strongest statement of the primacy of incentives (the irrelevancy of risk sharing) is in Allen and Lueck (1992b, 1993, 1995, 1996). Assuming risk neutrality, they construct a framework in which measurement and

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enforcement costs dictate the form of contract chosen. They use this framework to explain both the choice between cropshare contracts and others and the choice of input and output shares when cropshare contracts are used. Using data for farms in Nebraska and South Dakota, they provide evidence that is consistent with the importance of these measurement costs and the unimportance of risk-bearing costs in explaining contract choice. 4.2 Livestock Contracts The literature on livestock contracts never ignores risk but only sometimes treats risk sharing as an end in itself. Shelden (1996) adopts a principal-agent framework to characterize contracts as providing incentive for effort by rewarding growers on the basis of output, X, but at the cost of imposing risk on growers. Knoeber (1989) also treats incentive as primary, but argues that the design of broiler production contracts can be explained partly as intended to provide this incentive while minimizing the risk borne by growers. Reducing the risk cost of providing incentive allows for higher powered incentives. An interesting feature of broiler production contracts is that growers are rewarded based upon relative performance where performance is measured largely by feed conversion, the effectiveness with which feed is used to produce meat (effort, or a, is not measured). A grower’s pay rises as his performance improves, not absolutely but relative to the performance of other growers. This scheme, which is like a tournament, shifts risks which are common to all growers (weather, feed mix, chick genetics) to the integrator company (on relative performance payments, see Lazear and Rosen, 1981 and Holmström, 1982). Common shocks, like bad weather, reduce all growers’ absolute performance but leave each grower’s payment unchanged if relative performance is unaffected. For example, a contract that rewards a grower based upon his output relative to the average of other growers, uses Xi - ' X/n to measure grower i’s performance. If bad weather affects each grower identically, each grower’s X will move in lock-step, leaving grower i’s relative performance unchanged. Where substantial variation in absolute performance is common to all growers, contracts such as those used in the broiler industry can provide incentive to growers with less risk-bearing cost than contracts rewarding absolute performance. Knoeber and Thurman (1994) test a number of hypotheses arising out of the theory of tournaments using broiler production data. In addition to incentive for effort, livestock production contracts may be designed to alleviate another incentive problem. This is the hold-up problem discussed by Klein, Crawford and Alchian (1978). When production requires investing in an asset that is specialized to a particular trading partner, any deal made prior to investing in the specialized asset may not be enforceable once the investment is made. The non-investing party has an

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incentive to use his newly created bargaining power (the cost of the specialized asset cannot be recouped elsewhere) by demanding more favorable terms. Production contracts that require both parties to invest in assets specialized to the other (or an exchange of hostages as described by Williamson, 1983), as is the case where growers invest in animal houses and integrators invest in breeding facilities, feed mills, and processing plants, help to alleviate the hold-up problem. This role for livestock production contracts is emphasized by Knoeber (1989), Frank and Henderson (1992), Barry, Sonka and Lajili (1992) and Sporleader (1992).

5. Selection as a Motivation for Contracts Even with no concern for risk or farmer effort, asymmetric information may motivate the design of contracts. Where farmers differ in ability, it may be important to choose farmers to match productive circumstances. For example, for climates and crops where adaptability (decision making) is crucial, more able farmers are desired. Where rote response is sufficient, less able farmers are suitable. If only farmers know their own ability and if farmers are heterogeneous, the design of contracts may act to induce farmers to self-select into appropriate matches. Hallagan (1978) explains the simultaneous use of wage, share and rental contracts as a response to this selection problem where entrepreneurial ability is important. Where low entrepreneurial ability is sufficient, landowners will offer (low) wage contracts. Where high ability is necessary, landowners will offer (high) land rental contracts. Where intermediate ability is appropriate, share contracts will be offered. Those with the highest entrepreneurial ability will be willing to accept only the rental contract; those with the least ability will be willing to accept only the wage contract; and those with intermediate ability will be willing to accept only the cropshare contract. A similar argument, but viewing ability more generally, is developed by Newberry and Stiglitz (1979). Brown and Atkinson (1981) provide a test of this selection hypothesis by examining cropshare contracts in Indiana. They argue that where entrepreneurial ability is more important, the farmer’s share will be greater (this is closer to a rental contract), and test by examining the scope of farmer decision making across contracts with varying farmer shares. They find evidence that as the scope of decision making increases (ability becomes more important), farmer shares increase as well, consistent with the selection hypothesis. Allen (1982) argues that where it is only farmer ability that is asymmetrically known, wage and cropshare contracts are unnecessary to induce selection. If farmers have all decision-making authority, as is the case with rental contracts, they will sort themselves correctly. However, Allen

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(1982, 1985) also offers two reasons why share contracts may occur for selection purposes. First, if landowners wish to maintain some decision-making authority, as would be the case if in addition to asymmetric knowledge of farmer ability there is also asymmetric knowledge about land quality (landowners alone know the quality of their holdings), sharecropping may arise. Second, if contracts must be self-enforcing (courts cannot be counted on), sharecropping may arise. Since both rental and cropshare contracts necessarily imply a loan of land to the farmer until the crop is harvested, both are subject to farmer default. Default entails absconding with the entire crop or not paying the agreed upon rent. If landowners can learn farmer abilities by observing the size of the harvest, an equilibrium may arise where farmers of low ability select wage contracts, farmers of high ability select share contracts and are later rewarded for performance (not absconding) with larger plots (and so more income). Share contracts, then, provide a self-enforcing mechanism to induce selection. There may be a similar role for selection in livestock production contracts. These contracts require growers to build expensive animal houses, with little salvage value. Growers of high ability likely will find this investment profitable; those with low ability likely will not. Knoeber (1989, p. 280) notes that broiler companies (integrators) claim that an important reason for the use of contract growers is the refusal of high-quality growers to work for wages. That is, contract production selects for high-quality growers. The likely reason for the importance of high-quality growers is that suggested by Hallagan (1978); the rapid technological change which characterizes the broiler industry requires growers of high entrepreneurial ability.

6. Innovation and Contract Form Is there a link between innovation and contract form? Bhaduri (1973) claims that sharecropping retards innovation, but the case is not clear. Since a share contract divides the gains from innovation (like the gains from farmer effort) between landlord and tenant, neither seems to have sufficient incentive to innovate. But if transaction costs do not interfere, Cheung’s (1968) argument for the efficiency of share contracting applies equally to effort and to innovation. As long as contracts can be adapted easily, extant share contracts should have little influence on the incentive to adopt new technologies. Transaction costs aside, then, there should be no relation between the form of contracts (cropshare, lease, wage) and innovation. But transaction costs may matter. Newberry (1975) argues that innovation may both increase output and make it more difficult to provide incentive to tenant farmers (require more resources devoted to measuring a in order to assure

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that effort does not fall below that agreed upon or greater risk-bearing costs for the tenant if the (now, less precise) original measure of a is still used). If this is the case, innovations that would be undertaken with rental contracts may sometimes be foregone with share contracts. This transaction costs argument suggests less innovation with sharecropping. Empirical evidence, at least in developing countries, shows no relation between innovation and contract form. Parthasarathy and Prasad (1974) find no effect of share tenancy on the adoption of high yield varieties of rice in an Indian village. Ruttan (1977) summarizes research showing no persistent lag among sharecroppers in the adoption of new varieties of rice and wheat in Asia during the Green Revolution of the 1960s and 1970s. Similarly, Feder, Just and Zilberman (1985) conclude that no clear relation exists between tenancy and the adoption of agricultural innovations. These empirical findings are not surprising. If sharecropping’s effect on innovation were substantial, contracts that better facilitate innovation should replace share contracts. Interestingly, there appears to be a positive relation between the pace of technological innovation and contract production in livestock industries. Improvements in feed conversion in the United States have been most rapid and most persistent for broilers and turkeys where contract production dominates, recently rapid for hogs where contract production is increasing, and relatively slow for cattle where contract production is less significant (Knoeber, 1989). Similarly, adoption of new breeding technologies seems positively related to (contract) integration in livestock production (Johnson, 1995). This suggests that contracts may facilitate innovation. Knoeber (1989) provides an explanation for broilers. Here, decisions to adopt innovations (new genetics, and so on) are made by the integrator companies. Also, broiler contracts compensate growers based upon relative performance. These contracts serve two complementary purposes. First, they protect growers from the risk associated with innovation experiments. Innovations may raise or lower absolute performance, but have little effect on relative performance. So growers will not resist innovation. Second, these contracts automatically shift all of the gains from innovation (increases in absolute performance) to the integrator company. As a result, those making adoption decisions face the full costs and benefits of these decisions without the necessity to rewrite contracts (no additional contracting costs are incurred). The form of broiler production contracts seems particularly well adapted to an environment of rapid and persistent technological change.

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7. Contracts and Performance An important issue in the land tenancy literature but not in that on livestock contracting is the relation between contract form and performance. The primary concern is that sharecroppers who receive only a portion of the gains from effort will have too little incentive and perform poorly. Bardhan and Srinivasan (1971) model this effect. To the extent that contracts are imposed exogenously (or perhaps contractual choice is constrained politically), this concern may be warranted. If sharecrop contracts are imposed where rental or owner operation is optimal, sharecroppers should perform worse than renters or owner-operators and the cross-sectional relation between sharecropping and performance should be negative. But if contracts are chosen endogenously, share contracts (like others) should be chosen where they are most effective (Lucas, 1979; Rao, 1971; Morooka and Hayami, 1989; Chew, 1993; Tunali, 1993; and especially Otsuka, Hiroyuki and Hayami, 1992, pp. 2005-2008). Here, sharecroppers should perform no better nor worse than other farmers. As a consequence, there should be no cross-sectional relation between sharecropping (or other contract form) and performance (for a statement of this argument applied to the ownership structure of corporations and firm performance, see Demsetz and Lehn, 1985; for a test, see Agrawal and Knoeber, 1996). Any empirical relation is either spurious or results from failing to control for those features of the environment that make sharecropping (or rental, or owner operation) optimal. Empirical evidence is largely consistent with optimal (unhindered) contract choice. Bell (1977) and Shaban (1987) are exceptional in offering evidence of poorer performance by sharecroppers in India. Laffont and Matoussi (1995) also find evidence of poorer performance in Tunisia but do so within an explicit framework in which exogenously imposed credit constraints on farmers induce sharecropping. Most studies find no such effect. Rao (1971), Truran and Fox (1979) and Nabi (1986) are more typical in finding no performance difference for sharecroppers. Cropshare contracts appear to exist where they are optimal.

8. Next Steps A substantial portion of the literature on sharecropping has focused on its use and its effects in developing countries. This is appropriate both because these countries are more agrarian than their western counterparts and because sharecropping seems more dominant here. But sharecropping remains important in developed countries. For some crops and some areas, sharecropping is the primary form of contracting. For example, in the

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United States during the late 1980s, cropshare contracts were a large percentage of all lease contracts in the midwest where grain crops dominate (more than 50 percent in Kansas, Illinois, and Indiana; more than 40 percent in Iowa and Missouri). An important question is whether the function of sharecropping is the same in both developing and developed economies. The generally lesser use of cropshare contracts (relative to rental or wage contracts) in developed economies offers a clue. What is it about the development of markets that might lead to a decline in sharecropping? One possible answer is that with better markets also comes less risk or at least better ways to shift risk. More extensive agricultural markets reduce the effects that local conditions have on prices and so may reduce the risk associated with farming (depending upon the correlation of output among local farmers and the correlation between local output and price). But even if this is not the case, better insurance markets provide alternatives to sharecropping as ways to share risk. More developed markets reduce (or perhaps eliminate) the risk-shifting motivation for sharecropping. This may account for sharecropping’s lesser importance in developed countries. But more extensive markets and the anonymity that they allow also will affect measurement costs and so, in turn, the incentive motivation for share contracts. These changes in measurement costs, then, also may account for the lesser importance of sharecropping in developed countries (and for the variation in the importance of sharecropping across crops and regions). Both arguments are made by Otsuka, Kikuchi and Hayami (1986) to explain the lesser use of share contracts (relative to rental contracts) for drivers of jeepney (taxi cabs) in urban as opposed to rural areas of the Philippines. The ‘thicker’ urban market is less risky than rural markets making urban share contracts less desirable on risk-sharing grounds. But also tight-knit communities in rural areas (relative to the anonymity of urban areas) reduce the cost of monitoring drivers. Low effort by drivers is known more readily by owners in rural areas. So, measurement costs are relatively high in urban areas, again making share contracts less desirable. Similar arguments may explain the lesser use of cropshare contracts in more developed countries. If so, more active crop insurance markets (or more extensive government disaster payments) should coincide with lesser use of share contracts. Similarly, lesser migration (tighter knit communities) should coincide with greater use of cropshare contracts. Little role for risk considerations in contract choice in developed countries is consistent with the claim of Allen and Lueck (1996) who argue that transaction costs determine contract use in modern United States farming. Examining more carefully the nature of measurement and enforcement costs seems a fruitful approach to studying agricultural contracts. Allen and Lueck (1992a) do this to explain the length of farmland

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contracts and whether their form is oral or written. In related work (Allen and Lueck, 1997), they also address a very interesting puzzle, the continued dominance of family farms in the face of growing corporatism in other sectors of the economy. Once again, measurement costs are key. Family farms eliminate the need for measurement of effort since family farmers are residual claimants. But family farms also restrict the possibilities for specialization. Where measurement of effort is difficult and specialization unimportant, family farms should dominate. Where measurement of effort is easier and gains from specialization greater, partnerships and corporations should be important. Allen and Lueck treat (Mother) nature as determining measurement and specialization costs. Where production has a larger random element, the costs of measuring effort are greater. Where seasonality is less, specialization gains are more important. This implies that family farms will be more likely where nature (weather, pests, and so on) is a more important determinant of output and for more seasonal crops. Allen and Lueck also provide some confirming evidence. That nature and seasonality are more important for agriculture than for other industries is consistent with the continued dominance of family farms. Further, the importance of corporate firms in broiler production is ascribed to the elimination of nature’s role in much of the production process. Finally, the relative importance of family farms in British Columbia and Louisiana is explained by the extent of seasonality (more seasonal crops are more likely to be grown on family farms) and the degree to which nature influences output (weakly, irrigated crops, where rainfall is less important, are less likely to be grown on family farms). Similarly, despite much opposing commentary, risk costs may not be the primary motivation for the livestock production contracts increasingly used in the United States. Focusing on measurement and enforcement costs seems a fruitful avenue. Interesting puzzles are differences in the extent of contract use and the design of contracts across varieties of livestock. In the United States, contract production dominates for broilers and turkeys, is important for eggs (although vertically integrated companies are also important and some auction markets exist), is increasingly important for hogs (but still accounts for less than 25 percent of hog production), and is unimportant for cattle. No attempt has been made to explain this pattern. Additionally, broiler contracts reward growers based on relative performance; turkey contracts sometimes do and sometimes do not; and hog contracts almost never do. Contract producers of hogs receive bonuses if they meet absolute (fixed) performance standards. Tsoulouhas and Vukina (1997) suggest a risk-related explanation for this variation in contract form. Concern with bankruptcy risk precludes the use of relative performance compensation for contract producers of swine where integrators are predominately closely-held and where price volatility is large. In contrast, the predominance of publicly

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traded integrators in the broiler industry coupled with lesser price volatility allows the use of relative performance compensation for contract producers of broilers. But, there also may be a measurement cost explanation of this phenomenon. Relative performance is a less noisy measure than absolute performance whenever common shocks to performance (for example bad weather that affects all growers) are large and comparison growers are many. The reason is that relative performance differences-out the noise introduced by common shocks from a grower’s performance but also introduces the idiosyncratic variation from other growers’ performance (other growers’ performance is the benchmark). If the first effect dominates, relative performance is a less noisy measure. The noise added by the idiosyncratic variation in other growers’ performance is reduced when there are more of these other growers since the individual variations balance out (Hölmstrom, 1982). The number of other growers and their similarity, then, determine whether or not relative performance contracts are desirable (Knoeber, 1989 and Martin, 1994). Much remains to be done to explain the ongoing revolution in the contractual organization of livestock production.

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5930 TELECOMMUNICATIONS © Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest

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Kaserman, David L. and Mayo, John W. (1986), ‘The Ghosts of Deregulated Telecommunications: An Essay by Exorcists’, 6 Journal of Policy Analysis and Management, 84-92. Kilian, W. Picot, Arnold, Neuburger, R., Niggl, J., Scholtes, K.-L. and Seiler, W. (1994), Electronic Data Interchange (EDI), Aus ökonomischer und Juristischer Sicht, Forschungsbericht zu dem von der Volkswagen-Stiftung Geförderten Forschungsprojekt ELTRADA (Elektronische Transaktionen von Dokumenten zwischen Organisationen) (Electronic Data Interchange EDI from the Viewpoint of Economics and Law), Baden-Baden, Nomos. Knieps, Gunter (1983), ‘Is Technological Revolution a Sufficient Reason for Changing the System of Regulation? the Case of Telecommunications’, 139 Journal of Institutional and Theoretical Economics, 578-597. Levin, Harvey J. (1962), ‘Federal Control of Entry in the Broadcast Industry’, 5 Journal of Law and Economics, 49-67. Levy, Brian and Spiller, Pablo T. (1994), ‘The Institutional Foundations of Regulatory Commitment: A Comparative Analysis of Telecommunications Regulation’, 10 Journal of Law, Economics, and Organization, 201-246. Lueck, Dean (1996), ‘Ownership vs. Auctions: A Comment on Spiller and Moreton’, 39 Journal of Law and Economics. Macauley, Molly K. (1986), ‘Out of Space? Regulation and Technical Change in Communications Satellites’, 76 American Economic Review. Papers and Proceedings, 280-284. Manning, W. and Owen, Bruce M. (1976), ‘Television Rivalry and Network Power’, 24 Public Policy, 33 ff. Marshall, Robert C., Meurer, Michael J. and Richard, Jean Francois (1991), ‘The Private Attorney General Meets Public Contract Law: Procurement Oversight by Protest’, 20 Hofstra Law Review, 1-71. IRS Computer Modernization and Procurement, Hearing before the Senate Governmental Affairs Committee, June 25, 1991 and April 2, 1992 Marshall, Robert C., Meurer, Michael J. and Richard, Jean Francois (1993), ‘Incentive-Based Procurement Oversight by Protest’, in Leitzel, Jim and Tirole, J. (eds), Incentives in Procurement Contracting, Boulder, CO, Westview. Marshall, Robert C., Meurer, Michael J. and Richard, Jean Francois (1994a), ‘Curbing Agency Problems in the Procurement Process’, 25 Rand Journal of Economics, 297-318. Marshall, Robert C., Meurer, Michael J. and Richard, Jean Francois (1994b), ‘Multiple Litigants with a Public Good Remedy’, 16 Research in Law and Economics, 151-173. Melody, William H. (1989), ‘Efficiency and Social Policy in Telecommunication: Lessons from the U.S. Experience’, 23 Journal of Economic Issues, 657-688. Minasian, Jora R. (1969), ‘The Political Economy of Broadcasting in the 1920s’, 12 Journal of Law and Economics, 391-403. National Economic Research Associates (1989), Telecommunications in a Competitive Environment: Proceedings of the Third Biennial Telecommunications Conference, Marriott’s Camelback Inn, Scottsdale, Arizona, April 12-15, 1989, White Plains, N.E.R.A., 233 p. Noll, Roger G. (1987), ‘The Twisted Pair: Regulation and Competition in Telecommunications’, 11(3-4) Regulation, 15-22.

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Noo, Roger G. (1986), ‘State Regulatory Responses to Competition and Divestiture in the Telecommunications Industry’, in Grieson, Ronald E. (ed.), Antitrust and Regulation, Lexington, MA, Lexington Books, 165-200. Ohls, James C. (1970), ‘Marginal Cost Pricing, Investment Theory and CATV’, 13 Journal of Law and Economics, 439-460. Ohls, James C. (1971), ‘Marginal Cost Pricing, Investment Theory and CATV: A Reply’, 14 Journal of Law and Economics, 517-519. Olsen, Ole Jess (1989), ‘Deregulation and Reorganisation: The Case of the Danish Telecommunications’, 60 Annals of Public and Cooperative Economy, 251-258. Owen, Bruce M. (1970), ‘Public Policy and Emerging Technology in the Media’, 18 Public Policy, 539 ff. Owen, Bruce M. (1972a), Diversity and Television, OTP Staff Research Paper. Reprinted in Ginsburg, D.H., Regulation of Broadcasting, Mineapolis, West Publishing. Owen, Bruce M. (ed.) (1972b), Papers and Proceedings, Conference On Telecommunications Policy, Research Office of Telecommunications. Owen, Bruce M. (1973a), ‘The Role of Analysis in the Formation of Cable Television Policy’, in Park, R.E. (ed.), The Role of Analysis in Regulatory Decisionmaking: The Case of Cable Television, Lexington, MA, Lexington Books. Owen, Bruce M. (1973b), ‘Newspaper and Television Station Joint Ownership’, 18 Antitrust Bulletin, 787 ff. Owen, Bruce M. (1974), ‘Discussion Prepared for the Session on the Economics of the First Amendment, Annual Meetings of the American Economic Association, New York, December, 1973', 64 American Economic Review, 400 ff. Owen, Bruce M. (1975a), Economics and Freedom of Expression: Media Structure an the First Amendment, Cambridge, MA, Ballinger. Owen, Bruce M. (ed.) (1975b), Report of Papers and Proceedings, 1975 Conference on Telecommunications Policy Research, Aspen, Institute for Humanistic Studies Program on Communications and Society. Owen, Bruce M. (1977), ‘Regulating Diversity: The Case of Radio Formats’, 21 Journal of Broadcasting, 305 ff. Owen, Bruce M. (1978a), ‘Cable Television: The Framework of Regulation’, in X (ed.), Study on Federal Regulation, Appendix to Vol. XI, Framework for Regulation, Committee on Governmental Affairs, United States Senate, 95th Congress. Owen, Bruce M. (1978b), ‘The Place of Print in an Electronic Society’, in Robinson, G.O. (ed.), Communications for Tomorrow: Policy Perspectives for the Future, New York, Praeger Publishing Company. Owen, Bruce M. (1978c), ‘Diversity in Broadcasting: The Economic View of Programming’, 28 Journal of Communication, 43 ff. Owen, Bruce M. (1979a), ‘Structural Approaches to the Problem of TV Network Economic Dominance’, 59 Duke Law Journal, 191 ff. Owen, Bruce M. (1979b), ‘Five Propositions on the Social Effects of Television’, for the Sloan Foundation, Duke University. Owen, Bruce M. (1981), ‘The Rise and Fall of Cable Television Regulation,’, in Weiss, L. (ed.), The Regulatory Revolution, Boston, Little Brown. Owen, Bruce M. (1982), ‘Differing Media, Differing Treatment?’, in Brenner, D. and Rivers, W. (eds), Free But Regulated: Conflicting Traditions in Media Law.

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Owen, Bruce M. (1985), ‘Recent Developments in Cable Television Regulation’, 1 XXXRegulatory Reform: The ABA Section of Antitrust Law Industry Regulation Committee Newsletter. Owen, Bruce M. (1986), Horizontal Mergers: Law and Policy, ABA Section of Antitrust Law Monograph, No. 12. Owen, Bruce M. (1987), ‘Book Review of A. Brown, Commercial Media in Australia: Economics, Ownership, Technology and Regulation’, 17 Economic Analysis and Policy, 105 ff. Owen, Bruce M. (1988), ‘Book Review of P. Temin, the Fall of the Bell System’, 2 Regulation: AEI Journal on Government and Society. Owen, Bruce M. (1990), The Electronic Media, Proceedings of the 1990 Stanford Symposium on Democracy, Diversity, and News Media Ownership. Owen, Bruce M. (1996), ‘Book Reviw of G.W. Brock, Telecommunications Policy for the Information age’, Journal of Economic Literature. Owen, Bruce M. and Gottlieb, Paul D. (1986), ‘The Rise and Fall and Rise of Cable Television Regulation,’, in Weiss, Leonard W. and Klass, Michael W. (ed.), Regulatory Reform: What Actually Happened, Boston, Little Brown. Owen, Bruce M. and Greenhalgh, P.R. (1986), ‘Competitive Policy Considerations in Cable Television Franchising’, 4 Contemporary Policy Issues, 69 ff. Owen, Bruce M. and Manning, W.G., Jr (1974), Television Economics, Lexington, D.C. Heath. Owen, Bruce M. et al. (1973), Analysis of the Causes and Effects of Increases in Same-Year Rerun Programming and Related Issues in Prime Time Network Television, Office of Telecommunications Policy, Executive Office of the President. Owen, Bruce M. et al. (1993), ‘Cable Rate Regulation - A Multi-Stage Benchmark Approach’, Economists Incorporated. Owen, Bruce M. et al. (1995a), ‘An Economic Analysis of the Broadcast Television National Ownership, Local Ownership and Cross-Ownership Rules’, Economists Incorporated. Owen, Bruce M. et al. (1995b), ‘An Economic Analysis of the Prime Time Acces Rule, March 7, 1995, and A Supplementary Analysis of the Prime Time Acces Rule’, Economists Incorporated. Owen, Bruce M. and Wildman, S.S. (1992), Video Economics, Cambridge, MA, Harvard University Press. Pacey, Patricia L. (1985), ‘Cable Television in a Less Regulated Market’, 34 Journal of Industrial Economics, 81-91. Pera, Alberto (1989), ‘Deregulation and Privatisation in an Economy Wide Context’, 0(12) OECD Economic Studies, 159-204. Perrakis, Stylianos and Silva Echenique, Julio (1983), ‘The Profitability and Risk of CATV Operations in Canada’, 15 Applied Economics, 745-758. Peterman, John L. (1965), ‘The Structure of National Time Rates in the Television Broadcasting Industry’, 8 Journal of Law and Economics, 77-131. Peterman, John L. (1968), ‘The Clorox Case and the Television Rate Structures’, 11 Journal of Law and Economics, 321-422. Picard, Pierre (1988), ‘La Tarification Optimale des Télécommunications: une Présentation Synthetique (Optimal Pricing for Telecommunications: An Overview)’, 0(12) Annales d’Economie et de Statistique, 27-62.

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Richter, Wolfram F. and Weimann, Joachim (1985), ‘Ramsey Pricing the Telephone Services of the Deutsche Bundespost’, 141 Journal of Institutional and Theoretical Economics, 516-524. Rowley, Charles K. (1966), The British Monopolies Commission, London, Allen and Unwin. Rubin, Paul H. and Dezhbakhsh, Hashem (1995), ‘Costs of Delay and Rent-Seeking Under the Modification of Final Judgment’, Managerial and Decision Economics, 385-400. Samuelson, Paul A. (1964), ‘Public Goods and Subscription TV: Correction of the Record’, 7 Journal of Law and Economics, 81-83. Sardinas, Joseph L., Jr (1987), ‘Regulation of International Data Communications and the Effect upon Multinational Corporations’, in Most, Kenneth S. (ed.), Advances in International Accounting, Vol. 1, Greenwood, JAI Press, 305-315. Schenk, Karl-Ernst, Schmidtchen, Dieter and Streit, Manfred E. (eds) (1997), Neue Politische Ökonomie der Integration und Öffnung von Infrastrukturnetzen Jahrbuch für Neue Politische Ökonomie 16 (Integration of and Access to Infrastructural Networks), Tübingen, Mohr. Schmandt, Jurgen, Williams, Frederick and Wilson, Robert H. (eds) (1989), Telecommunications Policy and Economic Development, New York, Greenwood Press, 299 p. Shedd, M.S., Wilman, Elizabeth A. and Burch, R. Douglas (1990), ‘An Economic Analysis of Canadian Content Regulations and a New Proposal’, 16 Canadian Public Policy, 60-72. Smiley, Albert K. (1990), ‘Regulation and Competition in Cable Television’, 7 Yale Journal on Regulation, 121-139. Snow, Marcellus S. (1986), Marketplace for Telecommunications: Regulation and Deregulation in Industrialized Democracies, New York, Longman, 304 p. Snow, Marcellus S. (1988), ‘The State as Stopgap: Social Economy and Sustainability of Monopoly in the Telecommunications Sector’, 46 Review of Social Economy, 1-23. Snow, Marcellus S. and Jussawalla, Meheroo (1986), Telecommunication Economics and International Regulatory Policy: An Annotated Bibliography, New York, Greenwood Press, 216 p. Spence, M. and Owen, Bruce M. (1977), ‘Television Programming, Monopolistic Competition and Welfare’, 91 Quarterly Journal of Economics, 103 ff. Teske, Paul E. (1991), ‘Rent-Seeking in the Deregulatory Environment: State Telecommunications’, 68 Public Choice, 235-243. Trebing, Harry M. (1986), ‘Apologetics of Deregulation in Energy and Telecommuniciations: An Institutionalist Assessment’, 20 Journal of Economic Issues, 613-632. Vietor, Richard H.K. and Davidson, Dekkers L. (1985), ‘Economics and Politics of Deregulation: The Issue of Telephone Access Charges’, 5 Journal of Policy Analysis and Management, 3-22. Voigt, Stefan (1992), ‘Das Lizenzauktionsverfahren, Ein zielkonformes Instrument zur Regulierung lokaler Kabelfernsehstationen? Eine Analyse der anglo-amerikanischen Diskussion und Praxis (The Licence Auctioning System as an Instrument to Regulate Local Cable Stations)’, 17 The European Journal of Communications, 67-90.

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5940 PUBLIC UTILITIES Rick Geddes Assistant Professor, Department of Economics, Fordham University © Copyright 1999 Rick Geddes

Abstract In this chapter, I review the literature on public utilities. Public utilities include a wide range of industries, such as electricity, water, telecommunications, cable television, and railroads, among others. These industries share similar characteristics. I first examine utilities generally in the Introduction, focusing on issues common to them. I review alternative theories of why utilities have historically been either regulated or government-owned. In Part A, I examine the effects of regulatory reform, and the distortionary effects of utility regulation. I find that the effect of utility regulatory reform in the US has been positive. In Part B, I apply many of these general concerns to the US electric utility industry. I examine the regulatory history of this industry, the effects of structural change, the recovery of stranded costs, the natural industry structure, and issues of reliability. In Part C, I provide a brief overview of the literature on other utilities, including telephones, natural gas, and water utilities. In Part D, I summarize the literature on European utilities. JEL classification: K23, L43, L51, L9 Keywords: Utilities, Network Industries, Regulatory Reform

1. Introduction The term ‘public utility’ encompasses a wide variety of industries including, among others, airlines, telecommunications, oil, natural gas, electricity, trucking, cable television and railroads. These industries share a common ‘network’ structure, in that they have an extensive distribution system of lines, pipes, or routes requiring the use of public rights of way, often with strong physical linkages between component parts. In some cases, such as airlines, government owns a part of the infrastructure. Public utilities typically have substantial sunk costs because of the need for extensive infrastructure. Historically, utilities, where privately owned, have been rate-of-return regulated. Utilities are government-owned in some jurisdictions. In almost all cases, utilities have been granted legally enforced monopolies over their service territories. Public utilities have, in many jurisdictions, experienced regulatory reform. Reform has typically been in the form of increased competition through more 1162

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liberal entry. In some cases, the oil price shocks of the early 1970s de-stabilized the regulatory process. In others, new technologies made the old regulatory regime untenable. The paradigm for utility regulation has therefore changed dramatically. Where once regulated or government-owned monopolies dominated because of the belief that most utilities were ‘natural monopolies’, there is now a growing consensus that competition can perform a broader and more effective role. The social importance of public utilities collectively is huge, and the literature on them is correspondingly vast. I therefore focus on several salient issues. In Part A below, I survey several areas of the literature which are relevant for all utilities, including their structural similarities, the rationale for regulation, and the experience with regulatory reform. In Part B, I examine a more specific case, that of US electric utilities, and indicate how these general concerns apply in that industry. I then follow in Part C with brief discussions of telephone, natural gas, and water utilities. In Part D, I review the literature on European utilities.

A. An Overview of Utilities and Regulation In this part, I provide an overview of literature concerning regulation and utilities generally. I first discuss the structural similarities shared by utilities. I then review the literature on the various rationales for government intervention in these industries. This includes the ‘public interest’, ‘capture’, ‘economic’ and ‘contestability’ theories. In Section 4, I survey the distortionary effects of regulation, and then move on to the effects of regulatory reform. I conclude the part with a brief review of the literature on ownership form.

2. The Structural Similarities of Utilities Utilities typically create a good or service at one location, and then distribute it over a ‘network’ where it is delivered to numerous customers for end use. The use of a network structure creates special issues for utilities. The network often exhibits economies of scale and involves substantial sunk costs, so the issue of natural monopoly has played an important role in utility literature. The network may require the use of public streets or other rights of way, so government involvement is of particular concern. Since several firms often utilize the network, there are ‘network externalities’ or congestion if its use is not properly priced. The activities of utilities can be broken down into three components: production, transmission, and distribution. While the production component has, in the US, been almost exclusively privately owned, the transmission and distribution stages have been either private or government-owned. For example,

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in trucking and airlines, government-owned street, highways and airports are utilized. A useful way of describing this common structure in six utilities is illustrated in Table 1. Table 1 The Three Components of Six Utilities Industry

Production

Transmission

Distribution

Airlines

Airplanes

Air traffic control

Airports

Trucking

Trucks

Highways

Local streets, distribution centers

Telecoms Telecom terminal equipment

Long-distance cos. and local Local telecoms telecoms

Electricity Generating plants

High-voltage lines

Local power lines

Natural gas

Interstate pipelines

Local distribution companies

Trunk lines

Local sidings

Gas wells

Railroads Trains

Source: Crandall and Ellig (1997, p. 70) In some regulated utilities, the firm is fully ‘vertically integrated’ into all three activities, and a salient issue is the ‘unbundling’ of these functions under competition. Most commentators now agree that the production stage is inherently competitive in most utilities, so that different firms may perform the production and transmission/distribution functions (Crandall and Ellig, 1997). The focus is then on the proper structure for the transmission and distribution segments of the business, with particular attention paid to the question of entry by competitors, or ‘access’ to transmission and distribution infrastructure.

3. The Rationale for Regulation of Utilities As noted above, government entities have historically regulated utilities extensively. The debate in the academic literature over the rationale for this

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intervention has accordingly been considerable. The literature falls into two broad categories: positive and normative. The normative, or ‘public interest’ strand provides rationales for how and why government ought to intervene in utilities, typically pointing out ‘market failures’, or situations in which government intervention could, in theory, improve market operation. According to this approach, government enacts regulation in response to a market failure. This view was dubbed ‘normative analysis as positive theory’ (or NPT) by Joskow and Noll (1981) since it purports to explain what regulation ought to do. Natural monopoly theory has historically provided perhaps the most important public interest rationale for utility regulation. This theory holds that an industry is ‘naturally monopolistic’ if its product can be produced at least cost by a single firm. Traditionally, this was thought to be the case where a firm produces a single good and its long-run average cost curve is declining throughout the entire range of output. Therefore, to achieve productive efficiency, it is necessary to have only one firm operating in the industry (thus justifying legally protected, monopoly service territories). At the same time, this monopoly had to be regulated to prevent price gouging and to ensure it earned a ‘fair’ rate of return on its investment (Moorhouse, 1995, p. 423). Alternatively, this could be achieved through state ownership of the utility, as was more frequently the case in Europe. In this way, regulation (or ownership) would ensure both productive and allocative efficiency. There are at least four reasons why scholars, over time, became dissatisfied with the normative approach to utility regulation. Perhaps most importantly, it is at odds with empirical evidence. The incidence of regulation appears to be unrelated to the incidence of the observed characteristics of natural monopoly (Posner, 1974). Regulation occurs in many industries where the normative approach provides no rationale for it, such as potentially very competitive industries, including trucking and taxicabs. Second, since a firm’s profits are likely to be reduced if they are regulated in the public interest, the normative approach implies that firms are unlikely to favor regulation. Yet history shows that many regulated utilities actually lobbied for regulation (Viscusi, Vernon and Harrington, 1995, p. 326). Third, empirical evidence suggests that the prices of regulated firms do not behave as suggested by the normative approach. If regulation is designed to prevent monopoly gouging, then prices should decline when regulation is imposed. Stigler and Friedland (1962) examined electric utility prices from 1912 to 1937 and found that regulation had an insignificant effect on output prices. Fourth, this approach has been criticized because of its lack of a mechanism to translate market failure into regulation. That is, no model is provided of the economic behavior of regulators and interest groups which would lead to the suggested outcomes. Many bodies of research have dealt with these issues. I discuss two below: the ‘economic theory of regulation’ and ‘contestability theory’.

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The shortcomings of the normative approach led to the development of alternative theories of utility regulation. The initial attempt was provided by what came to be known as ‘capture theory’ (Jordan, 1972). Whereas regulation under the normative theory was presumed to be in the interest of consumers, under capture theory it was presumed to be in the interest of producers. This theory was able to provide answers to criticisms one, two and three, and was more consistent with available data. However, it also suffered from the fourth criticism. The capture theory did not provide any theoretical underpinnings of regulatory behavior. This led to a series of papers which attempted to provide a theoretical model and generate refutable hypotheses about the effects of regulation. This body of work became known as the ‘economic theory of regulation’ (ET). Its literature includes, among others, Coase (1959), Posner (1971, 1974), Stigler (1971) and Becker (1983). An excellent summary of this debate and its literature is provided in Priest (1993). Perhaps the most comprehensive theoretical treatment was provided in Peltzman (1976). While there are several implications of the theory, three are critical: (i) in a regulated environment, groups with low organization costs are likely to receive a disproportionate amount of economic rent; (ii) cost-based cross-subsidization is a likely outcome of the regulatory process; and (iii) in general, rents are likely to be spread among several competing groups, including politically influential consumers, rather than captured by only one constituency group, such as producers. Perhaps the most important prediction of the economic theory is that small, highly organized groups will be net winners in the regulatory process. Stigler (1971) emphasized the information and organization costs that groups face in delivering benefits to regulators. Groups that are low-cost providers of these benefits enjoy a comparative advantage in the regulatory process. The numerically smaller group will tend to face lower organization costs. Typically, the number of buyers is less than the number of sellers, so the theory predicts that regulation will benefit producers at the expense of consumers, as is frequently observed. An additional refinement of the ET in Peltzman (1976) is that regulators will allocate rents across both consumer and producer groups so as to maximize their total political support, and rents will likely fall into the hands of some consumers as well. Rent-spreading among consumers manifests itself through prices which attenuate differences in marginal cost across consumers. The ET predicts that there will be a tendency for high-cost consumers to receive a relatively low price-marginal cost ratio, which constitutes a cross-subsidy from low-cost to high-cost consumers. Indeed, a substantial empirical literature bears out many predictions of the economic theory, but inconsistencies with the data remain. Viscusi, Vernon and Harrington (1995, p. 341) provide a summary.

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A second line of research, which also questioned the natural monopoly rationale for regulation began with Demsetz (1968). He showed that there is a theoretical inconsistency in natural monopoly theory: the existence of a single producer in the market need not lead to monopolistic pricing. It is possible for competitors to bid for the right to serve the market. The threat of potential entry may discipline markets which have very few, or only one, producer actually in the market. Demsetz’s work highlighted the notion of what is now termed ‘potential competition’. This basic concept was vigorously analyzed in a series of papers developing ‘contestability’ theory. Willig (1980) first examined this notion in detail by applying it to postal markets. His inquiry led to a benchmark idealized market termed a ‘contestable’ market. As Baumol, Panzar and Willig (1988, p. xiii) state, ‘A perfectly contestable market is defined as one in which entry and exit are easy and costless, which may or may not be characterized by economies of scale or scope, but which has no entry barriers’. This notion was further developed in a series of papers, including Baumol, Bailey and Willig (1977) and Bailey and Panzar (1981). Eventually, Baumol, Panzar, and Willig (1988) published this body of work in a book entitled Contestable Markets and the Theory of Market Structure. This work called into question the original notion of natural monopoly and therefore the justification for monopoly rate-of-return style regulation of these firms. This theoretical approach encouraged a number of studies of the contestability of natural monopolies, including Coursey, Issac and Smith (1984) who used an experimental approach and concluded that (p. 111): The most significant result ... is that the behavioral predictions of the contestable market hypothesis are fundamentally correct. It is simply not true that monopoly pricing is a ‘natural’ result of a market merely because firms in the market exhibit decreasing costs and demand is sufficient to support no more than a single firm.

Moreover, serious theoretical problems with the traditional natural monopoly view arise when multi-product firms are considered. Almost all utilities produce more than one product. For example, utilities produce both peak and off-peak power, and telephone companies provide both local and long-distance phone service. In an important article, Baumol (1977) investigated the relationship between economies of scale and natural monopoly. He showed that the correct definition of natural monopoly is not that long-run average costs decline, but that the cost function is ‘sub-additive’. Briefly, subadditivity asks the question of whether it is more or less costly for two or more firms to produce the output rather than one firm. This is, therefore, a more appealing definition of natural monopoly. The cost curve is subadditive if one firm can produce a given output

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more cheaply than two or more firms. This analysis pointed out that economies of scale are a sufficient but not a necessary condition for the existence of natural monopoly. In the multi-product case, Baumol showed that economies of scale are neither necessary nor sufficient for the sub-additivity of costs. This is because of the interdependence of outputs in the multi-product case. An industry is a natural monopoly only if the firm’s cost function is subadditive over the entire range of outputs (Baumol, Panzar and Willig, 1982, p. 17). Inspired by Baumol, Panzar and Willig and other contestability literature, Gilsdorf (1995) tests for the subadditivity of vertically integrated electric utilities, and finds that there is no evidence for subadditivity in this industry. Gilsdorf thus concludes that integrated utilities are not multistage natural monopolies, thereby casting further doubt on the natural monopoly status of electric utilities. In interpreting the contestability literature, Moorhouse (1995, p. 425) concludes, ‘Thus this research suggests that competition can be substituted for government regulation and state ownership to assure good performance in, at least, the generation of electricity’. These literatures have led to a widespread change of perceptions in the need for and rationale for utility regulation. It is probable that they helped promote regulatory reform in many industries. An important question is the consequences of reform, which I discuss below.

4. The Effects of Regulatory Reform The term ‘regulatory reform’ itself has a variety of meanings. Here I focus on ‘deregulation’, using it in the sense of Stigler (1981) and Winston (1993): the withdrawal of the state’s legal powers to direct the economic conduct of non-governmental bodies. While this can occur in a variety of ways, most typically in utilities it refers to the relaxation of price, entry and/or exit controls. A wave of deregulation which began in the mid-1970s and which continues today has swept aside some of the most restrictive regulatory structures created in the US in the late nineteenth and early twentieth centuries. Regulated industries produced 17 percent of US GNP in 1977; by 1988 this had fallen to 6.6 percent (Winston, 1993, p. 1263). Continuing deregulation of electric utilities in some states, and of some aspects of telecommunications, further reduces this proportion. In this section, I review US deregulation’s effects in six industries, including airlines, trucking, telecommunications, cable television, railroads and natural gas. Winston’s (1993) survey of the literature provides an excellent overview of the outcomes. Since most economic deregulation in the US was complete by that time (and had a chance to have its full effect) it is possible to study its impact meaningfully. Winston compiled estimates of deregulation’s

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effects across a vast literature, and presented the range of estimates in the form of billions of annual 1990 US dollars. More recently, Crandall and Ellig (1997) summarized a large body of evidence on five industries (natural gas, telecommunications, airlines, railroads and trucking), examining evidence on price, quantity and quality. Here I report Winston’s estimates for selected industries and variables, and review Crandall and Ellig’s results, where applicable. In Table 2 below, I summarize estimates from Winston (1993) on the effects of deregulation on prices and, in some cases, service. A positive number in column 3 indicates a gain for consumers due to lower prices or improved service. With the exception of the lowest estimates for railroads, US consumers uniformly benefited from deregulation. For example, airline customers gained between $4.3 billion and $6.5 billion per year (in 1990 dollars) through lower fares from deregulation of airlines. They gained approximately $8.5 billion from greater frequency of service, but lost $3 billion from increased travel restrictions. Table 2 Summary of the Assessed Effects of Regulatory Reform on Prices and Service Industry

Effect on:

Outcome ($ bill.)

Airlines

Fares Service frequency Travel restrictions

Trucking

Common carrier rates Private carrier rates

Long-Distance Telecommunications

Rates

(0.73, 1.6)

Cable TV

Price and Service

(0.37, 1.3)

(4.3, 6.5) 8.5 -3.0 7.8 6.0

Railroads Rates (-2.1, 0.43) Source: Winston (1993, pp.1274-1275). Positive values indicate consumer gains. Values are in billions of 1990 dollars. In terms of percentage declines in airline fares, Crandall and Ellig (1997, p. 34) note that ‘yields’ (the average amount of revenue received per passenger mile) are commonly used by analysts to measure fare trends, and state:

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... the average yield fell from 21.65 cents in 1977 to 13.76 cents in 1995, a 37-percent reduction. Much of this decline occurred during the first 10 years of deregulation, when the yield fell by 29 percent, from $21.65 to $15.32. Interestingly, yields fell almost immediately in response to deregulation.

Crandall and Ellig (1997) also document the fall in the price of natural gas after deregulation. Adjusting for inflation, they find that wellhead prices fell by 60 percent between 1984 and 1995. They discovered that the prices actually paid by various classes of consumers (for example, residential, commercial, electric utility) also decreased significantly. Regarding interstate telecommunications rates, they find that after the AT&T divestiture in 1984, the Consumer Price Index for interstate long distance rates decreased from approximately 60 in 1984 to about 30 today. The intrastate rates have also fallen, but somewhat less rapidly. In Table 3, I report the findings of Crandall and Ellig on percent price reductions in five utilities two, five and ten years after deregulation. For ten years, they range from a low of 27 percent to a high of 57 percent, but they were uniformly positive. Collectively, these results suggest that deregulation of utilities provide benefits for consumers. Table 3 A Summary of Price Reductions from Deregulation in the United States Industry

Percent price reduction after . . . 2 years

5 years

10 years

Natural Gas

10-38% (1984-86)

23-45% (1984-89)

27-57% (1984-94)

Long-distance telecomm.

5-16% (1984-86)

23-41% (1984-89)

40-47% (1984-94)

Airlines

13% (1977-79)

12% (1977-82)

29% (1977-97)

Trucking

N.A.

3-17% (1980-85)

28-56% (1977-87)

Railroads

4% (1980-82)

20% (1980-84)

44% (1980-90)

Source: Crandall and Ellig (1997, p. 2)

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Winston also examined the effects of regulatory reform on profits. In Table 4 below, I report the effects of US deregulation on profits. Positive numbers represent profit gains. Table 4 Summary of the Assessed Effects of Regulatory Reform on Profits Industry

Outcome ($ bill.)

Airlines

4.9

Trucking

-4.8

Long-distance Telecommunications Cable TV

Small change Increase

Railroads 3.2 Source: Winston (1993, pp. 1278-1279). Positive values indicate a profit gain. Values are in billions of 1990 dollars. Most utilities experienced a profit gain from deregulation, with airlines enjoying the largest gain of $4.9 billion annually. The trucking industry is an anomaly, since it lost $4.8 billion annually from deregulation. The political economy behind trucking deregulation remains a mystery, since the economic theory of regulation predicts that the relatively small number of highly organized trucking companies would have successfully blocked deregulation, but did not. For most industries, then, deregulation increased profits, or at least did not significantly reduce them. In Table 5 below, I present Winston’s summary of the estimates of deregulation’s effect on wages and employment. Positive numbers indicate a gain to labor. While airlines experienced a small decline in wages, deregulation there led to an increase in employment, most likely due to an increase in the frequency of flights. Trucking experienced a decline in both wages and employment, suggesting that firms and workers shared the lost monopoly rents (Rose, 1985). Railroad workers also suffered a substantial decline in wages, while employment was not affected.

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Table 5 Summary of the Assessed Effects of Regulatory Reform on Wages and Employment Industry

Effect on:

Outcome ($ bill.)

Airlines

Wages Employment

Small decline Increase 6%

Trucking

Wages Employment

(-1.1,-1.9) Decline

Long-distance telecommunications

Wages (comm.) Wages (equip.)

No change Decline

Cable TV

Wages Employment

No assessment Increase

Railroads

Wages Employment

Decline 20% No Effect

Source: Winston (1993, p. 1282). Positive values indicate a gain to labor. Values are in billions of 1990 dollars. Given that some groups benefited while others lost, it is important to consider the net effects of deregulation. In Table 6, I report findings from Winston (1993) on the overall effects of regulatory reform in the US. This table sums the effects on both consumers and producers to obtain a total or ‘net’ effect of deregulation in that industry. Positive numbers in the ‘Total’ column indicate that deregulation overall produced a welfare gain. For all six industries examined here, the net effect was clearly positive, indicating that any welfare loss by producers (for example, truckers) were outweighed by consumer gains. Net gains thus suggest improvements in economic efficiency, most of which were captured by consumers. Winston notes that, when gains are summed across industries, society gained at least $36-$46 billion annually from deregulation. Estimates of total social gains are higher if firms are assumed to adjust optimaly to deregulation.

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Table 6 Summary of the Assessed Effects of Regulatory Reform Overall Industry

Consumers

Producers

Total

Airlines

(8.8, 14.8)

4.9

(13.9, 19.7)

Trucking

15.4

-4.8

10.6

Long-distance telecommunications

(0.73, 1.6)

___

(0.73, 1.6)

Cable TV

(0.37, 1.3)

___

(0.37, 1.3)

Railroads (7.2, 9.7) 3.2 (10.4, 12.9) Source: Winston (1993, p. 1284). Positive values indicate a gain to labor. Values are in billions of 1990 dollars. These estimates suggest that deregulation of numerous utilities in the US produced substantial social gains. It is therefore probable that utility regulation created a variety of economic distortions, which I discuss below.

5. Distortionary Effects of Regulation Several branches of research relating to utilities have focused on the distortionary effects of rate-of-return regulation. Here I review two branches of this extensive literature. One branch studies the effect of rate-of-return regulation on the firm’s input mix. In a seminal article, Averch and Johnson (1962) developed a model which implied that rate-of-return regulation would cause an industry to utilize a greater than optimal amount of capital. Early studies, including those by Baumol and Klevorick (1970), and Bailey and Malone (1970) and Zajac (1970), generalized the Averch-Johnson conclusions and found that there is an incentive for overuse of the rate-regulated input and over-production of output. Studies by Courville (1974), Spann (1974) and Boyes (1976) found empirical support for the Averch-Johnson predictions. These models were often based on certainty of demand and price, and were subsequently criticized for this. A new series of papers by Perrakis (1976), Meyer (1976), Peles and Stein (1976) and Das (1980) introduced uncertainty, and concluded that the existence of the effect was dubious. Baron and Taggert (1977) found under-capitalization. The results appear to be susceptible to the type of uncertainty introduced.

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A relatively new area of inquiry involves the question of the effect of the regulatory process on the internal structure of the firm. While this research itself has several branches, a main focus is regulation’s effects on senior executive behavior. Important variables considered include CEO pay and turnover. Alternative views of regulation’s effect on CEO pay include a ‘productivity hypothesis’, in which regulation reduces the complexity of the tasks performed by managers (Peltzman, 1989). Under these circumstances, it is efficient for firms to pay CEOs less, and to hire less able CEOs. An alternative is a ‘political pressure’ hypothesis, which suggests that the regulatory process politicizes certain firm choices, including CEO pay. Joskow, Rose and Shepard (1993) for example, argue that there are political constraints on executive compensation. A body of research has established that CEOs of regulated firms are, in fact, paid significantly less than those of unregulated firms. Joskow, Rose and Shepard (1993), after controlling for firm size, firm performance and characteristics of the CEO, find that the chief executive is paid less if the firm is regulated. Carroll and Ciscel (1982) find that regulation reduces the basic annual compensation of the chief executive. They suggest that lower risk, less CEO discretion, and political constraints may all help explain the lower observed compensation. Joskow, Rose and Wolfram (1996) attempt to distinguish between these explanations by examining differing regulatory environments. They evaluate alternative environments by how ‘pro-consumer’ they are as rated by an investment bank. They find that CEOs are paid less in relatively pro-consumer environments, and conclude that a political pressure view is supported. Regarding turnover, Geddes (1997) examines the turnover of senior executives of regulated firms and finds that it is not sensitive to the financial performance of the firm. This is important since researchers examining non-regulated firms have found such a relationship. Turnover of utility executives is, however, related to changes in the price of output. Higher electricity prices increase the probability that the identity of the CEO will change. This result is consistent with estimates in Joskow, Rose and Wolfram (1996) which show that pay is inversely related to the rate of growth of electricity prices. These latter results are also consistent with a ‘political pressure’ view of CEO behavior. In addition to regulation, the effects of and correct type of ownership form for utilities has been a matter of much discussion. Below I review literature in this area.

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6. Ownership Form The debate over government versus private ownership of utilities has always been a lively one. Early economists believed that there was a strong case for government ownership, which was dependent on their ‘natural monopoly’ structure, as discussed above. As Hausman and Neufeld (1991, p. 414) state, ‘[p]rominent founding members of the American Economic Association, including Richard T. Ely, Henry C. Adams, E.W. Bemis, Edmund J. James, and E.R.A. Seligman, rejected laissez-faire public policy and advocated government ownership of a class of businesses which they designated “natural” monopolies, including municipal gas companies, water-works, and electric utilities’. While there appears to be no generally accepted formal model of the effects of ownership form on firm behavior, Boardman and Vining (1989, p. 2) state ‘the dominant positive model of the effect of ownership is the public choice, or property rights, model’. Some authors have argued on theoretical grounds that privately owned firms should exhibit greater internal efficiency in the production of goods and services than publicly owned firms. De Alessi (1974, 1980) suggested that this was due to the inability of the owners of public enterprises to effectively incorporate the benefits of additional managerial monitoring into current transfer prices of the firm: The crucial difference between private and political [publicly owned] firms is that ownership in the latter effectively is nontransferable. Since this rules out specialization in their ownership, it inhibits the capitalization of future consequences into current transfer prices and reduces owners’ incentives to monitor managerial behavior. (De Alessi 1980, pp. 27-28)

Owners of public firms thus have less incentive to monitor managers, and the cost to public managers of taking additional non-pecuniary benefits, including shirking, is lower. De Alessi argued that public managers have more job security which will be manifested in longer tenure periods. He tested this proposition in De Alessi (1974) and found that public managers did exhibit longer tenure periods. Geddes (1997), however, re-estimated the De Alessi tests with a larger data set and more control variables, and found no significant difference in tenure periods across the two ownership forms. Spann (1977) attributed expected efficiency differences to two factors. First, public firms do not have the incentive to minimize costs as do private, profit-maximizing firms. Second, private firms naturally gravitate to the optimal size while public firms are restricted by political boundaries. Alchian and Demsetz (1972) and Frech (1976) suggested that there is a greater incentive for public employees to shirk since their wealth is not as closely tied

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to the work decisions they make. Other researchers have argued in a similar vein, including, among others, Davies (1971, 1977), Moore (1970), and Crain and Zardkoohi (1978). The available evidence indicates that the relative performance of public and private enterprise is also dependent upon the structure of the industry in which they operate, as well as ownership form. For example, Boardman and Vining (1989) examine the effect of ownership form on profitability and efficiency in a number of competitive industries. They find that dummy variables for both mixed and state-owned enterprises exert significant and negative effects on profitability and other measurers of performance. For valuable surveys of this literature, see De Alessi (1980) or Boardman and Vining (1989). Numerous researchers have examined the question of the efficiency of public versus privately owned electric utilities in particular. The literature has been characterized by increasing rigor in the econometric tests of efficiency used as well as changes in the conclusions of these tests. Moore (1970) used a model with linear input and cost equations and found that private electric utilities are 5 percent more efficient than municipal utilities. Meyer (1975a) used a quadratic function to estimate costs for public and private utilities, and concluded that publicly owned utilities are more efficient. Neuberg (1977) estimated that public firms are 6-20 percent more efficient, and Pescatrice and Trapani (1980) estimated public firms to be 33 percent more efficient. Using a variety of econometric methods, more recent investigations of relative cost efficiency have indicated that the two ownership forms display few significant differences. This list includes DiLorenzo and Robinson (1982), and Fare, Grosskopf and Logan (1985). Atkinson and Halvorsen (1986) estimated relative efficiency using a translog cost function and reached a similar conclusion. As Vickers and Yarrow (1988, p. 41) state: Taken in conjunction with the research on U.S. electric utilities, we are therefore led to the conclusion that, where firms face little output market competition and are extensively regulated, there is no generally decisive evidence in favor of one type or the other type of ownership.

A unique alternative approach is taken in Hausman and Neufeld (1991). They examine the very early period in the industry’s history (1897/98) in order to examine the relative efficiency of government versus privately owned utilities prior to state rate-of-return regulation. Using a non-parametric approach, they find that in this period government-owned utilities were relatively more efficient than their privately owned counterparts. They suggest that this finding is inconsistent with the property rights view of ownership, and attribute the observed difference to a greater ‘public spirit’ associated with the operation of government-owned utilities.

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The question of ownership and efficiency is still very much alive. Most recently, Pollitt (1996) in the Oxford Economic Papers examines government and privately owned nuclear power plants in the US and UK, using data envelopment analysis. He found that, when vintage effects and poor investment decisions were taken into account, there was some evidence that privately owned nuclear plants had lower costs.

B. The US Electric Utility Industry In this section, I examine a particular utility industry in detail. I focus on the electric utility industry in the United States. Many of the issues discussed above that are common to many utilities are particularly important in the electric utility industry. I first examine the history of regulation of this industry, and some interpretations of it. I focus on electricity for four reasons. First, as measured by total assets, it is an extremely large industry. In the US, it is the largest. Second, of all the services, electricity may be the most ‘fundamental’ in that most other utilities require it for their operation. Third, it is often considered the industry with the most ‘natural monopoly’ characteristics. Finally, many of the issues in electric utilities (such as the unbundling of services and the distortionary effects of rate-of-return regulation) are similar to those in other public utilities. I examine several aspects of the industry. I first review the regulatory history of the industry. This history is particularly pertinent today, since regulatory reform is underway in many places and under consideration in others. It is also illustrative of the application of the economic theory of regulation. In Section 8, I examine the effects of the economic shocks of the early 1970s on the industry, and discuss institutional changes that occurred as a result. In Section 9, I look at legislative acts which affected the industry, including the Public Utility Regulatory Policies Act of 1978, and the Energy Policy Act of 1992. I then move on, in Section 10, to summarize the current thinking on a critical policy question resulting from deregulation: whether or not utilities should be allowed to recover the cost of investments that are ‘stranded’ through open access to the transmission grid. In Sections 11 and 12, I examine the issues of industry structure and reliability, respectively.

7. Regulatory History of the Industry The founding of the electric utility industry is generally placed at 1879, when electricity was first used to light streets and some buildings (Bradley, 1996, p. 60). In its earliest stage, neither the states nor the federal government regulated

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the industry. Since cities and towns had to grant utilities the right to use public streets, the regulation of entry was de facto controlled by municipalities. Jarrell (1982) argues that at this time there was competition between firms, as cities often granted franchises to numerous companies in the same area. Indeed, this era of contending municipal franchises is known as ‘regulation by competition’ (Bradley, 1996, p. 60). With the passage in New York and Wisconsin in 1907 of landmark statutes which granted utilities monopoly power and created strong state utility commissions, the states entered the regulatory arena. The justification for this early state regulation of the industry has spawned substantial controversy, which continues today. Economists such as John R. Commons enjoyed formulating justifications for powerful regulation (Michaels, 1996, p. 48). These early economists explained that the industry had been regulated in order to correct ‘natural monopoly-style’ market failures, as discussed above. Questioning such a view, Jarrell (1982) argued that state electricity regulation was not designed to counter natural monopoly problems, the theory of which was developed later (Bradley, 1996; Priest, 1993). Instead, he asserted that utilities sought out the state’s regulation in order to protect them from intensively competitive conditions under municipal franchising. Jarrell thus relies on the economic theory of regulation to explain the evolution of electricity regulation. To test these alternatives, Jarrell divided states into two groups: those which passed regulation in an early wave of state reforms from 1912 to 1917, and those which passed regulation later and more slowly, after 1917. The normative theory predicts that regulation will be supplied earliest in states where natural monopoly problems are the most severe; where prices and profits are the highest, and output the lowest, since these states were most in need of regulation. The economic theory predicts the opposite; since regulation was established to create economic rents by shielding firms from competition, regulation will occur first in those states where prices and profits were the lowest. Jarrell found that those states which adopted regulation early had, on average, 45 percent lower prices, 30 percent lower profits and 25 percent higher per capita output before regulation than the states which adopted regulation later. This and other evidence lead Jarrell to conclude that regulation was passed in order to shield firms from competitive conditions prevailing when municipalities were the sole regulators. Bradley (1996) also examines the origins of state regulation of electricity. He focuses on the effect of utility interests (for example, Samuel Insull) pushing for regulation and suggests that it was an act of political opportunism designed to protect utilities from competition. Bradley concludes that, because the original motivation for government intervention in the utility industry was not due to market failure, the case for the industry’s deregulation today is stronger.

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8. The Effects of Structural Change Regardless of their justification, these regulatory arrangements were relatively stable until at least the late 1960s. Joskow (1989) presents a comprehensive analysis of the changes in the industry through the 1960s, 1970s and 1980s. He documents the economic forces which led to major changes in the industry’s regulation. The same basic economic forces were operating on utilities throughout the world. Joskow’s discussion is briefly summarized here. The decades of the 1950s and 1960s were relatively uneventful for the electric utility industry. The industry benefited from technological progress and economies of scale in generation, which led to falling nominal and real prices for electricity. Utilities performed well financially and rarely filed for rate increases, but instead often voluntarily decreased their rates. The regulatory system of extensive price and entry review by state and federal agencies worked well during this period. Electric utilities were able to keep their part of the regulatory bargain by providing reliable power to their customers while regulators allowed them an adequate return on investment. Public involvement in the regulatory process was minimal and rate changes were infrequent. Several factors worked in concert in the early 1970s to change this situation. Productivity gains slowed due to the exhaustion of scale economies in electric generation, while the cost of fuel and capital increased. The OPEC oil price shocks had a substantial effect on utilities. State public utility commissions, responsible for regulating electricity rates, were slow to respond to these changing factors. Rate increases often required a full year from inception at the utility to approval by the commission (Joskow, 1989, p. 159). Also, many commissions relied on a historical test year, which reflects outdated input costs, to set future rates. This regulatory lag resulted in inflexible rates which, in the face of rising costs, caused electric utilities to become less profitable. Rate hearings became more frequent after 1973 as utilities faced rapid fuel price increases. At the same time, numerous consumer groups were organizing to resist increases in electricity rates. This ratepayer activism made it increasingly difficult for utilities to adequately adjust to unexpected fuel price changes. Additionally, demand growth slowed in response to the rate increases that had occurred. Electricity demand grew at a 7.3 percent annual rate from 1960 to 1973, but slowed to 2.5 percent a year from 1973 to 1985 (Joskow, 1989, p. 150). This hurt the financial performance of many electric utilities, as construction projects were undertaken with the expectation of continued demand increases, thus decreasing capacity utilization. Under pressure from consumer groups, regulators were loath to include these new, under-utilized plants in the rate base. Traditional cost-of-service regulatory arrangements began to erode as public utility commissions adopted new tests for inclusion of

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capital in the rate base, such as requiring the economic value of the plant to be greater than its accounting cost, called the ‘used and useful’ test (Joskow, 1989, p. 161). Under these new rules, regulatory disallowances became more common, especially for nuclear capacity after the 1979 Three Mile Island accident. Electric utility profitability declined even more. After 1975, electric utility common stock price to book ratios fell below one, and earned rates of return fell far below allowed rates (Joskow, 1989, p. 157). The difference between utility return on equity and the yield on new debt fell from 1974 onward, reaching !3.91 percentage points by 1981. The financial condition of utilities did not improve until 1985. Under these pressures, it became clear that substantial reforms of the regulatory process were necessary. Reform came in several ways. In order to deal with regulatory lag, a number of states instituted fuel adjustment mechanisms (FAMs) which allowed utilities to adjust rates without a formal rate hearing when fuel costs changed. Many states embraced these mechanisms in the mid-1970s, so that by 1979 all but five states had adopted some sort of FAM. This reform shifted the risk of fuel cost changes from the utility to the consumer. A number of economists have studied the effects of FAMs. For example, Kendrick (1975) developed a framework of automatic adjustment clauses to protect utilities from general price increases. Gollop and Karlson (1978) empirically tested the effect of FAMs by estimating translog functions. Baron and DeBondt (1979) provided a history of FAMs and analyzed their effect on incentives for efficiency. Clarke (1980) examined the effect of FAMs on input choice and showed that the effect is in the opposite directions of the rate-of-return distortion. Isaac (1982) examined their impact when input prices are uncertain. Despite the adoption of FAMs, however, utilities confronted a number of significant problems. Regulatory disallowances made utilities reluctant to plan new capacity. Environmental concerns resulted in legislation which greatly increased costs. Additional reforms, therefore, were clearly needed. These came at the federal level and dealt chiefly with the emerging wholesale power market. Two important laws were the Public Utility Regulatory Policies Act of 1978 (PURPA), and the Energy Policy Act of 1992 (EPAct).

9. Legislative Steps Toward Regulatory Reform An important result of the political and economic upheavals of the 1970s was a growing wholesale power market. Heightened opportunities for wholesale trade in electricity materialized as a result of unanticipated price differences between alternative fuels, as well as excess generating capacity (Joskow, 1989). A critical piece of legislation which encouraged the growth of the wholesale market was the Public Utility Regulatory Policies Act of 1978 (PURPA). Title

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I of PURPA directs the states to consider introducing time-of-day rates and interruptible rates, which are alternatives to traditional ratemaking methods. The more important section, Title II, requires utilities to purchase power from companies that attach generation equipment to an existing heat source (cogeneration) or companies that use renewable sources and waste fuels. Small independent generation facilities are included in this section if they meet certain guidelines laid out in the Act. These cogenerators and independent power producers are referred to as ‘qualifying facilities’. While PURPA was passed in 1978, it did not have significant effects until the mid-1980s. The FERC did not issue regulations regarding PURPA until 1980, and several key issues were not resolved until court rulings in 1983. PURPA gave little guidance as to how these transactions were to be carried out, aside from stating that utilities had to purchase excess electricity from qualifying facilities at a price that could not exceed the ‘incremental cost to the utility of alternative electric energy’. PURPA was important because it created an independent generation sector, not subject to rate-of-return regulation that provided alternative energy sources at a time when established utilities were reluctant to construct their own additional generating capacity. This law, along with economic change, provided the first real opportunity for independent firms to produce electricity without encumbering rate and entry regulations. Available evidence reveals that the resulting wholesale power market is quite competitive. Joskow (1989, p. 189) summarizes: The experience since the enactment of PURPA indicates that there exists a very elastic supply of capacity that independent producers are willing to offer at attractive prices. In addition, active markets for short- and medium-term power in excess of the current needs of integrated utilities have emerged in most areas of the country. These markets are subject to only very loose FERC regulation. As a result of extensive interconnections, coordination arrangements, and voluntary wheeling, the anecdotal evidence suggests that these markets are often very competitive.

This independent generating sector has become an important component of the industry. As Baumol and Willig (1995) note, additional units of generating capacity are now just as likely to be provided by non-utility generators (NUGs) as by utilities. During 1990-91, NUGs added more net capacity then did utilities. Furthermore, forecasts suggest that the importance of NUGs will increase in the future. Michaels (1993) notes that, in 1983, NUGs provided only 2.5 percent of total US generating capacity. By 1991, however, NUGs were constructing over half of the new capacity installed in the US and provided over 9 percent of the total. More recently, the Energy Policy Act of 1992 facilitated wholesale competition. This act gave the FERC expanded authority to order utilities to

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provide wheeling services, thus further opening the wholesale power market (Baumol, Joskow and Kahn, 1995, p. 14; Walters and Smith, 1993). Pursuant to this provision, the FERC issued an order that requires all transmission-owning public utilities to open their transmission lines to eligible wholesale customers on a non-discriminatory basis. Providing access to the transmission network will increase competitiveness at the wholesale level and make the state regulator’s job easier and their regulation more effective. However, it also creates considerable problems regarding utilities’ existing investments, as discussed below. Importantly, the Energy Policy Act did not promote retail wheeling, which would enable retail customers to purchase power directly (Baumol, Joskow and Kahn, 1995, p. 14). The Act also removed barriers to acquisitions contained in the Public Utility Holding Company Act of 1935 (PUHCA). It defined a new class of wholesale generators which are exempt from regulation under PUHCA, called ‘exempt wholesale generators’ or EWGs. It permits any person, including a registered holding company, to acquire an EWG, wherever located, or a foreign utility company (FUCO) without seeking prior approval from the Securities and Exchange Commission (which would have been required under PUHCA). Thus, owners of EWGs are exempt from PUHCA regulation. The exempt wholesale generators now constitute an important source of non-utility generation. Therefore, the unintended consequence of PURPA was to move toward increasing competition in US wholesale electricity (Moorhouse, 1995). The Energy Policy Act then substantially strengthened this trend. In these laws, states retained much discretion to restructure their energy markets. As discussed in Lenard, Geddes and Block (1996), 46 states are currently studying options for restructuring their energy markets. California instituted a plan under which all consumers were able to choose their electricity provider on January 1, 1998. Massachusetts legislators recently announced that, beginning March 1, 1998, electric utilities will have to compete for customers. A rate reduction of 15 percent is guaranteed in the bill, and power companies are allowed to recover all of their past investments in generating facilities. Many other public utility commissions or state legislatures are close to adopting specific restructuring plans. Each of these states is proposing that retail customers buy electricity directly from generators or other alternative suppliers. In such transactions, the traditional franchise utility would merely transmit and distribute power. The benefits to customers of such market arrangements are obvious: consumers will not be captive customers of a franchise utility, relying on regulators to assure that their utility does not charge excessive prices. Instead, consumers will be able to shop for power the same way they shop for long distance telephone carriers.

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Competition between generators ultimately will lead to lower prices. For example, Maloney and McCormick (1996) estimated that retail competition would, in the long term, reduce the average residential customer’s bill by 43 percent, or about $30. They also predicted large price reductions for commercial and residential customers. They estimate that the total gains to consumers are between $422.1 and $107.6 billion annually. As a result of the growing competition in the industry, there has been increasing consolidation. As McLaughlin and Mehran (1995) document, for the entire period from 1960 to 1986 there were only 9 hostile takeover attempts in the industry, and none were successful. In the five years from 1986 to 1990, there were 13 takeover attempts, with one being successful. Recently, a number of utility mergers have been announced. There has been much discussion of the importance of repealing old laws which encumber the industry in preparation for eventual complete deregulation. It is important that firms have the ability to optimally adjust to new market conditions. One focus of this research is on the Public Utilities Holding Companies Act. PUHCA was passed during the Great Depression in response to the failure of a number of utility holding companies and subsequent investor losses. The Act defines a utility holding company as ‘any company which directly or indirectly owns, controls, or holds with the power to vote, 10 per centum or more of the outstanding voting securities of a public utility’ (Section 2(a)(7)(A) of PUHCA). Numerous holding-company activities are subject to regulation under PUHCA, including the acquisition and sale of securities, the acquisition of utility assets, intercompany transactions, service, sales and construction contracts, and reports and accounts. Importantly, PUHCA places restrictions on mergers involving registered holding companies. PUHCA remains a major barrier to utility takeovers. Numerous authors have discussed economic inefficiencies associated with the Act. For example, Geddes (1996) emphasizes its effects in inhibiting the market for corporate control. Lenard, Geddes and BLock (1996) emphasize its effects on limiting experiments in deregulation on the state level, as well as its redundancy. For additional analysis in a similar vein, see Joskow (1992) and Gordon (1992).

10. The Recovery of Stranded Costs A prominent aspect of the electric utility deregulation debate involves the question of the recovery of utilities’ ‘stranded investments’. These are investments made under regulation which electric utilities, in a fully deregulated setting, would be unable to recover through prices. This question is relevant for many utilities that are facing regulatory reform.

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Electric utilities estimate that they own between $100 and $300 billion of these investments, and almost one-third of the average electric bill in California is dedicated to paying off these costs (Michaels, 1996, p. 47). In some cases the potentially stranded costs exceed the entire equity value of the firm (Baumol, Joskow and Kahn, 1995, p. 36). This issue is crucial because it affects the pace and structure of deregulation. There are several perspectives on the recovery of stranded costs. According to one view (see for example Baumol and Sidak, 1996; Sidak and Spulber, 1996) in the course of state regulation of utilities, the utility and the state formed an implicit ‘regulatory compact’. Regulators imposed a burden on utilities to serve all customers and to construct plants in expectation of demand growth. In return, the utility received a legal monopoly and a ‘fair’ rate of return. This view implies that utilities are deserving of compensation for investments that were made under the compact which, in a deregulated setting, would not receive a fair rate of return. These authors thus contend that deregulation constitutes a form of breach of contract. They also suggest that (even if one does not accept the notion of a preexisting ‘regulatory compact’) utilities deserve compensation for what amounts to a ‘deregulatory taking’. Arguing in a somewhat different vein, Baumol, Joskow and Kahn (1995) present arguments in favor of the recovery of stranded costs. They suggest that both equity and efficiency considerations work in favor of recovery. In terms of equity, they argue that utility shareholders have not been previously compensated through allowed returns for such ‘deregulatory risk’, and that regulators approved these risk-allocation arrangements. They also contend that ratepayers benefited from the previous regulatory arrangement, in that much old equipment produced substantial value for ratepayers, even while some relatively new equipment has not. On the efficiency side, they submit that without stranded cost recovery it is unlikely that the most efficient supplier of electricity will prevail, since incumbent firms will be burdened by disproportionately large historic costs, and may not be able to effectively compete even if they are the least-cost provider. In other words, in order to provide a ‘level playing field’ for utilities in a deregulated setting, it is necessary to share these historical costs on a non-discriminatory basis. Otherwise the true efficient supplier will not be revealed through the market process. On the opposite side of this debate, commentators, such as Michaels (1996), reply that there never was a regulatory compact and that utilities therefore should not receive compensation for stranded investments. They argue that, unlike typical contracts, there is no indication that a voluntary agreement was made between utilities and customers, whom the regulation was ostensibly created to serve. Indeed, Michaels (1996, p. 49) notes that the term ‘regulatory compact’ first appeared in 1983 in a legal decision. They also point out that many of these now stranded investments were made at utilities’ urging. The

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conclusion here is clear: utilities should not be compensated for losses associated with stranded investments. In an interesting third view, Niskanen (1996) suggested that the problem of stranding is only necessitated by forcing utilities to provide access to their transmission services, a policy which does not respect property rights to the grid. That is, stranding of investment is created by the legislated deregulation of electricity markets through forced ‘open access’. This has been recognized by other commentators as well. As Baumol, Joskow and Kahn (1995, p. 35) state, ‘[t]he possibility of these costs being “stranded” would obviously be greatly increased if franchised utilities were required to offer competing generators direct access to their retail customers via the utility-owned transmission and distribution systems’. Such a requirement is an element of recent legislative proposals. Consequently, these writers maintain that concerns about deregulation constituting a ‘taking’ are justified only if access to the network is forced. Niskanen (1996, p. 17) states, ‘[m]andatory wheeling, whether at the wholesale or retail level, should be recognized as a restriction, a taking, of the property rights of a utility’. Regarding stranded costs, Niskanen’s view is that property rights consist of the right to use, exclude, partition and sell property, but the property owner does not have a right to the value of his or her property. By suggesting that deregulation requires compensation because of a preexisting regulatory compact, utilities are asserting a right to the value of their property, which overextends their true property right. Both the stranded investments and the takings issues could then be solved simultaneously if government would simply divest itself from the institutional setting. By eliminating state-enforced monopolies, and by letting utilities open the grid on their own, there would be no takings and no stranding. As an intermediate solution, this would allow utilities to recover some of their costs through the market process while respecting private property rights. Regardless of the approach that is ultimately adopted, it is likely that the ‘stranded investments’ issue will be central to the utility deregulation debate. Useful summaries of these views are contained in Baumol, Sidak and Michaels (1995) and Brennan, et al. (1996). Interestingly, very similar issues of cost stranding are now arising in other industries which are in different stages of deregulation. In railroads, an important stranding issue arises when captive shippers of coal are given access to rails. A wave of mergers in this industry has brought about this concern. A similar issue arises in local phone networks between long-distance and regional carriers. Long-distance carriers are seeking access to the local carrier networks at a government-determined fee. Local phone companies respond that such access would strand much of their sunk investment. Therefore, the stranding of investment is an important issue in deregulation which cuts across numerous

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industries.

11. The Natural Industry Structure There has been considerable debate over the ‘natural’ market structure of electricity provision, and therefore the expected structure if complete competition were allowed. It has long been supposed that natural monopoly characteristics inherent in the industry, as discussed above, precluded effective competition, and that regulated, legally granted monopolies were necessary. Moorhouse (1995, p. 423) concisely summarizes this perspective: The traditional economic justification for the regulation or state ownership of electric utilities is that utilities are natural monopolies. Economies of scale and scope, and the economies associated with vertical integration mean that unit costs decline throughout the relevant range of production as output increases. Such economies preclude competition, according to the conventional view, because a single firm could supply the entire service area at lower cost than could two or more firms. Given its cost structure, an established utility could undercut its rivals and drive them from the market. Moreover, attempted entry represents a waste of resources either because of an unnecessary duplication of facilities or because such investment would not be viable in the face of undercutting. Secure from competition, the monopolist would exploit the consumer if not for regulation or state ownership.

This view implies that important variables for empirical examination include the degree of economies of scale and scope. Thus a number of studies of electric utilities involve these questions. For example, Hulbert (1969) concluded that economies of scale could be achieved in systems up to 25,000 megawatts. Alternatively, Johnston (1960) and Nerlove (1963) determined that scale economies were exhausted even for firms of relatively small size. Barzel (1964) used a input demand model which showed scale economies at the plant level. Galatin (1968) found both scale effects as well as technical change. Atkinson and Halvorsen (1976) used a profit function specification. Cowing and Smith (1978) provided a survey of the literature on estimates of production technologies. In their landmark study, Christensen and Green (1976) examined economies of scale for US electric utilities and found that in 1955 there were significant economies of scale for almost all firms, but that by 1970 these economies had been virtually exhausted, and by then almost all utilities were operating in the flat portion of their average cost curves. Importantly, given how early this paper appeared in the deregulation debate, they submit that: ‘We conclude that a small number of extremely large firms are not required for efficient production and that policies designed to promote competition in

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electric power generation cannot be faulted in terms of sacrificing economies of scale’.

12. Reliability A related branch of research focuses on the question of reliability. It deals with the ‘public good’ nature of reliability, as well as the optimal level of reliability for an electrical system. This question is particularly relevant under competition. Telson (1975) examined the question of the optimal level of reliability and found that current levels in the US were excessive. Munasinge and Gellerson (1979) developed a model for finding the optimal level of reliability. Bental and Ravid (1986) and Sanghvi (1983) discussed methods to measure the costs of outages. There is a set of articles which emphasize that price, reliability and capacity should be jointly determined. Reliability is a feature of papers by Brown and Johnson (1969), Crew and Kleindorfer (1976, 1978), Sherman and Visscher (1978) and Chao (1983). Reliability is uniform throughout an electrical system, but customers differ according to their outage costs. Some articles have examined how prices should be set for customers with differing outage costs, but who consume the same level of reliability. Such studies include Chao (1983), Chao and Wilson (1986, 1987) and Woo and Toyama (1986).

C. The Experience in Other Utilities In this part, I review literature focusing on several utilities besides electricity. I first review selected work on telephone utilities. In Section 14, I describe several studies in natural gas, and in Section 15, I review work in water utilities.

13. Telephone Utilities Numerous interesting aspects of utility regulation are illustrated by the phone industry. I first briefly describe the regulatory history of the industry, and then review several important studies. In the US, the Mann-Elkins Act of 1910 first gave the Interstate Commerce Commission (ICC) the authority to regulate the intercity telecommunications market. Through entry control by the ICC, American Telephone and Telegraph (AT&T) obtained monopoly power in long-distance telephony, and was treated as a ‘natural monopoly’ (Viscusi, Vernon and Harrington, 1995, p. 487). It was believed that the need to string open-wire line (or coaxial cable) between cities raised the fixed costs of entering the market to the point were economies of scale were realized by single-firm operation. The Communications Act of 1934 transferred the power

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to regulate price and entry into the inter-city phone market to the Federal Communications Commission (FCC), which continues to regulate telecommunications today. Thus, AT&T was a rate-regulated monopolist until the late 1950's. The impetus for regulatory reform in this industry came from new technology: microwave transmission. This technology can transmit large amounts of information via radio beams, that is, without the use of extensive networks of wire or cable. Therefore, physical connection between two points was no longer needed for communications. In the 1950s, many firms began asking the FCC for permission to build private networks (Viscusi, Vernon and Harrington, 1995, p. 488). These requests led the FCC, in 1959, to issue the ‘Above 890 Mc’ decision, in which frequencies above 890 megacycles would be shared with private users. However, other users were not allowed to sell telecommunications services, so true competition was not established. In 1963, Microwave Communications Incorporated (MCI) petitioned the FCC to allow it to enter a specific inter-city market (St. Louis-Chicago), as a competitor to AT&T. It was not until 1969 that the FCC approved the request. This decision began a process of partial deregulation of the industry by the FCC, but with extensive built-in cross-subsidies and AT&T as the dominant supplier. After seven years of antitrust litigation by the US Department of Justice, AT&T was broken up into seven holding companies, called the regional Bell operating companies. AT&T is now no longer involved in any monopoly markets. Additionally, local phone companies face competition from several sources, including cellular phones. Below, I review several specific studies of the telecommunications industry. Oum and Zhang (1995) examine the effect of competition on the productive efficiency of the US telephone industry. Their model predicts that competition will reduce allocative inefficiency in the use of inputs, as caused by rate-of-return regulation (that is, the Averch-Johnson effect, discussed above). This is in addition to the usual improvements in technical efficiency observed when competition is introduced. They examine data over the 1951-90 period, and find that competition did in fact improve the allocative efficiency of incumbent firms. There are several studies which examine the effect of ‘incentive regulation’ in telephones. Incentive regulation suggests alternative regulatory approaches, such as ‘sliding scale’ plans and ‘price cap’ regulation, as reviewed by Joskow and Schmalensee (1986). Some studies have found efficiency improvements from these methods. For example, Majumdar (1997) examined the effectiveness of incentive regulation on the productivity of US local exchange carriers. He found that there was a lagged but substantial effect on technical efficiency from a pure price-cap scheme. He also found positive effects on scale efficiency. However, Kridel, Sappington and Weisman (1996) conducted a survey of studies on the effects of incentive regulation in the telecommunications

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industry. Collectively, the studies examine productivity, investment, profit levels, new service offerings and regulatory proceedings. They find no strong evidence that incentive regulation significantly reduced the costs of providing telephone service, nor has it substantially streamlined regulatory proceedings. As suggested above, a critical policy issue is whether or not the pre-divestiture Bell System was a natural monopoly. This requires detailed tests of the subadditivity of the cost function, as mentioned in Section 2. Previous studies of this issue, such as Evans and Heckman (1983), suffered from poor data quality (as they note). However, Shin and Ying (1992) attempt to overcome these data problems by focusing on local exchange carriers (which allow more degrees of freedom than previous tests). Their global subadditivity tests demonstrate that the cost functions of these firms are definitely not subadditive. Their results suggest that permitting entry and increasing competition in the local exchange market would enhance efficiency. There have been many studies of the local telephone market, where there has been rapid regulatory change. For example, Green and Lehn (1995) suggest that recent developments in the telecommunications industry have increased the likelihood that the regional Bell operating companies (RBOCs) will face new competition in the local telephone service market. They detail major developments in these markets, including the FCC’s decision to facilitate entry and application of new technology to the local telephone market, as well as strategic decisions by AT&T, MCI and Time-Warner to enter the market. They use event-study methodology to estimate the announcement effect of several events on the equity values of the RBOCs. They find that there is a negative and significant collective effect on their values. Cramer (1994) focuses on access and cable competition in local telephone systems in the US. He provides an overview of the development and scope of local phone competition, and some predictions as to the future of local service. In particular, he believes that policies will evolve to encourage cable companies to enter the telephone business.

14. Gas Utilities In this section, I review several studies of the natural gas industry. Crandall and Ellig (1997) provide a summary of natural gas regulatory reform in the 1980s and 1990s. Barcella (1996) provides an overview of the current structure of the industry. She finds that competition is well entrenched in the production sector of the industry, and is moving downstream into the transportation sector as well. She finds that there is increased ‘unbundling’ in the industry, as gas production is being separated from the sale of pipeline transportation services and local distribution services. ‘Gas marketing’ has emerged as a new industry, which will likely be affected by upcoming electric utility deregulation, and

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transformed into a multi-fuel marketing industry. De Vany and Walls (1994) examine recent regulatory changes in the gas market. Their article describes the institutions that were developed to support exchange in gas markets, and studies the performance of these institutions. They find that spot gas prices have converged and become highly correlated. Doane and Spulber (1994) examine the spot market in natural gas. They focus on the wellhead spot price of gas from 1984 to 1991 to see if open access affected the geographic scope of the spot market. They apply three statistical tests, including spot price correlations, Granger causality, and cointegration, and find that open access integrated the regional markets into a national competitive market for gas. King and Cuc (1996) also study the degree of price convergence in the US spot gas market since deregulation. Using a Kalman Filter (time-varying parameters) approach, which allows measurement of the strength of price convergence, they find that the degree of price convergence has increased significantly since deregulation in the mid-1980s. However, they emphasize that it is not yet correct to speak of ‘one price’ in North American gas markets. In reference to Europe, Grais and Zheng (1996) examine the potential benefits of East-West gas trade within the context of a game-theoretic model. They emphasize that economic change in the former Soviet Union and Eastern Europe have heightened uncertainties in this gas trade. Their model shows how to modify the trade contract to accommodate changes in the economic environment.

15. Water Utilities Water utilities have been somewhat less frequently studied than other utilities. Nevertheless, there are many interesting contributions, several of which I review here. Many of these focus on the proper pricing for water services. For example, Zarnikau (1994) examines economically efficient water rates. He advocates the application of short-run marginal cost or spot market pricing principles to the pricing of water resources. Kim (1995) also examines the pricing of water services. The article’s focus is on current pricing systems relative to marginal cost and second-best pricing rules. He estimates a translog multi-product cost function for US water utilities, and finds that the existing price structure does not depart significantly from second-best pricing principles, but does depart from marginal cost pricing. Similarly, Renzetti (1992) examines water supply costs and demands using data from Vancouver, Canada in order to estimate the welfare gain from altering water prices. His results show that a move to seasonally differentiated pricing raises aggregate surplus by four percent, which is higher than previous estimates. Raffiee et al. (1993) examine the efficiency of public versus private water providers by calculating

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the difference between the observed cost and the optimum cost. The latter is found using the ‘Weak Axiom of Cost Minimization’ for each water utility. They find that privately owned water utilities are more efficient than public.

D. Utilities in Europe 16. Utilities in Europe In this section, I briefly review several contributions to the literature on European utilities. Since Europe is introducing competition in several utilities, this literature is rapidly growing. With regard to environmental issues, Burtraw (1993) discusses the use of international tradable sulfur dioxide emission permits in Europe, with an emphasis on electric utilities. Because tradable permits provide agents with powerful economic incentives to reduce emissions at least cost, this method of controlling for acidification has met with great success in the US. Environmental goals have been met at low cost. Burtraw argues that, because of economic unification and the liberalization of energy markets in Europe, permits have wide potential application there. However, he points to several institutional features of the European electric utility industry that may undermine the effectiveness of transferable permits. Grohnheit and Olsen (1995) discuss the consequences of introducing a competitive electricity market in the Nordic countries. They note that Britain and the Nordic countries are instituting many competitive reforms in their power sectors, and argue that opening up a competitive electricity market has the potential to create substantial efficiency gains. They focus on the use of combined heat and power for district heating, and demonstrate that it would be competitive in an open electricity market. Percebois (1994) focuses on natural gas markets in Europe. He finds that natural gas is being increasingly used in the generation of electricity, and examines the likelihood and desirability of deregulation of the industry. He argues that the prospects for its growth in Europe are promising, but only with continued government involvement. Monnier (1993) focuses on the electricity market in Europe. The first part of his article provides a survey of the economics of electricity, and an overview of the structure of the industry in Europe. The second part examines the debate over electricity restructuring in Europe, but focuses on three questions: (1) What is the future of the electric utility industry in Europe?; (2) How will competition evolve in Europe?, and (3) How will this affect government versus private ownership of utilities? Doyle and Maher (1992) also focus on electricity. They find that electricity supply is under increasing pressure to become competitive, and that the experience in the United Kingdom demonstrates the feasibility of regulatory

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reform in Europe. They examine the relationship between the generation, transmission, and distribution sectors of the industry, and find that open access to the grid is desirable if accompanied by common carriage requirements and a competitive generation sector. They also examine the pricing of transmission services under open access. Amundsen and Singh (1992) examine risk-sharing arrangements which allow consumers and producers to hedge their price-risk in European electricity markets. Specifically, they examine the feasibility of establishing futures markets in electricity in Europe, with a focus on the United Kingdom and Norway. While there is sufficient price uncertainty to justify such arrangements, they are skeptical about the competitiveness of new spot-markets.

17. Summary and Conclusions In this chapter, I have attempted to provide an overview of the utility literature. Since the term ‘utility’ has been used to refer to a broad range of industries, this literature is quite large. I discuss several issues important for utilities generally. These issues include a discussion of the original justification for utility regulation, a comparison of alternative theories of regulation, an examination of the distortionary effects of regulation, an overview of the effects of utility deregulation, and a discussion of ownership form. These issues were then applied to the specific case of the electric utility industry. This industry is of particular importance today, perhaps most importantly because it is very large and is now undergoing substantial regulatory change. It appears that reform of utility regulation has been very successful, with large net welfare gains accruing to society. While many studies focus on the US case, the results have important implications for utilities in Europe and elsewhere. Utilities face differing ownership structures across countries, but they share common structural characteristics. Thus, it is likely that utility regulatory reform will have similar beneficial effects in other institutional settings.

Acknowledgements I am grateful to William Niskanen, Juri Hwang, and two anonymous referees for helpful comments, and to Yi Luo for capable research assistance.

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Fane, George (1991), ‘Piecemeal Tax Reforms, and the Compensated Radial Elasticities of Tax Bases’, 45 Journal of Public Economics, 263-270. Fazzari, Steven, Hubbard, R. Glenn and Petersen, Bruce (1988), ‘Investment, Financing Decisions, and Tax Policy’, 78 American Economic Review. Papers and Proceedings, 200-205. Fellows, Mary Louise (1990), ‘A Comprehensive Attack on Tax Deferral’, 88 Michigan Law Review, 722-813. Flowers, Marilyn R. (1987), ‘Rent Seeking and Rent Dissipation: A Critical View’, 7 Cato Journal, 431-440. Formby, John P., Keeler, James P. and Thistle, Paul D. (1988), ‘X-Efficiency, Rent-Seeking, and Social Costs’, 57 Public Choice, 115-126. Formby, John P., Keeler, James P. and Thistle, Paul D. (1991), ‘X-Efficiency, Rent-Seeking and Social Costs: Reply’, 68 Public Choice, 267-271. Frey, Donald E. (1991), ‘Optimal-Sized Tuition Tax Credits Reconsidered: Comment’, 19(3) Public Finance Quarterly, 347-354. Garcia Villarejo, Salinas, Avelino and Sánchez, Javier (1993), Manual de Hacienda Pública General y de España (Public Treasury Manual), Madrid, Tecnos. Gephardt, Richard (1985), ‘The Economics and Politics of Tax Reform’, 5 Cato Journal, 455-464. Gillette, Clayton P. and Hopkins, Thomas D. (1987), ‘Federal User Fees: A Legal and Economic Analysis’, 67 Boston University Law Review, 795-874. Gimeno Ullastres, Juan A. (1980), ‘La Incidencia del Gasto Público por Niveles de Renta: España 1990 vs. 1980 (The Effect of Public Expenditure by Levels of Income: Spain 1990 vs. 1980)’, in X (ed), I Simposio Sobre la Igualdad y Distribución de la Renta y la Riqueza, Fundación Argentaria, 63-121. Gimeno Ullastres, Juan A. (1981), ‘Reforma Fiscal y Sistema Tributario (Reforming the Tax System)’, in X (ed), Las Reformas Urgentes, Madrid, Taller Ediciones JB, 481-490. Gimeno Ullastres, Juan A. (1983), ¿A Quién Beneficia el Gasto Público? (Who Does Public Expenditure Favour?), Número Monografico de la Revista de Economía Pública e Historia Económica. Gimeno Ullastres, Juan A. (1984), ‘Los Recargos Locales sobre Impuestos Estatales (Local Overcharges on Central Taxes)’, 1114(21) La ley, 1-4. Gimeno Ullastres, Juan A. and Ruiz Huerta, Jesús (1979), ‘Descentralización Fiscal y Corresponsablidad a Través de las Grandes Figuras Tributarias (Tax Descentralization and Corresponsability)’, 3(1);2°ép Cuadernos Aragoneses de Economía, 29-40. Gimeno Ullastres, Juan A. and Ruiz Huerta, Jesús (1980), ‘Financiación Autonómica: Un Modelo Alternativo de Corresponsabilidad Fiscal (Financing the Communities: An Alternative Model for Tax Corresponsability)’, 15 Revista Valenciana de Hacienda Pública, 149-179. Gimeno Ullastres, Juan A. and Ruiz Huerta, Jesús (1981), El Nuevo Estado Fiscal Español (The New Spanish Fiscal State), Madrid, H. Blume, 315 p. Gimeno Ullastres, Juan A. and Ruiz Huerta, Jesús (1986), ‘Reforma Fiscal y Financiación del las CCAA: El Régimen Especial (Financing The Communities and Tax Reform: The Special Regime)’, in X (ed), Estado Federal/Estado Regional: La Financianción de las Comunidades Autónomas, Salamanca, Ediciones de la Diputación de Salamanca, 245-263.

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Gimeno Ullastres, Juan A., Ruiz Huerta, Jesús and Olleros, Jaime (1987), Una Reforma Fiscal para España (Tax Reform in Spain), Moneda y Credito S.A. Gordon, James P.F. (1991), ‘Tax Reform and Uniformity: Explaining the Hatta Result’, 45(2) Journal of Public Economics, 161-190. Graetz, Michael J. and Wilde, Louis L. (1985), ‘The Economics of Tax Compliance: Fact and Fantasy’, 38 National Tax Journal, 355-363. Graetz, Michael J., Reinganum, Jennifer F. and Wilde, Louis L. (1986), ‘The Tax Compliance Game: Toward an Interactive Theory of Law Enforcement’, 2 Journal of Law, Economics, and Organization, 1-32. Hansen, Susan B. (1985), ‘Tax Reform: Sound Economics or Power Politics? Comment on Dye’, 5 Cato Journal, 609-612. Hettich, Walter and Winer, Stanley L. (1988), ‘Economic and Political Foundations of Tax Structure’, 78 American Economic Review, 701-712. Hofmann, E. and Wehrt, Klaus (1992), ‘Die Reform der Kfz-Steuer - Wirtschaftspolitisch Betrachtet (Economic Analysis of the Reform of the Motor Vehicle Tax)’, 4 Zeitschrift für Verkehrswissenschaft, 263-271. Inman, Robert P. and Fitts, Michael A. (1990), ‘Political Institutions and Fiscal Policy: Evidence from the U.S. Historical Record’, 6(S) Journal of Law, Economics, and Organization, 79-132. Jackman, Richard (1986), ‘The Economic Effects of Tax Based Incomes Policy’, in Colander, David C. (ed), Incentive Based Incomes Policies: Advances in TIP and MAP, Cambridge, MA, Harper and Row, 95-109. Johnson, Calvin H. (1989), ‘Why Have Anti-Tax Legislation? A Response to Professor Zelenak’, 67 Texas Law Review., -625. Kalt, Joseph P. and Zupan, Mark A. (1990), ‘The Apparent Ideological Behavior of Legislators: Testing for Principal-Agent Slack in Political Institutions’, 33 Journal of Law and Economics, 103-131. Kaplow, Louis (1989), ‘Horizontal Equity: Measures in Search of a Principle’, 42 National Tax Journal, 139-154. Kaplow, Louis (1992a), ‘A Note on Horizontal Equity’, 1 Florida Tax Review, 191-196. Kaplow, Louis (1992b), ‘Government Relief for Risk Associated with Government Action’, 94 Scandinavian Journal of Economics, 525-541. Kaplow, Louis (1993), ‘Should the Government’s Allocation Branch be Concerned About the Distortionary Cost of Taxation and Distributive Effects?’, Program in Law and Economics Discussion Paper, 122 ff. Kaplow, Louis (1994), ‘Taxation and Risk Taking: A General Equilibrium Perspective’, 47 National Tax Journal, 789-798. Kaplow, Louis (1995a), ‘A Note on Subsidizing Gifts’, 58 Journal of Public Economics, 469-477. Kaplow, Louis (1995b), ‘A Fundamental Objection to Tax Equity Norms: A Call for Utilitarianism’, 48 National Tax Journal, 497-514. Kaplow, Louis (1996a), ‘Tax and Non-Tax Distortions’, 57 Journal of Public Economics. Kaplow, Louis (1996b), ‘Regional Cost-of-Living Adjustments in Tax-Transfer Schemes’, 51 Tax Law Review. Kaplow, Louis (1996c), ‘Fiscal Federalism and the Deductibility of State and Local Taxes in a Federal Income Tax’, 82 Virginia Law Review.

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Ramseyer, J. Mark and Nakazato, Minoru (1989), ‘Tax Transitions and the Protection Racket: A Reply To Professors Graetz and Kaplow’, 75 Virginia Law Review, 1155 ff. Reinganum, Jennifer F. and Wilde, Louis L. (1991), ‘Equilibrium Enforcement and Compliance in the Presence of Tax Practitioners’, 7 Journal of Law, Economics, and Organization, 163-181. Rice, Edward M. and Ulen, Thomas S. (1981), ‘Rent Seeking and Welfare Loss’, 3 Research in Law and Economics, 53-65. Rodios, Nikos D. (1986), ‘E Kampyle tou Laffer e Peri tes Phthinousas Apodoseos tes Phorologias (The Laffer Curve or On the Diminishing Return of Taxation)’, 53 Ephemeris ton Hellenon Nomikon, 216-218. Rogers, Carol Ann (1991), ‘A Simple Model of Endogenous Tax Reform’, 46 Journal of Public Economics, 91-111. Rogerson, William P. (1990), ‘Comment (on “Political Institutions and Fiscal Policy: Evidence from the U.S. Historical Record”)’, 6(S) Journal of Law, Economics, and Organization, 155-166. Rose-Ackerman, Susan (1990), ‘Comment (on Ferejohn and Shipan’s “Congressional Influence (on Bureaucracy)”’, 6(S) Journal of Law, Economics, and Organization, 21-27. Ross, Thomas W. (1986), ‘Store Wars: The Chain Tax Movement’, 29 Journal of Law and Economics, 125-137. Rowley, Charles K., Tollison, Robert D. and Tullock, Gordon (eds) (1988), The Political Economy of Rent-Seeking, Boston, Kluwer Academic Publishers. Ru, H.J. De (1988), Prijst de Wet Zich uit de Markt? (Does the Law Price Itself Out of the Market?), Zwolle, Tjeenk Willink. Ruiz-Huerta Carbonell, Jesús (1992), ‘Vigencia y Operatividad del Principio de la no Confiscatoriedad de los Tributos en el Ordenamiento Español (The Principle of Non Confiscation of Taxes: Enforcement in Spain)’, 64 Revista Crónica Tributaria. Ruiz-Huerta Carbonell, Jesús and Giménez, Antonio (eds) (1993), Estructura Institucional y Gestión del Gasto Público en algunos Paises de la OCDE (Institutuional Structure and Managment of Public Expenditure in Some Countries), Estudios de Hacienda Pública, Instituto de Estudios Fiscales. Russo, Enzo (1992), ‘L’Impatto Amministrativo della Riforma del Contenzioso: Spunti di Analisi Economica del Diritto (The Administrative Impact of the Reform of the Contentious Procedure: Hints of Economic Analysis of Law)’, Il Fisco, 10471-10479. Salinas, Javier (1990), Economía Política del Federalismo Fiscal España (The Political Economy of Spanish Fiscal Federalism), Madrid, Instituto de Estudios Fiscales. Schmalbeck, Richard L. and Myers, Gary (1986), ‘A Policy Analysis of Fee-Shifting Rules under the Internal Revenue Code’, 66 Duke Law Journal, 970-1002. Seidl, Christian (1980), ‘Historischer Abriß österreichischer Steuerstrukturen und Steuerreformen (A History of Austrian Tax Structures and Tax Reforms)’, in Helige, O. (ed), Dokumentation zur Steuerreformkommission, Wirtschaftsverlag Dr. Anton Orac, Wien, 219-231. Shachar, Avishai (1985), ‘The Importance of Considering Liabilities in Tax Transitions’, 98 Harvard Law Review, 1842-1868.

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Zelinsky, Edward A. (1986), ‘Efficiency and Income Taxes: The Rehabilitation of Tax Incentives’, 64 Texas Law Review, 973-1037. Zwemmer, J.W. (1995), ‘Belastingrecht op het Grensvlak van Economie en Recht (Tax Law on the Borderline of Economics and Law)’, in X (ed), Ondernemen tussen Macht en Ordening: Opstellen op het Grensvlak van Economie en Recht, Amsterdam, Thesis Publishers, 37-45.

6010 TAXATION: MACRO ASPECTS Jef Vuchelen Vrije Universiteit Brussel © Copyright 1999 Jef Vuchelen

Abstract This chapter on macro aspects of taxation begins with a discussion of the contribution of taxation to stabilization policies. The budget constraint of the government and the expectations of economic agents about taxation are crucial elements here. The effectiveness of countercyclical policies has, however, been challenged by questions about the relevancy of the timing of taxation. We therefore cover the Barro-Ricardo equivalence theorem. Next we review the literature on taxation and inflation and the positive approaches to taxation. The discussion so far relates primarily to closed economies. The last section surveys some of the publications on the macro aspects of taxation in open economies. JEL classification: H10, H30, H70 Keywords: Taxation, Government Budget Constraint, Stabilization Policies, Ricardian Equivalence, Inflation

1. Introduction Over the past decades taxation has increased to levels not experienced before, which has stimulated theoretical and empirical research on the effects of taxation. The search for policy instruments to stimulate economic growth, led most governments to reform taxation (= lower marginal rates), especially income taxation. Notwithstanding, for most economic agents total taxes are still the main single item on the expenditure side of their accounts. Reactions to current and expected taxation are therefore among the more important economic decisions to be made. These decisions cannot be neglected by policymakers. For economists, the sheer size of taxation implies that no macroeconomic shock can be analyzed without considering the effects on the government finances. Frequently in theoretical research the tax rate is assimilated to the income tax rate. The discussion about the effects of this tax could serve as a guide for the theoretical macroeconomic effects. The interest in taxation or, more generally, in public finances, has not only been stimulated by the rise in ‘instant’ taxation but also by the tax-postponing policies pursued by many governments since the mid -1970s through the accumulation of government debt. Analyses of the long-run problems related 11

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to large stocks of government debt were never as relevant. Data for, for example, the 15 countries of the European Union illustrate the extent of the accumulation of government debt. Total debt amounts now (1998) to about 5,270 billion ECU or 70.5 percent of GDP. This represents 153 percent of current yearly taxation. The per capita debt of every EU citizen equals nearly 14,000 ECU. Just as it does for any economic entity, a budget constraint unites all operations of the government. This constraint thus links tax policy with expenditures policy, deficits and monetary policy. Any distinction between the different policies is therefore somewhat arbitrary. Evidently some choices had to be made in this survey. We restrict this survey to issues that are directly related to the macroeconomic aspects of taxation. This implies that we will not discuss the relative merits of monetary and fiscal policy, or the link between taxation and government expenditures. We agree here with Kay (1990, p. 18): ‘The link between tax and spending is now close and symmetric. But this symmetry is rarely reflected in the theory, or the practice, of tax policy’. Furthermore, we will not consider sectorial, regional or local aspects. As a result, studies concerning, for example, the taxation of international income or commodity flows (tariffs) will not be surveyed. References related to the government debt will only be discussed when they have a direct impact on taxation. This explains, for example, the absence of studies on the world debt problem. Similarly, studies on the political determinants of the deficit or debt policies will not be surveyed; however, the political aspects of taxation will be covered. The literature on the history of taxation and the early discussion about the effects of taxation will not be surveyed. We refer to, for example, Webber and Wildavsky (1986) and Musgrave and Shoup (1959). Taxation is considered in a narrow sense so we will not cover alternatives to taxation such as regulation (see Chapter 5000). Note that because of lack of space, we could not include the literature on taxation and growth and the general equilibrium approach to taxation. We also refer the reader to other related chapters (6000 for optimal taxation, 6020 for tax evasion, 6030 property taxes, 6040 consumption taxes, 6050 income taxation, 6060 corporate taxation, 6070 inheritance taxation and 6080 international taxation). Our survey can be viewed as integrating the macroeconomic effects of taxation into the intertemporal budget constraint of the government. This constraint determines the sustainability of announced fiscal policies and therefore the perception of fiscal policy by economic agents. We start our survey with the contribution of taxation to stabilization policies (Section 2). In this discussion, the budget constraint of the government (Section 3) and the expectations of economic agents about taxation (Section 4) are crucial. The effectiveness of countercyclical policies has, however, been challenged by questions about the relevancy of the timing of taxation (Section 5). In the next section (Section 6) we review the literature on taxation and

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inflation. Section 7 provides an overview of the positive approaches to taxation. The previous discussion relates primarily to closed economies. The last section (Section 8) surveys taxation in open economies.

2. Taxation and Stabilization Policies The macroeconomic aspects of taxation and fiscal policy have systematically been assimilated with the stabilization function. (The allocative and distribution function being the subject of more specific instruments; they are part of other surveys.) More recent research has, however, been rather critical about the traditional approach because of the formulation of anticipations and medium and longer-run implications of the models under consideration. In the Keynesian tradition (see any textbook on macroeconomics or public finance; for expositions and extensions Modigliani, 1944; Peacock and Shaw, 1976; Turnovsky, 1977, and Frenkel and Razin, 1987; for an adaptation of traditional Keynesian demand management to the stagflation situation of the 1980s, we refer to Vines, Macriejowski and Meade, 1983; see also Baily, 1978, for a discussion of the changing economic environment and its impact on stabilization policies) fiscal policy, and therefore taxation, is one of the main instruments to stabilize the economy. Stabilization policies are designed to minimize the gap between current and potential production and employment and to limit the inflation rate. This importance of fiscal policy derived from the economic situation in the 1930s and 1950s and the perceived properties of the economy (deficient aggregate demand, rigid prices and wages, an elastic money demand and an inelastic investment function). The asymmetry in its implementation (expenditures and taxes were increased but rarely reduced) resulted in a structural increase in the relative size of the government budget. This was further stimulated by the Haavelmo effect (Haavelmo, 1945) or the balanced-budget multiplier. This effect holds that no deficit penalty for higher public spending financed by an increase in taxes exists since a similar increase in taxes and government expenditures would increase income by the same amount. Later Knoester (1980, 1983) disputed this result by stressing that instead an inverted effect exists as a result of the link between taxes and wages. Furthermore, much faith was placed in the automatic stabilizing properties of expansive policies: any budget deficit would soon disappear thanks to the induced beneficial effects on economic growth (recent work is by Rodseth, 1984; Kyer, Mixon and Uri, 1988; Uri, Mixon and Kyer, 1989a, 1989b). Cameron (1978) argues that the increasing openness of countries ‘created’ a demand for stabilization policies. The mainstream approach in the 1960s was to view the economy as similar to a system that, by a clever use of impulses, could be controlled. This led to an

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intensive search for the value of the multipliers. It explained, partly, the exploding use of large-scale econometric models (see Hickman, 1972, for the state of the debate at the beginning of the 1970s; see Sims, 1982, for an evaluation). However, also reduced form models gained some popularity. This could be explained by the success of the St. Louis model (named after the Federal Reserve Bank of St. Louis). That model (Anderson and Jordan, 1968) intensified the discussion between Keynesians and the monetarists since it was shown that monetary policy and not fiscal policy affected income. In these reduced forms no attention was paid to incentives effects, so we do not survey these studies. On the empirical level, one should remember the Goldfeld and Blinder (1972) point that reduced forms could give misleading results on the efficacy of fiscal policy if this policy is designed to stabilize the economy. Intuitively, if fiscal policy manages to stabilize income, no correlation between the deficit and income will be found. In the late 1960s and early 1970s thus a lively discussion about the most appropriate policy course emerged. Buchanan and Wagner (1977) argued that the Keynesian theory destroyed the classical thesis, strengthened by consititutional rules, that budgets should balance and that deficits were immoral. Until the early 1970s, the main - if not the only - argument to denounce fiscal policy concerned crowding out; that is, that the impact of an increase in government expenditures on total demand would be offset by lower private investment or consumption expenditures. (The traditional result could thus also be defined as ‘crowding in’.) Obviously, at full employment a complete crowding out of private by public expenditures occurs so fiscal policy can only determine the division of output between the public and the private sector. When resources are not fully employed, different effects matter such as the increase in the interest rate (financial crowding out), in wealth, the composition of wealth (portfolio crowding out) and inflation (see Spencer and Yohe, 1970; Carlson and Spencer, 1975, 1980; Meyer, 1975; Buiter, 1977; Cavaco-Silva, 1977; Scarth, 1977; Turnovsky, 1977; Cohen and McMenamin, 1978; Floyd and Hynes, 1978; Friedman, 1978; Bruce and Purvis, 1979; Stevens, 1979; Taylor, 1979; Aschauer, 1985, 1988; Aschauer and Greenwood, 1985). Besides crowding-out, many other questions on the business cycle stabilization potential of fiscal policy have been raised. How is a tax reduction or a deficit financed? Is the policy credible? Is the policy sustainable? What about the foreign effects? What motivates policymakers to modify taxes? The literature on some answers to these questions will be surveyed later. We will not extend the discussion into different versions of the Keynesian and classical models like the Tobin (Tobin and Buiter, 1976; Buiter and Tobin, 1980) or Brunner-Meltzer (Brunner and Meltzer, 1976) models, since they focus on and refine monetary transmission mechanisms, or extend on the neo-

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Keynesian or disequilibrium models. Finally, note that in recent research shocks in taxes are considered to produce business cycles fluctuations (Christiano and Eichenbaum, 1992; Braun, 1994b; McGrattan, 1994; Johnsson and Klein, 1996). This feeds the criticisms about the possibility to use taxes as a stabilization tool.

3. The Budget Constraint In the early stages of demand management policies, the ‘loose’ reasoning was that, by a judicious timing, no public finance instrument would, over the business cycle, create financing problems. This would be the result of the automatic stabilizing properties of taxation. This view was supported by the spectacular decline in the debt ratio after the Second World War. Later, however, the criticism by monetarists was supplemented by the argument that the budget constraint was neglected. By explicitly incorporating the financing aspects of government decisions two important modifications had to be made to the traditional analysis: fiscal and monetary policy became interrelated and the long-run multipliers were no longer uncertain. References to the basic articles and developments are: Ott and Ott (1965), Christ (1967, 1979), Silber (1970), Steindl (1971), Blinder and Solow (1973, 1976), Meyer (1975), Brunner and Meltzer (1976), Currie (1976), Tobin and Buiter (1976), Cavaco-Silva (1977), Smyth (1978), Cohen and De Leeuw (1980) and Mayer (1984) (surveys are to be found in Turnovsky, 1977; Artis, 1979; and Burrows, 1979). In these contributions, it is stressed that any tax reduction has to be financed implying that the budget constraint must be included in the analysis. This endogenized at least the supply of bonds, possibly money creation and therefore monetary policy. The longer-run consequences on the multipliers strengthened the macroeconomic importance of the marginal tax rate: any change in expenditures (or taxes) must be offset by an identical change in taxes (or expenditures) since no deficit and therefore no monetary or bond financing is allowed. The consequence is the irrelevancy of the method of financing the deficit; only the fiscal structure determines the long-run impact of fiscal policy. Note, however, that this attractive result disappears when interest payments are explicitly included into the budget constraint (Blinder and Solow, 1973, 1974). The size of the long-run multiplier associated with a bond-financed fiscal expansion increases, since taxes must now also finance the higher interest charges. The Blinder-Solow model was extended to include explicit stock-flows interaction of capital and bonds by Tobin and Buiter (1976). Calvo (1985) allows for price increases in a model were the money-bond ratio is important.

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4. Rational Expectations The budgetary constraint criticism of the traditional stabilization instruments is based on the accounting argument that expenditures and revenues are linked by the budget constraint. In the 1970s, further blows on the stabilization approach were inflicted on the basis of more behavioral arguments. Indeed, the traditional approach assumes, although implicitly, that all policy changes occur unexpectedly. The rational expectation assumption, based on Muth (1961), argues that economic agents form expectations about future events. These expectations are rational in the sense that they combine all the available information and therefore do not lead to systematic forecasting errors. The implication of the rational expectations hypothesis is that policies will only be effective when they produce surprises (= forecast errors). By definition, this is not possible in the long run since rational economic agents will detect any policy rule and will therefore no longer be surprised. This is also known as the ‘irrelevance hypothesis’. This view has been applied to several policy instruments, most of the time of monetary policy; the core arguments are, however, also relevant to fiscal policy and taxation. The main contributions can be found in Fischer (1980b) and Lucas and Sargent (1981); Baily (1978) and McCallum and Whitaker (1979) apply the monetary policy results to fiscal policy. For our problem at hand it implies that any general expected tax change will already have been discounted by the economic agents in their decision process. An unexpected transitory change in taxation will leave permanent income unchanged. Only permanent unexpected changes are of interest. When government expenditures remain constant, the Ricardo equivalence theorem applies (see below) so the new tax policy will be ineffective. If government expenditures are reduced, the traditional expansive effects, depending on the tax rate change, will apply. The final effects on macroeconomic variables depend on the specification of the model. For example, what is the impact of an increased demand on inflationary expectations? One important policy implication is that fiscal consolidations should not necessarily contract demand due to the benign effects on the expectations about future taxation (see Giavazzi and Pagano, 1990, for an application to Denmark and Ireland). Note that the introduction of uncertain shocks modifies the previous picture slightly in the sense that built-in stabilizers will reduce the variability of income since they provide an automatic and immediate adjustment to current disturbances (McCallum and Whitaker, 1979). The main publications are Lucas (1972, 1973, 1975, 1976), Sargent (1973), Sargent and Wallace (1975), Barro (1976), Infante and Stein (1976), Sargent and Wallace (1976), Fischer (1977, 1979a, 1979b), Kydland and Prescott (1977, 1980), McCallum (1977, 1980), Phelps and Taylor (1977), Shiller (1978), McCallum and Whitaker (1979), Begg (1980, 1982), Buiter (1980b),

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Taylor (1985), Lovell (1986) and Lucas (1986b). Notwithstanding the previous conclusion on the ineffectiveness of stabilization policies in a rational expectations framework, microeconomic considerations such as the incentives effects of marginal tax rates, social security payments, subsidies, and so on, on labor supply, saving behavior, investment, and so on, imply that even perfectly anticipated policy changes will have some real effects in the medium run. Furthermore, the previous analysis assumes a systematic clearing of the markets. If this assumption is relaxed and a disequilibrium framework is accepted, the standard Keynesian effects reappear even when expectations are rational (see Taylor, 1979; Begg, 1982; Neary and Stiglitz, 1983, and Buiter, 1980b).

5. The Timing of Taxation In the traditional stabilization approach, higher deficits are a crucial instrument to increase growth. However, if expenditures remain unchanged this implies, that sometime in the future taxes will have to be raised. Deficits are thus an instrument to transfer taxes intertemporally. Will citizens be aware of this and take future taxes into account in their decision process? In other words, is there a burden associated with government debt? The discussion on the burden of the government debt emerged forcefully around 1960 (most contributions are in Ferguson, 1964, and Kaounides and Wood, vol. 2, 1992; see also Buchanan, 1958; Modigliani, 1961; Bailey, 1962; Pesek and Saving, 1967, and Cavaco-Silva, 1977). The mainstream Keynesian position (also known as ‘the new orthodoxy’) was that government debt was different from private debt (repayment of principal and payment of interest is mortgaging future resources) since ‘we owe government debt to ourselves’: future generations pay interest and principal to themselves so leaving disposable income unaffected. This argument was reinforced by the proposition that the deficit cannot be a burden on future generations because their resources are unaffected; the exception being foreign debt. These views were criticized since higher deficits implied lower taxation. This allows current generations to consume more and so to crowd out investment. Future generations thus inherit less capital. The distinction between domestic and foreign debt is not relevant since, although foreign debt does not crowd out investment, the revenue from the capital will benefit foreign lenders. Posner (1987) extends this view by arguing that foreign borrowing allows higher investment. Ceteris paribus, the burden of the internally held debt will be higher than for foreign debt. In 1974, Barro rephrased the problem of the debt burden in ‘Are Government Bonds Net Wealth?’. By doing so, he could focus the attention on

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the behavior of taxpayers. Barro showed that the real burden on current and future generations occurs when government uses resources for consumption; the financing of government expenditures (taxes or borrowing) is not relevant: they are equivalent (tax neutrality). This proposition is now known as the ‘Ricardian equivalence theorem’ (some of the papers by Ricardo are reprinted in Kaounides and Wood, vol. 1, 1992; for a discussion on the historical origins see Buchanan, 1976; O’Driscoll, 1977, and Asso and Barucci, 1988; see also Hakes and McCormick, 1996). The novel feature of Barro’s approach is that he showed that intergenerational gifts and bequests turn an overlapping-generations economy with finite-lived households into an infinite-lived households economy whose consumption would not be affected by intertemporal redistributions of lump-sum taxes. Phrased in a stabilization framework, the Ricardian equivalence theorem holds that when the government issues bonds, at the same time a liability is incurred to pay interest annually and to reimburse the par value at the date of maturity. Formulated from a wealth point of view, the net present value of the future tax liabilities equals the price of the bond. If taxpayers do capitalize future tax liabilities, the positive gross wealth effects of a bond issue will be offset by an equivalent liability leaving net wealth unchanged. Government bonds will then not be part of net private wealth. In other words, a decrease in public saving will be exactly offset by an increase in private saving, leaving total saving unchanged. Formulated from a financing point of view, the financing of government deficits is irrelevant for the real side of the economy so a substitution of debt for taxation does not affect economic development. As a result, in this ultrarational situation fiscal policy is ineffective. This can be viewed as ‘ex ante crowding out’ (David and Scadding, 1974). If the macroeconomic effects of current taxation are comparable to those of deficits, a choice between current or future taxation will have to be made by considering allocative effects (see Ihori, 1988). General discussions of the Ricardian equivalence theorem can be found in Buiter and Tobin (1979), Brennan and Buchanan (1980b), Tobin (1980), Bernheim (1987, 1989), Modigliani (1987), Perasso (1987), Leiderman and Blejer (1988), Flemming (1988), Morris (1988), Barro (1989), Thornton (1990), Seater (1993), Van Velthoven, Verbon and Van Winden (1993). Tramontana (1985) and Fields and Hart (1990) place the discussion in a traditional IS-LM framework. The Barro proposition resulted in an intense discussion and many empirical tests. Several authors, especially Keynesians, questioned his assumptions. Since taxes are in general not lump-sum taxes, tax changes involve modifications in the size and timing of marginal taxation. This affects incentives and induces intertemporal substitution effects (Buiter, 1989, and Trostel, 1993). One can also question whether taxpayers are interested or informed about taxes and the

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government debt. This refers to the existence of fiscal illusion (Stiglitz, 1988). Similarly, is the public not assuming that government has no intention of paying off the principal (Cox, 1985)? Barro (1974) showed that the infinite life assumption is sufficient but not necessary for his proposition. A finite life assumption has the same implication if one assumes that the current generation considers the wellbeing of future generations and adjust intergenerational transfers (bequests or transfers inter vivos) to interventions of the government (for example, a tax reduction will be matched by an increase in voluntary tranfers). Expenditures on education are different since a government deficit can increase welfare: parents will be allowed to invest more in their children’s education (see Drazen, 1978). Further discussion about this issue is to be found in Blanchard (1985), Hubbard and Judd (1986), Auerbach and Kotlikoff (1987), Frenkel and Razin (1987), Poterba and Summers (1987), Weil (1987), Abel (1988), Bernheim and Bagwell (1988), Musgrave (1988), Kotlikoff, Razin and Rosenthal (1990), Lopez and Angel (1990), Abel and Bernheim (1991), Lord and Rangazas (1993) and Jaeger (1993). The assumption of perfect capital markets has been critized by several authors. Hubbard and Judd (1986) stress that consumers may face a liquidity constraint, so they prefer future taxes to be substituted for current taxes. Artis (1979) and Leiderman and Blejer (1988) argue that a higher discount rate may be applied to future tax liabilities (for example, as a result of a higher risk of default) compared to future interest payments so there is a gain in present wealth by using debt rather than taxes. In other words, since market imperfections create liquidity constraints, borrowing by the government is cheaper compared to household borrowing. Government surpluses and deficits may thus be used to reallocate consumption through time: a net positive effect of indebtness would thus occur if the government is more efficient than the private sector in carrying out the loan process between generations or if the government acts like a monopolist in the production of the liquidity services associated with debt issue (see Daniel, 1993). Webb (1981) stresses, however, differences in the ability to repay debt between households and the government. A point somewhat related to capital market imperfections is that bequests cannot be negative, which would be required if it is expected that future generations would be richer (Modigliani, 1987). Yotsuzuka (1987) stresses the importance of the exact type of capital market imperfections. The general conclusion that capital market imperfections imply debt non-neutrality is rejected. Buchanan and Wagner (1977) and Feldstein (1988) discuss the perfect certainty assumption of future tax liabilities. The complexity of the tax system would lead to an underestimation of future tax liabilities. Note that Barro (1974) argues that uncertainty would result in an overcompensation of future tax liabilities if, as could be advocated, households are risk averse (see also Chan, 1983, and Barsky, Mankiw and Zeldes, 1986). Boskin and Kotlikoff

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(1985), Leiderman and Razin (1988), Bomberger (1990), Croushore (1990, 1992, 1996), Handa (1993) and Strawczynski (1995) study the impact of uncertainty in income and returns in an intergenerational altruistic model. Cukierman (1986) considers uncertain lifetimes. The assumption made by Barro that taxes are lump sum has been frequently critized. A modification does, however, not lead to straightforward effects since many alternatives exist (taxation of consumption, income, profit, and so on) (see Abel, 1986, and Basu, 1996). Note also that transaction costs associated with the issue of debt are neglected (Carmichael, 1982). A point that surfaced only infrequently in the recent discussion on the Ricardian equivalence, but was omnipresent in the discussion of the early 1960s is the source of the deficit. Does it matter that a deficit is the result of an increase in government investment instead of in transfer payments? Barro assumed government spending to be constant so the only issue was the financing one. Buchanan and Roback (1987) discuss the importance of the source of the deficit; Kormendi (1983) and Bohn (1992) of spending (see also Katsaitis, 1987, and Cebula and Hung, 1996b). Liviatan (1982) critizes the neglect of the inflation tax as a source of government revenue. Since additional government debt is frequently financed by money creation, this revenue could partly offset increases in interest charges linked to the issue of government debt. Government bonds will then no longer be neutral. The list of empirical verifications of the Ricardian equivalence theorem by testing for the effect of the deficit and/or government debt, however defined, on consumption, saving or interest rates is long. Therefore, we are not able to provide any further guidance. Note that any article testing for the effect of the government debt or deficit on an economic or financial variable could be listed. This is especially the case for interest rate equations estimated before the publication of the 1974 article by Barro; we only list those articles that explicitly test for the Ricardo equivalence: (some of the papers are reprinted in Kaounides and Wood, vol. 3, 1992) Kochin (1974), Yawitz and Meyer (1976), Buiter and Tobin (1979), Tanner (1979), Holcombe, Jackson and Zardkoohi (1981), Dwyer (1982), Feldstein (1982), Plosser (1982), Seater (1982), Bennett and Dilorenzo (1983), Kormendi (1983), Koskela and Viren (1983), Makin (1983), Mascaro and Meltzer (1983), Blanchard (1984), Summers (1988), Aschauer (1985), Boskin and Kotlikoff (1985), Evans (1985), King and Plosser (1985), Kormendi (1985), Modigliani, Jappelli and Pagano (1985), Seater and Mariano (1985), Tanzi (1985), Barth, Iden and Russek (1986), Evans (1986), Hoelscher (1986), Kessler, Perelman and Pestieau (1986), Kormendi and Meguire (1986), Merrick and Saunders (1986), Modigliani and Sterling (1986), Barro (1987), Carroll and Summers (1987), Modigliani (1987), Evans (1987a, 1987b), Jones (1987), Modigliani and Japelli (1987), Motley (1987), Poterba and Summers (1987), Boskin (1988), De Haan and Zelhorst (1988), Evans (1988a, 1988b), Gruen (1988), Ihori (1988), Knight and Masson (1988),

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Leiderman and Razin (1988), Morris (1988), Nicoletti (1988), Tanzi and Blejer (1988), Viren (1988), Walsh (1988), Boothe and Reid (1989), Buiter (1989), Croushore (1989), Darrat (1989), Evans (1989), Reid (1989), Kormendi and Meguire (1990), McMillin and Koray (1990), Cadsby and Murray (1991), Evans (1991), Gruen (1991), Lee (1991), Standish and Beelders (1991), Whelan (1991), Dalamagas (1992a and 1992b), Graham (1992), Gupta (1992), Kazmi (1992), Nicoletti (1992), Beck (1993), Dalamagas (1993), Evans (1993), Jaeger (1993), Perelman and Pestieau (1993), Akai (1994), Beck (1994), Evans and Hasan (1994), Dalamagas (1994), Mukhopadhyay (1994), Graham (1995), Himarios (1995), Rose and Hakes (1995), Slate (1995), Cebula and Hung (1996a), Chakraborty and Farah (1996), Ghatak and Ghatak (1996), Leachman (1996) and Wagner (1996). Note that no standard approach exists so results are not always comparable. For a discussion of the robustness of the results, see Cardia (1997). Drawing conclusions from the empirical analysis is difficult. I am inclined to follow Seater (1993, p. 182) when he writes: ‘I think it is reasonable to conclude that Ricardian equivalence is strongly supported by the data’. This should not be interpreted absolutely but as a statement that the Ricardian equivalence theorem is an acceptable working hypothesis. The implication of the Ricardian equivalence theorem for the design of taxation policy (we refer to the chapter on optimal taxation for a more profound discussion) is that taxes should be kept as fixed as possible (‘tax smoothing’) to minimize the deadweight losses (Barro, 1979). This contradicts the countercyclical approach implied by the standard Keynesian models. In a tax smoothing framework the permanent tax rate should be set so as to finance the permanent primary government expenditures plus interest payments (see also Chari, Christiano and Kehoe, 1991, 1994). Government debt then functions as a cushion for deviations of government spending from its permanent level. We do not extend this analysis since it is part of the optimal taxation literature, covered in another survey. The Ricardian equivalence theorem does not, by definition, consider any problems related to the financing of the government debt. From a microeconomic point of view an automatic channeling of additional savings into government bonds cannot be assumed. Portfolio holders and tax payers do have alternatives for government bonds but their participation is required to defer taxes to the future. So the constraint should be imposed that bondholders evaluate the policy pursued by the government as credible. If, for example, an increase in inflation is to be feared, no bond issue will be possible (eventually issues of very short run bills are still conceivable). In the more extreme case of a possible repudiation, the demand for government debt will vanish completely. The difference between macro- and microeconomic considerations reflects that taxpayers will not only attempt to minimize their tax share but also to maximize the return on their savings so as to benefit from the postponement of

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taxes. This is nothing but another application of the saving paradox. The credibility of fiscal policy depends on expectations by taxpayers about future policies. The determinants of credibility can therefore not be straightforwardly determined. However, some crucial factors are evident such as a combination of taxes and expenditures that respect the intertemporal budget or present value constraint, that is, the solvency condition of the government. This constraint implies that the discounted value of future primary surpluses equals the outstanding stock of government debt. Note that this does not guarantee that the rise in the debt-income ratio will be bounded. All that matters is that the real growth rate of the debt should be lower than the real rate of interest; the growth rate of income or the tax base is not directly involved (see Persson and Tabellini, 1990, and the collection of papers in Persson and Tabellini, 1994). Although not identical to the Domar approach (Domar, 1944) (in its simple version a stabilization of the debt-income ratio requires that the real after tax interest rate be smaller than the real rate of growth) it is comparable. The Domar requirement was especially very popular in the early 1980s with international organizations such as the OECD and the European Commission, withsgovernment agencies and even governments since, given the high level of the interest rates, its policy implications were relatively straightforward: reduce the primary deficit to stabilize the debt-income ratio. Articles on this subject are Chouraqui, Jones and Montador (1986), Hamilton and Flavin (1986), Bispham (1987), Spaventa (1987), Kremers (1988, 1989), Trehan and Walsh (1988, 1991), Wilcox (1989), Blanchard et al. (1990), MacDonald and Speight (1990), Corsetti (1991), Hakkio and Rush (1991), Haug (1991), Smith and Zin (1991), Buiter and Patel (1992), MacDonald (1992), Bagliani and Cherubini (1993), De Haan and Siermann (1993), Heinemann (1993), Frisch (1995) and Vanhoorebeek and Van Rompuy (1995). Violations of the intertemporal budget constraint cannot be excluded, but what are the implications? Feldstein (1982) and Masson (1985) consider uncertainty about the required policy switch in case current policies are unsustainable and Leiderman and Blejer (1988) discuss the uncertainty as to how the spending-tax plan will be adjusted to satisfy the constraint. Bohn (1991) shows that in the United States over the past centuries 50-65 percent of deficits due to tax cuts and 65-70 percent of deficits due to spending cuts have been eliminated later by spending cuts; Kremers (1989) finds that the deficit policy of the 1980s is not consistent with the pattern of the previous decades. The extreme solution to violations of the intertemporal budget constraint is, of course, a default by the government on its debt. Chari and Kehoe (1993) present a general equilibrium model of optimal taxation were this is a policy option.

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6. Taxation and Inflation The literature on inflation is vast. We limit ourselves to two aspects that are especially relevant from a fiscal policy point of view. First, inflation as a tax. Inflation should indeed, as a process of price increases, be at least acknowledged, if not stimulated, by the government. The second question concerns the relationship between deficits and inflation. Unexpected inflation redistributes wealth between debtors and creditors. Since frequently the government is the major debtor, the budgetary consequences of inflation cannot be neglected. Inflation is thus an alternative for traditional taxation. Furthermore, tax systems are most of the time not indexed so, in general, the direct impact of inflation is a more than proportional rise in tax revenues. This is also the case for the taxation of the inflation premium included in interest rates (Darby,1975), Feldstein,1976, and Feldstein and Summers, 1978; see also Tanzi, 1984). In this approach inflation is viewed as exogenous. In the optimal inflation literature, inflation is explicitly considered as a policy instrument to generate seignorage revenues for the government. Without considering the numerous country applications, we mention Bailey (1956), Friedman (1971), Tower (1971), Barro (1972), Marty (1973), Phelps (1973), Auernheimer (1974), Cathart (1974), Kahn and Knight (1982), Barro (1983), Calvo and Peel (1983), Cox (1983), Remolona (1983), Brock (1984), Mankiw (1987), Weil (1987), Marty and Chaloupka (1988), Brock (1989), Kigel (1989), Vegh (1989), Bohanon, McClure and Van Cott (1990), Bruno and Fischer (1990), Calvo and Leiderman (1992), Calvo and Guidotti (1993), Guidotti and Vegh (1993a, 1993b), Steindl (1993), Banaian, McClure and Willett (1994), Braun (1994a), Chang (1994), Marty (1994), Mourmoras and Tijerina (1994) and Vegh (1995). The traditional assumption is that no alternative payment instruments to domestic money are available. Hercowitz and Sadka (1987) allow for currency substitution. As this limits the revenues from the inflation tax, governments will broaden financial regulations to minimize the domestic use of foreign currencies. Taxation and inflation are also, although less directly, linked by the budget constraint of the government. Note that taxation will directly affect the price level but since, in general, changes in tax rates do not occur continuously, they will not explain inflation. It is therefore more the decision not to increase taxation by incurring budget deficits that could be important for the inflation process. In general two main channels can be distinguished that link the budget deficit to inflation. A first link results from a monetization of deficits; a second, less direct link, is the consequence of crowding out. Indeed, when higher government expenditures substitute for investment, potential production declines which, when the stock of money remains constant, implies a price increase. Note that this is not the case when the deficit results from a decline in taxes since, following the previous argument, the price level will decline.

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Modigliani (1987), however, stresses reverse causation effects running from inflation to higher interest rates and so to deficits; furthermore, restrictive monetary policy to fight inflation lowers income which leads to increased deficits. Concerning the monetization of the deficit, references mentioned above about the budget constraint are also relevant here. The link between budget deficits, whatever the origin, and inflation was forcefully formulated by Sargent and Wallace (1981) in their ‘Some Unpleasant Monetarist Arithmetic’: interest payments will, when the government debt exceeds some upper limit, have to be financed by money creation due to a shortage of savings. The ‘unpleasant arithmetic’ stresses thus that a bond-financed deficit will eventually have to be financed by money creation and therefore lead to a higher inflation rate. Darby (1984) (reply by Miller and Sargent, 1984) argues that the situation described by Sargent and Wallace is unlikely to occur since it requires that the real bond rate exceeds the real rate of growth for a considerable time (see also McCallum, 1984). King and Plosser (1985) discuss, test and reject (for the US as well as for several other developed countries) the link between seignorage revenues and different policy variables. Sargent and Wallace assume that monetary policy accomodates fiscal policy (‘fiscal dominance’); Buiter (1987) and Buti (1990) consider different policy regimes (cooperation or leadership between monetary and fiscal authorities). Drazen and Helpman (1990) stress the importance of the policies expected to be used to reduce the deficit (see also Niskanen, 1978; Blinder, 1983; Miller, 1983, and Congdon, 1987).

7. The Positive Approach to Taxation In democratic societies, tax rates are fixed by politicians and not by technicians who aim for an optimal taxation. The traditional approach holds that taxation or government expenditures are instruments that policymakers modify to realize goals such as a stabilization of the economy, a reallocation of resources or a modification in the distribution of income and wealth. This fine-tuning policy faces several problems and risks. For example, the government can misjudge both the size and timing of interventions, many conflicting objectives need to be pursued, the effects of instruments are not known with certainty, data contain errors, the theoretical structure of the model, the parameters, the value of exogenous variables, the nature of exogenous disturbances are not perfectly known, time lags are involved (recognition, decision, execution and response lag), frequent changes in policy instruments affects policy credibility, and so on. See, for example, Friedman (1960), Okun (1972), Kydland and Prescott (1977), Lucas (1980), Cooley, Leroy and Raymon (1984); and see also the recent literature on taxation as a source of business cycle fluctuations: Christiano and Eichenbaum (1992), Braun (1994b), McGrattan (1994) and

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Johnsson and Klein (1996). The previous arguments (partly) explain the preference of several authors for policy rules. See the chapter on optimal taxation for more detail. In the public choice literature a different approach is taken. A typical formulation is Brennan and Buchannan (1980a) where a government is seen as a revenue-maximizing leviathan and taxes result out of a struggle between the government and citizens. Taxation is thus essentially viewed as an instrument to satisfy the wellbeing of the policymakers, not of the community and taxes are required to finance government expenditures. In this way taxes are more directly linked to government expenditures than in the ‘traditional’ approach. We refer to Downs (1957), Meltzer and Richard (1978), Anderson, Wallace and Warner (1986), Blackley (1986), Manage and Marlow (1986), Von Furstenberg, Green and Jeong (1986), Hibbs (1987), Ram (1988), Ahriakpor and Amirkhalkhali (1989), Mueller (1989), Blackley (1990), Holmes and Hutton (1990), Miller and Russek (1990), Cukierman and Meltzer (1991), Hoover and Sheffrin (1992) and Bella and Quinteri (1995). Consider also the collection of papers in Buchanan, Rowley and Tollison (1986). Several articles and books apply public choice arguments to a discussion of taxation or tax reform. It is impossibble to survey and list them. A pronounced view is Rose and Karran (1987). Citizens bear, however, also some responsibility: the aggregate demand for budgetary programs will be excessive since any taxpayer bases his demand on the asymmetry between his small share in the cost of the program he supports and the perceived benefits. Furthermore, they suffer from fiscal illusion (see Dollery and Worthington, 1996, for a recent survey of this literature) that is reinforced by debt finance. As a result, the perceived price of public goods is lower than the effective price resulting in a rise in the demand for these goods. On the other hand, there is little incentive to combat tax increases since the individual share is negligible. As a result the upward pressure on the supply of government programs is stronger than the incentive to hold down the budget so government expenditures tend to rise and be financed by tax increases. The literature on the ‘political business cycle’ should also be mentioned here. It concerns the creation of favorable economic conditions at election time so as to increase the re-election chances of the incumbent politicians. Obviously taxation is an instrument that could be used to generate these cycles. We refer to Alesina and Roubini (1992), Borooah and Van der Ploeg (1983), Nordhaus (1989) and Schneider and Frey (1988) for a general review of this literature. Unfortunately not much research has been performed on the use of taxes to generate a political business cycle (see, however, Tufte, 1978; Edwards and Tabellini, 1991; Grilli, Masciandaro and Tabellini, 1991, and Alesina and Rosenthal, 1995). Econometric tax functions, most of the time for separate taxes and, eventually, specified as reaction functions, have been estimated in many econometric models. More relevant here but much less numerous, are general

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tax equations that contain political determinants. We refer, however, to Frey and Schneider (1978), Alt and Chrystal (1981), Pommerehne and Schneider (1983), Renaud and Van Winden (1987), Van Velthoven (1989) and Ohlsson and Vredin (1996).

8. Open Economies The literature on fiscal policies is too vast to cover here in a few paragraphs so we limit ourselves to some general points (we refer to Chapter 6080 for international taxation). The point of departure for the analysis of the impact of taxation-fiscal policy in open economies is the Mundell-Fleming model (see Kenen, 1995, and Marston, 1995, for surveys). The magnitude and size of the multipliers depend on different parameters such as the effect on domestic interest rates (the assumption about the country size and capital mobility is relevant here) and the exchange rate regime. For example, a fiscal expansion in a ‘large’ country will raise world interest rates and appreciate the exchange rate; in a ‘small’ country a depreciation can be expected since the trade effects will tend to dominate. In the limiting case of perfect capital mobility, fiscal policy will not affect income: any tendency for interest rates to rise will be matched by a currency appreciation leaving total demand unchanged. In other words, exports are completely crowded out. Textbook references are relevant here. Extensions by McKinnon (1973), Floyd (1980), Dixit (1985), Persson (1985) and Frenkel and Razin (1987) make use of an intertemporal approach covering aspects ranging from the impact of capital mobility and overlapping generations to different specific tax instruments. One general result is that deficits increase world interest rates and lower consumption but the effects depend on whether a country experiences a surplus or deficit. McKibbin and Sachs (1988) and Kole (1988) consider the importance of country size. In the traditional view financial crowding out will not occur in small open economies since, assuming fixed exchange rates, interest rates are given on the world market. Adjustments to imbalances between saving and investment occur through foreign borrowing by way of current account deficits. As a consequence, fiscal policies in all countries determine crowding out, also in countries with balanced budget. In a Ricardo world, this no longer holds. The previous results must, however, be modified when non-traded goods are introduced. Some models focus more explicitly on the dynamics and on the budget constraint of the government. Work by Frenkel and Razin (1987) and Knight and Masson (1988) demonstrates that, if bonds are net wealth, fiscal expansions will appreciate the exchange rate so as to finance the government deficit. Buiter (1987) takes the impact of interest rates on investment into account so deficits increase interest rates and as a result lower future domestic

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and foreign income. For a given level of government expenditures this constrains future taxes (see also Blanchard et al., 1990; Frisch, 1995). An interesting collection of additional work on the international aspects of fiscal policy is Frenkel (1988). The survey by Dixit (1985), although limited to tax policy in open economies, should also be mentioned. Concerning the Ricardian equivalence theorem in an open economy, (see Morris, 1988, for a discussion of the Barro-Ricardo equivalence in open economies) we recall earlier comments about the burden of external versus internal debt. Note that a huge literature exists about the international coordination of fiscal policy and about fiscal policy in a monetary union. We also stress the important literature on the Maastricht convergence criteria for the European monetary union.

9. Conclusion The macroeconomic aspects of taxation have evolved considerably over the past decades.This is linked to the changing ideas about the role of the government. In a nutshell the dominating current views hold that the government should focus on longer-term goals and be very critical about short-term intervention. Due to the difficulty in modifying tax instruments, this is especially true for taxation. This also holds for the process of shifting taxes through time by piling up debt. Such policies do, however, create uncertainty as to the type of taxes and time at which they will be collected. A modern view of the goals of government intervention will therefore be much less ambitious compared to thirty or forty years ago: the actions by the government should be as predictable as possible so as to reduce uncertainty and support the development of the private sector.

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6020 TAX EVASION AND TAX COMPLIANCE Luigi Alberto Franzoni University of Bologna, Italy © Copyright 1999 Luigi Alberto Franzoni

Abstract This chapter offers an overview of the theoretical and empirical research on tax evasion, delineating the variety of factors affecting noncompliance and examining possible remedies. Particular emphasis is placed on the institutional and procedural rules governing the tax enforcement policy. JEL classification: K34 Keywords: Tax Enforcement, Compliance, Taxpayer’s Behavior, Tax Gap

1. Introduction Tax evasion is said to occur when individuals deliberately fail to comply with their tax obligations. The resulting tax revenue loss may cause serious damage to the proper functioning of the public sector, threatening its capacity to finance its basic expenses. Although tax compliance is a major concern for all governments and analytical investigation of tax evasion can be traced as far back as the work, one of the pioneers of ‘law and economics’, Cesare Beccaria (1764), the problem was long segregated from the main body of economics and left essentially to the attention of tax authorities and jurisprudence. The modern use of economic tools for the analysis of tax compliance can be credited to Allingham and Sandmo ([1972] 1991), who extended the influential work of Becker (1968) on law enforcement to taxation using modern risk theory. In the decades since, the literature on tax evasion has blossomed (as witnessed by the voluminous bibliography enclosed). Probably no aspect of tax compliance has escaped at least preliminary scrutiny. Detailed introductions to this theme are now available, as in the monographs of Cowell (1990) (theoretically oriented) and Roth, Scholtz and Witt (1989) (an interdisciplinary perspective), and the surveys of Andreoni, Erard and Feinstein (1998) (including a thorough discussion of empirical results) and Slemrod and Yitzhaki (1998) (with large sections devoted to avoidance and administration). As a complex phenomenon, tax compliance can be addressed from a variety of perspectives. Taxpayers’ stance is influenced by many factors, including their disposition towards public institutions, the perceived fairness of the taxes, 52

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prevailing social norms, and the chances of noncompliance being detected and punished. Without questioning the relevance of ethical and sociological motivations, the economic analysis of tax compliance has focused mainly on how evasion can be deterred through detection and sanctions. The thesis is that the taxpayer’s behavior can be fruitfully seen as the result of a rational calculus, a careful assessment of the costs and benefits of evasion. Since even in the simplest tax and enforcement systems the incentives to comply are far from obvious, this economic perspective offers precious insights that can be used to derive suitable policy measures. Yet, given the complexity of the economic set-up in which the taxpayer usually makes compliance decisions, no simple policy prescription should be expected. In fact, as we will see, to date theoretical and empirical research has managed to establish very few firm points. Nevertheless, the general picture of tax compliance is much clearer now than just a few decades ago. At least the literature has shown that evasion is a serious problem, too complex to be solved by simple policy adjustments, and that the set of instruments for controlling it is vast. This chapter provides an overview of the findings of the theoretical and the empirical literature on tax evasion. Section 2 defines tax evasion, as opposed to tax avoidance and other unlawful activities. In Section 3, Allingham and Sandmo’s basic model of tax evasion is presented and discussed, with a brief review of its numerous extensions. Section 4 surveys the empirical evidence on taxpayer compliance. Section 5 deals with optimal tax enforcement policy, and investigates some possible strategies for combating evasion. Section 6 examines additional policy issues, connected with the institutional and procedural aspects of tax enforcement. Section 7 provides some concluding observations.

2. Definition and Extent of Tax Evasion By distancing effective payments from statutory taxes, tax evasion defines a specific revenue deficiency, known as the ‘tax gap’ (in the US, for example, the federal income tax gap has been estimated at 17 percent). Let us emphasize from the outset that the tax gap is not equal to the amount of additional revenue that would be collected by stricter enforcement, for perfect enforcement would significantly affect the economic scenario (some firms would go bankrupt, taxpayers would modify their labor supply, prices and incomes would change, and so on), so the tax base would surely be altered. As a result, at least in theory, net revenue could even turn out to be smaller. Thus standard measures of tax gaps must be interpreted cautiously. They are only roughly suggestive of the likely immediate effects of marginal improvements in enforcement. Also, one should be wary of the cliché that statutory taxes represent the ideal world and tax gaps an intrinsic evil. This is not only because

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taxes may not be ‘just’, but also because statutory taxes themselves are usually determined by a legislature that is perfectly aware that they will only be partially enforced and therefore differ from those that would be optimal under perfect enforcement. On closer scrutiny, therefore, estimation of the tax gap merely portrays the wedge between economic reality and a purely legal construct called ‘statutory taxes’. Reality and its legal representation may differ for any number of reasons, among which, as we shall see, the willful misrepresentation of tax liabilities is just one. In economic terms, evasion problems originate in the fact that the variables that define the tax base (incomes, sales, revenues, wealth, and so on) are often not ‘observable’. That is, an external observer cannot usually see the actual magnitude of an individual’s tax base, and hence cannot know his true tax liability. Sometimes this knowledge can be obtained by means of costly audits, in which case we say that the tax base is verifiable (at a cost). In other cases, as when it is related to cash payments, the tax base cannot be verified at all. Taxpayers can take advantage of the imperfect information about their liability and elude taxation. A related concept is tax avoidance (or reduction), by which individuals reduce their own tax in a way that may be unintended by tax legislators but is permissible by law. Avoidance is typically accomplished by structuring transactions so as to minimize tax liability. In some cases, avoidance is encouraged by legislation granting favorable tax treatment to specific activities in contrast to general taxation principles. From a legal standpoint, evasion differs from avoidance in being unlawful, and hence punishable (at least in theory). As far as economic function is concerned, however, evasion and avoidance obviously have very strong similarities; sometimes, indeed, they can hardly be distinguished (see for instance Feldman and Kay, 1981; Cowell, 1990; McBarnet, 1992). This adds to the difficulty of interpreting the real implications of the tax gap. Another problem with the measurement of tax evasion relates to its proper delimitation within the broader set of the informal economy. No taxes are generally levied on transactions in the home and criminal sectors, which are usually beyond the reach of authorities and official statistics. Hence, proper determination of the boundaries of evasion is a formidable task, in that evasion is often inextricable from other illegal and unrecorded activities. What, one might ask, is the evaded tax of a hired killer? Aggregate estimates of evasion must deal with all these problems, in addition to the classic problem of lack of direct data. Various estimation methods have been devised, some based on data collected by fiscal authorities, others - less reliable - on data derived from national accounts and surveys. Their application suggests that in the Western industrialized countries evaded

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taxes amount to between 5 percent and 25 percent of potential tax revenue, depending on the technique adopted and the country (see monographs by Feige, 1989; Pyle, 1989, and Thomas, 1992), with higher figures (up to 30-40 percent) for less-developed countries (Tanzi and Shome, 1994). As noted, one should not attach too much importance to such estimates, which essentially tell us that statutory taxes are not the whole story. What matters is effective taxation, that is, the net tax burden on individuals. This has major implications bearing on the economic consequences of evasion: the main question is not how evasion alters the shape of statutory allocation of the fiscal burden, but how it constrains the set of policies that can be implemented. When taxes can be evaded, taxation will prove to be an imperfect tool for pursuing government aims (be they redistribution, efficiency, or whatever), which will be only partly achieved. Indeed, effective taxation may turn regressive, as the more affluent usually have better opportunities to evade (or avoid) taxes. Also, evasion may be powerfully deleterious to horizontal equity, owing to unequal distribution of opportunities to evade and of the willingness to seize them. This in turn may induce production inefficiencies, because competition would be distorted by the unequal distribution of the tax burden among firms. The adverse consequences of tax evasion are sometimes exacerbated by laws, or even constitutions, drafted as if the tax base were observable, limiting the set of corrective instruments available to the government (which cannot, for instance, set tax rates according to their presumed degree of enforceability). In order to evaluate the way in which noncompliance affects the actual tax payment of individuals, one must examine taxpayers’ compliance behavior more closely. This can be done by developing a theoretical model to predict how taxpayers’ behavior is affected by the relevant variables. The following section reviews some models and assesses their fit with observed practise.

3. The Decision to Evade Compliance with the tax law typically means: (i) true reporting of the tax base, (ii) correct computation of the liability, (iii) timely filing of the return, and (iv) timely payment of the amounts due. The bulk of tax evasion involves the first point. Most evaders either do not declare their liability at all, or declare it only in part. In the following, we concentrate on the problem faced by an individual who has to decide how much of his tax aggregate to report, or whether to report it at all. The focus is on income taxes (which account for a large part of fiscal revenue in most countries). However, the insights provided can be applied to other taxes as well.

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3.1 Allingham and Sandmo A useful model of taxpayers’ evasion decision is that developed by Allingham and Sandmo ([1972] 1991) and Srinivasan (1973), and revised by Yitzhaki (1974). Evasion is viewed as a portfolio allocation problem: the taxpayer must decide what portion of his income y (postulated as exogenous) to invest in the risky activity labeled ‘tax evasion’. If the taxpayer does not want to take any risk, he reports his income in full; otherwise, he reports only a fraction of it and bears the risk of being caught and fined. The problem is thus to choose the optimal tax return, when the income reported is taxed at a fixed rate t and evasion is fined at a penalty rate f proportional to the tax evaded. The probability of an audit, that is, the probability that the true income level will be discovered, is a constant denoted by a. The taxpayer decides the amount to conceal so as to maximize his expected utility from net income. If we call yNA the net income when the evader is not audited (gross income less taxes on reported income) and yA the net income when he is audited (gross income less taxes on true income less the fine), we can write the taxpayer’s expected utility as EU(e) = (1!a) u(yNA) + a u(yA) = (1!a) u[y!t(y!e)] + a u(y!ty!fte), where e denotes the amount of income concealed. This representation yields some interesting results from the standpoint of comparative statics. On the reasonable assumption that the taxpayer is risk averse, it can be shown that the amount of tax evaded, te* , varies inversely with the audit rate a and the penalty rate f, while it depends negatively on the tax rate t and positively on income y if and only if the taxpayer’s utility function displays Decreasing Absolute Risk Aversion. Further, the proportion of tax evaded, te*/y, increases with income if and only if taxpayer’s utility function displays Decreasing Relative Risk Aversion (see Cowell, 1990). Of these results, the least obvious is surely the inverse correlation between the amount of evasion and the tax rate (with DARA). This stems from the fact that both the direct gain from evasion (taxes saved) and the expected fine depend proportionally on t. Hence, an increase in the tax rate does not induce the ‘substitution’ of the risky asset for the safe one, but operates solely through the reduction in disposable income (Yitzhaki, 1974). Once the optimal amount of underreporting, e*, has been calculated, one can easily derive the ‘evasion rent’, defined as the monetary benefit accruing to the evader (more precisely, the amount of income that he would be willing to pay to switch from a virtual system of perfect enforcement to the actual, imperfect, one): Evasion rent = [1 ! a(1 + f )]te* ! RP(e*), where RP(e*) is the risk premium associated with the audit lottery. The evasion rent is therefore equal to the net return on evasion (evaded taxes less expected sanctions) less the ‘loss’ due to the riskiness associated with random auditing

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(note, incidentally, that if taxpayers were risk-lovers, the risk premium would effectively represent a ‘gain’). Several observations are in order. First, for evasion rent to be positive, the net return on evasion has to be positive (the evasion gamble needs to be ‘better than fair’). That is, for evasion to occur at all, it is necessary that a(1 + f ) < 1; that is, the penalty and audit rates must be sufficiently low. Second, when the net return on evasion is positive, the only reason why taxpayers may not evade their whole taxes is the fear of uncertainty (the risk premium loss). Indeed, if taxpayers were infinitely averse to risk, they would report their income in full even if the net return on evasion were positive (taxpayers are hyper-pessimists and behave as if they were to be audited for sure). Finally, the risk premium produces a differential between the rent to the taxpayer and the net revenue loss to the tax authorities. Hence, it provides a monetary measure of the ‘deadweight loss’ due to the randomness of tax enforcement (Yitzhaki, 1987). 3.2 Extensions This basic model gives an account of taxpayers’ evasion decisions in a very simple set-up: taxes and penalties are proportional, the audit rate is constant, only one form of evasion is available. In addition, the taxpayer is assumed to rely on expected utility theory and to be perfectly amoral, that is, to make compliance decisions with exclusive reference to the consequences for net income. All these assumptions are open to criticism, and models based on alternative assumptions have been developed. The following touches briefly on these contributions. One standard criticism of the Allingham and Sandmo model is grounded in the belief that compliance decisions depend on moral views. This is clearly a problematic issue, one that cannot be captured by the consequentialistic set-up of standard decision theory. Bordignon (1993) makes an interesting attempt to account for non-self-motivated decisions in tax evasion. He develops a compliance model in which taxpayers are guided by suitably defined ‘Kantian principles’, which determine the amount that each taxpayer considers fair to pay. Under this assumption, it turns out that tax evasion is generally lower than under selfish behavior, that compliance depends on the level of public expenditure, and that evasion is likely to increase with tax rates. Other authors have stressed the ‘social’ factors at the basis of the taxpayers’ decision (see Roth, Scholtz and Witt, 1989, for an excellent account of the sociological research). Economists have emphasized the ‘stigma’ attached to the violation of social norms and shown that tax evasion may have strong spillover effects. Social stigma is likely to give rise to a multiplicity of possible equilibria: when most people evade, the stigma effect is small and evasion is not in fact discouraged; when few evade, the stigma effect is great and evasion is discouraged. The transition from one equilibrium to the other takes the form of a ‘noncompliance epidemic’: if, for some reason, more people start to evade,

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the stigma decreases and evasion spreads to an ever larger fraction of the population (see Benjamini and Maital, 1985; Gordon, 1989, and Myles and Naylor, 1996). Alm and McCallin (1990), Landskroner, Paroush and Swary (1990), Yaniv (1990), and Wrede (1995) have extended Allingham and Sandmo with models in which taxpayers face more complex ‘portfolio’ set-ups offering other risky activities and alternative forms of evasion. Wadhawan (1992) posits that audits detect only a fraction of taxpayers’ evasion, while Das-Gupta (1994) analyses the case in which taxpayers’ income derives from a multiplicity of transactions. Scotchmer and Slemrod (1989) and Scotchmer (1989) consider the effect of randomness in tax liability assessments. Among other things, both papers conclude that uncertainty over the true liability level or outcome of the audit increases net tax revenue, either because increased uncertainty makes evasion more costly (when taxpayers are risk averse) or because it may lead taxpayers to underreport their income and be subject to a fine (whereas overreporting only yields a rebate of the overpaid tax). Several authors have tried to extend Allingham and Sandmo’s model to include the labor supply decision, so as to endogenize taxpayers’ gross income (see, among others, Andersen, 1977; Pencavel, 1979; Isachsen and Strom, 1980; Isachsen, Samuelsen and Strom, 1985, and Cowell, 1985). The problem is that as soon as the labor decision is factored in, the simple comparative statics of Allingham and Sandmo are lost. Depending on the taxpayer’s marginal disutility from labor and her risk-attitudes, all predictions become possible. This problem is usually overcome by imposing strong restrictions on the utility function. Cowell (1985) takes a different course, assuming that decisions are made in two separate stages: first, the taxpayer decides how many hours to work; then he allocates this total labor supply between legal and illegal activities (alternatively, between reported and unreported income). On this assumption, Cowell is able to show that Allingham and Sandmo’s results carry over (with some qualifications) to the extended set-up if taxpayer’s labor supply is forward rising. Perhaps more importantly, he shows that the comparative statics results are strictly dependent on the nature of the evasion choice, as it can be tied either to the amount of income to report (for the self-employed) or to the amount of time to spend in ‘off the books’ activities (for the moonlighter). The insights drawn from analysis of income tax evasion usually apply to other forms of evasion as well. Different considerations may be relevant, however, when the taxpayer is a firm subject to indirect taxation, as the evasion decision may affect output or pricing policy (tax shifting). However, Marrelli (1984) derives a separability result for the case of a monopolist: the evasion and shifting decisions are independent of one another as long as the audit probability is constant (see also Yaniv, 1995). The same result applies to oligopolistic markets when firms compete à la Cournot (Marrelli and Martina,

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1988). Here, the amount of evasion by each firm is shown to depend, apart from the enforcement parameters, on the degree of collusion and on market shares. Gordon (1990) offers an interesting insight on sales tax evasion. He suggests that under-the-counter cash sales may serve as a means of price discrimination: cash discounts are the best pricing strategy when the demand for cash purchases is highly elastic. The author also shows that, in order to reduce cash sales, a liability on detected cash customers could be imposed, but on the condition that this is an additional liability, and not just a transfer of a part of the supplier’s existing liability onto the consumer. As is clear from the foregoing, taxpayer noncompliance decisions may be very complex and are likely to be powerfully affected by the practical framework in which decisions are made. This thesis is strongly supported by the empirical evidence, which we now briefly review.

4. Empirical Evidence on Taxpayers’ Behavior Evidence on taxpayers’ behavior is notoriously difficult to come by. Data on the extent of evasion may be confidential (not available for external analysis) or not completely reliable (such as those derived from national accounting sources). All the same, empirical studies on the determinants of taxpayers’ compliance decisions have proliferated. The most detailed are based on the American Taxpayer Compliance Measurement Program (TCMP), conducted regularly by the IRS and based on a ‘line by line’ audit of a sample of 45,000 to 55,000 tax returns. In addition to statistical estimates, major insights on the dynamics of compliance have been obtained from questionnaires and experimentation. In his pioneering analysis, Clotfelter (1983) uses TCMP data for 1969 to investigate the determinants of underreporting, which is defined as the difference between the income reported and that assessed by IRS examiners. He finds that both the marginal tax rate and after-tax income have significant effects on individual underreporting. In contrast to Allingham and Sandmo’s prediction, he finds that elasticities with respect to marginal tax rates are positive and range from 0.5 for non-farm business to 0.8 for non-business returns. In line with Allingham and Sandmo, elasticities with respect to after-tax income are positive and range from 0.3 for non-business returns to 0.65 for farm returns. Also, wages, interest and dividends are associated with better compliance and underreporting is higher for the youngest age-groups. Witte and Woodbury (1985) also analyze data from the TCMP for 1969, but focus on the effect of enforcement parameters. They find that the percentage of underreporting is related inversely to the probability of audit (with a lagged effect), and directly to the ‘opportunities’ for tax evasion (absence of withholding and information reporting) and to income, though in a decreasing

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way. Dubin and Wilde (1988) criticize Witte and Woodbury’s results and highlight the potential endogeneity of audit rates. The idea is that audit rates are decided by the IRS in view of their potential yield: a decrease in noncompliance rates reduces the net return from auditing and leads the IRS to devote less effort to auditing. Using the IRS budget per return as an instrumental variable for the audit rates, they find the audit rate to be endogenous in 5 out of 7 audit classes. They also find that audits have a deterrent effect on evasion, and that noncompliance is positively related to the unemployment rate and the nonwhite fraction of the population. Feinstein (1991) uses a sophisticated estimation technique, which allows for partial detection by IRS examiners. His results confirm the great unevenness in compliance attitudes between groups of taxpayers, with ‘own business’ and ‘farm’ filers scoring the lowest compliance rates. Using TCMP data for 1982 and 1985, Feinstein more easily disentangles the effects of marginal tax rates and gross income (taxpayers with identical incomes filing in different years face different marginal tax rates). He finds that the effect of marginal tax rates on evasion is negative and highly significant, while the effect of income is essentially zero. The former finding is consistent with Allingham and Sandmo’s predictions, while the latter is not. Another finding is that greater propensity to evade is accompanied by a higher detection rate (thanks to greater IRS examination effort). Studies based on IRS data provide a picture of the compliance phenomenon in which many factors come into play: income source, socioeconomic grouping (age, sex, location), detection probability, marginal tax rate and income level. Notably, the severity of the sanction does not seem to play a significant role (partly because in the US sanctions are rarely inflicted). Estimates based on IRS data, however, are subject to several weaknesses. First, by definition, TCMP programs relate to filers only, whereas in 1976, for example, strategic non-filers accounted for an estimated 36 percent of all unreported income. In addition, it is well known that IRS examiners have only limited capacity to detect evasion, especially on income from moonlighting and cash-only businesses. Finally, strong assumptions underlie the choice of instruments and variables as exogenous regressors. Another important source of information about taxpayers’ attitudes is surveys. Much work has been done in this area, and results cannot be easily generalized (see, among others, Vogel, 1974; Spicer and Lundstedt, 1976; Lewis, 1979; Westat, 1980; Scott and Grasmick, 1981; Mason and Calvin, 1984; Yankelovich, Skelly and White, 1984; Kinsey, 1992; Sheffrin and Triest, 1992; and de Juan, Lasheras and Mayo, 1994). On the whole, though, these studies would support the deterrence hypothesis. Specifically, the following factors have been found to be significant determinants of tax compliance: (1) the perceived probability of detection; (2) the severity of informal sanctions; (3) moral beliefs about tax compliance; (4) experience with other noncompliers and

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past experience with IRS enforcement (both encouraging evasion), and, (5) demographic characteristics (older people seem to be more compliant) (Klepper and Nagin, 1989). These results are largely concordant with those based on TCMP data. The main additional insight they provide lies in the importance of sociological factors, which can hardly be detected by other means. Survey studies face several problems, however. First, results depend crucially on the representativeness of the sample, which is often difficult to assess. Second, respondents are reluctant to report acts of noncompliance (see, for instance, Elffers, Weigel and Hessing, 1987). Third, causal relationships are difficult to establish. The finding that respondents who perceive the highest probability of detection are most compliant, for instance, is consistent both with the standard ‘deterrence hypothesis’ and with the ‘experiential hypothesis’ whereby taxpayers initially overestimate detection probabilities and evaders later lower their estimates if they are not detected (Saltzman et al., 1982). Finally, individuals often seek to provide a consistent image of themselves, offering ad hoc rationalizations for their behavior (Elffers, Weigel and Hessing, 1987). A third, increasingly widespread empirical approach is based on ‘laboratory’ experiments (see, for instance, Baldry, 1987); Webley et al., 1991; Alm, Cronshaw and McKee, 1993; Alm, Jackson, and McKee, 1993; and Alm, Sanchez and de Juan, 1995). Individuals (often students) are asked to participate in games simulating tax compliance, where they can underreport and incur the risk of a penalty. At the end, they receive a real reward proportional to their laboratory performance. The results tend to be very sensitive to the particular design of the experiment. In general, this research suggest that audit rates may play an important role in compliance decisions (especially for those who have already been audited), and that compliance is an increasing function of income and a decreasing function of the tax rate, while it is hardly affected by the size of fines (unless the audit rate is very high). These experiments also suggest that social norms and ethical attitudes play an important part in evasion choices, that individuals often take an all-or-nothing stance, that they tend to overweight low probabilities, and that the structure of the taxes is important (Baldry, 1987). While the empirical research is far from conclusive, it does appear to support the hypothesis that expected punishment (that is, the size of sanctions discounted by the probability of incurring them) is relevant. Sociological and ethical factors surely play an important role too, although their effect is subtler and harder to measure. This suggests that standard enforcement polices based on apprehension and punishment should not be abandoned. They could be supplemented by alternative approaches, seeking to appeal to taxpayers’ moral conscience or to reinforce social cohesion. The following section treats the question of optimal design of tax enforcement policy, focusing on detection and punishment of evaders.

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5. Evasion and Enforcement Let us go back to the model of Allingham and Sandmo. While it provides a fairly sophisticated description of taxpayers’ evasion decisions, it leaves very little scope for enforcement policy. The latter is essentially reduced to two parameters: the penalty rate and the audit rate. The main policy prescription implicit in the model and most of its variants is that, in order to curb evasion, audits have to be stepped up and fines increased. And given that raising the audit rate is likely to require public resources while an increase in the penalty rate is not, the end result is likely to be one with Draconian but rare punishment, a rule such as ‘hang evaders with probability (close to) zero’. This is a difficult prescription to elude. But in fact it is not clear whether curbing or eliminating evasion is always a desirable goal. In general terms, the desirability of perfect enforcement is tied to the ‘goodness’ of the tax to be enforced. For instance, when perfect enforcement of income tax would result in the collapse of the taxed activity, one may well ask whether such unbearable burden represents the right policy. Even if perfect enforcement were theoretically beneficial, however, it would not be likely to be cost free, as suggested by the Draconian rule. For instance, when adjudication is not perfect and innocent individuals can be convicted, infinite sanctions may entail very high welfare costs. Also, when individuals may engage in activities to avoid conviction, the social cost of enforcement may increase with the penalty (Malik, 1990)). From a practical point of view, the major impediment to infinite fines derives from taxpayers’ limited wealth. Since convicted evaders cannot be forced to labor, they will be able to foot a penalty at most as great as their own wealth. The Draconian rule thus needs to be rephrased as follows: when strict enforcement is desirable, the optimal penalty is that which expropriates the taxpayer of all his wealth. Enforcement policies, however, can be much more sophisticated than the combination of two variables, the penalty and the audit rate. The audit probability itself, for instance, need not be the same for all taxpayers. Indeed, a simple way of making audit strategy more effective is to base it on information specific to the taxpayer, which may include any observable characteristic correlated with real tax liability, from compliance records to consumption patterns. Clearly, the relation of an individual’s reported tax liability to the average for similar taxpayers may then become the key to singling out candidates for auditing. In an important article, Reinganum and Wilde (1985) prove that by making audits conditional on the level of reported liability, the enforcer can increase net revenue. They analyze a simple cut-off rule, whereby an audit is triggered if and only if reported income is ‘too low’. They show that this rule dominates the

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random audit rule considered by Allingham and Sandmo, and that it is the most economical way to foster truthful reporting when taxpayers are risk neutral and taxes and fines are lump sum. Scotchmer (1987) and Sanchez and Sobel (1993) extend this result, proving that the cut-off audit rule is the optimal policy for a net revenue-maximizing enforcer when taxes and fines are proportional and taxpayers are risk-neutral. These findings prompt the following observations. First, cost-efficient enforcement requires that audits be used primarily as a deterrent rather than as a means to collect fines. Their function is to foster correct self-reporting by individuals. Indeed, under the optimal policy audits will be performed only on people who are found (ex-post) to be honest - hence no fines will ever be collected. Second, the optimal cut-off level is strictly dependent on the distribution of income among the population: effective auditing requires reliable information on taxpayers’ expected liability. Finally, optimal enforcement is likely to induce a strong regressive bias, as it provides high-income taxpayers with better chances to evade than low-income taxpayers. The idea is that high-income individuals have greater opportunities to misreport, and since it is more costly to dissuade them from evading, one should let them off the hook (on this, see also Scotchmer, 1992). This problem may be alleviated by shaping audit policy according to indexes correlated with true income (Scotchmer, 1987) and, to a lesser extent, by suitably adjusting the tax rate (Cremer, Marchand and Pestieau, 1990). These considerations indicate that simple models in the Allingham and Sandmo mold are not adequate to the problematic issues underlying the design of an effective enforcement policy. The matter becomes still more complex when one considers the interrelation between optimal enforcement and optimal taxation. Border and Sobel (1987), Mookherjee and Png (1989), Marhuenda and Ortuno-Ortin (1994), Hindriks (1994), and Chander and Wilde (1998) address the simultaneous definition of the optimal audit and tax schedules, assuming that taxpayers are subject to limited liability and risk neutral, and that the enforcer seeks to maximize net tax revenue. The main finding of this literature is that, at the optimum, effective taxation is regressive and the audit function is non-increasing in reported income. Hence, the repercussions of noncompliance for effective taxation indicated by Scotchmer (1987) and Sanchez and Sobel (1993) carry over to this more general set-up. An interesting insight (Border and Sobel, 1987) is that when sanctions are upper-bounded and taxpayers are risk neutral, it is optimal to audit taxpayers with a very small probability and to provide infinite rewards for truthful reporting. The so-called ‘principal-agent’ approach to enforcement discussed in the foregoing paragraphs constitutes one of the most general frameworks for analyzing tax evasion and its relation to public policy. The main pitfall is its extremely demanding assumptions concerning the enforcer’s ability to devise

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and execute the optimal policy. Indeed, one may argue that actual tax enforcers do not always possess the features that would qualify them as ‘rational’. Like other branches of the public administration, they often have conflicting or ill-defined incentives, they may be governed by ‘process’- rather than ‘outcome’-oriented rules, and they are likely to have short-sighted and perhaps multiple goals. This suggests that the enforcer may tend to act myopically and just ‘react’ to impulses from the economic system. Thus the enforcer may decide auditing policy taking the amount of evasion in the economy as given and aiming to maximize detection, disregarding deterrence. This view, based on the assumption that the tax enforcer cannot credibly precommit to any specific auditing policy, is forcefully advanced by Graetz, Reinganum and Wilde (1986) and Reinganum and Wilde (1991). Their argument is that since actual audit rates are not observed by taxpayers, the enforcer has an incentive to relax any announced auditing policy once taxpayers have reported their incomes, that is, after the policy has performed its deterrent effect. Since taxpayers will anticipate the enforcer’s ex-post deviation, they will not rely on the announced policy and will engage in greater evasion. The bottom line is that, in equilibrium, audits will be performed on likely evaders rather than on compliant (that is, deterred) taxpayers. This would appear to be a most reasonable prediction, and it tallies with actual enforcement practices. The comparative statics of the no-commitment model differ in nature from those of commitment models. With no-commitment, the evasion rate and the audit rate are determined simultaneously, whereas under commitment the audit rate determines the evasion rate. Consider, for instance, the effect of an increase in the audit cost. In the no-commitment model, evaders will evade more because they know that, ceteris paribus, the enforcer will react less harshly (due to the higher enforcement costs). The higher evasion rate, however, rises the net return from auditing and restores the enforcer’s incentive to exert effort. In equilibrium, the evasion rate will increase and the audit rate will not decrease. In the models with commitment, an increase in the audit cost means that audits become a more expensive deterrent tool. The enforcer will hence use them more parsimoniously and evasion rate will increase. In contrast to the no-commitment model, the equilibrium audit rate will decrease. The two types of model provide different insights on tax enforcement. ‘Principal-agent’ models (with commitment) are probably best used to define the constraints that tax evasion puts on the effective tax system. They neatly define the set of implementable allocations on the assumption that the enforcer performs at maximum capacity. The ‘no-commitment’ approach, with a lower profile, aims at capturing a version of tax enforcement closer to actual practice. On the whole, however, these models still provide a very ‘stylized’ view of enforcement practice. They focus on just two enforcement tools, that is, the

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penalty and the audit probabilities, and ignore most of the institutional features of real enforcement.

6. Procedures and Institutions It is clear by now that real compliance decisions are much more complex than those depicted by standard economic models, in that taxpayers are subject to a wide variety of sociological and ethical factors. Nor is even the effect of enforcement policy itself fully captured by standard models. Real enforcement is unquestionably more than a mere combination of penalty and audit probabilities (regardless of how sophisticated these can be made). The process that leads from the checking of tax returns to the conviction of evaders is lengthy and complex, perhaps involving various bodies (tax administration, tax courts) and procedures (interviews, cross-examinations, settlements, and so on). The shape of the prosecution process affects taxpayers’ attitudes towards compliance in two ways. First, it determines the actual probability that a sanction will be imposed on evaders and, possibly, innocent taxpayers; and second, it may affect the degree of ‘hostility’ in the taxpayer’s perception of the tax system. In a word, institutional and procedural features matter. They impose costs on taxpayers and affect the outcome of the prosecution process. We will touch briefly on some of these aspects, starting with the costs. According to a number of studies, the cost to the taxpayer of compliance with the most common taxes (income and VAT) in industrialized countries can be as high as 10-13 percent of the total tax liability (see the pioneering contribution of Sandford, 1973, as well as Sanford et al., 1981; Slemrod, 1989; Pitt and Slemrod ,1989; Sandford, Goodwin, and Hardwick, 1989; Blumenthal and Slemrod, 1992, and Sandford, 1995a). High compliance costs, which may be due to complex tax schedules and rules, not only tilt the ‘cost-benefit analysis’ towards evasion, but may also generate resentment, weakening taxpayers’ moral conscience or even prompting them to evade as a form of ‘punishment’ for the tax administration. Legislatures should accordingly avoid the vicious circle of countering evasion by increasing the complexity of tax regulations, which raises compliance costs and fosters further evasion. When the tax legislation is very complex, taxpayers usually have to turn to tax experts (CPAs or tax preparers), who have great power to influence their clients’ attitudes towards evasion, thanks to their superior knowledge of enforcement patterns. An interesting empirical study by Klepper and Nagin (1989b) on the United States suggests that tax preparers encourage compliance with regard to unequivocal items, and discourage it with regard to ambiguous ones. (Other investigations of this issue can be found in Scotchmer, 1989; Reinganum and Wilde, 1991; Erard, 1993, and Franzoni, 1998a.)

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Costs are also entailed in mandatory record-keeping and reporting, whose role is to increase the visibility of offenses, that is, the ‘frequency and ease with which they come to the attention of and can be proved by enforcement officials’ (Kagan, 1989). As noted in Section 3, noncompliance varies greatly with economic grouping, as tax violation by different groups has different degrees of ‘visibility’. Unsurprisingly, therefore, evasion is apparently most common among independent contractors, professionals, and farmers. Conversely, compliance is highest among payroll employees subject to withholding. In a technical sense, higher visibility makes it easier both to ‘observe’ the real situation or behavior of the taxpayer (by signaling potential violations) and to ‘verify’ it (prove it in court). Some forms of mandatory record-keeping, for example, serve a legal evidentiary function, implying a de facto shift in the burden of proof. It is the taxpayer who has to prove his compliance with the law, and bear the costs thereof. The question of the optimal amount of compliance duties to impose on taxpayers is therefore bound up with the optimal allocation of the burden of proof. Generally, the efficient allocation is that which places the onus of the proof on the party for which it is least costly (given its level of informativeness). Another important factor in the ‘visibility’ of tax law violations is the standard of proof. Indeed, the difference between the ‘observability’ and the ‘verifiability’ of the tax base is precisely defined by the type of evidence that is necessary to asses it legally (and possibly prove that the original payments were not correct). In most countries, tax authorities have the power to estimate taxpayer’s liability by discretionary means when the information supplied by the taxpayer is deemed insufficient or clearly incorrect (OECD, 1990). Clearly, under these circumstances the standard of proof can be rather lax, and the use of mere statistical evidence can be used to prove taxpayers’ obligations. Presumptive taxation is a case in which statistical estimates and proxies are used ab origine to define the tax obligation, resulting in the automatic visibility of the activities covered and imposing virtually no compliance costs on taxpayers (see Tanzi, 1991). Note that simplifications and reductions in compliance costs will ordinarily be achieved only at the expense of reduced ability to discriminate among taxpayers (for purposes of either vertical or horizontal equity). As is pointed out by Kaplow (1996), a trade-off is likely to arise between containing compliance costs and accuracy in liability assessment. On the procedural side, another important consideration is the possibility of resolving disputes through amicable settlements between taxpayers and the administration. In most countries, taxpayers can make a ‘deal’ with inspectors and obtain substantial penalty discounts in exchange for collaboration (OECD, 1990). When deals are left to the discretion of the revenue service, enforcement is likely to be adversely affected. Discretionary deals not only reduce the administration’s ability to precommit itself to any specific enforcement policy

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but may also foster opportunism, tempting the administration to increase its inefficiencies (for example, lengthy and invasive prosecution procedures) so as to increase its ‘take’ at the settlement stage (Franzoni, 1995). Tax amnesties, though sharing some of these problems, may prove desirable, as they offer taxpayers social insurance against unexpected shocks, allowing them to complete their payments after uncertainty (about their income or their true preferences) has been resolved (Andreoni, 1991; Malik and Schwab, 1991). A fundamental problem in considering the optimal institutional design of tax enforcement relates to incentives for enforcers. More fundamentally, the question is whether enforcement should be the job of public or private agents. First raised in general terms by Becker and Stigler (1974), the issue has been examined in the specific context of tax evasion by several authors. While in most countries taxes are collected by a public agency, in a few cases (as with import duties in Indonesia) collection is delegated to private contractors. Melumad and Mookherjee (1989) show that delegation of tax enforcement to a private party may be viable (that is, it can replicate the full-commitment solution) if it is backed by an incentive scheme based on publicly observable aggregate variables (audit expenditure, taxes filed and fines collected). This scheme rewards the agent for collecting fines, or, when no fine is collected, for meeting the target audit budget. Toma and Toma (1992) observe that different institutional arrangements may entail different agency costs so that depending on their incidence either public or private enforcement may be desirable. A key agency cost is that associated with the danger of corruption. Since the personal aim of enforcement officers may not correspond to institutional purposes, there is scope for collusion with taxpayers. This seriously complicates the analysis, as a third constraint (no collusion) must now be taken into account. For while it may be contended that combating corruption can help control tax evasion, it may well be that anti-evasion measures as such ultimately just increase the scope and the extent of corruption (see Chu, 1990a; Chander and Wilde, 1992a; Besley and McLaren, 1993; Mookherjee and Png, 1995; Flatters and McLoad, 1995; Hindriks, Keen and Muthoo, 1996). This confirms that the institutional features of the enforcement system represent a point of fundamental importance. These features define the incentive structure governing the conduct of enforcers and crucially affect the actual functioning of all enforcement tools.

7. Conclusions The foregoing offers an analytical framework for treating some salient aspects of tax noncompliance, suggesting causes and possible remedies. As must be clear by now, tax evasion is a complex phenomenon that cannot be eradicated by marginal changes in enforcement practice. Social and moral attitudes, which

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play a very important role, are very slow to change and are often beyond the reach of public policy. Standard enforcement therefore remains crucial. The empirical evidence suggests that a stricter enforcement regime is likely to induce greater compliance; the key variable here is the probability of detection. To date, most studies in this field have focused on two enforcement tools: penalty rates and auditing probabilities. Much work remains to be done to ascertain the impact on compliance of less striking but nonetheless important procedural and institutional factors. Actually, closer examination of institutional reality suggests that the audit rate may not be the relevant variable. What really matters is the probability that an investigation will eventually result in conviction and sanction for the wrongdoer. Here a host of additional factors come into play: whether evasion leaves detectable traces, the specific ability and expertise of the auditors, the set of investigative tools at their disposal (for example, the degree of banking secrecy), the possibility of inducing taxpayer collaboration, the feasibility of out-of-court settlements, the standard of proof, the definition of ‘fault’, the clarity of the tax law, the number of levels of appeal, and so on. Research into the impact that these procedural aspects have on taxpayer compliance is still in its infancy. Better integration of the research on tax evasion with the ‘law and economics’ analysis of legal rules is definitely desirable. As theoretical analysis proceeds, additional empirical work will be needed together with more extensive study of comparative tax enforcement law and procedure.

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6030 PROPERTY TAXES David L. Cameron Professor of Law, Willamette University, College of Law © Copyright 1999 David L. Cameron

Abstract The consideration of property taxation has long been a part of the development of economic analysis beginning with the French Physciocrats, through Ricardo, and then George. As a result, the economic literature concerning property taxation is vast. This chapter surveys an important slice of that literature which considers the incidence of property taxes. Over the past thirty years, three theories have been proposed to describe the economic effect of property taxes. The ‘Traditional View’ suggests that, because of the fixed supply of land, taxes on land will be borne by the owners or renters of land. The ‘New View,’ however, concludes that a tax on land is largely equivalent to a general tax on all capital. Finally, the ‘Benefit View’ suggests that property taxes are appropriately viewed, not as a tax, but as an efficient user charge for local public services. Empirical study to date has not determined whether the new view or the benefit view is the more appropriate model of property taxation. JEL classification: H2, H22, K3, K34 Keywords: Property Taxation, Economic Rent, User Fee, Fiscal Zoning

1. Introduction Property taxes are typically defined to encompass those taxes levied on both real and personal property that are dependent on the value of the property itself. Generally, a property tax is administered through the use of a uniform tax rate imposed on the assessed value of the property subject to tax. Within a given jurisdiction, the tax rates frequently vary depending on the type or class of property being taxed. More importantly perhaps for comparative purposes, property tax systems vary significantly across jurisdictions with respect to the types of property that comprise the tax base as well as the exclusions for specific types of property, the assessment techniques used to determine the value of the property subject to the tax, and the tax rates applicable to the various classes of property. Within the United States, the property tax is the principal source of revenue for county and municipal governments. The economic literature that considers the law of property taxation is extremely broad in scope. Economists have developed various theories 95

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concerning the incidence of property taxes and have conducted empirical studies to test those theories. The study of property taxation is closely tied to the study of the provision of public goods as any general equilibrium analysis of property taxation must consider the public benefits provided through a system of property taxation. The following discussion will consider the three principal models of the incidence of property taxes, and in particular the taxation of land, that form the basis for the examination of property taxes from an economic perspective. These economic models of property taxation have also served as the basis for public policy proposals under which differential property tax rates or assessment procedures could be used to protect agricultural lands or encourage development in urban areas. Economists have also examined the administration of property tax systems, including the proper assessment procedures for the valuation of property for tax purposes.

A. Conceptual History of the Property Tax 2. Survey As described by Winfrey (1973), as well as Buchanan and Flowers (1975), property taxes were one of the earliest forms of taxation to be considered from an economic perspective. Beginning with the French Physiocrats of the mid-eighteenth century, including Francois Quesnay their leader, early economists concluded that property, and more specifically land, was the only logical base for taxation. The Physiocrats viewed agricultural land as the only ‘productive’ sector of the economy, producing a surplus over the real costs of production. All other sectors of the economy simply provided services or transformed goods from one form to another. The English classical economist David Ricardo also maintained that land was the appropriate factor of production to be taxed. According to Ricardo, increases in population increased the demand for agricultural goods, thus causing more marginal lands to be brought into use. Because greater labor was necessary to make these more marginal lands productive, Ricardo reasoned that these greater costs would be reflected in higher prices for agricultural goods. These higher prices, in turn, increased the return to the owners of the more productive land who did not confront the greater costs of production applicable to the more marginal lands. According to Ricardo, this increased return or ‘rent’ represented ‘the original and indestructible powers of the soil’. Ricardo maintained that this ‘surplus’ should be taxed as it did not represent a real cost of production. The views of the Physciocrats and Ricardo served as the basis for the single tax movement which gained strong support in the United States at the end of the nineteenth century under Henry George. George (1879) maintained that the

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return on land represented an economic rent that could be taxed away without distorting the allocation of resources that would otherwise result in the absence of the tax. In today’s terminology, an economic rent is defined as the return to any factor of production in excess of that which the factor could receive in its next best employment. Thus, the taxing of only the economic rent attributable to any particular factor will not result in the transfer of that factor from its current use to an alternative use. In addition, the Georgists maintained that any increase in the value of land resulting from growth in the economy was viewed as a surplus created by society that could rightfully be taxed. As stated by George: Taxes levied upon the value of land cannot check production in the slightest degree, until they exceed rent, or the value of land taken annually, for unlike taxes upon commodities, or exchange, or capital, or any of the tools or processes of production, they do not bear upon production. The value of land does not express the reward of production, as does the value of crops, of cattle, of buildings, or of any of the things which are styled personal property or improvements. It expresses the exchange value of a monopoly. It is not in any case the creation of the individual who owns the land; it is created by the growth of the community. Hence the community can take it all without in any way lessening the incentive to improvement or in the slightest degree lessening the production of wealth. Taxes may be imposed upon the value of land until all rent is taken by the State, without reducing the wages of labor or the reward of capital one iota; without increasing the price of a single commodity, or making production in any way more difficult. (George, 1879, p. 413)

George’s claim that a tax on the value of land is nondistortionary has been supported by modern commentators such as Wildasin (1982), Vickrey (1970), and Tideman (1982) provided the tax is imposed on pure land rentals, defined as the value of the land independent of anything that might be done with the land, and not, as Bentick (1982) and Mills (1981) point out, on the current market value of land which reflects present and future uses of the land. Unfortunately, the Physciocrats, Ricardo, and George all failed to recognize that rents may be attributable to all factors of production. Under a marginal analysis, each factor of production - labor and capital, as well as land - will receive the value of its marginal product in a competitive economy. Land alone cannot be viewed as receiving the residual value of all production. As noted by Fischel (1985, pp. 16-17), ‘the only economic difference between land and the other factors of production is that [land] is fixed in supply by virtue of its immobility’. As discussed below, this characteristic - the fixed supply of land as a result of its immobility - remains important in understanding the economic effects of property taxation.

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In the United States, the use of property taxation is largely limited to state and local jurisdictions. In addition, revenues collected through the imposition of property taxes on personal property has declined in relation to the imposition of property taxes on real property (Netzer, 1966). Although George’s single tax movement was never fully implemented, principally because of administrative difficulties (Holland, 1970), it remains visible in those property tax regimes under which land is more heavily taxed than other forms of property (Oates and Schwab, 1997).

B. The Modern Theoretical Framework 3. Overview Economists have developed three principal theories under which the incidence of property taxation has been considered. Importantly, each theory distinguishes between taxes on land and taxes on capital. The observation that a property tax may have a differential effect on land as opposed to other forms of capital results from the difference in elasticity of the supply of each item. Based on the assumption that the supply of land subject to taxation in a given jurisdiction is fixed, the ‘Traditional View’ suggests that taxes on land will be borne by the users of land, that is, the owners or renters of the land (Netzer, 1966). The ‘New View,’ however, concludes that a local tax on land can be broken into two components, a ‘profits tax’ and an ‘excise tax’ (Mieszkowski, 1972b; Aaron 1975). Because the profits tax component is equivalent to a general tax on all capital, that portion of any property tax will fall on the owners of all capital. Finally, the ‘Benefit View’ suggests that property taxes are appropriately viewed as a user charge for local public services (Hamilton, 1975b, 1976b; Fischel, 1985, 1992). Because consumers of public services are mobile, the benefits view suggests that a property tax is in many situations is an efficient financing mechanism for public services.

4. The Traditional View The traditional view of property taxes was originally articulated by Simon (1943) and Netzer (1966). The traditional view adopts a partial-equilibrium approach under which property taxes are considered as separate payments for capital and land. The supply of capital is considered to be perfectly elastic, and the supply of land is considered to be perfectly inelastic. As shown in Figure 1, the return to owners of capital is at a nationally determined rental rate for capital (Rn). If a jurisdiction enacts an ad valorem property tax (t) on capital,

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the price of capital will rise to Rn (1 + t) in order to maintain an after-tax return on capital of Rn and the amount of capital in the jurisdiction will fall from C0 to C1. This effect can be modeled as a decline in the demand for capital from D to D'. This effect will also occur if the jurisdiction enacts an increase in the rate of an existing property tax.

If the ad valorem property tax is also imposed on the jurisdiction’s perfectly inelastic supply of land, the result is the perfect capitalization of the tax in the return of the land. As shown in Figure 2, the return on the land will fall from Rn to Rn (1- t). Nevertheless, because the supply of land in the jurisdiction is fixed, the tax has no effect on the quantity of land but results only in a reduction in the price of land.

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The traditional view has been employed to conclude that the imposition of a property tax on residential land is regressive in nature. This conclusion is based on the assumption that the proportion of income spent on housing falls as income rises. Based on the traditional view, Netzer (1966), however, concluded that, in the aggregate, the property tax was more nearly proportional than regressive. Nevertheless, with respect to housing, Netzer recognized that the property tax was regressive based on empirical studies available at that time. Netzer (1973) later cautioned that studies concluding that the property tax was regressive in nature were biased because they typically adopted current income rather than normal or permanent income. He hypothesized that the regressive aspects of the property tax would be diminished if the studies, like consumers themselves when making housing decisions, considered income prospects over periods longer than a single year.

5. The New View The new view of property taxation was originally developed by Thomson (1965), Mieszkowski (1972b) and Aaron (1975) and reformulated byMieszkowski and Zodrow (1986). The new view adopts a general equilibrium analysis for all jurisdictions in a country, and assumes that both the capital in the country and the land in any one jurisdiction are fixed.

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As described by Wassmer (1993), the analysis underlying the new view is often simplified by assuming that only three types of jurisdictions exist which differ in the demand for local services - low, medium, and high. In the short run, property, which is made up of capital as well as land, is considered fixed in each jurisdiction at P0. Prior to the introduction of the tax, the return on capital is at a nationally determined rate, Rn. Following the introduction of the tax, the return on capital declines by the amount of the tax in the same manner as that described under the traditional view for land alone. The decline will be greatest in the jurisdiction for which the demand for services is highest as greater revenues are necessary to provide the services demanded. As shown in Figure 3, the return declines to Rh1 in the high demand jurisdiction, Rm1 in the medium demand jurisdiction, and Rl1 in the low demand jurisdiction. The decline in the return on property in the medium-demand type jurisdiction from Rn to Rm1 has been referred to as the ‘profits tax’ effect, a decline in the market value of property across all jurisdictions by the average rate of taxation. (Zodrow and Mieszkowski, 1989). The profits tax effect is exacerbated in the high-demand type jurisdiction by a negative ‘excise tax’ effect equal to the difference between Rh1 and Rm1 resulting from a higher tax rate in the high-demand type jurisdiction as compared to the medium-demand type. The profits tax effect is partially offset, however, in the low-demand type jurisdiction by a positive excise tax effect equal to the difference between R11 and Rm1 resulting from a lower tax rate in the low-demand type jurisdiction as compared to the medium-demand type jurisdiction. Because the relative return on property among the three types of jurisdictions differ and because capital is assumed to be perfectly mobile in the long run, capital will exit the high-demand type jurisdiction where the return on property is the lowest, decreasing the supply of property in that jurisdiction from P0 to P1. This capital will enter the low-demand type jurisdiction where the return on property is the highest, increasing the supply of property in that jurisdiction from P0 to P1. The decrease in the supply of property in the high-demand type jurisdiction will increase the return on property from Rh1 to Rh2. The increase in the supply of property in the low-demand type jurisdiction will decrease the return on property from Rl1 to Rl2. Equilibrium will be achieved when the after-tax return on property is equalized across all three types of jurisdictions at Rh2, Rm1, and Rl2. Importantly, however, the excise tax effects of the property tax, as described above, will result in distortionary effects in the high- and low-demand type jurisdictions.

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Figure 3

As shown in Figure 3, the rental rates paid for property in the three types of jurisdictions differ. The rental rate in the high-demand type jurisdiction, Rh3, exceeds the rental rate in the medium-demand type jurisdiction, Rn, which, in turn, exceeds the rental rate in the low-demand type jurisdiction, Rl3. To the extent that the higher rental rates in high-demand type jurisdictions are not offset by increased utility from higher service levels, individuals may move from high-demand type jurisdictions to medium- or low-demand type jurisdictions. Conversely, to the extent that higher rental rates are offset by increased utility from higher service levels, individuals may move from low-demand type jurisdictions to medium- or high-demand type jurisdictions. Such a movement would cause rental rates across all three types of jurisdictions to converge but, unless individuals are assumed to be perfectly mobile, rent differentials will persist. Unlike the traditional view, the incidence of the property tax under the new view is generally seen as progressive. This is because the property tax results principally in a decline in the return on capital by the ‘average’ rate of taxation in the nation. Because capital is disproportionately held by those with higher incomes, Mieszkowski and Zodrow (1989) conclude that the profits tax portion of any property tax under the new view is ‘highly progressive’.

6. The Benefit View The benefit view, which extends the analysis of the new view, includes within its analysis the benefits conferred on property owners through property taxes. As developed by Hamilton (1975b, 1976b), the benefit view adopts the assumptions underlying the new view but also assumes the perfect mobility of

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individual consumers and the ability of jurisdictions to engage in fiscal zoning. If the provision of public services is viewed as a public good, the new view suggests that incentives exist to utilize land in a high-demand type jurisdiction in such a manner that the benefit of public services exceeds the burden of the property tax. The benefit view assumes that jurisdictions will engage in fiscal zoning under which the value of the housing units permitted within the jurisdiction will be restricted to some minimum value, typically through the use of the jurisdiction’s zoning authority or through some other power to control land uses and intensities. At this minimum value, the revenues generated through the property tax will exactly offset the value of the public services obtained. The benefit view, thus, follows a Tiebout (1956) model under which the property tax becomes a head tax or nondistortionary user charge for public services. Assuming a sufficiently large number of jurisdictions within a larger metropolitan region offering a diversity of public services and assuming further the mobility of consumers for those services, the property tax represents an efficient means of financing the provision of public services. Importantly, the benefit view does not require that any particular jurisdiction be homogenous with respect to residential values. Hamilton (1976b) demonstrated that, in heterogenous communities, differentials between benefits received through public services and taxes paid will be capitalized into the price of the property. Fischel (1975) and White (1975a) have extended the benefit view to the taxation of commercial and industrial property. Viewing the property tax as a head tax or a user charge for the provision of public services under the benefit view, the concerns involving the progressivity or regressivity of the property tax under the traditional and new views do not arise based on the relationship between the property tax and the provision of public goods and services and the assumption of consumer mobility.

7. Evidence Concerning the Validity of the Alternative Theories Commentary and empirical studies concerning the validity of the traditional, new, and benefit views have reached no definitive results. For example, Netzer (1973), a proponent of the traditional view, suggests that the lack of uniformity of the property tax, at least on a national level in the United States, means that it is not even ‘sensible’ to speak of a partial tax on capital (such as a property tax in only one jurisdiction) in terms of a tax that lowers the average rate of return on all capital as proposed under the new view. This observation is disputed by Mieszkowski and Zodrow (1989) who suggest that the work of Lin (1986) concludes otherwise. The proponents of the new view have suggested, in turn, that little evidence exists to support the view that jurisdictions engage in perfect fiscal zoning or that any benefit or burden differentials are perfectly capitalized into the value

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of property as required by the benefit view. Nevertheless, Fischel (1985, 1992) suggests that the multi-dimensional land use restrictions available to communities under typical zoning enabling acts can be effective mechanisms to engage in fiscal zoning. In addition, Fischel (1992) maintains that the widespread use of exactions or impact fees may directly substitute for expenditures otherwise financed by property taxes. The existence and relative importance of exactions and impact fees are typically overlooked in studies of the property tax itself. Fischel (1989) also maintains that the benefit view is supported by voter hostility towards property taxation when the level of benefits typically paid for through the imposition of property taxes, such as expenditures for education, are no longer related to the property taxes paid. Fischel suggests that the overwhelming voter support for property tax reduction in California in 1978 under Proposition 13 was the result of the California Supreme Court’s 1976 decision in Serrano v. Priest (135 Cal. Rptr. 345) requiring stringent equality in spending per pupil across California school districts. Empirical studies of various types have not succeeded in fully determining whether the new view or the benefit view provides the more valid description of the property tax. As summarized by Mieszkowski and Zodrow (1989), the majority of empirical studies have focused on the extent to which property taxes and local government expenditures are capitalized into property values. These studies by Oates (1969), Edel and Sclar (1974), and Hamilton (1976b, 1983) as well as others indicate that property taxes and government expenditures are capitalized into property values. This observation does not confirm the benefit view, however, because the new view also implies some capitalization. The existence of capitalization of benefits, such as school quality, further supports the benefits view (Gurwitz, 1980; Hoxby, 1997). Responding to the suggestion of Mieszkowski and Zodrow (1989, p. 1131), Wassmer (1993), Carroll and Yinger (1994) and Man (1995) conducted studies considering changes in the aggregate value of the property tax base and intermetropolitan rent differentials. The results of these studies support the new view’s conception of the property tax as, at least in part, a distortionary tax on capital. Wildasin (1986a) has suggested that neither the new view nor the benefit view may be entirely correct, however, and that, because of imperfect fiscal zoning and imperfect capitalization, the property tax may best be considered as a combination of a capital tax and user charge. Despite the fact that the benefit view has not been entirely validated based on empirical study, it has focused inquiry on the question whether property taxation can be properly analyzed in isolation from the public goods and services that it finances. This aspect of the benefits view, in turn, has spurred more recent research into the political behavior of local governments, particularly in the area of tax competition as governments compete for capital through adjustments in property tax rates (Coates, 1993; Edwards and Keen, 1996; Nechyba, 1997).

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6040 CONSUMPTION TAX, VALUE ADDED TAX, EXCISE TAX AND SALES TAX © Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest

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6050 PERSONAL INCOME TAXATION Yoshihiro Masui Associate Professor Graduate School of Law and Politics, The University of Tokyo

Minoru Nakazato Professor Graduate School of Law and Politics, The University of Tokyo © Copyright 1999 Minoru Nakazato and Yoshihiro Masui

Abstract This survey traces the literature on the three fundamental components of personal income taxation: base, unit and rates. It first discusses the debates between income tax base and consumption tax base in a chronological order, starting from Simons, and continuing up until the law and economics literature in the 1990s. The chapter then reviews recent law review articles on tax units. Finally, it examines discussions on progressive rate structures. This article finds a distinct shift in appproach, due to the emergence of optimal tax theory. JEL classification: K34 Keywords: Taxation, Income, Consumption, Tax Base, Tax Unit, Tax Rates

1. Introduction Taxation is an ‘old’ area of law and economics studies. It has been studied by economists as an important area of public finance as well as by lawyers as an integral branch of law governing private property. Thus, personal income taxation, especially after its emergence as a major revenue raiser in industrially developed countries, could be called one of the oldest research subjects in law and economics. Indeed, the modern concept of comprehensive income can be traced back to Schantz (1896) who, based on the ability-to-pay (Leistungsfaehigkeit) tradition of tax theory, argued against his predecessors by defining income broadly as the increase of net assets during a given period. It is well known that his conception was well received on the other side of the Atlantic. It was refined by Haig (1921) and Simons (1938). Particularly the latter laid down a conceptual foundation of personal income taxation in the US, refuting the Fisherian concept of income as consumption.

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On the other hand, lawyers’ inquiries into issues of personal income taxation have differed from country to country. It is by no means the US that has produced the richest volume of academic work on the law and economics concerning taxation. In Germany, legal scholars traditionally have been remote from law and economics studies. Although Germany is the mother country of Adolf Wagner and Georg Schantz, capital gains from personal property have been excluded from the taxable income of individuals, which is a significant deviation from the comprehensive income principle. The UK has traditionally adhered to a schedular system of personal income taxation, rather than comprehensive conception of income; tax lawyers are trained in an environment where they tend to view income tax as a set of various levies on transactions, rather than a personal tax on a single base. In Japan, lawyers began a systematic research on income taxation after the 1949 Shoup Recommendation (for a synthesis, see Kaneko, 1995), and their interest has been recently bolstered by developments in law and economics studies in general.

2. The Scope and Structure of this Survey Given the long history of tax research and the variety of studies taking place in different regions, it is impossible to introduce all the major works on the subject; by its very nature, the quest for creating an academic inventory has to be partial. Instead of being exhaustive, this chapter shall trace those articles, mainly written in English, which aroused salient debates on the three fundamental components of personal income taxation: base, unit and rates. Accordingly, the chapter proceeds as follows. Part A will trace the major debates between income tax base and consumption tax base in chronological order, starting from Simons (1938), and continuing up until the law and economics literature in the 1990s. Part B will review recent law review articles on tax units. Part C will examine the literature on progressive tax rate structures. Part D will conclude briefly. The line taken here is basically within the ET (equitable taxation) paradigm (Musgrave, 1976) in the sense that personal income tax versus consumption tax is contrasted as measures of equitable taxation. However, it is necessary also to introduce the OT (optimal taxation) perspective, since recent articles increasingly employ the OT analysis. For a convenient anthology of these articles, see White (1995), Baker and Elliot (1990), and McIntyre, Sander and Westfall (1983). The impact of OT perspective is discussed in Cooper (1994).

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A. Base 3. Origins In the late nineteenth century, researchers started to discuss the concept of income as a basis for personal taxation. The various concepts of income of the time were reviewed by Wueller (1938a, 1938b, 1939) as belonging either to an ‘accrual type’, which focuses upon inflow, or to a ‘disposition type’, which focuses upon expenditure or disposition. The latter type of definition was put forward by Irving Fisher, and represents an alternative stream within following discussion. It was advocated most notably by Kaldor (1958), who elaborated an expenditure tax design. However, expenditure tax was considered unpractical until recently. The ‘accrual type’ income concept has many varieties. Without going into preceding constructions, let us start directly from Henry Simons whose formulation dominates the following debates. For readers interested in a historical review of the scholarly works of this period, McCombs (1990) gives a good summary of discussions by Haig, Hewett, Simons and Vickrey. For analyses of Simons’ value judgement, see Hettich (1979), Kiesling (1981) and Long (1990).

4. The Impact of Henry Simons Simons (1938) measured personal income as ‘the algebraic sum of (1) the market value of rights exercised in consumption, and (2) the change in the value of the store of property rights between the beginning and end of the period in question’. The essential feature of this formulation is that it defines income as gain to someone during a specified time period. The definition is comprehensive in the sense it does not make any distinction according to source or recurrence; it includes income in kind, gratuitous receipts such as gifts or bequests, and capital gains. Simons saw the comprehensive income as an appropriate tax base for persons, since, by this construction, taxes may be distributed to persons in an equitable manner, especially using a graduated rate structure. Simons’ book covered most of the basic issues in personal income taxation, and his initial definition is modified in order to account for the implementation needs in the real world. Although never fully implemented in any country, Simons’ concept of income became an analytical framework commonly used by researchers especially in the Anglo-Saxon tradition. This was especially true in the US after the Second World War, where numerous casebooks of Federal Income Taxation were compiled with an emphasis on the concept of income as it appeared in legal rules and court cases. Surrey (1973) was one of the most prominent

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proponents of comprehensive income taxation, arguing that the concessions to deviate from the normal income tax structure constitutes another form of subsidy - the so-called ‘tax expenditure’. Based on this idea, the tax expenditure budget was introduced in 1974. Surrey and McDaniel (1985) traced the development since 1973 of the tax expenditure concept, considering its impact on budget policy, on tax policy and administration, and on government decisions between using tax expenditure or direct spending to implement subsidy programs. It is noteworthy that the idea of comprehensive income taxation as developed elsewhere, too. In Japan, Kaneko (1966-75) carefully traced the various concepts of income by public finance economists and, based on his detailed comparative survey on the legal systems in various countries, applied the comprehensive concept to the Japanese positive tax law on the issues of realization, imputed income, and illegal income.

5. Comprehensive Tax Base Debate During the same period when proponents of comprehensive income taxation were making efforts to streamline the tax system, growing dissent was emerging, and culminated in the so-called comprehensive tax debate of the late 1960s. The debate was started by Bittker (1967), who argued that a neutral, scientific measure of taxable income is a mirage (for his earlier examination of personal expenditures, see Bittker, 1973). Bittker argues that the concept of Haig-Simons economic income yields no help in many of the contentious areas of income definition. Based on this observation, he concludes that there is no touchstone for tax reform: proposals must be considered provision by provision and policy by policy, on their own particular merits. Bittker’s penetrating criticism invited rejoinders from the proponents of comprehensive income tax such as Musgrave (1967), Pechman (1967) and Galvin (1968). The debate made clear that in many senses the existing income tax base inevitably departed from a pure concept of comprehensive income and that the concept itself has vague outer boundaries. However, Bittker was not formulating a systematic alternative, which may be a reflection of his agnosticism towards the foundations of tax policy. This explains why Surrey, despite Bittker’s criticism, was able to institutionalize a tax expenditure budget after the debate.

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6. Andrews’ Breakthrough It did not take long for an alternative construction to come to emerge in discussion. Two works by William Andrews changed the landscape of the debate. While agreeing that it is useful to evaluate departures from an ideal income tax as tax expenditures, Andrews (1972) maintained that the ideal for this purpose must be carefully stated and worked out to embody the intrinsic objectives of the tax. Starting from the Simons’ formulation, Andrews argued that an ideal income tax is one in which tax burdens are apportioned to a taxpayer’s aggregate personal consumption and accumulation. Focusing on the consumption component of the tax base, he contended that there are persuasive reasons why the concept of personal consumption for tax purposes should be elaborated in a way that excludes medical services and whatever satisfactions one obtains from making charitable contributions. One is struck by Andrews’ careful reading of the Simons’ formulation, distinguishing the consumption and the accumulation components of the personal income tax base. By showing that an exclusion of the accumulation component from the income tax base delivers a graduated personal consumption tax, Andrews paved the way for a renewed discussion of tax on personal consumption. Andrews (1974) extended this analysis further. He asserted that the worst inequities, distortions and complexities in the present tax, and the most intractable difficulties in approaching the accretion ideal, have essentially to do with the accumulation component of accretion. He therefore urged that consideration be given to an alternative ideal in which personal taxable income would be computed on a simple cash flow basis to reflect only personal consumption, with accumulation in the form of business and investment assets being comprehensively eliminated. He showed how pursuit of this would produce a substantial net simplification of the tax as well as a fairer and more efficient distribution of tax burdens. Unlike Bittker, who tended to take a piecemeal approach, Andrews was able to build on a conceptual framework based on the economics of time value of money, an essential analytical tool for the accumulation component of the income tax base. Andrews’ work was a breakthrough: while the earlier version of the consumption tax scheme required computation of borrowing, dissaving and imputed income from assets, his prepayment system simply exempts the yield from capital, arriving at the consumption component by deducting the accumulation portion from the tax base. Moreover, Andrews successfully showed that the existing personal income tax is a hybrid of the consumption and accretion models in relation to accumulation, and his diagnosis became accepted by tax theorists and policymakers alike, regardless of their positions for or against his specific proposals for reform.

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7. Income or Consumption? Recognizing that the existing personal income tax is a hybrid, opinions diverged whether to pursue a comprehensive income tax ideal or a consumption tax ideal. In the debates that followed, several factors were posited and examined, such as fairness, efficiency and administrative feasibility. On the fairness issue, Warren (1975) suggested that the neutrality of the consumption-type tax is obtained at the cost of allowing income from wealth to escape taxation. Finding the consumption-based tax to be analogous to a tax on wages alone, Warren rejects it as an insufficient compromise in regard to the various legitimate objectives of a basic tax system. To this, Andrews (1975) replied that Warren’s observations do not refute the conclusion that a consumption-type tax would be fairer, pointing out important differences between a wage tax and a consumption-type personal income tax. To Andrews, an income tax, even a true accretion-type tax, was a deficient device for attacking disparities in wealth. Five years later, Warren (1980) further evaluated the arguments that have been advanced in favor of the consumption criterion being superior to the income criterion. He concluded that while either tax can be justified as a means of implementing a plausible principle of distributional equity, the case for superior fairness of the consumption tax is not persuasive on its own terms. Fried (1992), provisionally setting aside the Hobbesian foundational argument that asserts wealth ought not to be regarded as appropriated for private purposes until withdrawn for personal use from the common pool, focused on the unfairness argument of taxing returns to capital per se. She distinguished three theories implicit in the arguments for exempting the return to capital: (1) returns to capital should be exempted as a means of perfecting the income tax; (2) they should be exempted as a means of implementing an endowments tax; and (3) they should be exempted to preserve the relative pre-tax welfare of savers and spenders. Her conclusion was that none presents a persuasive case for the greater fairness of a consumption tax. On efficiency, economists are almost unanimous in holding that an income tax base discriminates against savings and favors current consumption, whereas a consumption tax base is more neutral as regards the saving decision of individuals. On administrative feasibility, Graetz (1979) applied his general analysis of legal transitions to the issue of substituting a progressive consumption tax for income tax, and suggests that the obstacles to implementing a progressive personal tax on consumption would be substantial, but not prohibitive. Given practical difficulties, however, he warned that proponents of an expenditure tax should be required to demonstrate that its claimed advantages in terms of equity and economic efficiency are real and cannot be achieved in a simpler fashion. He asserted that unless and until this burden of proof is met, replacing the income tax with a progressive personal tax

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on consumption should remain low on the list of political priorities, and that the principal utility of expenditure tax analysis should continue to lie in illuminating issues of income taxation and increasing the understanding of tax policy. Shachar (1984) examined the issue of transition, proposing that changes in the tax treatment of both assets and liabilities must be considered on a case-by-case basis in order to determine which type of transition rule would place the tax burden on the superior risk bearer. He pointed out that transition rules are necessary to avoid windfalls and double taxation. Serious debates in academic and policy circles followed between income tax proponents and consumption tax proponents (Pechman, 1977; Gulper and Pechman, 1980; Aaron, 1988; and Marshall and Wells, 1993). Some tried to pave the way to an income tax model (Gunn, 1979; Shakow, 1986; Fellows, 1990), while others urged the move to a consumption tax model (Institute for Fiscal Studies, 1978; Bradford et al. 1984; and Bradford, 1986). Nakazato (1991a) supported the consumption tax base from a lifetime perspective, arguing that Simons’ income artificially limits the time range of base measurement, that the traditional equity justification of Simons’ income lacks grounds, and that the consumption tax base is neutral in the time preferences of individuals.

8. Extension In the meantime, the relevance of a comparison between income and consumption tax bases was questioned by Strnad (1985). Strnad argued that in a non-general-equilibrium setting where the effect of taxes on pre-tax prices is not included in the analysis, the cash-flow income tax and not the traditional income tax implements the Haig-Simons ideal; thus, the generally accepted income tax analyses of activities as disparate as corporations investing in machines, individuals contributing to pension funds, and businesses financing their operations by debt have no theoretical basis. Strnad’s sensational reappraisal was rejected by Kaplow and Warren (1986), who demonstrated that Strnad’s conclusion that a cash flow tax properly implements a tax on ‘income’ is a correct, but tautological, derivation from the starting point of Strnad income, which is not the same as Haig-Simons income. Popkin (1986) agreed with Kaplow and Warren in that Strnad’s conclusion rests on a definition of the Haig-Simons ideal that already contains a bias in favor of the consumption tax. Further he added that the Strnad version of the Haig-Simons definition is defective on basic fairness grounds because it adopts a mistaken view of when a taxpayer has fairly discharged a tax obligation to the government. Strnad (1986) and Strnad (1987) are replies to Popkin and to Kaplow and Warren respectively. Strnad (1990) dealt with the question of ‘periodicity’ - how often changes in value should be assessed and taxed - in the context of implementing

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accrual taxation. Despite heated debates and strong criticism, the robustness of income tax idea proved itself in the real world. The US Department of the Treasury (1984) opted for an expansion of the income tax base with a less graduated rate structure, which became a basis for the 1986 Reagan Tax Reform. In the late 1980s, similar tax reforms with base-broadening and rate-flattening followed in other countries, although no country ever switched completely to a consumption tax structure. The income tax system remains a hybrid. It has not been perfected as a pure accretion model, nor has it undergone a complete change to a consumption tax model. From his perspective as a political scientist, Witte (1985) attacks Simons’ position as ultimately resting on an unclear set of value premises, but still defends a comprehensive income tax on pragmatic grounds such as revenue capacity, administrative efficiency, certainty, simplicity and legitimacy, rather than by traditional value criteria such as fairness and efficiency. While casting a doubt on the future of income taxation, Isenberg (1990) rejects the adoption of a personal tax on consumption, and opts for a value added tax which is essentially a tax on firms. Noting the near consensus among economists that long-term growth would be less hampered by additional taxes if they fell on consumption rather than on income, Graetz (1992), nonetheless, cautions against a broad-based tax on consumption, instead advocates a tax on energy consumption.

9. Enter Optimal Taxation For traditional income tax idealists the hybrid system may seem like a stalemate, but for newer generations the hybrid tax is already a given. Discussions in 1990s tend to focus on the policy evaluation of specific rules and provisions within the hybrid tax framework, but made little direct normative assessment over the appropriateness of either tax base. Underlying this newer work is the emergence of the optimal tax framework and the elaboration of finance theory. McCaffery (1992) argues that one should accept the fact of a hybrid income-consumption tax and begin to examine how best to structure it. Dividing savings into three categories (life cycle, precautionary, and bequest savings), McCaffery contends that because of the different values one places on the different types of savings, some form of a hybrid may in fact be ideal and not merely a practical necessity. Although more empirical work and normative exploration is necessary, his work exemplifies a new trend of discussion on an old issue. Knoll (1994) seeks to direct scholarly attention towards large-scale redesign of the hybrid, away from both marginal improvements in the existing hybrid and the debate over whether there should be an income tax or a consumption tax. He describes and evaluates three hybrid taxes. A blended hybrid, which would reduce the tax rate on investment income, is rejected

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because of the impossibility of allocating returns between capital and effort and among various investments. A simple hybrid, which would supplement economic depreciation with an immediate write-off of a given fraction of the investment, and a COCA (Cost of Capital Allowance) system, which would supplement economic depreciation by providing a deduction based on the undepreciated portion of a taxpayer’s assets, are held to serve as models for comprehensive reform. Significance of risk rather than deferral is articulated by Bankman and Griffith (1992). By reviewing historical data, they reveal that substantially all of the real return realized on investments during the past 60 years has been attributable to investment risk, and contend that thus it is appropriate to center the income versus consumption tax debate on the way in which the two tax bases treat risky investments, rather than the way the two tax bases treat interest (interest being defined as the inflation-adjusted return on riskless assets). According to their analysis, taxation of risk premia is much less troublesome than taxation of interest, because many taxpayers will be able to offset the effects of taxation of risk premia by increasing the proportion of risky assets in their portfolios, and because such taxpayers will not be disadvantaged by an income tax. On the other hand, Bankman and Griffith conclude that taxation of risk premia without full loss offsets will disfavor investors in risky assets and raise efficiency concerns. While previous analyses have focused on the time value of money aspect, Bankman and Griffith have highlighted the way in which risk matters. The conceptual weakness, even as an analytical tool, of the Haig-Simons definition of income as a first-best tax principle is revealed by Shaviro (1989b). Shaviro defines as selective limitation of tax benefits those provisions in the Revenue Code that, in response to preferences and resultant income undermeasurement, make certain tax benefits conditional on the character or amount of other items on the taxpayer’s return. He argues that such selective limitations cannot be analyzed solely through the consideration of first-best tax principles, notably the Haig-Simons definition of income, and that the question gives rise to second-best issues that have a discernible theoretical structure with identifiable tradeoffs but are indeterminate in the absence of empirical information. Shaviro (1990) shows the similar indeterminacy of the Haig-Simons definition of income in the measurement of taxable consumption. Shaviro (1992) makes an efficiency analysis of the hybrid tax system and argues that the main advantage of realization and recognition rules, as compared with no tax at all even upon realization, is that they may tend to equalize the ex ante expected taxes from alternative activities or investments. Appeal to definitions, which has been the basic communication code of the income versus consumption tax debate, is set aside by Kaplow (1991), who views that debates about definitions cannot give meaningful guidance to policy unless informed by the objectives underlying the definitions. Kaplow prefers evaluating directly the effects of possible tax rules on individuals’ well-being. He reconsiders the justification for casualty loss and medical expense

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deductions, taking into account the availability of private insurance. He argues that when individuals can insure, the second level of insurance implicit in the casualty loss and medical expense deductions has undesirable effects on consumption choices and insurance decisions: individuals may be more exposed to losses because of tax deductions commonly believed to mitigate them. He concludes that, given the option, individuals would prefer a regime that eliminated the deductions and offered correspondingly lower tax rates. His later work (Kaplow, 1994) is another example of his contribution by the use of direct explorations. Here he shows the arithmetic interchangeability between standard deduction and floors. Zolt (1996) examines the case for uniform taxation on efficiency and equity grounds. He concludes that neither economic theory or equity considerations require uniform treatment. He contends that even if we could devise rules that taxed ‘appropriately’ such items as unrealized gains, imputed income, or government services, we may still be able to achieve efficiency and equity gains using tax treatment that varies by type of income or type of taxpayer. He carefully adds, however, that the desirability of the use of nonuniform taxes likely varies among countries and over time.

10. Paradigm Shift Recent law and economics contributions to the debate thus reflect the mainstream intellectual trends in public sector economics which have leaned away from the traditional ET paradigm and towards the OT framework. It is an interesting question if and how this academic work will have an impact on real-world policymaking.

B. Unit 11. The Choice: Individual, Marital, or Family In order to measure income during a specified period, it is necessary to identify whose income is in question. Simons (1938) seems to have advanced his theory on the assumption that natural persons should be taxed as isolated individuals. His approach is a logical consequence of methodological individualism. Others may view persons as social beings whose family ties affect their taxpaying capacity. Underlying this view is the rejection of naked individualism in favor of a conception of ‘self’ which is encumbered with communal conditions. Personal tax units may be designed as based on either of the following: individual, marital, or family. Which system to adopt has been long discussed

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in many countries, producing numerous legislative movements. For a comparative survey, see Pechman and Engelhardt (1990), and Kaneko (1996b). Among OECD countries, the design of tax units differs from country to country: some adopt an individual unit system (Australia, Canada, Denmark, Italy, Japan, the UK, and Sweden), some employ a marital unit system (Belgium, Germany and Spain), and others have a family unit system (France and Luxembourg). The US provides multiple tax rates for (1) single individuals, (2) married individuals filing joint tax returns and surviving spouses, (3) married persons electing separate tax returns and (4) heads of households. In addition to the diversity of treatments among different countries, systems in each country often have undergone numerous changes. The discussion of tax unit has multiple facets because it is a reflection of how one views a family, a very controversial institution in our swiftly changing societies. The difficulty of finding common ground is aggravated by the fact that the treatment of a family under personal income taxation is related to all three of the fundamental elements of taxation: base, unit and rates. For example, within an individual unit system, personal deductions could be introduced to make adjustments according to the family status of an individual. Moreover, many legal issues concerning family taxation are inherent to progressive rate structure.

12. Early Discussion Although recognizing the aforementioned difficulty, Oldman and Temple (1960) tried to illuminate the guiding policies for the design of tax units. With a detailed description of the systems then in operation in the Philippines, UK, Sweden, Canada, US and the Netherlands, Oldman and Temple supported the marital unit system as a more reasonable choice than the individual unit system in light of economic realities and administrative feasibility. In so doing they suggested the following: (1) a married couple with only one spouse having an income should pay a greater total tax than a married couple with both spouses working, assuming both couples have the same total income (imputed income from household services); (2) the dual-income couple should pay a greater total tax on its two incomes than would be paid by two single persons with corresponding incomes (economic advantages of joint living); (3) one single person should pay the same or a greater tax than the married couple with one income (the advantages of joint living are never so great that two can live more cheaply than one). Bittker (1975) questioned the validity of these guiding policies. He demonstrated that it is impossible to have (a) progression, (b) equal taxes on equal-income married couples, and (c) a marriage-neutral tax burden. In discussing the relative tax burdens of married couples and other taxpayers, he

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examined whether the assumptions of commentators, such as marital burden of supporting a spouse, economies of scale, and unpaid household services, would hold in reality. He concluded that theoreticians, regardless of their backgrounds, be it economics, anthropology or sociology, cannot ‘solve’ the problem of taxing family income; they can only identify the issues, point out conflicts among objectives, propose alternative approaches, and predict the outcome of picking one route rather than another. Having performed these functions, the expert must give way to the citizen, whose judgments can rest on nothing more precise or permanent than collective social preferences. Bittker thus exposed the fundamental dilemma between neutrality among couples and neutrality on marital decisions under a progressive income tax. No commentators since have been able to escape this dilemma. In the face of controversy surrounding the treatment of the family in federal income tax, McIntyre and Oldman (1977) developed a normative model for the taxation of the family based on the ideal of a comprehensive tax base. From this ideal, they suggested a program for reform in which tax burdens would be distributed in accordance with practical estimates of the monetary income enjoyed by individual taxpayers.

13. Divergent Family Models, and a Look at Behavioral Response Although the debate in the 1970s seemed to have led to a fairly widespread consensus that the married couple is an appropriate tax unit, in the 1980s more emphasis was given to the aspect of marriage penalty, rather than the aspect of non-neutrality among couples. Gann (1980) argues that a marriage-neutral income tax system under which all individuals file separate returns under a single rate structure is the most defensible position in the long run. Gann (1983) criticizes the earned income deduction provisions introduced in the US by the 1981 Act, urging that the earned income deduction cannot be supported on an equity criterion of marriage neutrality, although noting that it produces some efficiency gains. Kornhauser (1993) examines the premise that married couples share or pool their incomes. She surveys the changing concept and reality of the ‘family’ and examines several empirical studies that address the issue of the allocation of financial resources between members of a couple living together. Her findings are: not all couples pool assets; that pooling is not confined to married couples, and separation of assets is not confined to non-married couples; that financial arrangements sometimes change during the course of the relationship; and that even among those couples who claim they pool, the non-earner spouse often does not have equal access to assets. Based on this evidence, she argues that the joint filing system is unfair, because it is both under-inclusive (barring some

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unmarried poolers from its benefits) and over-inclusive (bestowing its benefits on non-pooling married couples). McCaffery (1993) explores how the tax laws provide behavioral incentives that affect three types of decisions: whether to marry, whether to form a oneor a two-earner household, and whether to work full or part time. He finds that tax laws contribute to the marginalization of women in the workplace, and that they impede a more creative formulation of alternative models of work and family. Pointing out strong class dimensions in the actual patterns of effects, he urges to take steps to put one- and two-earner families on an equal footing. He thus argues a case for altering the basic rate structure to provide significantly lower, even negative, rates for secondary earners, financed by higher rates on primary earners. McCaffery’s approach was to focus on behavioral incentives, where traditional tax policy analysis looked at distributive burdens. McCaffery (1997) is a synthesis of his research based on this approach. Struggling with the dilemma posed by Bittker, Zelenak (1994b) argues that American society at the end of the twentieth century would be better served by separate returns, predicting that the joint return system will eventually disappear, the only question being when. Nakazato (1995) applies Gary Becker’s theory of productive consumption to the treatment of households under the comprehensive income tax model, examining income transfer, imputed income and leisure within a family. He concludes that tax units and income deductions do not provide a satisfactory solution, and that full implementation of a comprehensive income base under an individual unit system would approximately achieve tax neutrality towards the organization of a household. The design of tax units and of various deductions and credits within a household has another dimension: its role as an instrument of welfare and family policies. Alstott (1995) examines the role of tax system in welfare programs, arguing that the case for the EITC (earned income tax credit) has been oversimplified in two significant ways. First, the conventional policy debate over the EITC’s behavioral incentives has been framed too narrowly. Second, the EITC, as a tax-based income-transfer program, faces inherent institutional constraints not present in traditional welfare programs. These include problems of inaccuracy, unresponsiveness and noncompliance that are inherent in tax-based administration.

14. Expansion of Arena In sum, recent studies embody analyses of people’s behavioral responses to the structure of tax units, as well as wider examinations of family taxation in interaction with social and welfare policies.

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C. Rates 15. The Conundrum Concerning Progression The most significant issue on the tax rates of personal income tax is progression. The progressive tax rate structure is one component of the progressive tax mechanism, and the overall progression of the tax is dependent on all three elements of personal income taxation: base, unit and rates. Simons (1938) recognized this, arguing against the theory of declining utility and examining the case for redistribution of income and wealth in its own terms. The support for redistribution and for progressive taxation as a means to more economic equality was strong among New Dealers. One example is Vickrey (1947), who proposed an agenda for progressive taxation: he devoted a chapter on the graduation of taxes, examining the methods of graduation, the choice of graduation curves, the use of mathematical formulas, and the size of tax brackets. Throughout the decades after the Second World War, the patterns of Federal Income Tax legislation in the US were consistently progressive.

16. The Uneasy Case It is ironic that Blum and Kalven (1953), the most widely acknowledged academic work on the issue of progression, claimed that the case for progressive taxation is uneasy. They traced various affirmative arguments for progressive tax on all incomes over a minimum subsistence exemption, looking at: (1) maintaining economic stability and a high level of business activity; (2) taxes levied in accordance with the benefits received; (3) the declining utility of money (sacrifice theory); and (4) mitigating economic inequality. They also examined the implications of exemptions on the case for progression, and considered whether any of the preceding analysis of the merits of progression would be affected by considerations regarding how the government spends the tax money that it collects. They concluded that the case for progression turns out to be stubborn but uneasy. Galvin and Bittker (1969) made several points in support of a progressive federal income tax rate structure. They note that (1) if the case for progression is ‘uneasy’, so too is the case for a proportional rate schedule; (2) progression in federal income tax serves to counterbalance the regressive tendencies in other federal, state and local taxes; (3) progression is an inevitable consequence of allowing personal exemption in computing income tax liability; (4) economic security increases more than proportionately as one moves up the income scale; (5) benefits of government expenditures increase progressively with income and wealth; and (6) progressive tax rates

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serve as a measure to reduce economic inequality, fitting comfortably within the forms of democratic capitalism.

17. Flat Tax and the Optimal Taxation Framework It was not until the 1980s that the progressive rate structure was overhauled. Various proposals were made to make the personal income tax rates flat in the US Congress. The 1986 Tax Reform reduced the number of brackets and the top marginal income tax rate significantly. Subsequently, rate cutting, coupled with base broadening measures, became a worldwide trend in tax reform in other countries. Graetz (1983) addresses the problem of the transition to a flat-rate tax, arguing that the minimum tax amendments of the 1982 Act in the Internal Revenue Code constitute a transitional mechanism that can be regarded as a first step to phasing in a broad-based tax. Hall and Rabushka (1995) propose a flat-tax plan under which all income would be taxed once at a uniform rate of 19 percent, based on the consumption tax principle. O’Kelley (1985) describes how adopting a flat rate comprehensive income tax that uses personal exemption could result in tax burdens substantially more progressive than under the then current system, arguing for a personal exemption equal in amount to the minimum wage, and for integrating the income tax and the social security systems. Bankman and Griffith (1987) re-examine the traditional economic arguments against progressive taxation from the perspective of distributive justice. They critically analyze both the labor-related efficiency costs of progressive taxation, and the traditional arguments that progressivity imposes significant administrative costs, promotes misallocation of capital, and increases tax evasion. They go on to describe an optimal tax model for calculating the most desirable tax rate, balancing the costs of progressivity against possible gains from redistribution. Their model suggests that under most welfare theories, the optimal tax rate should be progressive, but not confiscatory, and that a progressive tax is best implemented not in the form of graduated or rising marginal rates, but rather through a combination of cash grants and constant or even declining marginal rates.

D. Conclusion 18. From Definition to Numbers This chapter briefly reviewed the existing literature on personal income taxation. Overall, the survey shows a shift in approach, which broadly involved a change ‘from definition to numbers’. Traditionally, the main interests of

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researchers were how to define the concept of income, how to structure an appropriate tax unit based on taxpaying capacity, and how to design the rate according to some intuitive notion of vertical equity. More recently, with the emergence of optimal taxation theory, discussions are beginning to focus on the implications of social welfare functions, and on the market responses to particular tax rules. Looking at the names of authors cited, one may note that this intellectual shift is due to the advent of new generation of law and economics scholars armed with analytical devices which connect policy discussions directly to normative criteria such as equity and efficiency. Personal income taxation has strong connections with other elements of human behavior, including the formation of human capital, the choice between labor and leisure, the investment decision, the compliance and evasion of legal rules, and the geographical location of resources. Hereby, personal income taxation is but one aspect of a larger inquiry into the connection between law and human behavior. As such, interested readers should consult other chapters in this volume relating to the family, finance, labor, social security and administration.

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O’Kelley, C.R. (1981), ‘Rawls, Justice, and The Income Tax’, 16 Georgia Law Review, 1-32. O’Kelley, C.R. (1985), ‘Tax Policy for Post-Liberal Society: A Flat-Tax-Inspired Redefinition of the Purpose and Ideal Structure of a Progresive Income Tax’, 58 Southern California Law Review, 727-776. Oldman, Oliver and Temple, Ralph (1960), ‘Comparative Analysis of the Taxation of Married Persons’, 12 Stanford Law Review, 585-605. Paci, Pierella (1988), ‘Tax Based Incomes Policies: Will They Work? Have They Worked?’, 9(2) Fiscal Studies, 81-94. Parsons, Ross W. (1986), ‘Income Taxation An Institution in Decay?’, 3 Australian Tax Forum, 233-266. Pechman, Joseph A. (1967), ‘Comprehensive Income Taxation: A Comment’, 81 Harvard Law Review, 63-67. Pechman, Joseph A. (1977),Comprehensive Income Taxation, Washington, Brookings Institution, 311 p. Pechman, Joseph A. (1980),What Should Be Taxed: Income or Expenditure?, Washington, Brookings Institution, 311 p. Pechman, Joseph A. and Engelhardt, Gray V. (1990), ‘The Income Tax Treatment of the Family’, 43 National Tax Journal, 1-22. Peterson, Wallace C. (1991), Transfer Spending, Taxes, and the American Welfare, Dordrecht, Kluwer, 192 p. Pope, Jeff (1989), ‘The Compliance Costs of Personal Income Taxation: A Review of the Issues’, 6(2) Australian Tax Forum, 125-142. Pope, Jeff and Fayle, Richard (1990), ‘The Compliance Costs of Personal Income Taxation in Australia 1986/87: Empirical Results’, 7(1) Australian Tax Forum, 85-126. Popkin, William D. (1986), ‘Tax Ideals in the Real World: A Comment on Professor Strnad’s Approach to Tax Fairness’, 62 Indiana Law Journal, 63-72. Rea, Samuel A., Jr (1984), ‘Taxes, Transfers and the Family’, 34 University of Toronto Law Journal, 314-340. Roin, Julie, A. (1988), ‘United they Stand, Divided They Fall: Public Choice Theory and the Tax Code’, 74 Cornell Law Review, 62-134. Ruiz-Huerta Carbonell, Jesús (1995), Las Rentas de las Personas Mayores (Eldest Citizens’ Income), SECOT. Ruiz-Huerta Carbonell, Jesús, Alvarez, Jesús, Ayala, Luis, Iriondo, Iñaki, Martinez, Rosa and Palacios, Juan Ignacio (1995), La Distribución Funcional y Personal de la Renta en España (Functional and Personal Distribution of Income in Spain), Premio de Investagión 1995 del Consejo Económico y Social. Rupley, Lawrence A. (1978), ‘Personal Income-based Taxation in the Northern States of Nigeria and the Effect of Uniform Income Taxation’, 32(89) Bulletin for International Fiscal Documentation, 401-410. Russell, R. Robert (1986), ‘Tax Based Incomes Policies: Some Skeptical Remarks’, in Colander, David C. (ed.), IncentiveBased Incomes Policies: Advances in TIP and MAP, Cambridge, MA, Harper and Row, 159-175. Salzyn, Vladimir (1988), ‘Desigining an Optimal Personal Income Tax Rate Structure: Goals and Criteria’, 26 Osgoode Hall Law Journal, 577-602.

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6060 CORPORATE TAXATION Charlotte Crane Northwestern University School of Law © Copyright 1999 Charlotte Crane

Abstract Much of the traditional economic literature has until relatively recently ignored almost all of the details of the coverage of the tax and the legal institutions within which the tax has developed. As a result, most of the rules used in establishing corporate tax liabilities are the outgrowth of legal formalisms. Although many discussions of reforms of tax rules use as their starting point some rudimentary assumptions about incentives and effects, few of these discussions consider less obvious incentives and interactions or attempt to verify their analysis empirically. This chapter will therefore focus primarily on those treatments that go beyond these typical rudimentary assumptions. The bibliography deals only with those works that go well beyond descriptive treatments and practical expositions of the legal rules in question. JEL classification: K22, K34 Keywords: Corporate Income Tax, Tax Burden and Incidence, Corporate Financial Structure

1. Introduction and Note on Scope Corporations, measures of corporate profits, and taxes imposed thereon are uniquely legal institutions. They have no physical reality; they are entirely the product of legal and accounting rules. But because of the importance of corporate activity in modern economies, scholars in economics and finance who have no other interest in law or legal institutions have long had an interest in analyzing the effects of corporate taxes. To the extent that this work uses economic analysis to understand and predict the behavior of firms as well as the development of legal rules, this body of literature must be considered in any review of the treatment of the corporate tax as ‘law and economics’. References to works in a wide variety of methodologies are therefore included in this bibliographic review. Much of this traditional economic literature has until relatively recently ignored almost all of the details of the coverage of the tax and the legal institutions within which the tax has developed. At least in the United 165

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States, these details have evolved through a continuing dialog between the legislature (which until relatively recently formally prescribed only the most skeletal of rules) and the courts (which have felt free to allow the approaches of the common law to contribute to the development of the legal rules), as prompted by the Internal Revenue Service. As a result, most of the rules used in establishing corporate tax liabilities (for instance, those according to which entities are classified as subject to the tax, those according to which debt is distinguished from equity, those according to which share redemptions are distinguished from dividends, and those according to which corporate reorganizations are classified as taxable or nontaxability) are the outgrowth of legal formalisms, particularly the idea that a corporation can be an entity entirely separate from its participants. These formalisms developed without any conscious attention to their economic effect. There are therefore only a few justifications and analyses of the substantive rules of corporate taxation of the sort those well-read in other areas of law and economics might find familiar. Indeed, a leading monograph analyzing the corporate law through the lens of law and economics makes only scant reference to the possibility that taxes have an influence on the legal relationships between corporations and their shareholders (Easterbrook and Fischel, 1991). Furthermore, the evolution of most of these details has historically been, and continues to be, dominated by manipulation of these formal constructs by institutions for which there is only rudimentary understanding of their nature as ‘economic’ actors. Although many discussions of reforms of tax rules use as their starting point some rudimentary assumptions about incentives and effects (most commonly, that taxpayers will attempt to minimize tax burdens at least to the extent that the avoided burden exceeds the cost of avoidance and that differential treatment of economically similar transactions will produce inefficient distortions), few of these discussions consider less obvious incentives and interactions or attempt to verify their analysis empirically. (Roin, 1988; Kanda and Levmore, 1991, and Arlen and Weiss, 1995, are notable exceptions). This review will therefore focus primarily on those treatments that go beyond these typical rudimentary assumptions. Thus only a small portion of the literature considered here can be solidly classified as ‘law and economics’, rather than traditional economic analysis of the effect of tax laws on legal institutions. This chapter focuses on the effects of taxes that are encountered only by incorporated entities, and does not consider the effects of taxes that are imposed regardless of the legal form in which capital is held. Thus it does not generally consider the effect of taxes on overall capital formation beyond basic questions of corporate financial structure. However, many of the works cited herein, particularly earlier works, may have (in many cases knowingly, but in other cases unwittingly) assumed a substantial congruence between

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the ‘business’ and ‘corporate’ sectors, and there is, therefore, a substantial overlap with that literature. For survey treatments of capital and business taxes generally, see Gravelle (1994) and Halpern and Mintz (1992, with emphasis on Canada). This bibliography deals only with those works that go well beyond descriptive treatments and practical expositions of the legal rules in question. The reader is cautioned, however, that, perhaps more than other areas of the law, the rules outlining the base of the corporate income tax are complex, and that assumptions about the impact of potential tax liabilities can rarely be made without a relatively sophisticated understanding of them. Comprehensive introductions to the overall income tax systems of various jurisdictions and an introductory bibliography can be found in Ault (1997); additional descriptions of the corporate tax systems in specific jurisdictions can be found in Brooks (1997) (Canada); Pender (1997) (Australia); Muten (1997) (Scandinavia); Teixeira (1997) (Portugal, Great Britain, Holland). More detailed surveys of tax-base defining rules and rates can be found in the looseleaf services of the International Bureau of Fiscal Documentation, as well as in various pamphlet series of the larger accounting firms, including Coopers and Lybrand, Klynveld Peat Marwick Goerdeler, Price Waterhouse, and Deloitte Touche Tohmatsu International. Useful short summaries of various topics include Auerbach (1990) (the predominant features of the classical double tax), Shoven and Waldfogel (1990) (the treatment of debt and equity), Scholes and Wolfson (1991) (the general pattern of rules for mergers and acquisitions) and the international scheme generally. Wiseman (1974), Harberger (1983) and Goode (1951) should give the reader good perspective on the early contributions of traditional economists. A useful survey of the issues raised by the presence of taxes in the traditional corporate finance literature is provided by Gordon and Malkiel (1981). Other more recent surveys of slightly different scope include that by Head (1997), Mintz (1995) (including tables showing the prominent features of the tax schemes used in various jurisdictions and providing more general background on taxes, costs of capital and risky investments), and Cnossen (1997), focusing on the OECD jurisdictions.

2. Overview of the Tax Under the ‘classical’ scheme for taxation of corporate income, corporations are recognized as separate taxable entities, legitimately subject to tax upon their income. Distributions of earnings to shareholders are also taxed as income to shareholders, as if they represented entirely new values available to be taxed. Such schemes essentially tax the earnings on corporate equity

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investments twice, once at the corporate level as earned and later upon the distribution of the earnings to the shareholders. Bittker and Eustice (1994) provide a comprehensive summary of the complex US tax rules controlling corporate/shareholder relations. Clark (1977) provides useful insights into legal concepts behind the classification of various corporate/shareholder transactions in the classical scheme. Stephan (1990) provides a slightly more intricate update of US taxation of corporate/shareholder relations, taking into account both the many legislative changes occurring in the 1980s and more recent theoretical analysis of corporate/shareholder relations. Not all business activity is subject, even nominally, to the corporate tax. Much business activity is undertaken by entities, including charities (Hansmann, 1981; Rose-Ackerman, 1982) and local governments, that may be entirely exempt from income taxation. Even in the for-profit sector, there is much business activity that is not subject to corporate tax. In the classical system, the corporate tax only attaches to those entities that are in fact incorporated, or are deemed to be operating as if they were in fact incorporated. It does not attach to joint ventures and partnerships. In the US, the legal nature of business entities is a matter of state, not federal law, while the reach of the federal income tax on corporations has been a matter of federal law. As a consequence, in the US, an entity could be subject to the corporate income tax regardless of its formal legal classification as a partnership or trust. As an historical matter, entities that enjoy limited liability, free transferability of interests, centralized management, and continuity of life traditionally were subject to corporate tax even if unincorporated. In the US, this line proved very difficult to police. See Klein (1972), Lee (1988) and Hobbes (1995) for a review of this history. Recent regulatory changes in the US have made avoidance of the classical double tax scheme elective for all but publicly traded entities. Even a publicly traded entity can also avoid the classic double tax if its activities and capital requirements can fit certain rigid structures, generally designed for entities serving as financial intermediaries, see, for example, Gergen (1997) and Clark (1975). For an overview of current thinking about the scope of the corporate tax base in the US, see Yin (1997) and Klein and Zolt (1995). In other jurisdictions, the formal legal status of the business entity is likely to determine whether the entity is subject to the income tax (Thomas, 1997). Under the traditional income tax, an increase in the value of corporate stock is not taxed to shareholders until it is ‘realized’, generally, reduced to cash in the hands of the shareholders. There are recurring proposals to alter this rule, especially with respect to publicly held debt and equity (Slawson, 1967; Davies, 1975; Dodge, 1995). Under the classical scheme, dividends distributed to shareholders are taxed without offset for shareholder

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investment or credit for corporate taxes paid. Increased share value, however, can be realized by shareholders by selling shares to third parties. This value can be both realized by the shareholder and removed from the corporate solution if it is the corporation, not a third party, who purchases the shares. In the US scheme, the rules applicable to such tactics sometimes leave the consequences of such transactions uncertain. Kingson (1976) and Jassy (1974) explore these rules in detail; Chirelstein (1969) explores the effects of such transactions on the remaining shareholders. Shareholders can ordinarily enjoy the benefits of increased share value without such values leaving corporation solution merely by selling shares. When such a sale is for cash or other relatively liquid consideration, the shareholder will ordinarily be taxed. However, increased share value can often be enjoyed without any taxation at the shareholder level as a result of tax-free mergers with corporations the stock of which represents more diversified holdings or is more easily pledged, through sophisticated futures and other hedging transactions. Such tactics can result in permanent escape from income tax on increases in share value when stock need not be liquidated until after the shareholder’s death because, upon death, the shareholder’s basis (that is, deemed after tax investment) is increased to fair market value. Some investors, especially offshore investors, will effectively be subject to income tax upon dividend payments but not on stock sales. Finally, tax exempt shareholders, including pension plans, will be taxed neither on dividend receipt or sale, although their beneficiaries will be subject to tax upon the ultimate payout. Most classical schemes are designed to avoid full taxation of earnings at more than one corporate level, limiting the tax burden to a ‘double tax’. In the United States’ income tax this is achieved by allowing a deduction for dividends received, which may vary with the extent of payee ownership in the payor corporation, and through the elimination of the ordinary consequences of asset transfers among very closely related corporations. This feature of the classical scheme, considered together with the number of shareholders that are explicitly exempt from taxation (including pension plans) and effectively exempt (including foreign shareholders), reduces the extent to which the classical scheme in fact results in double taxation of corporate enterprise.

3. Other Taxes Attaching to the Corporate Form Corporate income taxes can be combined with various other adjunct taxes designed to offset various undesirable effects of the classical income tax or some particular implementation feature of it. Such devices include the undistributed earnings (or accumulated earnings) tax (designed to offset the

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incentive to retain earnings in corporations rather than distribute them and subject them to the shareholder level tax), excess profits taxes (designed to capture the excessive return thought to be available during war time) and minimum taxes (designed to counteract perceived flaws in the ordinary rules defining the tax base). Lyon (1997) examines the inefficiencies introduced by one such tax in the US, the alternative minimum tax, the aim of which was to reduce the claimed overuse of certain incentive provisions in the US corporate income tax. Other taxes may be specifically imposed only on corporations, including franchise and capital taxes, property taxes at special rates, net worth and gross asset taxes can be imposed with or without regard for their relation to the corporate income tax. Taxes generally imposed on property, value-added, imports, sales and sales are almost never coordinated with corporate income taxes, although such payments are ordinarily allowed as business expenses in the computation of corporate income. The problems inherent in defining corporate income have led to recent proposals alternative measures. Knoll (1996), following Bankman (1995) sets out the conditions under which a corporate tax, imposed directly on the corporation, for increases in its total market value would replicate the current, accounting based tax. The possibility that even a perfectly defined income tax creates disincentives for investment has fueled additional proposals for substantial changes in the definition of the tax base that includes corporate income. Zodrow (1997), King (1987) and Auerbach (1990) build on earlier work to propose a corporate cash flow tax that would sever a corporate tax from its routes in profit accounting and eliminate any tax-driven biases regarding corporate structure and investment; the base of such a tax could be approximated to all current distributions to shareholders (both of dividends and share repurchases) by reducing corporate receipts for all new investment.

4. The Origins of the Corporate Income Tax The earliest attempts to impose taxes upon corporations, rather than upon any particular corporate activity or holding, appear to have origins in efforts to include individual wealth represented by corporate interests in property tax bases. Taxation of the corporation itself could serve as a surrogate for taxation of the wealth of the shareholder, and would be preferred by those jurisdictions which could claim that the corporation was entirely within its taxing jurisdiction, even if its shareholders were not. Initial efforts focused on the par value of the stock, or its paid in capital, but as it became clear that these legal and accounting concepts had no economic meaning, jurisdictions either switched to, or added, corporate income as the measure of the tax.

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Further support for the tax derived from the notion that doing business as a corporation was a privilege for which charging a fee or franchise tax was appropriate. (These franchise taxes are thought to have played an important part in the competition among states for the most attractive law governing corporate shareholder relations, see Cary, 1974, pp. 668-669.) With the possible exception of the privilege of limited liability (which is now frequently available without subjection to the classical tax regime), this justification now has limited appeal. A good survey of the historical attitudes in the US can be found in Goode (1951, pp. 24-43). The introduction of the modern corporate income tax at the federal level in the US has alternatively been explained as an early effort to respond to the popular pressure to regulate corporate activity without infringing upon the state’s prerogatives in corporate law (Kornhauser, 1990). The details of its later development has been described (by a political scientist reaching conclusions that except in their general optimism, resemble a public choice approach) as a reflection of a coalition between elected government and the business community to promote economic growth (Martin, 1991).

5. Modern Justifications for the Corporate Income Tax Some early writers simply assumed that the corporation, as a separate legal entity, was appropriately subject to tax. Corporate income taxes remain politically popular, especially among those who view corporations as sources of wealth entirely independent of shareholders, employees or customers. But most modern justifications for the tax are even less unsatisfying than those relied upon historically. Some justify the tax as necessary to secure the goals of other tax regimes. When corporate income tax is part of a larger scheme of income taxation, particularly a scheme with substantial redistributive goals implemented through progressive rates, the corporate tax can be viewed as an expedient buttress to the income tax. Without a corporate tax, the personal income tax would be substantially undermined by entrepreneurs who could shift the return on their efforts into untaxed corporate profits. (Gordon and Mackie Mason, 1995, explore this rationale as an explanation for the presence of corporate income taxes even in small capital importing jurisidictions.) Even if taxation of return to effort were not at issue, corporate earnings would be retained, providing economic benefit to shareholders, outside of the reach of the income tax. Under this justification, the corporate tax serves as a withholding tax to insure at least minimum correspondence with the nominal personal income tax scheme. This rationale, however, can only justify the imposition of the tax upon the income when realized by the corporation, not the failure to avoid taxing the remaining value again upon its distribution to shareholders (Gabinet and

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Coffey, 1977). Alternatively, the corporate income tax would be fully justified, however, as a means of buttressing the personal income tax in cases in which jurisdiction is lacking to tax shareholders (Musgrave, 1987). Under this justification, however, some credit for corporate taxes paid should be allowed at least to domestic taxpayers. Some claims have been made that the corporate tax under the classical scheme can be justified because of certain other economic characteristics of corporations. (Caution must be used in relying upon such justifications, since there is unlikely to be an identity between the entities attracting the tax and these characteristics. Only relatively recently have the rules for determining which entities will attract the tax actually reflected any of these justifications.) Early writers relied upon the benefits of limited liability to justify the imposition of tax. Goode (1951), Break (1969) and Rudnick (1989) all suggest that liquidity, resulting both from marketability and from the limited liability ordinarily afforded to shareholders, justifies attracting an entity level tax. Kose, Senbet and Sundaram (1994) outline the contours of a tax that would more precisely internalize the costs of limited liability. Stiglitz (1973, 1976) posits that the corporate tax should be viewed as only a tax on pure profits and entrepreneurship, a tax which allows the government a partial return on an implicit partnership with the owners of equity. This view relies heavily on the notion that all ordinary returns to capital can be paid out as returns to debt finance which returns are not subject to tax because they are deducted from corporate income, but does not attempt to reconcile the actual contours of the tax with this description given the fact that corporations frequently do not appear to be so fully leveraged. Head (1997) provides an in-depth examination of these various explanations of the corporate tax in light of the current finance literature. Even if the corporate tax can only be explained as an historical accident, its persistence in the face of its apparent inefficiencies remains an enigma. One possible explanation is that corporate managers have little incentive to lobby to eliminate the corporate tax, or to otherwise integrate the personal and corporate taxes, when they can enjoy a higher payoff from lobbying to alter the corporate tax base in ways that benefit them as managers even if integration or elimination would benefit shareholders more (Arlen and Weiss 1995). Still others have suggested that the corporate tax can serve to avoid the agency costs that would be incurred if other means were used to resolve the conflicts over timing of income among stakeholders facing different tax consequences upon corporate asset sales and distributions (Kanda and Levmore, 1991; Snoe, 1993).

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Cooper (1994) considers the possibility that corporate managers consider tax compliance as a financing and investment decision, and the implications of this view for tax administrators.

6. The Definition of the Corporate Tax Base Perhaps because there can be no economically sound justification for the corporate income tax under the classical scheme, there has been little serious effort to develop an economically sound measure of the corporate income tax base (Levmore, 1988). (This is in stark contrast with the individual income tax base, for which the combined articulations of Georg Schanz, Robert M. Haig and Henry C. Simons (Simons, 1938) provides the most common measure.) There is a general consensus, for instance, that the current standards for base-defining are far from that which would justify the corporate tax as merely a tax on economic rents under the Stiglitz view (Bond and Devereux, 1995). The few preliminary attempts have merely deduced from the existing accounting rules defining the corporate base that their overall purpose seems to be the taxation of all income, above and beyond the contributions made by the shareholders, that the corporation can be expected to make available to shareholders in the future (Bryan, 1984; Crane, 1988). Levmore (1987) suggests that at least some of the rules used to define the corporate tax base and which govern corporate shareholder relations serve to constrain managers in an efficient way. Repetti (1997) explores some more closely tailored efforts in the US to manipulate the incentives of corporate managers through particular base-defining provisions. The corporate tax base is frequently defined so as to identify a base only roughly equivalent to profit for other purposes. Accounting for tax purposes may deviate substantially from accounting for financial, rate-making or internal purposes. Some such disparities are introduced to overcome the bias of financial accounting against overstating earnings. Cummins, Harris and Hassett (1995) offer some preliminary analysis of the relative effects of such ‘one-book’ and ‘two-book’ regimes, as well as survey information on various tax schemes in place. Other disparities between book and tax income are deliberate preferences, introduced to provide incentives for investment, sometimes available only for investment by entities subject to the corporate tax. Auerbach (1982) and Hulten and Robertson (1982) examine the accelerated depreciation scheme in place for a brief time in the US in the early 1980s, which under many plausible conditions, and in connection with mechanisms for transferring tax losses that temporarily moved the US system closer to full loss offsets (see Gravelle, 1982), effectively eliminated the corporate tax. Interest generally is deductible, producing a potential bias

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against equity and in favor of debt financing (see Warren, 1974, and below). Although preferential treatment may be available for capital gains, the corporate tax base frequently includes extraordinary gains as well as income from operations. Corporate income is ordinarily computed on an annual basis, with only clumsy mechanisms for carrying back and forward losses to smooth out income. Among the shortcomings in such mechanisms are nonrefundability and an unwillingness to allow the loss incurred with respect to one corporate investment to be available to shelter the gain from a previously unrelated investment, or to allow adjustments for the timing of payment and refund. Many systems provide for carrybacks and carryforwards of losses, but few provide for full loss offsets. Failure to provide such offsets may affect the type of risks undertaken and may provide an advantage for diversified over undiversified firms (Romano and Campisano, 1981). Those firms with loss carryforwards ordinarily face a lower than statutory rate on earnings from new investments (since carryforwards effectively postpone tax payments), while those with carrybacks face the statutory rate (since carrybacks produce current refunds). Auerbach and Poterba (1987b) find that the presence of such carryforwards can have significant effects on investment incentives. Although corporate income is taxed both to the corporation and when realized by shareholders, most classical tax schemes include some mechanism whereby additional levels of corporate tax are avoided. Dividends from wholly-owned subsidiaries are frequently eliminated entirely in the measure of corporate income; dividends on portfolio stock maybe partially eliminated; certain other transactions among related, and sometimes even among unrelated, corporations may be given special tax accounting treatments (see generally Mundstock, 1988). As noted above, interest paid on debt is generally deductible, while returns paid on equity are not. Despite the apparently enormous consequences, distinction between debt and equity is not easily maintained, Plumb (1971) contains a thorough examination of the case law attempting to establish the distinction; Bulow, Summers and Summers (1990) examine more recent devices used to obtain debt tax treatment for equity investment. Scholes and Wolfson (1990) explore the extent to which this distinction can be exploited to avoid the double tax completely; and ultimately conclude that, as long as competitive investment is available, full self-help integration is not possible.

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7. Measures of Corporate Tax Burden and Incidence. Establishing Effective Corporate Tax Rates Despite the obvious significance of the question, very little conclusive analysis or reliable data is available regarding the actual burden of the corporate tax. Frequently, information about the tax liabilities of particular firms is simply not available. It is generally accepted that effective corporate tax rates are likely to differ from statutory rates in at least three important ways, even if tax payments can be matched with reliable information about income for tax purposes. First, if the permanent preferences that are available for certain types of corporate income (as are commonly offered for corporate dividends paid on stock held by corporations) have been capitalized, an implicit tax will reduce corporate tax payments without increasing corporate after-tax income. Second, some express preferences reduce current corporate tax liabilities but increase future tax liabilities, resulting in deferred taxes. Third, tax accounting rules (such as the limitation on corporate capital losses) will frequently result in additional timing disparities that make comparisons of tax payments with corporate income in any one year difficult. Perhaps the most controversial efforts to estimate the effective corporate tax rate in the US have been prepared with the popular press in mind. McIntyre and Folen (1984), McIntyre and Wilhelm (1986), Marovelli and Moser (1990) provide calculations of effective corporate tax rates in the United States based on publicly available data; such analysis frequently is limited by the fact that it can compare only current taxes with current financial income, with no accounting for implicit taxes or even for deferred taxes. Dworin (1985) demonstrates how difficult reliance on such data can be. A somewhat more sophisticated analysis is offered by Shevlin (1990). Collins and Shackelford (1990) attempt to use data available from financial statements to establish average effective tax rates in various jurisdictions. Auerbach and Poterba (1987a) provide some more meaningful measures of corporate tax payments in the United States from the mid-1950s to the mid1980s. Mintz (Canada, 1985) and Mayer (United Kingdom, 1986) analyze the effect of loss carryovers on tax rates. It must be noted that effective tax rates on capital are difficult to determine without taking into account personal taxes as well as corporate taxes and the interplay between personal taxes, corporate taxes, the form of business organization and the form of financing, for example, King and Fullerton (1984). But in the presence of an open international market these relationships may not hold.

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8. Incidence of Corporate Tax Although the primary legal incidence of the corporate income tax is on the corporation itself, the economic incidence is uncertain. If corporate investment must take the form of equity, and if current earnings must be distributed, the classical system will create a bias against investments in corporations, but the prevalence of those conditions is uncertain. Furthermore, the use of the corporate form to allow maximum use of preferences for capital gains and basis step-up at death for share appreciation when earnings can be retained, the availability of preferences only for investment in corporate form, and the use of debt as a means of distribution for those returns that cannot be retained all mitigate the bias against investment in corporate form. Nevertheless, it is generally assumed that the classical corporate tax system raises the corporate cost of capital and therefore increases the share of capital allocated to the noncorporate sector. Under such a view, the burden of the corporate tax might well be ultimately borne equally by corporate and noncorporate capital owners, but the distorting effects on the allocation of capital between corporate and noncorporate are great (Harberger, 1962, 1966; Shoven and Whalley, 1972; Shoven, 1976; Ballard et al., 1985; Gravelle and Kotlikoff, 1989; but Harberger, 1983). McLure (1981) provides a perspective on this literature and applies its insights to questions regarding the determination of sub-national tax incidence. Rogers (1996) provides a useful summary of the research and issues. Empirical work regarding the incidence of the corporate income tax has been, and is likely to remain, inconclusive. In one early and interesting effort, Krzyzaniak and Musgrave (1963) contended that corporations are in fact able to more than fully recoup additional taxes, but were quickly criticized by many, including Cragg, Harberger and Miezkowski (1967) and Slitor (1966). Fullerton and Lim Rogers (1993) report that because very little corporate tax is actually paid, its effect in the United States is primarily through relative price changes, and that because those who are relatively poorer spend more of their incomes on goods produced in the corporate sector, and thus bear a relatively higher burden.

9. Corporate Tax and the Choice of Business Form Very few of the jurisdictions committed to a classical corporate tax attempt to impose taxes on aggregations of business capital or business activity that would remove the tax disincentive to use the corporate form. (However, one such proposal was included in US Treasury, 1992.) Hence there is likely to

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be a bias against incorporation where non-tax considerations allow the activity to be conducted and the required aggregation of capital without incorporation. The bias against suggested by the classical double tax scheme will not be present, however, if the corporate tax rate is substantially lower than the individual tax rate, whether because of difference in statutory rates, or because of special provisions (including deductions for deferred compensation and cost recovery) available only to corporate taxpayers. Such conditions were likely to be present in the US prior to the mid-1980s. Auerbach (1997) summarizes the changes in US law introduced in 1986. The bias against moving capital into corporate form seems likely to have increased given the increasing availability of limited liability, in the US at least, without submission to a corporate level tax. For summaries of the changes in US legal rules that have led to complete avoidance of corporate level tax for new business investment in the absence of public trading, see Burke (1995). The overall impact of the incentives against moving capital into corporate form remains undecided. Mackie-Mason and Gordon (1997) and Gordon and Mackie-Mason (1994) report that changes in organizational form are sensitive to changes in tax rates. Gordon and Slemrod (1998) concur, demonstrating that much of the apparent rise in personal incomes in the US after 1986 resulting from shifts in business activity away from the corporate form, implying a strong response. Finally, even if the double tax aspects of the corporate tax do not entirely discourage incorporation, they are likely to affect the ways in which capital is provided to corporations, since returns provided as wages, interest, rents, and royalties will be deducted from the corporate tax base while returns on equity contributions will not.

10. The Corporate Tax and Corporate Financial Structure Under the classic corporate tax, dividends are not deducted from corporate income as paid, but in general interest is deducted as it accrues. It is generally accepted that the resulting removal from the corporate tax base of returns to debt is likely to create a strong incentive toward financing with debt. Indeed, if all corporate earnings are paid out as return on debt financing rather than return on equity, the disincentive resulting from presence of the corporate tax to use the corporate form can be eliminated. There is a general consensus, however, that there is not as much corporate debt as would be expected if taxes were the only consideration. Good general summaries of the issues and current research in the US can be found in Scholes and Wolfson (1992) and Auerbach (1990).

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The fact that the classical corporate tax provides an incentive to finance through debt does not, however, suggest that only debt be issued, despite Modigliani and Miller’s early suggestion (1963) that the optimal source of all capital should be debt in the presence of such a preference. Miller (1977) observed that at some point, the price that must be offered to attract debt financing will offset the tax advantage of debt, at least if there is any preference for returns on equity. Furthermore, other aspects of tax accounting and tax preferences will make some firms less able to take advantage of the tax incentive afforded by debt, and may result in lower levels of debt (DeAngelo and Masulis, 1980). Although it is hard to explain changes in the amount of corporate leverage without understand more about the phenomenon generally, several empirical studies suggest that corporate debt levels do indeed respond to relative tax rates on corporate income. Auerbach (1985) (finding relation between debt levels and low effective rates resulting from carryforwards, but not composition of asset cost recovery), Bartholdy, Fisher and Mintz (1985) (a one-point increase in Canadian corporate tax results in 3/4 point increase in corporate debt/equity ratio), Mackie-Mason (1990), Graham (1996) and others have attempted to estimate the sensitivity of this relationship (Rangazas and Abdullah, 1987). Gentry (1994) shows an increase in debt by firms who can pass-through tax losses to investors. Schulman et al. (1996) report that imputation integration in New Zealand and Canada reduced debt/equity ratios. Others, however, have failed to find tax effects on levels of corporate borrowing (Ang and Peterson, 1986; Bradley, Jarrel and Kim, 1984). Taggert (1985) concludes that although tax factors have played a role in the increased debt levels of corporations in the United States, they do not provide a complete explanation; Gordon and Mackie-Mason (1990) similarly find less response to taxes than predicted. Even less certain is whether this possible distortion in favor of debt financing should be considered inefficient. The discipline that debt brings to managers is likely to reduce agency costs, but the losses occurring as a result of the incentive to choose less risky and shorter termed investments which are not wealth-maximizing may outweigh them. Full consideration of equity/debt and corporate financial structure beyond the scope of this article; more general surveys of optimal capital structure can be found in Barclay, Smith and Watts (1995), Myers (1993), Harris and Raviv (1991), Taggert (1985), Auerbach (1985) and Jensen and Meckling (1976).

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11. The Corporate Tax and the Incentive to Distribute Corporate Earnings Under the classic corporate tax, individual shareholders that receive dividends are taxed on the full amount of those dividends, usually without preference and without offset for their investment in their shares. Shareholders who realize their returns through the sale of shares, on the other hand, frequently enjoy a capital gains preference, and can offset proceeds with investment basis on all sales of shares. They may be able to avoid tax entirely through the rules avoiding income tax on gains remaining unrealized at death. (Although this fact is almost entirely overlooked in the analytical literature mentioned below, there are significant exceptions to this general pattern of tax burden on dividend payments in the US. First, payments denominated ‘dividends’ will be subject to only capital gains taxation if there are no corporate earnings for tax purposes (‘earnings and profits’), even though ordinarily there must be earnings for corporate law purposes in order for dividends to be paid. Such ‘return of capital’ dividends are highly likely when cost recovery allowances for tax purposes exceed similar allowances for corporate law purposes, and when corporations are successful in engaging in restructuring transactions which reduce earnings for tax purposes. Second, only individual shareholders are in fact subject to the double tax: corporate shareholders are allowed to eliminate a substantial portion of dividends paid by domestic corporations, and tax-exempt entities, including pension plans, pay no tax at on dividend receipts at all.) This disparity between the tax treatment of shareholders who receive dividends and shareholders who participate in sale transactions led to an early debate about whether the regular payment of dividends lowered share prices and required higher dividend rates, for example, Litzenberger and Ramaswamy (1979, 1982), Bradford and Gordon (1980), Miller and Scholes (1982), Morgan (1982), Poterba and Summers (1984), Wu and Hsu (1996). This disincentive would not, however, affect dividend behavior if the share price of corporate stock is set by investors for whom the tax impact of dividends and capital gains are the same (Miller and Scholes, 1978). Miller (1986) reviews this literature. Similarly, it is frequently supposed that the classic corporate tax provides a imposes a cost on the distribution of earnings, and that an increase in the tax cost of dividend distributions should result in a lower level of dividend payouts. Some empirical studies support this view: Brittain (1966) (analyzing US dividend behavior from 1920 to 1960); Feldstein (1970) (British firms from 1953 through 1964); King (1971, 1972) (British firms from 1949 through 1967), but Feldstein (1972); Poterba and Summers (1985); Poterba (1987) (US firms through 1986). On the other hand, there should be no incentive to avoid distribution of corporate earnings simply to avoid the shareholder level tax on the

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distribution, if those earnings must eventually be distributed and must be subject to the same tax in the future. (Under this view, the tax cost of a distribution must decrease the overall return to the shareholder, whether it does so on an immediate distribution that reduces the net-after-tax amount received by the shareholder now, or whether, if the earnings are retained, reinvested, and distributed in the future, it reduces the net-after-tax amount received by the shareholder on that future distribution (Auerbach, 1990). Thus, there should be no effect on the marginal investment decisions of firms as a result of the double tax resulting from the taxation of dividends. Although the tax treatment of dividends should create a disincentive to new contributions to firms through new share issues and should generally reduce the amount by which such new share issues increase the value of the firm, this tax treatment would not change the firm’s dividend behavior, which would be governed by nontax considerations. In the absence of any significant nontax benefits to distributions, the firm would pay dividends only when no profitable investment could be made. A permanent change in the tax on dividends would not affect distributions, but would operate only as a charge on retained earnings and on new equity contributions. Under this view (sometimes still referred to as the ‘new’ view), equity is ‘trapped’ in corporate form, and the inevitable tax on payout is capitalized into share price. Early contributions supporting this view include King (1974, 1977), Auerbach (1979, 1983b), Bradford (1981). In fact, however, the future tax on distributions can be avoided in several ways: (1) if no current distribution of corporate funds is ever made and the shareholder’s return is received through the sale of stock (especially when this return is, as is frequently the case, entitled to a special capital gains rate or to the benefit of forgiveness at death through stepped up basis) and (2) distributions are made from the corporation in the form of share redemptions (not permitted in all jurisdictions) and distributions made in connection with acquisitions, both of which may also be subject to more favorable tax treatment. If corporate earnings can be transformed without significant cost to borrowings (for instance through redemptions of stock held by exempt shareholders) there may in fact be little or no disincentive for current distribution of corporate earnings through such non-dividend techniques. Shoven (1987) reviews the tax consequences and provides estimates of such behaviors by firms in the 1970s and 1980s. Bagwell and Shoven (1989) provide a useful summary of the various incentives faced by corporate managers and conclude that the increased use of non-dividend techniques for distributions to shareholders may be attributable to the simple phenomena of an increased awareness and understanding of the ‘technology’ of implementing such devices under relatively complicated tax rules.

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The debate about the limitations inherent in the assumptions necessary to the ‘new view’ and the implications of the new view remains unresolved. Most agree that for the traditional view to hold, there must be some countervailing benefit to the corporation or its managers upon the distribution of dividends, but there is little agreement as to whether those benefits include signaling or merely provide a mechanism for disciplining corporate management. If there is such a benefit, it may be exceeded by an increased tax cost of dividend distributions and, therefore, increased tax burdens on dividends would decrease dividend payouts. Most also agree that one strong implication of the new view is that the net value of the firm’s shares must be less than the total value of the firm’s assets. Such a discount to share value would be present unless there were some inherent advantage to investments conducted through the corporate form, but the identification of this advantage has been elusive (and will likely remain elusive as the tax law, at least in the US, continues to shift). This appears to have led some to conclude that the new view can hold only if share repurchases are prohibited, since if they were not, firms would simply repurchase shares until the discount was eliminated. Sinn (1991c) argues that the traditional view implies that corporations do not minimize their cost of capital, and further that the new view is plausible even when share repurchases can be made, so long as limits on such devices are present. Zodrow (1997, 1991), Poterba and Summers (1985) and Sorensen (1995) also elaborate upon the implications of the ‘traditional’ and ‘new’ views. Zodrow (1997) and Gerardi, Graetz and Rosen (1990) both conclude, after reviewing the empirical literature, that it primarily supports the traditional view. Perhaps the most significant practical implication of the new view is that to the extent that the new view is correct, the burden of the double tax on corporate dividends is capitalized in the market value of its shares. Any lessening of the burden of double taxation through any form of integration would therefore create a windfall for shareholders of firms with retained earnings. The likelihood that the new view is correct at least to this extent explains at least part of the reluctance in the US to move toward full integration (Hubbard, 1993; Halperin, 1992, considering the conclusions reached in American Law Institute, 1979, 1989).

12. Jurisdiction over the Corporate Tax Base and Sufficiency of Nexus to Tax Corporate economic activity frequently ignores the political boundaries by which jurisdiction to tax is ordinarily assigned. Rarely are there constitutional barriers to the assertion by each polity with which the activity

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has some minimal nexus asserting the power to tax such economic activity and to define the base according to which that tax will be assessed. Nevertheless, most polities acknowledge a need to avoid overtly duplicative taxes, especially when the chosen base is income. A good survey of the issues and patterns of solutions can be found in Easson (1997). There are two principal approaches that can be used to assign taxing power among competing taxing polities. Under an assignment or sourcing method, each polity adopts rules according to which a corporation’s income is categorized as most closely related to one taxing jurisdiction. If more than one jurisdiction asserts the power to tax this income, a credit can be given (generally by the home polity) for the taxes paid elsewhere (generally the foreign site of the economic activity). McIntyre (1994) provides an overview of this approach as applied by the United States; Green (1993) Ault and Bradford (1990) and Hufbauer (1992) highlight the issues inherent in its use. Under the apportionment method, a corporation’s income can be apportioned to each taxing jurisdiction according to a formula that takes into account the location of the business activity (frequently sales, payroll and property). Even if two jurisdictions adopt the same approach to avoiding duplicative taxes, there is rarely any device for ensuring that the implementation of the approaches are consistent. Avi-Yonah (1995) explores agency-theory-based rationales for the approaches taken for operational and passive income. Each state in the United States, for instance, is free to define its own apportionment formula so long as that apportionment formula, if adopted by every state, would avoid duplicative taxes (McLure, 1986; Gordon and Wilson, 1986; Hreha and Silhan, 1986). Each of these approaches must include variants to take into account the fact that frequently corporate activity that encompasses more than one jurisdiction will be undertaken by more than one formal corporate entity. Generally, jurisdictions (including the United States) that rely on an assignment approach will require that transfer prices among entities be at ‘arm’s length’ prices so as to avoid jurisdictional distortions (see generally Avi-Yonah, 1995). Jurisdictions that use an apportionment method are likely to require that all related corporations ‘combine’ their income, so that apportionment will take into account all related entities. Each approach must also consider how to treat transfers of dividends to related corporations that are not wholly or exclusively subject to their taxing power. Under the assignment method as implemented by the United States, income of foreign subsidiaries will ordinarily not be subject to United States’ tax as earned, but will be subject to United States’ tax as it is repatriated as dividends, and a credit for foreign taxes paid will be available upon repatriation. Under a fully combined apportionment method, dividends paid to related corporations should be ignored.

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Finally, it is highly likely that any one taxing scheme will, at least in some of its details, include features from both approaches. For instance, despite the fact that the United States in general uses sourcing with arm’s length pricing to establish the taxable income of multinational groups, since 1986 interest expense must be apportioned according to asset holdings. (For an analysis of this change, see Froot and Hines, 1995; Altshuler and Mintz, 1995.) There is at least some evidence that sourcing systems impose significantly greater compliance costs than apportionment systems (Blumenthal and Slemrod, 1996).

13. Effect of Corporate Taxes on Investment in Multinational Economies Although it might not be obvious to the modern observer, the pattern of taxation for multinational businesses was the product of more systematic thinking than many other areas of US federal taxation. Graetz and O’Hear (1997) recount the role of early economists in this history. Picciotto (1992) provides an exhaustive review and analysis of the current patterns. A good summary of the relevant rules and a straightforward review of the most prominent empirical research can be found in Hines (1997). (In this review, Hines concludes that real responses to taxes are as one would expect: there tends to be more direct investment where corporate tax burdens are anticipated to be lower.) Gordon and Mackie-Mason (1995) offers interesting speculation about the incentives leading to the prevailing patterns of international tax, and conclude that significant parts of the current pattern reflect the need to preserve the personal income tax on the return to entrepreneurial labor. Some jurisdictions, including the US, claim the right to tax all income, domestic and foreign, of their resident taxpayers, including corporations. However, in keeping with the classical corporate income tax, the income of separately incorporated foreign entities conducting active businesses is ordinarily not subject to US tax until it is repatriated through dividends. Hartman (1985) theorized that if such repatriation taxes are unavoidable, their existence should not affect the decision whether to repatriate or reinvest in the source jurisdiction, essentially applying a ‘trapped equity’ analysis to the repatriation decision. Hines (1994) and Leechor and Mintz (1993) point out that variations in income-defining rules can be sufficient to alter this result. Empirical studies (Goodspeed and Frisch, 1989; Hines and Hubbard, 1990; Altshuler, Newlon and Randolph, 1995) suggest that repatriation taxes do in fact vary sufficiently to provide other incentives. Hines (1997) suggests that the tax costs of repatriation may encourage undercapitalization of foreign subsidiaries so that profitable opportunities

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remain for the reinvestment of retained earnings, and notes that this incentive may make attempts to measure the influence of foreign tax rates on foreign direct investment. Roin (1988) develops a public choice analysis of the exceptions to the limitations on deferral for relatively passive foreign acitivities. In the US, a credit against domestic taxes is allowed for foreign taxes paid. It has sometimes been assumed that the foreign tax crediting device used by the US results in a lower national return on foreign direct investment by US corporations than the national return on displaced domestic investment (for example, Dutton, 1982). Recent analysis suggests that the loss due to taxes yielded to the foreign jurisdiction may be offset by the overall greater return resulting from lower costs of foreign capital (Feldstein, 1995). At the multinational level, all of the possibility of tax effects on choice of form and financial structure found domestically are present, with additional possibilities resulting from the variety of rates, the special treatments afforded by treaty, and the arbitrary and inconsistent nature of the rules used by the various jurisdictions for allocating items affecting measures of income. Predictably, multinationals structure their transactions in ways that, for instance, yield accounting profits in low tax jurisdictions and place the tax shields afforded by debt finance. Hines (1997) reviews the empirical studies evidencing this behavior. Among the most difficult, and yet most fundamental, problems in analyzing the effect of national corporate income taxes on corporate behavior and general business investment is a determination of the effective tax rates in the various jurisdictions to be studied. The problem is complicated by the fact that stated nominal tax rates and published legal rules are unlikely to provide complete information about the tax burdens actually felt by corporations. The most ambitious empirical study, and an enormous amount of data regarding rates and bases can be found in OECD (1991). Attempts to further analyze and update such data include Jun (1995).

14. The Corporate Tax and Corporate Mergers and Acquisitions Any corporate income tax scheme, whether classic or integrated, must set out criteria for determining when transactions relating to corporate assets and to corporate stock interests will be treated as events that will trigger corporate income tax. (Such events frequently will trigger all unrealized gain on assets and will trigger reconciliation of various suspended accounting preferences.) The US scheme has evolved largely through judicial interpretation with only limited statutory modification. Very little

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attention has been given to the distortions created by the resulting framework, perhaps because the framework, although arcane, provides sufficient flexibility. Under the US scheme for taxing restructuring transactions, shareholder realization is frequently tied to corporate realization, and flexibility in accommodating all shareholder interests may be difficult. Ginsburg and Levin (1996 and updated regularly) provide an intricate account of the current US rules. Some changes in control will be treated as merely continuing the tax existence of a corporation, and thus will not result in the triggering of gains on assets, the loss of grandfathered accounting methods, or the discontinuance of carryover tax losses. Other changes in control may be treated as discontinuous, and will trigger gains, force new accounting methods and cut off unused losses. Under certain circumstances prior to 1986, however, such a change in control that is treated as discontinuous could have produced a highly desirable result for US corporations, since it allowed a step-up in tax-basis of assets held at the corporate level without the payment of corporate level tax. These rules must establish highly arbitrary distinctions upon which rest frequently enormous stakes. For instance, sales of stock among shareholders will not ordinarily trigger gain on corporate assets, since the formal identity of the owner of the assets has not changed, but transfers of assets to different corporate entities will trigger gain on those assets unless there is substantial overlap between the owners of the new entity and the owners of the old. Therefore when an existing corporation is acquired, there can be enormous tax differences depending upon whether the transaction is viewed as a transfer of assets or of stock. To complicate things further, corporate tax regimes frequently will include special rules designed to mitigate the arbitrariness of such distinctions, but that make it still harder for observers to ascertain the effect of any particular set of rules. (For instance, until 1986, the United States allowed certain purchases of corporate stock to be treated as purchases of stock for the purpose of taxing shareholders, but as purchases assets for the purpose of the corporate level tax. This special rule was available only if the purchaser was a domestic corporation that acquired at least 80 percent of the stock of the target.) These arbitrary distinctions clearly have an enormous influence on the form that changes in corporate control take. It is less clear, however, whether they have any effect upon the frequency or price at which changes in corporate control occur. In the older literature it was generally assumed that at least some some changes in corporate control occurred in which the only motivation was tax-related (see Feld, 1982; Hellerstein, 1959; Butters, Lintner and Cary, 1951). More recent literature suggests that at least in the aggregate, the presence of tax gains are not as certain to have increased acquisition activity.

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Auerbach and Reishus (1988a) provides a useful summary of the various incentives in US law. Gilson, Scholes and Wolfson (1988) review the overall interaction of the pre-1986 United States tax rules most frequently thought to produce tax gains from acquisitions, and conclude that many such gains could be accomplished in other ways. Their conclusions seem too dependent on the availability of other means of accomplishing the tax gains, which although plausible for some tax gains when viewed separately, seem less likely to be available in conjunction with other tax gains and with other goals. Another study by Auerbach and Reishus (1988b) however, concluded that in a least a fifth of the mergers studied, occurring between 1968 and 1983, the merger allowed a corporation to free itself from constraints on the use of tax benefits but did not find useful measures either of increased cost recovery or increase debt shields. One survey of transactions concluded that the primary gains from management buyouts were tax gains (Lowenstein, 1985). Jensen, Kaplan and Stiglin (1989) argue that certain acquisition activities actually increase tax revenues, although Bulow, Summers and Summers (1990) demonstrate that an increase in revenue is not necessarily inconsistent with a tax incentive derived subsidy. Some of the earlier writing regarding tax-motivations for corporate acquisition activity assumed that such activity would be socially undesirable. Several recent writers have challenged this assumption in passing, and offered several possible scenarios in which tax-motivated acquisition activity could produce social gains. Tax gains from various acquisition activities could, for instance, increase the premium for successful searches for operating efficiencies through acquisition activity (Gilson, Scholes and Wolfson, 1988); or restore incentives for investment by restoring tax incentives for investment that are weak in the absence of positive corporate tax liabilities (Auerbach and Reishus, 1988). Changes in the US law in 1984 (eliminating the possibility of stepping up depreciation deductions without a corporate level tax), and in 1986 (generally eliminating the exemption from capital gains taxation for distributed assets imposing additional limits on the use of carryover losses after a merger transaction), have substantially decreased the likely to be obtained through merger activity. The changes appear to have lessened interest in the study of tax motivations for merger activity, despite the possibility that data reflecting the change in tax regimes may be more useful than that studied previously. An analysis of these changes, and some discussion of their impact appear in Scholes and Wolfson (1991). Hayn (1989) provides an interesting study of the effect of the value of tax attributes on merger activity for which a IRS ruling was requested.

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15. Integration of Corporate and Individual Level Income Taxes Under ‘integrated’ schemes, various devices are used to attempt to eliminate or minimize this double tax effect. Among the simplest of such devices is a ‘passthrough’ of corporate income to the shareholders even in the absence of a distribution of earnings, producing a liability at the shareholder level even if the corporation retains the funds generating the liability. Later distributions of corporate earnings are not subject to tax. (Although the classic scheme prevails for capital transferred to corporations before 1986, an increasing number of US enterprises can enjoy both passthrough integration and the limited liability associated with incorporation by using either the special rules available under subchapter S of the Internal Revenue Code (at the cost of a being restricted to a very limited number of shareholders and corporate structure), or by using the newly emerging limited liability company (at a cost of uncertainty regarding both the tax consequences and the default rules governing stakeholder relations).) Yin (1992) and Warren (1981) provide an exhaustive summaries of the available choices for implementing integration from the starting point of the classical system in the US. Integration can also be accomplished by allowing dividends to be paid without tax consequence to shareholders. Other more complicated integration devices include a corporate level tax, with a credit for such tax to be claimed by the shareholder upon the ultimate distribution of the earnings and after the amount of tax actually paid is imputed as part of the distribution (Australia, New Zealand, Canada, France, the United Kingdom and Germany all have used some form of imputation credit to accomplish varying degrees of integration), a split rate tax (under which distributed earnings are taxes at a lower rate than undistributed earnings, used by Japan and Germany), or a credit to the paying corporation upon the distribution of dividends. To the extent that the anticipated burdens of the classical double tax have been capitalized in existing capital, the considerations involved in moving from a classical scheme to an integrated scheme differ from those that would be considered prior to the imposition of any tax because a transition device would be necessary to avoid a windfall to existing corporate holdings. It is not clear, however, that such windfalls would be present, as suggested by the lack of price response to the announcement of integration in the United Kingdom in 1970 revealed by Poterba and Summers (1985). Auerbach (1990), McLure (1979), Sunley (1992), Cnossen (1993) and US Department of the Treasury (1992) provide in-depth discussions of the circumstances under which various approaches to integration might be desirable. International considerations make integration issues even more difficult, especially since there is no consensus about whether the jursidiction to tax should lie primarily with the jurisdiction in which business activity is

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conducted or the jurisdiction whose resident is supplying capital through share or debt ownership. Uncertainty about tax effects in open and closed economies makes evaluations of integration proposals especially difficult (Boadway and Bruce, 1992; Devereux and Freeman, 1995). Under the more common approaches to the integration, relief form double taxation is appropriate only for resident shareholders (Ault, 1992; Doernberg, 1992).

Bibliography on Corporate Taxation (6060) Abbott, Ashok Bjardway (ed.) (1987), The Valuation Effects of Tax Legislation in Corporate Sell Offs, Ph.D. Thesis, Virginia Polytechnic Institute and State University. Aivazian, Varouz A. and Turnbull, Stuart M. (1988), 'Taxation and Capital Structure: A Selected Review', in Coffee, John, Lowenstein, Louis and Rose-Ackerman, Susan (eds), Knights, Raiders and Targets: The Impact of the Hostile Takeover, Oxford, Oxford University Press, 230-277. Allen, Franklin (1989), ‘The Changing Nature of Debt and Equity: a Financial Perspective’ (Discussion), in Hart Oliver D. and Merton Robert C., Are the Distinctions Between Debt and Equity Disappearing? Allerdings, Jeffrey Paul (ed.) (1992), The Effects of the Corporate Alternative Minimum Tax on Corporate Tax Liability, MS Thesis, San Francisco, State University. Allsop, Peter (1991), 'Taxation Aspects of Corporate Finance', in Coffee, John, Lowenstein, Louis and Rose-Ackerman, Susan (eds), Knights, Raiders and Targets: The Impact of the Hostile Takeover, Oxford, Oxford University Press, 443-466. Alstott, Anne L. and Mackie, James B. (1992), 'Approaches to Corporate Integration: The Treasury Department Report’ Ph.D. Dissertation, 45 National Tax Journal, 209-223. Altshuler, Rosanne T. and Auerbach, Alan J. (1990), 'The Importance of Tax Law Asymmetries: An Empirical Investigation', 105 Quarterly Journal of Economics, 61-86. Altshuler, Rosanne T. and Mintz, Jack M. (1995), 'United States Interest-Allocation Rules: Effects and Policy', in Giovannini, A., Hubbard, R.G. and Slemrod, J. (eds), Studies in International Taxation, Chicago, University of Chicago Press. Altshuler, Rosanne T. and Newlon, T. Scott (1993), 'The Effects of U.S. Tax Policy on the Income Repatriation Patterns of U.S. Multinational Corporations', in Giovannini, A., Hubbard, R.G. and Slemrod, J. (eds), Studies in International Taxation, Chicago: University of Chicago Press, 77-115. Altshuler, Rosanne T., Newlon, T. Scott and Randolph, William C. (1995), 'Do Repatriation Taxes Matter? Evidence from the Tax Returns of U.S. Multinationals', in Feldstein, M. (ed.), The Effects of Taxation on Capital Accumulation, Chicago: University of Chicago Press, 253-276. Alworth, J.S. (ed.) (1988), ‘Investment and Taxation Decisions of Multinationals', in Coffee, John, Lowenstein, Louis and Rose-Ackerman, Susan (eds), Knights, Raiders and Targets: The Impact of the Hostile Takeover, Oxford, Oxford University Press.

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Wilson, G. Peter (1993), ‘The Role of Taxes in Location and Sourcing Decisions’, in Giovannini, A., Hubbard, R.G. and Slemrod, J. (eds), Studies in International Taxation, Chicago, University of Chicago Press. Winsen, Joseph K. (1992), ‘The Interaction Between Fringe Benefits Tax, Salary and Franked Dividends’, Sept Australian Tax Review, 149-154. Wiseman, Jack (1974), Theoretical and Empirical Aspects of Corporate Taxation. Wolfman, Bernard (1979), ‘Integration of the Corporate and Individual Income Taxes in the United States’, 33 Bulletin for International Fiscal Documentation, 305-309. Wolfson, Mark, Alan, ‘The Effects of Ownership and Control on Taxes and Financial Reporting Policy’, 22 Economic Notes, 318-322. Woodside, Kenneth (1982), ‘The Symbolic Politics of the Corporate Income Taxation: Canada and Britain, 1945-1980’, in Stone, Alan and Harpham Edward (eds), The Political Economy of Public Policy, Sage, Beverly Hills. Woodworth, Jay N. (1990), ‘Different Economic Systems: Vast New Opportunities for Business Economists: NABE Presidential Address’, 25(1) Business Economics, 10-17. Wozny, James (1991), ‘The Taxation of Corporate Source Income in Jamaica’, in Bahl, Roy (ed.), The Jamaican Tax Reform, Cambridge, MA, Lincoln Institute of Land Policy, 265-323. Wu, Chunchi (1996), ‘Taxes and Dividend Policy’, 5 International Review of Economics and Finance, 291-305. Wu, Chunchi and Hsu, Junming (1996), ‘The Impact of the 1986 Tax Reform on Ex-Dividend Day Volume and Price Behavior’, 49 National Tax Journal, 177 ff. Yin, George K. (1990), ‘A Different Approach to the Taxation of Corporate Distributions: Theory and Implementation of a Uniform Corporate-Level Distributions Tax’, 78 Georgetown Law Journal, 1837 ff. Yin, George K. (1992a), ‘Achieving Corporate Integration Through Double Taxation’, 56 Tax Notes, 1365-1368. Yin, George K. (1992b), ‘Corporate Tax Integration and the Search for the Pragmatic Ideal’, 47 Tax Law Review, 449-468. Yin, George K. (1997), ‘The Taxation of Private Business Enterprises: Some Policy Questions Stimulated by the "Check-the-Box" Regulations’, 51 SMU Law Review, 125 ff. York, Harold L. (1993), ‘An Applied General Equilibrium Model of International Tax Competition among the Group of Seven Countries’, 15(56) Journal of Policy Modeling, 653-672. Young, K. H., ‘The Effects of Taxes and Rates of Return on Foreign Direct Investment in the U.S’, 41 National Tax Journal, 109-121. Zarin Nejadan, Milad (1992), ‘Fiscalite, q de Tobin et Investissement Prive en Suisse’, 58(2) Recherches Economiques de Louvain, 213-235. Zelenak, Lawrence (1984), ‘Serving Two Masters: Commercial Hues and Tax Exempt Organizations’, 8 U.P.S. Law Review, 1 ff. Zelinsky, Edward A. (1990), ‘Greenmail, Golden Parachutes and the Internal Revenue Code: A Tax Policy Critique of Sections 280G, 4999 and 5881’, 35 Villanova Law Review, 131 ff. Zelinsky, Edward A. (1993), ‘The Tax Policy Case for Denying Deductibility To Excessive Executive Compensation: Disguised Dividends, Reasonable Compensation, and the Protection of the Corporate Income Tax Base’, 58 Tax Notes, 1123 ff.

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6070 INHERITANCE AND GIFT TAXATION Paul B. Stephan Percy Brown, Jr. Professor and Barron F. Blak Research Professor, University of Virginia School of Law © Copyright 1999 Paul B. Stephan

Abstract This chapter reviews the economic literature on inheritance and gift taxation. It discusses, among other things, the arguments for subsidizing transfers, the advantages of and problems with accessions taxation, the relationship of transfer taxes to income tax, proposals for unification of tax rates, proposals for base integration, special rules for transfers within family units, problems with interspousal transfers, and the implementation of generation-skippingtransfer taxes. JEL categories: K34 Keywords: Life-Cycle Assets, Transferor Tax, Accessions Tax, Interspousal Transfers, Generational Issues

1. Introduction Although death duties and comparable excises have existed since ancient times, long outstripping income taxation in length of history, no modern industrial or postindustrial state relies on estate, inheritance, or gifts taxes (‘transfer taxes’) for a significant portion of its revenues. As a result, transfer taxation plays almost no role in fiscal policy. Moreover, in most countries transfer taxes affect a small proportion of the population. In the United States, for example, less than 1 percent of all decedents who have died since the 1981 rate cuts went into effect have had to file estate tax returns, much less pay any tax. But for the few persons affected by transfer taxation, either as a potential transferor or transferee, the levy can be huge. For the wealthiest persons in the United States, a bequest to grandchild might be taxed at a 78.25 percent marginal rate.

2. Historical Pattern Perhaps for these reasons, the law and economics literature has not focused on transfer taxation to the extent it has on other tax issues. Rather, one may detect a pattern where, every generation or so, there takes place broad normative 239

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discussions of transfer tax design. The discussion plays itself out, usually without much consequence for the actual tax rules. The topic disappears from view, to return some years later. When less radical changes do transpire, the ensuing commentary reflects the broad-based literature but does not necessarily build upon it. Thus in the 1960s Meade (1964), Shoup (1966), Tait (1967), Jantscher (1969), and Andrews (1973), among others, either initiated or responded to proposals for systemic and expansionary transformation of transfer taxation. These proposals in turn drew on ideas propounded in Simons (1938) and Vickrey (1947). Two decades after this flurry of interest in increasing the effectiveness of transfer taxation, Bracewell-Milnes (1989) presented diametrically opposed, but at least as radical, proposals to abolish taxes on gifts and bequests. These works and the scholarly traditions to which they have contributed have framed a number of policy issues, some fundamental and others more technical, but have not provided definitive answers to any of the questions raised.

3. Role in Redistribution of Wealth Most transfer tax systems, and particular that of the United States, target the rich, either largely or exclusively. Much of the debate about these taxes therefore turn on assumptions about the existing distribution of wealth and the feasibility of effecting a redistribution. Both sides of this debate accept for purposes of argument the legitimacy of wealth redistribution as a social goal. Proponents of transfer taxation argue that ownership of assets is concentrated among a small portion of the population, that this concentration of wealth does not represent only differences in lifetime consumption, and that transfer taxation represents an effective way of redressing the misdistribution of economic power. These points are forcefully put in Vickrey (1947), Meade (1964), Shoup (1966), Tait (1967), Jantscher (1969), Kurtz and Surrey (1970), Brannon (1973), Graetz (1983) and Pechman (1987). Critics argue that measures of the concentration of wealth are underinclusive and therefore exaggerate the exent of concentration, that a large portion of wealth represents provisions against future consumption, and that the causes of inequality in society either are not related to family property holdings or cannot be remedied by a tax on gratuitous transfers of property. Variations of these points can be found in Collie (1973), Covey (1973), McCaffery (1994), Wagner (1977) and Bracewell-Milnes (1989).

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4. Life-Cycle Assets versus Capital Assets One important emprical question that underlies the debate over the efficacy of transfer taxation as a means of redistributing wealth is the proportion of wealth that is transferred gratuitously. The literature has developed a distinction between life-cycle assets, which represent household savings intended to finance future consumption, and capital assets, which households accumulate with the purpose of transferring to future generations. If most wealth is acquired for future consumption, a tax that applies only to transfers will not reach it. People would die holding assets only because of unanticipated mortality, and transfer taxes would serve only to punish the unlucky. If, on the other hand, a large portion of wealth constitutes capital assets, a tax on gratuitous transfers would have a significant impact on its ownership and could contribute to its redistribution.

5. Relative Mix of Life-Cycle and Capital Assets A sharp disagreement exists among researchers who have tried to estimate the relative mix of life-cycle and capital assets. Modigliani (1988) estimates that 80 percent of US wealth constitutes life-cycle assets, while Summers (1981) and Kotlikoff (1988) argue that more than half of all wealth represents capital assets. The gap reflects a dispute over how to characterize particular types of transfers, in particular income from inherited property and support of children over the age of majority but still in school. Underlying these disagreements are deep problems. In a post-industrial society, one might argue, the education purchased by affluent parents may prove to have greater income-generating capacity than financial property such as stock and bonds. This claim would support the characterization of tuition payments and similar support to students as the creation of a capital asset. But, at least in the United States, a substantial portion of the cost of education is financed by alumni, who make deferred payments in the form of nominally charitable contributions once their investment reaches its peak income-producing potential. If parental funding is incidental to education’s wealth-creating potential, then one instead might characterize education-related payments as a form of intrahousehold consumption.

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6. Research on Distribution of Wealth Aaron and Munnell (1992) provide a relatively recent review of the research on the distribution of wealth and the relative distribution of assets used for consumption and other purposes. W1 consists of tangible assets, equities and bonds, and the cash surrender value of trust funds and pension plans. W2 adjusts W1 to take into account the full value of trust funds and pension plans. W 3 adds the discounted present value of future social insurance receipts. The authors further attempt to estimate the distribution of life-cycle wealth and capital wealth by splitting the difference between the Modigliani and SummersKotlikoff approaches. If one looks only at W1, the data suggest that in the United States the proportion of capital wealth to life-cycle wealth has grown significantly between 1930 and 1990, which in turn implies an increase in the power of assets holders to wield dynastic power. If one instead includes W3, the data indicate that the proportion of capital wealth to total wealth has remained fairly steady. In other words, the rich are getting richer, but only at the same rate as everyone else. Other survey data suggest that the amount of W1 held by the wealthiest 1 percent of the population increased substantially during the 1980s, after the 1981 transfer tax rate cut went into effect, but these surveys do not measure W3 after 1983. Studies of Great Britain and Sweden show a marked decline in the concentration of ownership of W1 between 1940 and 1980.

7. Unconventional Forms of Property Part of the debate over the efficacy of transfer taxation as a means of redressing wealth inequality turns on the capacity of such taxes to reach not just traditional forms of property, but other kinds of rights, powers, and expectations that might seem analogous to property simpliciter. One much-discussed problem is the so-called ‘estate freeze’, which allows an owner to retain some degree of control over an asset while transferring the formal right to enjoy all further appreciation in the asset’s value. A simple example would be a restructuring of a family business in which the sole owner of a company transfers a new class of common stock to children while retaining preferred stock equal in value to the firm’s current worth. US lawmakers have taken several stabs at limiting the freedom of owners to achieve these results, notably in the Revenue Act of 1987 and the Budget Act of 1990 (which substituted a new scheme for the one created only three years previously). Most observers, however, believe that the capacity of families to accommodate their business transactions to the forms required by the tax law outstrips the ability of the legislature to attack the problem. As a result, the transfer tax seems largely an excise extracted from the inattentive or improvident wealthy. Shoup (1966) asks the question of why

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wealthy persons ever find themselves in the position of paying the federal estate tax, given the many means available for avoiding it. At the same time he recounts substantial anectdotal evidence indicating that some extremely rich people do fall prey to this levy.

8. Contribution of US Tax to Progressivity Reforms proposed in 1969 and to some extent adopted in 1976 broadened the scope of US transfer taxation but did not significantly change the rate schedule as such. In 1981 the United States both lowered the maximum tax rates applicable to gifts and estates and increased the amounts that could be transferred exempt from tax. In real dollar terms, the enlarged exemptions were still smaller than those in effect in 1932, when the federal taxes were made permanent. Nonetheless, a number of commentators contend that the 1981 changes represented a significant departure from the previous policy of promoting the redistribution of wealth. Graetz (1983) argues that the pre-1981 federal transfer taxes, although insignificant in terms of absolute amount of government revenues, were responsible for about a third of the total amount of progressivity in federal taxation. He defines progressivity as the increment in taxes collected from persons with greater than average wealth over the amount they would pay if average tax rates applied at all levels of income. He deplores the move away from redistribution implied by the 1981 changes. However, he does not consider the claim that such progressivity as the pre-1981 taxes achieved represented levies against unusually improvident or poorly advised persons, rather than a systematic effort to redistribute wealth.

9. Welfare Analysis of Voluntary Wealth Transmission The intuition that a gratuitous transfer represents a form of valuable consumption for the transferor while benefiting the transferee by increasing either capital or the capacity to consume appears in Simons (1938). The transferor has revealed a preference for the transferee’s welfare, which the transferor values at least as much as possession of the property transferred. The transferee is enriched by the value of the property, defined as the amount for which the property could be exchanged. A formal statement of the claim can be found in Becker (1974). The implications of this insight for tax policy took longer to work out. For Simons, it was enough to show that gratuitous transfers were economically indistinguishable from other transactions normally subjected to income taxation. Following a principle of strict nondiscrimination among categories of income, he therefore would have included the transfers in the

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transferee’s income tax base while continuing the existing rule of not allowing transferors a deduction. A Canadian government study proposed exactly this step in 1966 (Jantscher, 1969), and a study commissioned by the US Treasury explored the implications of such a system in 1976. Other scholars, notably Dodge (1978), also have advocated including gratuitous transfers in the income tax base.

10. Arguments for Subsidizing Transfers More recently, scholars have seized on the welfare implications of Simons’ insight to argue against transfer taxation. Bracewell-Milnes (1989) puts the argument in nontechnical terms by coining the term ‘owner’s surplus’ to connote the value owners attach to their assets in excess of the discounted present value of the asset’s anticipated income stream. He claims that gratuitous transfers, whether charitable or intrafamilial, increase welfare by bestowing owner’s surplus on transferees while providing transferors with value equal to the discounted present value of the anticipated income from the asset. Kaplow (1995) states the argument in formal terms and with great rigor. They both conclude that, to the extent welfare maximization is a legitimate social end, society ought to subsidize gratuitous transfers rather than tax them. Kaplow notes that a number of rules found in US law - income tax deductibility of charitable transfers, the treatment of gratuitous transfers as a nonrealization event to the transferor and as excluded from the transferee’s income tax base, and the basis increase for assets received from a decedent - might be characterized as a kind of subsidy for giving.

11. Arguments for Subsidizing Earlier Transfers A variation on this argument looks at evidence suggesting that younger owners may tend to prefer riskier investments than do older persons. To the extent this claim is true, it would imply that, ceteris paribus, younger owners might underwrite a greater amount of technological innovation and therefore increase social welfare. The data presented by Menchick and David (1983) is suggestive but not conclusive. Stephan (1986) uses this hypothesis to support an argument for tax rules that subsidize lifetime gifts relative to deathtime bequests. He notes that US law generally encourages gifts: the effective gift tax rates are substantially less because the tax is not included in the base, as it is with respect to estates. US income tax rules do disfavor gifts to the extent that gifts are not eligible for the basis step up to fair market value that applies to bequests, but in many cases this distinction is inconsequential because of the upward basis

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adjustment available to gifts subject to the gift tax.

12. Rate Differential Depending on Whether First- or Later-Generation Wealth Economists have made a somewhat different distinction between wealth in the possession of the person who accummulated it and inherited wealth. Rignano (1924) was the first to argue that either an estate or inheritance tax should base the rate of taxation on the age of the wealth. He would have imposed low rates on wealth being transferred by the person who created it and progressively higher rates on those who acquire wealth by inheritance and then seek to pass it on to later generations. He argued that such a system could achieve significant socialization of wealth without destroying the incentive to save and take risks. Kiesling (1992) returned to this proposal and defended it against criticisms based on its difficulty of administration. He proposed operating with a presumption that all wealth passing at death had been ‘aged’ and then placing the burden on the decedent or his beneficiaries to present evidence justifying lower rates. The US generation-skipping-transfer tax, discussed below in Sections 34-35, offers an alternative approach to an analogous problem.

13. Transferor Tax versus Accessions Tax Were all transfers taxed at a uniform rate, it would make no difference whether the levy fell on transferors or transferees. For most purposes the administration of these taxes is indistinguishable, especially if one party has secondary liability for the other’s tax obligation. But as soon as one introduces exempt amounts and a progressive rate structure, the identification of the taxpayer becomes significant. Estate and gift taxes calculate the amount owed by reference to the size of the decedent’s holdings. Inheritance and other accessions taxes look instead at what the transferee receives. The United States and the United Kingdom tax transferors, although their systems differ substantially. Most Continental European countries have accessions taxes instead.

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14. Advantages of Accessions Taxation Advocates of accessions taxes contend that this system has two main advantages over the estate tax (see Andrews, 1973, and Aaron and Munnell, 1992). First, to the extent gratuitious transfers involve life-cycle assets and therefore increase the transferee’s consumption, the tax should fall on the person engaged in the higher level of consumption. Second, to the extent that the tax is intended to encourage the redistribution of capital assets through dispersion of ownership, it should impose a lower burden on bequests to multiple beneficiaries. An estate tax, which does not take into account how a decedent spreads the estate among noncharitable beneficiaries, cannot do this.

15. Income Taxation of Transfers as an Alternative Accessions Tax A variation on the imposition of accessions taxes would be the inclusion of bequests and gifts in the income tax base, as advocated by Simons (1938) and Dodge (1978). The 1966 Canadian proposal contains the most detailed analysis of what this approach would entail. One important collateral consequence of including accessions in income would be the greater likelihood of high taxes during years in which a taxpayer received an extraordinary accession, such as a once-in-a-lifetime bequest. The Canadian proposal would have introduced a form of income-averaging to alleviate this problem.

16. Problems with Accessions Taxes A complication associated with accessions taxes is the opportunity trusts present for separating the transferor’s relinquishment of ownership from the transferee’s accession to wealth. The creation of the trust may give beneficiaries an expectation sufficient to alter their behavior but not create property interests substantial enough to sustain immediate taxation (compare Dickens, 1861). The problem does not exist in the case of trusts where all interests are fixed (for example, to A for life, remainder to B), because an inheritance tax can be levied on the discounted present value of a vested future interest. But it is easy enough to design trusts where vesting is delayed (for example, to W for life, then income divided equally among those of my children alive at the time of W’s death, then the corpus distributed equally to my issue per stirpes; only W’s interest would be vested). Nor is there a problem even in such cases, if the trust corpus grows at the rate that the designated discount rate assumes. The increased tax paid on distribution attributable to appreciation of the trust property would offset the benefit of deferral. But discount rates are only guesses

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as to future value, and become less useful to the extent that trust corpus does not comprise assets for which reliable and thick markets exist. Income taxation of the trust may substitute in part, but is not equivalent to an immediate levy at the inheritance tax rate on the discounted present value of the future distribution.

17. Withholding on Trusts under Accessions Taxation An alternative approach would be to impose a withholding tax on complex trusts that could be credited against accessions taxes due on distribution of trust property (see Andrews, 1973). To be a complete substitute for the ultimate inheritance tax payable, however, the credits attributable to withholding would have to be refundable and interest would have to be paid, by the taxpayer or the government as the case may be, on any difference between the amount withheld and the amount of tax payable at the time of distribution. Such refinements would add to the administrative burden of the tax and to that extent make it somewhat less attractive.

18. Relationship of Transfer Taxes to Income Tax Transfer taxes, and in particular taxes levied on transferors, are sometimes defended on the grounds that the property subject to these levies benefits from unavoidable but undesirable gaps in the income tax. Gutman (1981) argues that the US estate and gift taxes compensate for the income tax deferral implicit in the rule treating gifts as nonrealization events, and for the foregone income tax produced by the basis increase enjoyed by holders of propertry received from a decedent. More generally, capital assets tend to benefit from the realization principle, which defers taxation of capital gain until the holder sells or exchanges the asset. Imposition of a substitute tax on persons who benefit from these gaps brings the income tax closer to the ideal of nondiscrimination among types of income.

19. Difficulties with Nondiscrimination Principle Appeals to the nondiscrimination principle have a certain intuitive attraction but often obscure difficult issues. Recalling the concept of W3, for example, one might note that most income taxes do not include social insurance in their base. Yet transfer taxes for the most part reach very few people who benefit from this exclusion. The point is illustrative: all income taxes in practice contain many

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violations of a strict nondiscrimination principle, and the nondiscrimination norm standing alone does not suggest a weighting strategy that can indicate which violations should be seen as more serious than others.

20. Choice of Nondiscrimination Principles Moreover, as Andrews (1974) was among the first to note, to the extent existing law indicates adherence to any nondiscrimination principle, it suggests a commitment to neutrality among types of consumption, with a surtax on the kinds of capital held by the most wealthy. The US (so-called) income tax, like those of many countries, excludes from the base imputed rents from owneroccupied housing and most employer contributions to retirement savings. The exclusion of imputed rents in turn can be seen as equivalent to allowing an immediate deduction for the cost of acquiring an asset, as a consumption tax would require. And for the nonwealthy, housing and pension plans are the most significant forms of savings. In other words, when considered from the perspective of neutrality among types of consumption, these systems discriminate against financial assets such as stock and bonds, the ownership of which (disregarding tax-favored retirement savings) is heavily concentrated among the wealthiest persons. Taking this point to its logical conclusion, one might argue that the structure of the income tax implies an argument against any further taxation of wealth transfers.

21. Unification of Transfer Taxes Some countries tax gifts separately from deathtime transfers, others treat gifts as deathtime transfers if the donation precedes death by less than a specified period, and a few attempt to treat gifts and deathtime transfers as functionally equivalent. Aaron and Munnell (1992) and Andrews (1973) advocate development of an accessions tax that would include gifts and bequests in an integrated base, with the tax rate increasing with the amount of the transferee’s lifetime receipts. Shoup (1966), Kurtz and Surrey (1970), Brannon (1973) and Sims (1984) instead call for an integrated progressive transfer tax that would determine its rate by reference to the sum of the transferor’s lifetime and deathtime transfers.

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22. Unification and US Practice Before 1976 US law subjected lifetime and deathtime transfers to completely different levies. Gifts made in ‘contemplation of death’, a gloriously openended standard, were subjected to both taxes, but the gift tax paid on these transfers was both credited against the estate tax and excluded from the estate tax base. Since 1976, the US has had a partially integrated system. The rate of tax on estates depends on the decedent’s lifetime taxable transfers, and all transfers have a single ‘unified credit’ to offset gift and estate taxes. But gifts occurring more than three years before death (whether made in contemplation of death or not) enjoy a distinct benefit. First, a per-person exemption of $10,000 a year exists for gifts. The gift tax base does not include the amount of tax. By contrast, the estate tax base is tax inclusive. To illustrate, a US transferor in the highest rate bracket would part with $ 1,550,000 to effect a gift of $1,000,000 (disregarding the $10,000 exemption). A decedent in the highest bracket (because of lifetime gifts) would have to have a taxable estate of $2,222,222 to make an after-tax bequest of $1,000,000. Stated differently, the top gift tax rate, translated into tax-inclusive terms, is slightly in excess of 36 percent, while the equivalent estate tax rate is 55 percent.

23. Proposals for Unification of Tax Rates In 1984 the US Treasury proposed a more complete integration of the gift and estate taxes (Department of the Treasury, 1984). This would have been accomplished by increasing the tax rate on gifts. This proposal was not incorporated into the major tax changes enacted in 1986. Stephan (1986) subsequently criticized it for its failure to take account of differences in both the income tax treatment and welfare implications of gifts and bequests.

24. Issue of Base Integration A different kind of integration occurs when the same transaction comes under both taxes. A simple example would involve a trust in which the transferor retains income for life, remainder to the beneficiary. The creation of the vested remainder constitutes a completed gift and is subject to tax. This transaction, however, seems functionally indistinguishable from retention of full ownership until death, at least for those persons with no need to invade capital. As a result, US law for many years also has included the full value of the trust corpus in the decedent’s taxable estate. The decedent is given a credit against the estate tax for the gift tax payable on the remainder.

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25. Historical Dimensions of Problem The actual rules for determining which lifetime transfers are includible in the estate tax base are complex and inconsistent. During the early years of the US estate tax, the Supreme Court expressed its hostility to this levy by imposing narrow constructions on the statutory language. These decisions in turn provoked the Congress to overrule the Court through new legislation. In the period after World War II, a more liberal Court both repudiated some of its earlier decisions and imposed expansive constructions on the new legislation, provoking a by-then more conservative Congress to enact further legislation. The resulting hodge podge produces rents for professors and specialists but otherwise serves no apparent good.

26. Proposals for Base Integration Various suggestions have been made for cutting this Gordian knot. The Department of the Treasury (1984) would subject all transfers to either a gift or an estate tax but not both. It would have included transactions where the transferor retained some form of present enjoyment in the estate tax base. In all other cases, it would have imposed a gift tax on the value of the transferred property. Isenbergh (1984) and Sims (1984) offer schemes that differed in detail but in general followed the Treasury’s ‘easy to complete’ preference for earlier gift taxation. Stephan (1986) instead favors ‘hard to complete’ rules that would classify more transactions as deathtime. His rule would regard any transfer where the determination of the interest depends on the transfer’s life as testamentary. Thus in the case of a trust with income to accumulate, then the corpus to B at the transferor’s death, only the estate tax would apply.

27. Special Rules for Transfers within Family Units Most transfer tax systems, whether levied on transferors or transferees, contain special exemptions or reduced rates where the transfers involve specific family relationships. Transfers between spouses present particular problems, because the underlying law of ownership may depend on marital status. In the United States, for example, an asset acquired by a married couple living in a community property state often will become the common property of the couple, regardless of who furnished the consideration for the acquisition. In 1948 the United States sought to create a uniform national tax rule by allowing a 50 percent deduction for gifts to a spouse and a deduction up to half the size of the taxable estate for deathtime transfers. The 1981 amendments exclude most

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interspousal transfers from both taxes.

28. Implications of Complete Exclusion for Interspousal Transfers A rule of complete exclusion creates a hypothetical possibility for indefinite avoidance of the transfer taxes in cases where remarriage occurs successively. As a practical matter, however, the progressive nature of the transfer taxes still creates an incentive for most spouses to split their estates between the survivor and other noncharitable beneficiaries. All other things being equal, under a progressive rate structure a tax equal to twice the tax on half of a large sum is less than the tax on that sum. In other words, spouses still will benefit if their property is distributed in such a way that at least one is treated for estate tax purposes as having an estate that does not fall into the top taxable bracket.

29. Problems with Interspousal Transfers Transfers to spouses in trust continue to present problems. In the simplest case, namely a transfer to a spouse for life, remainder to the children, permitting a deduction for the spouse’s interest may present tax avoidance opportunities. If standard actuarial tables overestimated the spouse’s actual life expectancy or if the applicable discount rate underestimates the appreciation of the corpus, a present tax on the remainder interest will not be economically equivalent to a deferred tax on the full value of the property. US law instead denies a deduction for the spouse’s interest in most cases where that interest terminates and, upon that event, others acquire an interest in the property. The rules implementing this policy, which contain many exceptions, are exceedingly complex and have occasioned much litigation.

30. Nonspousal Intrafamilial Transfers Interspousal transfers aside, US gift and estate taxation generally attaches little significance to consanguinity. Most inheritance taxes, however, do increase the rate of tax with the degree of separation between transferor and transferee. As Tait (1967) observes, to the extent these taxes are designed to break up economic dynasties, this characteristic seems perverse. Bequests to children suffer lower taxes than bequests to strangers. Nor, in Tait’s view, do there exist other reasons for treating transfers among close family members more favorably than others. He dismisses one common claim - that inheritances from distant relatives come as windfalls and therefore are more easily surrendered to the tax

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authorities - as dependent on what he considers the dubious assumption that expectancy is correlated with closeness of relationship.

31. Defenses of Consanguinity Preferences In response to Tait, Richter (1987) argues that consanguinity rate reductions make sense if one regards inheritance taxation not as a mechanism to redistribute wealth, but rather as a form of social insurance. Drawing on Friedman (1957), Richter distinguishes between ‘permanent’ and ‘transitory’ inheritances. The former are reliable, in the sense that the potential beneficiary reasonably may make plans based on the expectation of receiving them. The latter become reliable only if the beneficiary can insure against nonreceipt. The market does not supply inheritance insurance as such, but a tax on transitory inheritances, to the extent that the tax receipts are converted by the state into commonly shared benefits, serves the same function. To conclude the argument, Richter maintains that consanguinity is a good proxy for the relative mix of permanent and transitory components in any given inheritance.

32. Consanguinity Preferences and Redistribution Cremer and Pestieau (1988) extend Richter’s argument to defend the consanguinity perference on grounds of promoting redistribution. Their model assumes variablity in the number of children, including the existence of childless transferors. They show that under certain plausible assumptions about inheritance patterns, wealth transferred to lineal descendents result in dispersion of property among children and grandchildren. Transfers to collateral relatives, however, may result in concentration of multiple couples’ assets in the hands of a single niece or nephew. A rate preference for lineal over collateral transfers thus may reflect a desire to disperse the ownership of property.

33. Generational Issues Although US estate taxation does not take consanguinity into account, the system does adjust the tax rates to take into account wealth transfers that skip over one or more generations. The argument for this surtax on generationskipping transfers is that the transfer taxes should function as a once-ageneration levy on financial capital. Moderately wealthy people transfer capital to children, with the assumption that the children will consume the income thrown off by the assets and then transfer them to grandchildren. Persons so

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wealthy that they can provide for their children and still have capital left over to transfer to grandchildren should be taxed as if their capital first passed through their childrens’ hands, whether or not the children directly benefited from the property. An exception to this policy exists for orphaned grandchildren, who are treated as if they were the transferor’s children.

34. Implementation of the Generation-Skipping Transfer Tax The United States first enacted a generation-skipping transfer (GST) tax in 1976 but deferred its implementation for several years. In 1986 Congress created a significantly different tax in place of the earlier one. The current levy imposes a flat rate of 55 percent on generation-skipping transfers in excess of $1,000,000 per transferor. The statute assigns persons to generations based on lineal relationship to the transferor; nonrelative transferees are assigned to a generation on the basis of difference in age with the transferor. The tax is calculated by reference to the amount received by the transferee, which means that any estate or gift tax generated by the transfer will not be included in the tax base. The amount of GST tax is, however, treated as a taxable gift. The GST tax on direct transfers is not included in the GST tax base, but the tax on generation-skipping transfers from trusts, either of income or corpus, is.

35. Technical Issues in Generation-Skipping Transfer Taxation The GST tax treats direct transfers to grandchildren more favorably than it does trust transactions that encumber financial capital and delay ultimate power to dispose of the property. Stephan (1986) observes that this difference parallels the lower rates imposed on gifts as opposed to deathtime transfers, and may reflect a similar policy of encouraging wealthy people to transfer control over financial capital to younger persons sooner rather than later.

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Bibliography on Inheritance and Gift Taxation (6070) Aaron, Henry J. and Munnell, Alicia H. (1992), ‘Reassessing the Role for Wealth Transfer Taxes’, 45 National Tax Journal, 119-143. Andrews, William D. (1973), ‘What’s Fair About Death Taxes?’, 26 National Tax Journal, 465-469. Blum, Robert (1973), ‘Estate and Gift Taxation Moderator’s Remarks’, 26 National Tax Journal, 439-440. Bracewell-Milnes, Barry (1989), The Wealth of Giving: Every One in his Inheritance, London, Institute of Economic Affairs, 112 p. Brannon, Gerald M. (1973), ‘Death Taxes in a Structure of Progessive Taxes’, 26 National Tax Journal, 451-457. Collie, Martin K. (1973), ‘Estate and Gift Tax Revision’, 26 National Tax Journal, 441-449. Covey, Richard B. (1973), ‘Estate and Gift Taxation’, 26 National Tax Journal, 459-463. Cremer, Helmuth and Pestieau, Pierre (1988), ‘A Case for Differential Inheritance Taxation’, 0(9) Annales d’Economie et de Statistique, 167-182. Dodge, Joseph M. (1978), ‘Beyond Estate and Gift Tax Reform: Including Gifts and Bequests in Income’, 91 Harvard Law Review, 1177-1211. Graetz, Michael J. (1983), ‘To Praise the Estate Tax, Not to Bury It’, 93 Yale Law Journal, 259-286. Gutman, Harry L. (1981), ‘Reforming Federal Wealth Transfer Taxes after ERTA’, 69 Virginia Law Review, 1183-1272. Isenbergh, Joseph (1984), ‘Simplifying Retained Life Interests, Revocable Transfers, and the Marital Deduction’, 51 University of Chicago Law Review, 1-33. Jantscher, Gerald R. (1969), ‘Death and Gift Taxation in the United States after the Report of the Royal Commission’, 22(1) National Tax Journal, 121-138. Kaplow, Louis (1995), ‘A Note on Subsidizing Gifts’, 58 Journal of Public Economics, 469-477. Kiesling, Herbert J. (1992), Taxation and Public Goods - A Welfare-Economic Critique of Tax Policy Analysis, Ann Arbor, MI, University of Michigan Press, 362 p. Kotlikoff, Laurence J. (1988), ‘Intergenerational Transfers and Savings’, 2 Journal of Economic Perspectives, 41-58. Kurtz, Jerome and Surrey, Stanley S. (1970), ‘Reform of Death and Gift Taxes: The 1969 Treasury Proposals, the Criticisms, and a Rebuttal’, 70 Columbia Law Review, 1365-1401. McCaffery, Edward J. (1994), ‘The Uneasy Case for Wealth Transfer Taxation’, 104 Yale Law Journal, 283-365. Menchik, Paul and David, Martin (1983), ‘Income Distribution, Lifetime Savings, and Bequests’, 73 American Economic Review, 672-690. Modigliani, Franco (1988), ‘The Role of Intergenerational Transfers and Life Cycle Saving in the Accumulation of Wealth’, 2 Journal of Economic Perspectives, 15-40. Richter, Wolfram F. (1987), ‘Taxation as Insurance and the Case of Rate Differentiation According to Consanguinity under Inheritance Taxation’, 33 Journal of Public Economics, 363-376. Rignano, Eugenio (1924), The Social Significance of the Inheritance Tax, New York, Knopf, 128 p.

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Shoup, Carl S. (1966), Federal Estate and Gift Taxes, Washington, Brookings Institution, 253 p. Sims, Theodore S. (1984), ‘Timing Under a Unified Wealth Transfer Tax’, 51 University of Chicago Law Review, 34-90. Stephan, Paul B. (1986), ‘A Comment on Transfer Tax Reform’, 72 Virginia Law Review, 1471-1496. Summers, Lawrence H. (1981), ‘Capital Taxation and Capital Accumulation in a Life Cycle Growth Model’, 71(4) American Economic Review, 533-544. Tait, Alan A. (1967), The Taxation of Personal Wealth, Urbana, University of Illinois Press, 283 p. Wagner, Richard E. (1977), Inheritance and the State-Tax Principles for a Free and Prosperous Commonwealth, Washington, American Enterprise Institute for Public Policy Research, 95 p.

Other References Andrews, William D. (1974), ‘A Consumption-Type or Cash-Flow Personal Income Tax’, 87 Harvard Law Review, 1113-1188. Becker, Gary S. (1974), ‘A Theory of Social Interactions’, 82 Journal of Political Economy; 10631091. Department of the Treasury (1984), Tax Reform for Fairness, Simplicity, and Economic Growth - The Treasury Department Report to the President, 2 vols, Washington, US Treasury, 262 and 408 p. Dickens, Charles (1861), Great Expectations, London, Chapman and Hall, 225 p. Friedman, Milton (1957), A Theory of the Consumption Function, Chicago, University of Chicago Press, 243 p. Meade, James E. (1964), Efficiency, Equality, and the Ownership of Property, London, Allen and Unwin, 92 p. Pechman, Joseph A. (1987), Federal Tax Policy (5th edn), Washington, Brookings Institution, 430 p. Simons, Henry C. (1938), Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy, Chicago, University of Chicago Press, 238 p. Vickrey, William (1947), Agenda for Progressive Taxation, New York, Ronald Press, 496 p.

6080 INTERNATIONAL TAXATION Timothy J. Goodspeed Hunter College and CUNY Graduate Center

Ann Dryden Witte Florida International University, Wellesley College and NBER © Copyright 1999 Timothy J. Goodspeed and Ann Dryden Witte

Abstract We consider various systems for taxing international income (source vs. residency systems) and international transactions (origin vs. destination systems) and the empirical literature that has addressed issues related to such systems. The optimal taxation literature finds a conflict between static and dynamic efficiency considerations but fails to consider such important aspects of taxation as the benefits arising from public goods and services, compliance costs and administrative costs. Empirical work finds that the level of taxation significantly affects the location of investment and the way in which investment is financed. However, estimates of the magnitude of these effects of taxation are varied. Non-tax considerations (for example, political and economic stability) often dominate tax considerations in firm decision making. Firms use intra-company prices (for example, transfer prices) to reduce the total amount of taxes paid, but the magnitude of this type of evasion does not appear to be large. Countries often use their tax systems to encourage exports and to attract investment. Many tax treaties between developed and developing countries have tax sparing provisions that allow firms to credit unpaid taxes due to ‘tax holidays’. We suggest that future research on international taxation consider second-best worlds, incorporate administrative considerations and consider the effect of regulatory as well as tax regimes. This research could also usefully incorporate equity considerations and such non-tax aspects of international decision making as the availability of skilled labor, infrastructure and legal and regulatory environments. JEL classification: F2, F3, H2, K3, M4, O0 Keywords: International Taxation, Transfer Pricing, Foreign Investment, Tax Treaties, Capital Taxation

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1. Systems of International Taxation International taxation generally refers to the tax treatment of cross-national transactions. Since each nation has its own tax rules and the rules of one nation are rarely perfectly meshed with those of another, it is possible that income will be taxed more than once (sometimes referred to as double taxation) or that it will go untaxed by any jurisdiction. To prevent this, countries employ different methods. In principal, two methods of taxation have been distinguished for direct taxes such as personal and corporate income taxes: the territorial (or source) system of taxation and the worldwide (or residence) system. Under a pure source system, all income earned in a country is taxed by that country regardless of whether the earner is deemed to be foreign. A pure residence system taxes income regardless of where it was earned as long as the earner is deemed to be a resident of the country. An analogy to the familiar distinction between gross domestic product (GDP) and gross national product (GNP) may be helpful. GDP includes all income produced domestically, whether by domestic or foreign nationals, and is analogous to income taxed under the source method. GNP includes all income produced by nationals, whether at home or abroad, and is analogous to income taxed under the residence method. As long as those receiving income are classified by all countries in the same mutually exclusive way as residents or nonresidents, and all countries use the same method of taxation, there is no problem of double taxation. (However, there are efficiency issues, which we address in the next section.) Double taxation problems arise because countries have different residency rules and tax systems. For example, some countries use a territorial system when defining income while others use a residence basis for determining what income is taxable. Further, no country uses the pure form of either of these systems. All countries claim the right to tax all income generated within that country’s border; that is, all countries begin with a source basis for taxation. This is reasonable in terms of both tax administration and tax compliance. It is always easier to assess and collect taxes on income earned in the taxing jurisdiction. Source taxation also accords with the widely accepted principle of taxing individuals who receive benefits from public expenditures (the benefit principle of taxation). For the most part, the government of the country in which that taxpayer is physically present provides the public goods and services consumed by a taxpayer. Both efficiency and common concepts of fairness dictate that those who benefit from government should help to pay for it. However, most nations try to tax at least some of the foreign income of their residents. These attempts to tax the foreign income of residents result in a mixed source and residence basis for taxation. For instance, the US Government claims the right to tax all income earned in the US, a source system of taxation. However, it also claims the right to tax some of the income

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that its permanent residents and citizens earn abroad, a residence basis of taxation. Countries that tax such foreign-source income normally provide a credit for foreign taxes paid (up to a limit discussed below). Other countries such as France come closer to a true source/territorial basis for taxation. These countries generally exclude the foreign income of their residents from domestic taxation. Regardless of which method of direct taxation is used, the tax code must provide a set of rules determining residency. For individuals, residency is usually determined by a test based on the number of days an individual is present in a country. Unlike other countries, US citizenship also triggers the definition of a resident for US tax purposes. For corporations, this may be triggered by incorporation (as in the US) or by the place of management and control. The UK relied exclusively on the place of management and control until 1988. Since 1988, UK residency for a corporation may be triggered either by incorporation, or by the place of management and control. A second question in countries that tax foreign source income is the timing of such taxation. For a business, the way in which foreign operations are set up can influence when taxes are paid. For instance, a US corporation can set up an overseas operation as a branch, which is not separately incorporated. The income (or loss) of a foreign branch is combined with domestic income and taxed currently. The companies that tend to set up foreign operations as branches are concentrated in the banking and petroleum industries (Goodspeed and Frisch, 1989). Alternatively, the foreign operation can be set up as a controlled foreign corporation (CFC). CFCs are incorporated in the foreign country, but a controlling share of their stock (over 50 percent for the US) is owned by domestic shareholders. Except for certain types of income (described below), the income of a CFC is only subject to domestic taxation when it is repatriated. Since a CFC can delay subjecting its income to tax by not repatriating income, this feature of international tax law is commonly referred to as ‘deferral’. Many countries (for example, the US, Germany and Japan) allow deferral on undistributed income. These countries also generally have ‘anti-deferral’ regimes that restrict the types of income on which taxation may be deferred until repatriation. The US anti-deferral regime began with the addition of Subpart F to the US Internal Revenue Code by the US Revenue Act of 1962. Subpart F provides for current taxation of certain types of unrepatriated income of US CFCs. Unrepatriated income subject to Subpart F is treated as if it had been repatriated as a dividend. The income subject to Subpart F provisions has been broadened over the years and the US has enacted other anti-deferral rules. However, deferral remains important. The US Treasury estimates that deferral cost $2 billion in lost tax revenue in 1997 (OMB, 1996). See Ault (1997) or Gramwell, Merrill and Dubert (1996) for a detailed discussion of anti-deferral regimes in a number of countries.

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Residents of countries that tax on a worldwide basis will have their foreign source income taxed twice, first in the foreign country where the income is earned and next in the home country. Most countries that attempt to tax the worldwide income of their residents allow a credit or deduction for taxes paid to foreign countries. To avoid giving refunds for high foreign taxes, the credit is limited to the tax that would have been paid had the income been earned in the home country (usually given both the home country tax rate and the home country definition of the tax base). This creates two types of resident taxpayers; those that receive full credit for foreign taxes paid and those that do not. Taxpayers who are not able to credit all taxes paid abroad against taxes in their home country are said to be in an ‘excess credit’ position. Taxpayers who do receive full credit are said to be in a ‘deficit of credit’ or ‘excess limitation’ position. Two methods are used to determine the foreign tax credit. One method treats income in each foreign country separately in determining the credit. The second method determines the credit on a worldwide basis. Income and taxes from all countries are added to determine whether the limitation applies; thus, the taxpayer will be in excess credit if its (weighted) average foreign tax rate is greater than the home country tax rate. Consequently, a taxpayer may be able to reduce its home country tax liability because of the averaging of high and low taxed income. Consider, for instance, a multinational with a large proportion of income coming from investments in high-tax countries and a small proportion of income coming from investments in low-tax foreign countries. The multinational will not obtain full credit for foreign taxes paid; that is, it will be in an excess credit position. This firm would then have an incentive (absent under a per-country limitation) to try to shift income from high-tax to low-tax foreign countries so that the average foreign tax rate falls below the home country rate. The multinational will thereby obtain credit for all foreign taxes paid. (The shifting of income may not require actually shifting production facilities; it could be accomplished through paper transactions - see the later section on transfer pricing.) To combat this tendency of the worldwide credit system, some countries force multinational companies to make separate credit calculations for particularly high- or low-tax categories called ‘baskets’ of income. The US basket classification system is particularly complex. Prior to the US Tax Reform Act of 1986 (TRA86), there were five baskets. TRA86 substantially increased the number of baskets by expanding the Internal Revenue Code Section 904(b) interest income basket to include all passive income and adding four new baskets: (1) high withholding tax on interest (defined as 5 percent or more), (2) financial services income, (3) shipping income, and (4) dividends from each uncontrolled foreign corporation. This last basket potentially created a large number of new baskets since the credit on dividends from each

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uncontrolled foreign corporation had to be computed separately. The basket system is designed to prevent US taxpayers from combining high-taxed and low-taxed foreign income in order to receive a credit for taxes paid in excess of the US rate on one portion of income. To some extent, countries can be classified on the basis of whether their foreign tax credit systems are per-country or worldwide. The US, Japan and Iceland provide credits on a worldwide basis; Canada, Germany, Greece, Ireland, Italy, the Netherlands, New Zealand, Norway, Portugal, Spain, Turkey, and the United Kingdom use a per country limit in determining the foreign tax credit. However, as Ault (1997) notes, this division is somewhat misleading. In the UK, for instance, the per-country credit limitation can be avoided by routing income through a nonresident holding company. The income going through this ‘mixer’ company is considered all from one source, and hence averaged and the per-country limitation avoided. (There are no ‘pass-thru’ rules in the UK as there are in the US.) Ault suggests that the use of such companies is common. In principal, the resident system taxes individuals on their worldwide income. However, since most countries determine resident status by a test based on the number of days one is in a country, most expatriates are not residents of their home country for tax purposes. The US is an exception. Since US citizens are considered US residents, US expatriates are required to file US tax returns as well as tax returns for the country in which they reside. However, if a US citizen is not in the United States for 11 out of 12 consecutive months, the individual can exempt $70,000 of income earned abroad from US personal income taxation. Self-employed US citizens working abroad will still owe the 15 percent US payroll tax for Social Security, but this is often overridden by treaty if the US citizen pays the foreign social security tax, and the foreign social security tax otherwise qualifies for the foreign tax credit. Lower-level governments that form a federation sometimes use a somewhat different arrangement for apportioning the tax base of firms with operations in a number of different taxing jurisdictions. The approach used is called formula apportionment. The US states that belong to the Multi-State Tax Compact, Canadian provinces, and Swiss cantons use formula apportionment to tax corporations (Daly and Weiner, 1993). Formula apportionment can be considered a source-based approach to taxation. The formula used under a formula apportionment system divides the entire tax base of the corporation (for example, the worldwide base) among a participating set of taxing authorities. Each authority taxes only that portion of the tax base attributed to it. If all regions use the same formula and the same definition of profits, the portions are mutually exclusive and exhaustive, and the ‘worldwide’ base is taxed only once. Formula apportionment begins by selecting a set of indicators (for example, sales, property value, and wage payments of a corporation in the case of US states) to reflect the level of economic activity of a taxable economic

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entity in a tax jurisdiction. It then weights these indicators to form an index of economic activity in a jurisdiction. The jurisdictions split the taxable base on the basis of this index. In practice, one problem that this method encounters in the US is that states use different weights in determining the index so that the base ends up being taxed more than once. The economic effects of formula apportionment have been explored by McLure (1980, 1981), and have even been discussed in the context of the European Union (Daly and Weiner, 1993). On a broader international basis, formula apportionment is rarely used because of difficulty agreeing to the ‘formula’ and enforcing its use. A second set of taxes on foreign income, both for wage and capital income, are termed ‘withholding taxes’. These taxes are applied at source, usually on gross income. For instance, interest income received by a British citizen holding money in an Italian bank would have taxes withheld prior to remittance to the British citizen. The same holds for wage income: a US citizen working in Spain for a few months is subject to a 15 percent withholding tax. The income is also subject to US tax, although the individual can get credit for the 15 percent Spanish withholding tax. The reason for withholding tax on the income of nonresidents is principally for compliance purposes.Without withholding, individuals may fail to report such income in both home and source country. Bilateral treaties generally reduce withholding taxes on dividends and interest. In addition, the US has unilaterally eliminated its withholding tax on interest income (both for individuals and corporations). For a summary of reductions see Gramwell, Merrill and Dubert, 1996. Countries may also enter into information exchange agreements and other cooperative arrangements. Since tax treaties are bilateral and only cover selective countries, withholding tax rates can vary widely. This creates incentives to funnel income through third countries that have a low withholding tax rate. (See Giovannini, 1989, for an example.) As described in Hufbauer, Elliott, and Maldonado (1988), tax treaties grew out of recommendations by the League of Nations in 1927 as a way to reduce double and zero taxation, and to reduce withholding taxes. They also serve the purpose of stimulating international investment and structuring cooperation among different national taxing authorities. ‘Model’ tax treaties were developed by the OECD in 1963 and the UN in 1979. The OECD issued its most recent model treaty in 1994. These model treaties are meant to serve as general guidelines. The US has from time to time issued its own model treaty. The most recent US model was issued in 1996. Countries do not have tax treaties with all other countries. For example, France has treaties with approximately 90 countries while the US has treaties with approximately 50 countries (see Gramwell, Merill and Dubert, 1996 for a summary). Indirect taxes, such as sales and value-added taxes, also suffer from problems of double taxation. As with direct tax systems, international indirect tax systems can in principal be of two types: a destination system or an origin

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system. The destination system taxes goods where they are consumed and is analogous to resident taxation; the origin system taxes goods where they are produced and is analogous to source taxation. International trade agreements have set rules for indirect taxation so that taxes cannot be used to favor domestically produced goods. Under the General Agreement on Tariffs and Trade (GATT) indirect taxes can be imposed on import and rebated on export. This is consistent with the destination system of indirect taxation.

2. Theory: Equilibrium, Efficiency and Tax Competition Having outlined various systems of taxation, we turn to the nature of the equilibrium under various forms of taxation and the relative efficiency of different systems. While the residence and source principles of taxation apply to labor as well as capital taxation, most of the literature discussing these concepts relates to capital taxation, and our discussion will therefore proceed in terms of capital taxation. The standard view is that pure residence taxation promotes efficiency in investment decisions while pure source taxation promotes efficiency in savings decisions. To understand why, we must first consider the nature of the equilibrium under source and residence taxation. Recent discussions of equilibrium in international taxation can be found in Keen (1992); we follow the notation of Keen. Consider two countries, A and B. Each country can be characterized by a representative investor who can earn a pre-tax return rk in country k. Each investor faces two possibly different tax rates, one on domestic income and one on foreign income. Denoting the foreign income tax rate with an asterisk, this means that there are potentially four different tax rates: TA, TB, TA* , T*B . Tk is the tax rate of an investor from k investing in k, while T*k'‘ is the tax rate of an investor from k investing abroad. An equilibrium is characterized by a lack of arbitrage possibilities for each investor. Hence, for the investor from A, equilibrium requires equality of after tax returns in each country: rA (1 ! TA) = rB (1 ! TA*). Similarly for the investor from B, rA (1 ! T*B) = rB (1 ! TB). Dividing the arbitrage condition for the investor from A by that for the investor from B yields (1 ! TA)/(1 ! T*B) = (1 ! TA*)/(1 ! TB). Since we have four possible variables for only one equilibrium condition, existence of a unique equilibrium is far from guaranteed. Despite these possible problems in the existence of an equilibrium, both pure source taxation by both countries (TA = T*B and TB = TA*) or pure residence taxation by both countries (TA = TA* and TB = T*B) present no existence problems. We now consider the implications of an equilibrium under pure source and pure residence taxation. Consider first the case of pure source taxation with differential tax rates so that TA … TA* (and similarly for B). Given the equilibrium condition for the investor from A, differential tax rates imply that

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rA … rB. That is, the before-tax return in A is not equal to that in B. Since factors are paid their marginal product, this implies that the marginal product of capital in A is not equal to that in B. If TA > TA*, then rA < rB, and we could therefore reallocate capital from A to B and increase total production. Another way to think of this is that differential tax rates have set up a fiscal incentive to locate capital in the low-tax country so that too much capital will flow to the low-tax country. Source taxation therefore is said to distort the location of capital and investment decisions. In its pure form, the residence approach leads to production efficiency. To see this, note that the definition of residence taxation (TA = TA*) implies from the equilibrium condition that rA = rB. There is no tax-induced incentive for capital to locate in one country over another with residence-based taxation. While residence based taxation therefore eliminates the incentive for capital to move from high-to low-tax jurisdictions, it may induce the owners of factors to change their residence. (The effect of such migration incentives are apparent in the decision of high income individuals to locate across the border in Greenwich, Connecticut rather than New York (avoiding taxes on capital income) or the migration of high income individuals from high tax countries such as Sweden.) Moreover, since TA … T*B, the after-tax return of an investor from A will differ from the after-tax return of an investor from B. Since saving depends on the after-tax return, a given level of world savings will be misallocated between investors from A and B. If TA > TB*, investors from A realize a lower after-tax return and will save too little, while investors from B will save too much. Since the value of an extra dollar of savings is greater for investors from A than for investors from B, we could increase welfare by transferring some of the future consumption generated from the savings of investors from B to investors from A. In contrast, source taxation leads to an efficient allocation of savings since investors from A and B face the same after-tax return. To summarize, source taxation leads capital to locate inefficiently (production inefficiency) but leads to intertemporal exchange efficiency. Resident taxation leads to efficiency in capital location but violates intertemporal exchange efficiency. In a first-best world (that is, when we can raise revenue without distortions), both efficiency conditions are required. These two efficiency concepts have often been captured in the literature by the terms ‘capital export neutrality’ and ‘capital import neutrality’. Capital export neutrality is associated with pure residence taxation: facing the same tax consequences at home or abroad, capital is neutral as to its location. (As mentioned above, it is not neutral as to its choice of residence.) Capital import neutrality is associated with pure source taxation: capital from abroad is taxed the same as domestic capital, so there is no tax discrimination for or against foreign capital. Horst (1980) and Dutton (1982) suggest that the optimal tax on foreign income will balance these two efficiency concerns; the proper balance, they

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suggest, depends on the elasticities of capital demand and supply. For instance, Horst shows that if the elasticity of supply of capital is zero and the combined tax on international income is equal to the tax on domestic income in the capital exporting country, the optimal tax on foreign source income results in capital export neutrality. Intuitively, there is no saving distortion for this case. To ensure an efficient allocation of capital, the capital exporting country should tax the worldwide income of its residents and provide an unlimited credit for taxes paid abroad. Horst also shows that when the elasticity of demand for capital is zero and the combined tax on international income is equal to the tax on domestic income in the capital-importing country, the optimal tax on foreign source income results in capital import neutrality. To ensure an efficient allocation of capital, the capital-exporting country should exempt foreign source income from tax. It is sometimes argued that capital export neutrality is more important, possibly because savings elasticities are often thought to be low and the elasticity of the demand for capital relatively high. Gordon (1986) points out an interesting parallel to the ‘production efficiency lemma’ of Diamond and Mirrlees (1971) that also supports capital export neutrality. Diamond and Mirrlees showed (under some rather stringent assumptions) that the optimal commodity tax system will lead to productive efficiency; that is, no input taxes should be used if commodity tax rates are set optimally. Gordon shows that it will be optimal for a small open economy to set its tax rate on capital equal to zero. As Gordon explains, since capital supply is perfectly elastic for the small open economy, a tax on capital will be borne by labor and hence will create the same labor market distortion as a direct tax on labor; in addition, however, the tax on capital will reduce capital investment in the small open economy, and will therefore be dominated by a direct tax on labor. The implication is that capital export neutrality will be part of the optimal tax system for small open economies. We suggest below some possible new directions for the literature on the optimal tax on foreign source income. First, given the reality that for administrative reasons all countries start from source taxation, it may be worthwhile for the theoretical literature to incorporate this important institutional detail that turns the problem into one of second-best. An interesting question to analyze is whether it is better to augment the initial source taxation by further source taxation (excluding foreign-source income from tax), by residence-based taxation (using a credit system to avoid double taxation), or perhaps by some combination of the two. Perhaps the difficulties in establishing an equilibrium has precluded this sort of discussion in the past, and this is a formidable problem to overcome; still, one might be able to use the approach of Slemrod (1988), for instance, to model an equilibrium and gain some insight into the efficiency consequences of current practices. Second, the optimal tax should incorporate administrative issues (for example,

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administrative costs, enforceability) as well as more traditional efficiency issues. (See Slemrod, 1990a, for an excellent and very readable discussion of optimal taxation that also incorporates administrative concerns.) Third, since no country has an unlimited foreign tax credit, the limitation is another institutional constraint that should be incorporated in the theoretical problem. Fourth, the literature tends to ignore benefits provided by the government that tax payments support; presumably owners of capital would willingly pay for government expenditures that enhance capital investments (for example, infrastructure investment). Fifth, externalities generated by capital location decisions have not been dealt with, and would presumably alter optimal taxation rules. As a normative concept, economic efficiency naturally refers to the maximization of world welfare. Positive issues of why tax systems develop in certain ways presents another set of issues. One of the first issues of a positive nature to be raised concerns the sort of tax system that maximizes national welfare. Musgrave (1969) (also clearly discussed in Caves, 1982) raises the point that a capital exporting country (that is large enough to alter the return on capital) will maximize national income by using a deduction system rather than a tax-credit system. This conclusion has a number of qualifications discussed in Hartman (1980), but still raises the question of why a large capital exporting country like the US relies on a tax-credit system. While international taxation naturally involves more than one country, analysis until recently has considered the situation of a single country under the assumption that other countries’ tax systems do not matter. Several recent papers, however, use game theoretic frameworks to analyze strategic decisions between countries that use a corporate income tax. One of the first is Feldstein and Hartman (1979), who find that if one takes into account the reaction of the (small) capital importer, the optimal tax from the large capital exporter’s perspective is even higher than otherwise, which seems to add to the puzzle of why the US has a tax-credit system. A more recent paper Bond and Samuelson (1989), finds that the only Nash equilibrium for two countries under a tax credit system is zero tax rates on capital. This is also found by Razin and Sadka (1991c). Bond and Samuelson find that a deduction system yields positive tax rates on capital, again adding to the puzzle of why we do not typically observe the deduction system in practice. In an interesting variation on strategic behavior, Gordon (1992) finds that if one country (for example, the US) acts as a Stackelberg leader, and countries use tax crediting systems, positive tax rates on capital income emerges as the equilibrium solution. Strategic considerations have also been a recent focus of international commodity taxation. In an early study, Mintz and Tulkens (1986) analyze the inefficiencies liable to arise from duopolistic competition in commodity taxes. One problem with these early studies is that no equilibrium in pure strategies exists because of discontinuities in reaction functions. More recently, Kanbur

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and Keen (1993) use a simpler model, in which an equilibrium exists, to examine the merits of cooperative tax agreements versus tax competition. They find that two countries with different tax rates may be worse off if both countries are forced to set an average tax rate, while both may be better off if a minimum tax rate is imposed. The literature on tax competition and international taxation is closely related to the fiscal federalism and local public finance literatures, a point made by Gordon (1990) and Goodspeed (forthcoming). A seminal treatise on fiscal federalism and local public finance is Oates (1972). Since there are several surveys for the reader (Wildasin, 1986; Zodrow and Mieszkowski, 1986; Rubinfeld, 1987; Oates, 1994) and since the focus of this entry is international taxation, we do not undertake an exhaustive survey. Rather, we briefly point out some similarities and differences, and suggest some ways that research on international taxation can benefit from the local public finance/fiscal federalism perspective. The key similarity of the literatures on international taxation and local public finance/fiscal federalism is that both study the taxation of mobile factors of production. The heart of the fiscal federalism/local public finance literature begins with the Tiebout (1956) model, which postulates many communities offering different tax-expenditure packages. The basic message from the Tiebout literature is that, given the proper type of financing (that is, given that consumers of publicly provided goods face ‘prices’ that reflect marginal social cost), individuals and firms will sort themselves among communities in an efficient manner. Tax bills (or effective tax rates) may differ across communities, but this will simply reflect differing demands for public services. An efficient locational equilibrium in the Tiebout model is therefore characterized by tax rates that differ across regions. This may at first seem in stark contrast to the international tax literature, but the similarity is evident upon further reflection. Two differences are particularly noteworthy. First, the Tiebout model considers both the expenditure and tax sides of a government’s budget. In contrast, the international taxation literature ignores the expenditure side, or, equivalently, assumes that the taxed factor gains no benefit from public goods and services that are provided by tax revenues. Secondly, a crucial aspect of locational efficiency in the Tiebout model is the method of taxation. Efficiency requires taxes that reflect the marginal social cost of a resident. However, as suggested by Oates (1972) and others, taxes such as income or property taxes may create externalities so that tax-prices diverge from social marginal cost. If externalities are present, incentives for inefficient location decisions are created. In addition to these problems, taxation in an open economy can result in several other sorts of externalities (for example, benefit spillovers); Gordon (1983) provides an elegant and concise derivation of the many types of externalities that may arise from local (as opposed to national) taxation.

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The local public finance literature has focused on cases in which efficiency is achieved in small open economies. Some, such as Hamilton (1976), argue that zoning laws in the US effectively convert the property tax (the major source of locally raised revenue in the US) into a benefit tax. If this is the case, and there are enough jurisdictions to satisfy different preferences both for housing and public goods, the taxation of mobile individuals will lead them to choose their place of residence efficiently. Moreover, a modification of Hamilton’s argument made by Fischel (1975) suggests that local property taxes on businesses may represent payment for disamenities suffered by residents from business location. Incidentally, the zoning argument is quite general. If one could zone on the basis of income, income taxes could also be converted to benefit taxes, at least for jurisdictions within a country. Such zoning is generally rejected on the grounds of equity and social stability. However, many immigration laws suggest that countries are well aware of the benefits of wealthy immigrants and the costs of poor ones. As international taxes may not represent benefit taxes, they may lead to location distortions. However, one of the first studies to measure the efficiency loss that results from income taxes in a general equilibrium model of an open economy (Goodspeed, 1989), finds relatively small differences in the way individuals allocate themselves under a head tax and under an income tax. Consequently, he finds a small welfare loss resulting from income taxation of mobile individuals. This suggests that the magnitude of the welfare loss from income taxes in an open economy may not be very large. The international tax literature tends to ignore the link between taxes and benefits that is the focus of the Tiebout model. Moreover, Wilson (1993) suggests that such benefits may be as important as taxes in multinational planning decisions. As Hubbard (1993) notes in his comment on Wilson’s paper, ‘part of the apparent insensitivity to tax considerations could reflect the link between taxes paid and the provision of important infrastructure (for example, in education and transportation support)’. This would be an important area to develop in further studies of international taxation. The fiscal federalism literature on tax competition has revolved around the type of financing that is used for public services. One of the first modern formulations of tax competition in local public finance is Zodrow and Miezskowski (1986), who show that if communities rely exclusively on taxes on mobile capital, an externality is created by the tax system, and competition leads to an underprovision of public goods. Closer to results obtained in the international tax literature is the finding of Oates and Schwab (1988) that if both benefit taxes and non-benefit taxes on capital are available, efficiency will result if governments choose a zero non-benefit tax on capital and finance entirely from benefit taxes. Goodspeed (1995) shows that political considerations are important for this result to hold. He shows that an

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asymmetric income distribution may lead to a median voter who chooses to finance via non-benefit taxes despite the inefficiency that results from the mobility of the taxed entity. This work suggests that political considerations could also be used to explain equilibrium outcomes of international tax systems.

3. International Taxation and Corporate Behavior A key question in the study of any tax is the extent to which the tax distorts behavior and thereby creates economic inefficiencies and alters the revenue potential of the tax. Broadly speaking, one can think of the effects of taxation on the multinational firm as affecting (i) the location of investment, (ii) the method of financing an investment, and (iii) intra-multinational transfer pricing decisions. We begin by discussing two opposing theoretical hypotheses about the effects of the tax system on multinational decisions concerning the location of investment and the method of finance. We then discuss the empirical literature on the effect of taxation on the location of investment, followed by a discussion of the empirical literature on financing decisions. Hines (1996b) provides a thorough review of the empirical literature on the effect of taxation on foreign investment and financial decisions, which we have relied upon. Finally, we discuss tax-related issues concerning transfer pricing and review the empirical literature on the prevalence of tax avoidance by judicious use of transfer prices. We have relied on Goodspeed’s (1997) review of the empirical transfer pricing literature. For a comprehensive treatment of transfer pricing issues see Lowell, Burge and Briger (1994). A starting point for understanding the empirical literature on investment and financial decisions are the theoretical works of Horst (1977) and Hartman (1985). Somewhat surprisingly, these two works come to different conclusions about the incentive effects of a foreign tax credit system. The traditional view, laid out by Horst (1977), is that incentives are different for excess credit and deficit of credit firms. The excess credit firm faces the tax rate of the country in which it invests on the margin; the deficit of credit firm faces the tax rate of the home country no matter where it invests. One way to interpret this in terms of our previous discussion of source versus resident taxation is that once a firm has hit the limit of creditable taxes (as is the case for an excess credit firm), the marginal return on an investment faces a source tax system, and the firm should compare the home and foreign after-tax returns when deciding where to invest. If a firm has not yet hit the limit of creditable taxes (the case of a deficit of credit firm), the marginal return on an investment faces a resident tax system and hence faces the tax rate of the home country no matter where the investment takes place.

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In contrast, Hartman argues that deferral combined with the fact that mature firms finance investment from retained earnings that are already abroad implies that the foreign tax credit position of the multinational is irrelevant for investment decisions. Both deferral and an investment financed from retained earnings that are already abroad are necessary for Hartman’s result. These two conditions essentially convert the tax-credit system of the home country into a source-based system; hence, the firm should compare the home and foreign after-tax returns when deciding where to invest, and the tax-credit position of the multinational is irrelevant. The Hartman result is often explained by reference to an analogy relating to the debate on the effect of dividend taxes in a closed economy setting. The ‘old view’ of dividend taxes assumes that dividends have some intrinsic value as either a signal (Bhattacharya, 1979) or as a control on managers (Jensen and Meckling, 1976). Hence, there will be an optimal dividend payout rate that balances the intrinsic benefit of dividends and their tax cost. But this implies that dividend taxes matter: a higher tax on dividends leads to a lower optimal dividend payout rate. The ‘new view’ of dividend taxes (King, 1974; Bradford, 1981; Auerbach, 1983) disputes this and suggests that dividend taxes are irrelevant. In the new view, dividends are ultimately the only way that the returns to equity-financed investment can be distributed to shareholders. Hence, according to the new view, dividend taxes are lump-sum taxes that cannot be avoided; consequently, they have no effect on the dividend payout rate. (See, for instance, Zodrow, 1991, for a nice summary and further discussion of these views.) The Hartman scenario is similar to the new view of dividend taxation. In Hartman’s case, deferral does not help firms that invest funds that are already abroad and must eventually be repatriated; the return on those funds must eventually absorb the home country tax. Hence, the investment rule for excess-credit and deficit of credit firms is the same: invest abroad if the after-foreign-tax return is higher than the after-domestic-tax return. While the Hartman result depends on an unchanging home tax rate (Altshuler and Fulghieri, 1994; Keen, 1990) among other things, it has become a focal point in many studies. Nevertheless, the difference between the traditional and Hartman views may not be of much consequence in terms of economic efficiency. As detailed in Goodspeed and Frisch (1989), there is little difference between the traditional and Hartman views in terms of the amount of US earnings abroad that face the foreign tax rate on the margin. While the Hartman view is that 100 percent of earnings abroad (of mature firms that finance from retained earnings) face the foreign tax rate, data from 1984 indicate that in that year the traditional view implied that 82 percent of foreign earnings faced the foreign tax rate on the margin. Under either view, therefore, most foreign earnings faced the foreign tax rate on the margin, as would be the case for a source-based tax system.

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Most studies of the effect of international taxation on investment location have concentrated on the United States, examining both US investment abroad and foreign investment in the US These studies have used time-series data, cross-sectional data, and a pooled approach that combines cross-sectional and time-series data. We first examine the time-series studies, then the cross-sectional studies, and finally the studies that pool cross sectional and time series data. Time series studies typically use aggregate annual data on direct investment collected by the Bureau of Economic Analysis (BEA), US Department of Commerce Department. Early time-series studies are based on the seminal work of Hartman (1981, 1984), and include Boskin and Gale (1987), Newlon (1987), and Young (1988). These early studies ignore the tax credit position of the parent, and so implicitly assume that the Hartman (1985) model is correct. More recent time-series studies have used somewhat more disaggregated BEA data. Swenson (1994) disaggregates the BEA data by using 18 industries, and tries to gain insight into the reactions to the Tax Reform Act of 1986. Slemrod (1990b), in the first study to actually attempt to test some implications of Hartman’s (1985) model for investment decisions, is able to use information on the tax systems (exemption versus foreign tax-credit) of seven countries that invest in the US. He does not, however, find much evidence that allows him to differentiate between the Hartman and traditional views for foreign firms investing in the US. Cross-sectional studies have also been able to tap into the BEA data by using country information; for instance, Hines and Rice (1994) use data from 1982 for 73 countries while Grubert and Mutti (1991) use the 1982 data for 33 countries. Hines (1996c) is able to generate enough data points for a meaningful regression using a cross-section of 1987 BEA data for 7 countries by exploiting differences in US state taxes. In contrast to Slemrod’s (1990b) study, Hines (1996c), does find evidence of differences in the choice of highor low-tax US states by foreign firms depending on whether the firm comes from an exemption or a foreign tax credit country, which contradicts the Hartman view (if the investment coming from foreign tax credit countries is financed by retained earnings already in the US). Data from tax returns have also been used in cross-sectional studies, either aggregated from the Statistics of Income (SOI) such as in Frisch and Hartman (1983), or at the firm level as in Grubert and Slemrod (1994). Several studies that use pooled time-series and cross-sectional data have used Compustat as a data source. Studies using pooled data include Harris (1993), Auerbach and Hassett (1993) and Cummins and Hubbard (1995). Other pooled data sources are Labor Department Surveys, utilized by Bond (1981), and Commerce Department Surveys, utilized by Ondrich and Wasylenko (1993). The time-series estimates that use BEA data tend to find an elasticity

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of investment with respect to the after-tax return in the vicinity of 1. This is true even through the most recent study of Swenson (1994), who investigates the effect of the Tax Reform Act of 1986. Cross-sectional results are more varied. Hines and Rice (1994) find an elasticity of the demand for capital with respect to the tax rate of about -3 while Grubert and Mutti (1991) find an elasticity of only -0.11. Cummins and Hubbard (1995), using an unbalanced panel of foreign subsidiaries of US firms, find an elasticity of investment with respect to the after-tax cost of capital of between -1 and -2. Hines (1996c) finds a large impact of taxes on FDI coming from tax-credit as opposed to exemption countries. While his elasticity is not quite comparable to those mentioned, his finding that a 1 percent reduction in tax results in a 9-11 percent increase in the share of investment coming from tax-credit countries suggests a large tax impact. The overall conclusion of this literature is that taxes play a statistically significant role in determining the location of foreign direct investment, but the magnitude of the impact of taxes remains uncertain. While time-series studies seem to produce similar elasticities of about 1, the rather large range of elasticity estimates that result from cross-sectional estimates indicates some uncertainty about the magnitude of the effect that taxes have on foreign investment. Additional panel studies that control for unobserved heterogeneity across firms, such as that of Cummins and Hubbard, may provide additional confidence concerning the range of estimates. One possible reason for the large effect found by Hines is that, by studying investment in a single country and using state dummies, he has effectively controlled for some unobserved heterogeneity that cross-country regressions lack. One aspect that a firm needs to consider as it evaluates an investment project is how that project will be financed. In general, a project can be financed from debt or equity; the way in which a multinational finances a project will have different tax consequences. For instance, as discussed earlier, those profits of a CFC of a US multinational (or the CFC equivalent of a non-US multinational) that are financed by equity (and not subject to Subpart F in the US or equivalent rules in other countries) are not taxable by the home country until repatriated as dividends. If the CFC is instead financed by debt issued by the parent, the interest paid by the CFC is taxable foreign source income for the parent. The interest payments are (usually) deductible in the country in which the CFC is located. As mentioned previously, withholding taxes (often reduced by treaty) are also usually owed to the host country for interest (as well as dividend and royalty) payments. If interest paid by a CFC is deductible and interest received by the parent is taxable foreign source income, a multinational that has a CFC located in a high-tax (including withholding taxes) country would do better to finance the CFC’s investment by debt since it will save money by deducting the interest in the high-tax country and paying tax at home. Countries tend to restrict the use

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of debt to some extent by using ‘thin-capitalization’ rules that specify certain limits in terms of a debt-to-asset ratio. The financing decision of the multinational is a bit more complex for the case of a subsidiary located in a low-tax country because of the Hartman (1985) argument. Traditionally, the argument is that an excess credit multinational might prefer to finance an investment project by equity since it could use deferral to avoid paying the high home country tax for a while. As explained above, however, the implication of Hartman (1985) is that deferral has no value because the present value of the deferred dividend will equal that of the repatriated dividend. Since after-tax returns are equated in equilibrium, there is no advantage to deferral in this view. One of the first studies to examine the dividend decisions of multinationals is Kopits (1972), who uses aggregate country-level data. Mutti (1981) is able to take advantage of tax return data for subsidiaries and finds that higher US taxes reduce dividend payments. Hines and Hubbard’s (1990) paper is the first in a series of modern studies on the dividend repatriation decision. They are able to take advantage of a data set constructed using three separate US tax forms filed by multinationals in 1984: the basic corporate Form 1120, the foreign tax credit Form 1118, and the controlled foreign corporation Form 5471. This data set details information on the parent company (including whether the parent is in excess or deficit of credit) and the repatriations of the parent CFCs. They not only find that higher taxes on dividends reduce dividend payments, but also that the excess credit position of the parent matters in the repatriation decision; excess credit firms tend to have a higher dividend pay-out ratio. This is inconsistent with the Hartman (1985) hypothesis. Two studies, the first by Altshuler and Newlon (1993) and the second by Altshuler, Newlon, and Randolph (1995), extend the Hines and Hubbard study. The first of these studies uses 1986 tax return data and specifies somewhat more completely the tax price of dividend repatriations. The second study uses a panel of tax data for the years 1980, 1982, 1984 and 1986 to investigate the effect of transitory versus permanent tax changes. Transitory changes are found to influence dividend repatriations, while permanent changes do not. This is consistent with Hartman’s view of dividend repatriation. One other study of dividend behavior focuses on a slightly different issue. Hines (1996a) compares dividend payout rates of foreign and domestic subsidiaries. He finds that foreign subsidiaries tend to have a much higher dividend payout rate than domestic subsidiaries; the additional personal tax that is owed on these dividends implies that the cost of capital from foreign investment may be higher than previously thought. As noted above, a multinational with subsidiaries in high-tax locations will normally do better (from a tax perspective) by financing an investment project by debt so that it can deduct the interest payments in the high-tax location.

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Grubert (1995) confirms this pattern. Hines (1994a) develops a model in which the opposite (a positive correlation between greater use of debt finance and lower tax locations) may result over a certain range. This is confirmed in his empirical work in which he finds a quadratic relationship between tax rates and debt levels across countries. Although most studies concentrate on the effect of taxes on one form of finance, taxes may cause substitution among different sources of finance. For instance, the 1986 Tax Reform Act (TRA86) restricted the deductibility of interest expenses. Interest expenses deemed to be ‘foreign’ are only allowed to be deducted against foreign, not US, income. The consequence of this is that foreign interest expense will benefit a firm in a deficit of credit position, but not one in an excess credit position. The deficit of credit firm will reduce its taxable income (and maximum credit) by the amount of interest expense; since it has not reached the limit of its foreign tax credit this means that it will reduce its US tax liability. An excess credit firm reduces its taxable income, but also its foreign tax credit by the amount of interest expense; hence, this type of firm does not benefit from foreign interest expense. Two studies (Collins and Shackelford, 1992, and Altshuler and Mintz, 1995) find that firms tended to substitute debt-like instruments for debt after TRA86. Grubert (1995) and Grubert (forthcoming) are the first studies to jointly estimate separate equations for dividend, interest, and royalty payments. Grubert (forthcoming) finds that taxes have a large effect on the composition of repatriations. That is, differential tax treatment of interest, dividends, and royalties is found to influence the form in which income is repatriated. Similarly, Altshuler and Grubert (1996) examine the complex incentives created when repatriation can flow through several entities. Rather than repatriating through different forms of income, however, they examine the flows between a multinational’s CFCs and find that tax incentives have significant effects. Finally, with respect to repatriation decisions, the role of exchange rate gains and losses should be mentioned. As the world moved from an era of fixed to flexible exchange rates, issues of how and when transactions would be translated into the home currency became relevant. One of the first discussions of the issues involved is Musgrave (1975). As she describes, the taxpayer was given much latitude in the translation of profits into the home currency. This can create problems for the taxing authority because the taxpayer will naturally attempt to time the translation so as to minimize taxes. Wahl (1989) notes that TRA86 in the United States tightened up on translation rules so that most hedging transactions are taxed on accrual, leaving the taxpayer little latitude to time the transactions. However, some transactions are still taxed on realization, which may lead to some loss in revenue through judicious timing of the translation.

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Although most empirical studies tend to confirm that multinationals are sensitive to tax considerations in their financial decisions, Hines (1996b), after a thorough survey of the literature, suggests that a more complete analysis would consider the fact that taxes influence financial and investment decisions simultaneously. This is one avenue for further study. In addition, nontax considerations may also play a major role in financial and investment decisions. As we have noted, the local public finance literature suggests that consideration of the expenditure side of the budget is important. This suggests that such factors as road and transportation networks, communications facilities, the quality of the local workforce (and hence investment in schools), and other public infrastructure investments may be important. Other regulatory issues, such as bankruptcy or bank secrecy laws, may also be a reason that firms willingly pay taxes when deciding where to invest. Finally, a country’s economic and political stability may also be an important consideration. We next turn to issues in intra-multinational transfer pricing. Multinational corporations, usually organized as a set of separate entities, typically involve a parent corporation and a set of subsidiaries. The parent is typically the major stockholder in its subsidiaries, often controlling 100 percent of a subsidiary’s stock. Various transactions may occur between the parent and subsidiary companies within the multinational, such as the sale by a subsidiary of an input that is used in the parent’s production process or sale of a trademark by the parent to a subsidiary. The prices attached to these transactions that occur between corporations within a multinational are referred to as ‘transfer prices’. While transfer pricing occurs (implicitly or explicitly) with any intrafirm transfer, the feature that has made transfer pricing so important and controversial is its possible use to avoid taxes. For instance, suppose that the parent is located in a high-tax country while the subsidiary is located in a low-tax country. Assuming that the multinational is trying to minimize its total tax payments, the multinational will try to price transfers so that most of its profits appear in the low-tax country. For example, if the subsidiary is providing the parent with an input, there is an incentive to charge a very high price for the input. Since this will result in high revenue in the low-tax country and high costs in the high-tax country, the effect will be to transfer profits from the high-tax to the low-tax country. The multinational’s taxes will be lower and its after-tax profits higher than would otherwise be the case. Transfers between entities that make up a multinational firm can be bi-directional. We first consider the transfer pricing decisions of a home country multinational that invests abroad (outbound investment), and then the transfer pricing decision of a foreign multinational that owns a corporation in a home country (inbound investment). For each category, we discuss the general nature of the problem and the empirical literature. Finally, we discuss some solutions that governments have implemented to try to reduce tax

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avoidance and tax evasion by means of transfer pricing. Transfer pricing can be used to reduce taxes for either the source/territorial or the resident/worldwide tax system. The simplest cases can be illustrated for a multinational that has foreign profits generated in a single foreign country as well as profits generated at home. Abuses under the territorial system are perhaps the most obvious: taxes can be reduced by transferring profits out of the high-tax country and into the low-tax country. A purported advantage of the worldwide system is that this incentive disappears for a multinational that invests in a single foreign country with a tax rate lower than the home country. In this case, income derived from the foreign investment will be taxed at the home country tax rate and the incentive to shift income is eliminated. However, several complications of the tax systems of countries that purport to use the worldwide system of taxation allow multinationals to use transfer pricing to reduce taxes. First, consider a multinational in a low-tax country that invests in a single high-tax country. By definition, this firm would be in an excess credit position. The multinational will not receive a credit in its home country for some of the taxes paid in the high-tax country unless it is able to shift some income back to its low-tax home. The multinational can use transfer prices to shift profits to the home country. Second, since multinationals typically have investments in a variety of foreign countries, the way in which the credit is computed is important. As mentioned above, some countries aggregate income over all foreign countries in determining the limit. In addition, the use of ‘mixer’ companies in countries that use a per-country limitation can also result in income averaging. For these countries, a multinational with a large proportion of income coming from investments in high-tax countries and a small proportion of income coming from investments in low-tax foreign countries will not obtain full credit for foreign taxes paid. This firm would then have an incentive to use transfer prices to shift income from high-tax to low-tax foreign countries and thereby obtain credit for all foreign taxes paid. Third, the use of deferral effectively converts a worldwide tax system into a territorial system, at least until profits are repatriated. Although Subpart F provisions in the United States have limited deferral, the transfer pricing problems associated with territorial tax systems become relevant when a worldwide system incorporates deferral. The evidence on the use of transfer pricing is consistent with tax-minimizing behavior, although the magnitude of abusive transfer pricing appears to be moderate. Outbound investment by US multinationals has been investigated by Harris, et al. (1993), who use Compustat data to investigate whether taxes paid to the US are influenced by the location of the multinational’s profits overseas. Since the US taxes multinationals based on a worldwide system and computes the foreign tax credit by aggregating on a worldwide basis, the multinational can get credit for income tax paid in a

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country with a tax rate higher than the US rate by judicious use of transfer pricing. It simply needs to shift income from a high tax to a low tax location so as to avoid hitting the credit limit. Harris, et al. find that a multinational that has a subsidiary in a low (high) tax country has a lower (higher) than average ratio of US tax to US assets. This is consistent with the use of transfer pricing to minimize worldwide taxes, although they find that the aggregate effect on US tax revenues is moderate. Hines and Rice (1994) investigate transfer pricing of outbound investment by concentrating on the use of ‘tax havens’ (a set of very low-tax foreign countries) by US multinationals. They find that reported profit rates are sensitive to local tax rates, although they note that this may not be bad for US revenue since the US is now a relatively low-tax country. A US multinational whose foreign source income comes primarily from a high tax country will not be subject to additional US tax. If however, the multinational is able to shift income so that its foreign source income appears to come primarily from a low tax country, the US will gain tax revenue equal to the difference between taxes paid and what would be paid in the US We next consider transfer prices used by foreign corporations operating in the home country (that is, inbound investment) to transfer profits out and so avoid home country taxes. This has become an important topic, particularly in the United States, because the aggregate rate of return for foreign-controlled companies in the US is observed to be much lower than the rate of return of domestically controlled companies. A concern expressed by the US Congress is that foreign-controlled US corporations are not paying their fair share of US taxes. The suggested culprit is transfer pricing. There are several reasons other than transfer pricing that might explain low rates of return of foreign-controlled companies operating in a home country. First, foreign companies may at first experience a lower than average rate of return because of the revaluation of the assets of new acquisitions or because of the start-up costs of a new business. Second, a low average rate of return in any one year may not be indicative of a long-run trend. That is, although foreign companies may have difficulty in adjusting to the nuances of a foreign market at first, one would expect this to change over time as the firms mature. Finally, unexpected changes in exchange rates can have a large effect on profits. An unexpected fall in the dollar, for instance, would increase the cost of components imported into the US and therefore temporarily decrease the profits of a foreign-controlled company in the US. This effect also would be expected to diminish over time. Inbound investment in the US is investigated by Grubert, Goodspeed and Swenson (1993) using both a 1987 cross-section and a 1980-87 panel data set. They use data from the tax returns of US corporations to investigate the difference in taxes paid by foreign-controlled as opposed to US-controlled corporations. The aggregate data suggests a much lower ratio of taxable income

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to assets for foreign-controlled corporations. However, the authors find that the revaluation of assets after merger or acquisition (captured by an age effect), exchange rate changes and a maturation effect account for about half of the difference. The remaining difference could be due to transfer pricing, and the authors present some evidence that indicates that foreign-controlled companies tend to be more concentrated at zero taxable income than domestic companies. They also remain in the zero-profit state longer than domestic companies. This suggests that transfer pricing may be used to some extent to reduce taxes, although less than feared when the transfer pricing issue first arose in the US Congress. Grubert (1997) updates the study of Grubert, Goodspeed and Swenson by repeating the previous analysis (with some modifications) for a 1993 cross-section and a 1987-1993 panel. He finds that for some specifications purely cross-sectional variables can explain almost 50 percent of the difference in rates of return, rather than the 25 percent explained in the previous study. This appears to be partly due to the fact that US companies are receiving more income from foreign dividends. The panel estimation corroborates the earlier finding of a maturation effect. Overall, Grubert is able to explain somewhat more than the earlier 50 percent (up to 75 percent) of the difference between foreign-controlled and US-controlled corporate returns in the US. Since transfer pricing can be used to evade taxes, governments have naturally developed a set of rules to try to minimize this potential source of tax evasion. The problem is to find an ‘objective’ way of valuing tangible and intangible assets transferred across national boundaries by multinational corporations. The widely accepted international standard is that such transfers be assigned the prices that would have been charged if the transactions had occurred between independent entities. Such prices are referred to as ‘arm’s length’ prices. The basic notion is that a transaction between a parent and its subsidiary should be priced as if it had occurred between two unrelated parties in a competitive market. However, arm’s length transfer prices are not always easy to calculate because comparable transactions by unrelated parties may not exist. This issue is pervasive for intangible assets because the value of most intangible asset arises from market power generated by the intangible. For example, how should McDonald’s price the right to use its golden arches? McDonald’s does not sell use of its golden arches to unrelated parties. The value of the golden arches arises from the rents that the use of this trademark generates. There are no comparable arm’s length prices and alternative methods for pricing this type of transfer must be used. A general framework and some specific standards for transfer pricing are suggested in OECD (1979). Revisions have recently been proposed in OECD (1995). Specific rules that are acceptable to a country’s taxing authority

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generally vary from country to country but, in general, the prices charged in comparable arm’s length transactions are preferred. (See Ault, 1997, for a discussion of practices in several countries, and Molina Gómez-Arnáu, 1997, for the case of Spain.) When exactly comparable transactions do not exist, the government often provides some guidance in the form of regulations or case law (usually based on OECD, 1979) on the range of transfer prices that will be deemed acceptable. Such guidance may include a cost-plus calculation, reference to some industry average such as a rate of return on assets or a margin on sales, or attempts to adjust ‘inexact’ comparables to obtain transfer prices. Profit-based methods (for example, ‘comparable profits’) as opposed to transactions methods tend to be the most controversial. Some countries do not allow comparable profits methods. The methodology used to determine the proper transfer price has become increasingly sophisticated. Frisch (1989) and Witte and Chipty (1990) suggest the use of the capital asset pricing model to determine a proper return for a project. Appropriate transfer prices are then calculated as the prices necessary for the project to have that rate of return. Horst (1993) suggests using regression analysis to determine an appropriate rate of return. The US Internal Revenue Service (IRS) has adopted an open approach on the methods used to obtain transfer prices. Multinational companies may now propose a method for determining transfer prices. The IRS examines the proposed method and determines whether or not the methodology is acceptable. If the methodology is acceptable, the IRS enters into an ‘advanced pricing agreement’ (APA) with the multinational. The agreement allows the multinational to use the mutually agreed upon methodology to set transfer prices for the firm for a period of 3 to 5 years. The APA may involve the other countries impacted by the agreed transfer price. APAs are also possible in some other countries (for example, Germany and The Netherlands). One of the more subtle elements of corporate international taxation is that the tax system can be used to create subsidies. Although the thrust of the General Agreement on Tariffs and Trade (GATT) is to prohibit discrimination between domestic and foreign produced goods, corporate tax systems have been used to subsidize exports and investment. We consider below two specific US tax provisions (foreign sales corporations and sales source rules) that provide subsidies for goods exported from the US. We then consider the general concept of tax holidays, and its relation to tax sparing in tax treaties. The US Congress created Domestic International Sales Corporations (DISCs) in 1971. DISCs were essentially conduits through which export transactions could be recorded. Exports carried out through DISCs received favorable tax treatment. This subsidy was found to be in violation of GATT’s prohibition of export subsidies in 1976. The reaction of the US was to replace DISCs by Foreign Sales Corporations (FSCs), which perform much the same

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function, but are able to pass muster under GATT rules. As long as title is passed overseas, a portion of FSC income is exempt from US tax; hence, a subsidy is created for a product to be produced domestically and exported rather than manufactured and sold abroad. A second type of export incentive in the US tax code is that produced by the sales source rules (Section 863(b) of the US Internal Revenue Code). These rules allow a multinational to reclassify part of its export income as foreign source. If a multinational is in an excess credit position, the US tax rate times foreign source income is the binding constraint on the foreign tax credit. Hence, each dollar that an excess credit firm is able to reclassify as foreign rather than domestic source will result in extra foreign tax credit equal to the US tax rate. For example, if a multinational is in an excess credit position and faces a US tax rate of 35 percent, each dollar that it is able to reclassify as foreign rather than domestic source will result in savings of $0.35. The rules thus provide an incentive for US excess credit multinationals to export rather than produce abroad. While the US Treasury issues periodic reports on FSCs, little academic literature has investigated the export incentives hidden in corporate tax codes. An early exception is Horst and Pugel (1977). One recent study is Rousslang and Tokarick (1994), who use a general equilibrium model to examine the consequences of the tax-based export incentives. They find that the tax provisions increase the volume of trade but that domestic welfare is worsened because the terms of trade are worsened for the US. Apart from export incentives, a second set of tax subsidies arise because of developing countries’ efforts to attract multinational investment. Many developing countries give multinationals ‘tax holidays’. During periods of tax holiday, multinationals may pay no taxes or, at a minimum, lower taxes than would otherwise be due. Such tax breaks only provide incentives for multinationals to invest in the developing country if the multinational’s home country taxes on a source basis. For countries that tax on a worldwide basis, tax holidays provide no incentive to locate in the developing country since the income of the multinational will be taxed at the home country rate. Recognizing this, some countries (for example, Germany and Japan) that tax on a worldwide basis allow their multinationals credit for such tax holidays; that is, they allow credit for taxes that have not actually been paid. This is often referred to as ‘tax sparing’. Tax sparing provisions are often written into tax treaties between a developed and a developing country. Although most countries grant tax sparing in treaties with many developing countries, the US does not. However, the US has had a set of rules (contained in Section 936 of the US Internal Revenue Code) that provide tax subsidies for corporations that locate in US Possessions (the primary beneficiary being Puerto Rico). In part, Section 936 allows tax sparing, and since Puerto Rico

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offers tax holidays, US multinationals received tax credits for taxes that were not actually paid to Puerto Rico. The 936 rules were tightened in 1993, however, through a limitation on the allowable tax credit. Further, 1996 legislation began a phase out of Section 936. It is scheduled to be eliminated completely by 2005. While the US Treasury provides periodic reports on the tax treatment of Possessions’ corporations, the academic literature on the effect of Section 936 is sparse. One older study is that of Bond (1981). Grubert and Slemrod (1994) provide a more recent study of the effect of Section 936 in Puerto Rico. Grubert and Slemrod’s findings suggest that firms with high levels of intangible assets (for example, drug companies) located in Puerto Rico because it was relatively easy, through transfer pricing, to shift profits to Puerto Rico. The profits thus shifted gained the tax advantage provided by Section 936.

4. Issues in International Indirect Taxation The destination and origin principles for indirect taxation are analogous to the source and resident principles for direct taxation. The difference between the destination and origin principles is that the destination principle imposes tax where consumption takes place whereas the origin principle imposes tax where production takes place. As with source taxation, one might argue that the origin principle distorts the location of production. As with resident taxation, one might argue that the destination principle causes distortions in relative savings decisions across countries. Despite the analogy of the destination and origin principles for indirect taxation and the source and resident principles for direct taxation, and our previous discussion of the efficiency differences of the source and resident principles for direct taxation, much has been made of the fact that the destination and origin principles of indirect taxation are, under certain conditions, equivalent. This is noted in Cnossen and Shoup (1987) and demonstrated formally in Lockwood, de Meza and Myles (1994a). The equivalence comes from the fact that balanced trade implies that aggregate production and aggregate consumption are the same. Consequently, a destination based tax (on aggregate consumption) and an origin-based tax (on aggregate production) are equivalent. However, this result requires some very strong assumptions, and there are several models, outlined in Keen and Smith (1996), in which the equivalence result fails to hold. One such model is an overlapping generations model of Bovenberg (1994) in which the two principles can have different intergenerational effects. A second situation in which equivalence fails is when countries do not tax all commodities at a uniform rate. See Sinn (1990) and Feldstein and Krugman (1990).

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Assuming that the equivalence result does not hold brings us back to our discussion concerning efficiency for direct taxation and the trade-off between production efficiency and exchange efficiency. Again appeal might be made to the Diamond and Mirrlees (1971) result that the optimal commodity tax system is characterized by production efficiency, which would suggest a preference for the destination principle. However, the Diamond-Mirrlees framework is one of perfect competition and 100 percent taxation of pure profits. Some interesting new work relaxes some of these assumptions and indicates some scope for origin taxation in an optimal tax system. For instance, Keen and Lahiri (1996) consider a model of Cournot duopolists. As noted in Keen and Smith (1996), part of the difference in this type of setting is that, unlike the Diamond-Mirrlees framework, it is recognized that countries have their own distinct revenue constraints. Again, the relevance of the fiscal federalism literature, which studies the relationship between jurisdictions with distinct revenue constraints, is evident. A somewhat different tact would be to investigate models of illegal activity. For instance, there may be an incentive under destination taxes to bypass legal rules and smuggle goods from low-tax/low-enforcement countries to countries with high and well enforced consumption taxes. Much of the recent interest in these issues has arisen because of the elimination of controls on the movement of both capital and labor in the European Union. (But see also Grubert and Newlon, 1995 for an examination of recent proposals in the US to replace the income tax with a consumption tax.) European countries typically raise a substantial portion of revenue through value-added taxes (VATs). As these countries eliminate controls on the movement of both capital and labor, there is increasing concern about the possibility of cross-border shopping that could result from VAT systems that have different tax rates applied to the same products. A good review of some of the early concerns can be found in Cnossen and Shoup (1987) and Lee, Pearson and Smith (1988); a more recent treatment is that of Keen and Smith (1996). The issues here are whether consumers would engage in cross-border shopping to avoid high taxes, whether competition would force these taxes to some common rate, and the welfare impacts of these possibilities. These issues are directly related to the tax competition literature mentioned earlier, and some papers mentioned there (for example, Mintz and Tulkens, 1986; Kanbur and Keen, 1993) explicitly address tax competition for indirect rather than direct taxes. One practical set of issues for the European Union’s concerns how countries can best make ‘border adjustments’, that is, the rebate of VAT on export and its imposition on import. The required tax adjustments have been made at the border and, hence, the term border adjustments. Cnossen (1983) has proposed that a ‘clearinghouse’ be set up to handle border adjustments. Under the clearinghouse proposal, a country would, in the aggregate, either be net owers or receivers of VAT revenue depending on their trade balance and VAT rates.

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The function of the clearinghouse would be to determine the net position of each country rather than have countries give or receive VAT on a transaction by transaction basis. The European Commission has considered this proposal, but has not been able to come to agreement. Instead, they moved in 1993 to a transitional system. This system has eliminated border adjustments for consumer purchases for personal use (so that personal consumption purchases are now taxed on the origin principle), although border adjustments are still made for transactions between firms. Keen and Smith (1996) point out a number of problems with the transitional system, and propose an alternative, which they call a Viable Integrated VAT (VIVAT). They compare the VIVAT to the transitional system as well as other systems (including a clearinghouse mechanism), and suggest that the VIVAT is superior. VIVAT, as described by them, is a combination of harmonized VAT rates and different retail sales tax rates. Their proposal combines the origin and destination principles, and offers the advantage of national autonomy in setting taxes (emphasized in the fiscal federalism literature) with the self-policing advantages often ascribed to VAT.

5. Some Suggestions for Future Research To date, work on the efficiency effects of various methods of international taxation have assumed a first-best world. The complexity and many distortions present in the international arena suggest that work that considers a world with distortions other than those caused by the international tax regime would be useful. The administration of international taxes has received relatively little attention. Careful examination of the administrative provisions of tax treaties might provide a useful base for thinking about administrative issues. Application of the arm’s length standard often involves very high transaction costs. Tax agencies experiences with Advanced Pricing Agreements might provide some guidance for alternative systems. It would be important to estimate and compare both the efficiency and transactions costs of the arm’s length standard and other proposed systems. To date most work on international taxation has considered only efficiency effects. Interesting new insights might be obtained by examining equity and public choice considerations. In this context examinations of tax sparing provision might be interesting. Comparisons of the US that does not have tax sparing provisions (except with Possessions) with European countries and Japan that have tax sparing provisions with many developing countries could be revealing.

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Increases in the flow of financial services and the opening of telecommunication markets raise important new issues regarding the way in which international tax and regulatory regimes interact. While research that introduces regulations as well as taxation would be difficult, such work could provide important new insights. Trade blocks have become increasingly important and, yet, we have no work that tells us the implication of such blocks for international taxation. Close examination of the development of the tax systems of the European Union as the Union becomes more closely integrated would be valuable. Work that considers both the implications of changes for the Union, and for other countries and trading blocks would be informative. To date the literatures on foreign investment and international taxation have been largely distinct. Integration of insights from the two literatures would enhance our understanding of the way in which multinational corporations operate. Models used to discern the effects of international taxes have generally assumed perfect information and abstracted from risk. Such assumptions do not well characterize the international arena. Relaxation of these assumptions would be fruitful.

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Sorensen, Peter Birch (1988), ‘Optimal Taxation of Capital and Labor in a Small Open Economy’, Paper presented at the International Conference On ‘Tax Reform for Tax Neutrality’, University of Bielefeld, Germany, May 30 - June 2, 1988. Sorensen, Peter Birch (1992), ‘Coordination of Capital Income Taxes in the Economic and Monetary Union: What Needs to be Done?’, Mimeo. Sowle, L.A. (1989), ‘International Debt for Equity Swaps: Does Revenue Ruling 87-124 Make Sense? (Comment)’, 83 Northwestern University Law Review. Steines, J.P. (1994), ‘Colloquium on NAFTA and Tradition: Commentary: Income Tax Implications of Free Trade’, 49 New York University Tax Law Review, 675 ff. Stevens, G.V.G. and Lipsey, R.E. (1992), ‘Interactions Between Domestic and Foreign Investment’, 11 Journal of International Money and Finance, 40-62. Stockmann, Frank (1995), ‘Should the Exemption Method Have Priority over the Credit Method in International Tax Law?’, 49(6) Bulletin for International Fiscal Documentation, 285-288. Sullivan, Mark (1984), ‘In Memoriam: Stanley S. Surrey: Appendix’, 97 Harvard Law Review. Surrey, Stanley S. (1958), ‘The United States Taxation of Foreign Income’, 1 Journal of Law and Economics, 72-96. Swenson, D. (1994), ‘The Impact of U.S. Tax Reform on Foreign Direct Investment in the United States’, 54 Journal of Public Economics, 243-266. Tanzi, V. and Minassian, T.T. (1987), ‘The European Monetary System and Fiscal Policies’, in Cnossen, S. (ed.), Tax Coordination in the European Community, London, Kluwer Law and Taxation. Tanzi, Vito (1995), Taxation in an Integrating World, Washington, Brookings Institution. Tatarowicz, P.M. and Mims-Velarde, R.F. (1986), ‘Symposium on State and Local Taxation: An Analytical Approach to State Tax Discrimination Under the Commerce Clause’, 39 Vanderbilt Law Review. Tiebout, Charles M. (1956), ‘A Pure Theory of Local Expenditures’, 56 Journal of Political Economy, 416-424. Tillinghast, D.R. (1996), ‘Tax Treaty Issues’, 50 University of Miami Law Review, Trachtman, J.P. (1991), ‘Recent Initiatives in International Financial Regulation and Goals of Competitiveness, Effectiveness, Consistency and Cooperation’, 12 Journal of International Law and Business, 241 ff. U.S. Congress, Joint Commitee on Taxation (1987), General Explanation of the Tax Reform Act of 1986, Washington, Government Printing Office. U.S. Congress, Joint Commitee on Taxation (1991), Factors Affecting the International Competitiveness of the United States, Washington, Government Printing Office. Ulph, D.T. (1987), ‘Tax Harmonisation and Labour Mobility’, in Cnossen, S. (ed.), Tax Coordination in the European Community, London, Kluwer Law and Taxation, 305-317. Utz, S.G. (1994), ‘Taxation Panel: Tax Harmonization and Coordination in Europe and America’, 9 Connecticut Journal of International Law, 767 ff. Vagts, D.F. (1981), ‘Comment: Are There No International Lawyers Anymore?’,75 American Journal of International Law, 134 ff. Vann, Richard J. and Parsons, Ross W. (1986), ‘The Foreign Tax Credit and Reform of International Taxation’, 3(2) Australian Tax Forum, 131-221. Vernon, R. (1977), Storm Over the Multinationals: The Real Issues, Cambridge, Harvard University

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Press. Wahl, J. (1989), ‘Tax Treatment of Foreign Exchange Gains and Losses and the Tax Reform Act of 1986', 42(1) National Tax Journal, 59-68. Waterland, L.J. (1985), ‘Note: Container Corporation of America v. Franchise Tax Board: The Supreme Court Encourages Apportionment Taxation’, 26 William & Mary Law Review, 683 ff. Weinberg, K. S. (1994), ‘Arbitration Procedures in the United States-German Income Tax’, 12 Boston University International Law Journal, 180 ff. Weiner, Joann (1996a), ‘Using the Experience of the U.S. States to Evaluate Issues in Implementing Formula Apportionment at the International Level’, Dec. 23 Tax Notes International, 2113-2144. Weiner, Joann (1996b), ‘Estimates of How the Unitary Tax Affects Business Investment’, Working Paper, Jan. 3, 1996. Wheeler, J.E. (1988), ‘An Academic Look at Transfer Pricing in a Global Economy’, 87 Tax Notes, 96 ff. Whitman, D.S. (1995), ‘Recent Developments: Barclays Bank v. Franchise Tax Board of California: Worldwide Combined Reporting Survives For State Taxation of Multinational Enterprises’, 3 Tulane Journal of International and Comparative Law, 265 ff. Wildasin, David E. (1986), Urban Public Finance, New York, Harwood Academic Press. Willard, Kristen L. (1994), Essays On International Taxation, Princeton, Princeton University Press. Wilson, G.P. (1993), ‘The Role of Taxes in Location and Sourcing Decisions’, in Giovannini, A., Hubbard, R.G. and Slemrod, J. (eds), Studies in International Taxation, Chicago, University of Chicago Press. Wong Pakshong, Michael (1980), ‘The Future Position of Singapore in International Taxation’, 34(4) Bulletin for International Fiscal Documentation, 146-149. Workman, D.J. (1982), ‘Comment: The Use of Offshore Tax Havens for the Purpose of Criminally Evading Income Taxes’, 73 Journal of Criminal Law and Criminology, 675 ff. Young, Garry (1994), ‘International Competitiveness, International Taxation and Domestic Investment’, 0(148) National Institute Economic Review, 44-48. Young, K.H. (1988), ‘The Effects of Taxes and Rates of Return on Foreign Direct Investment Into the United States’, 41 National Tax Journal, 109-121. Zodrow, George R. (1991), ‘On the “Traditional” and “New” Views of Dividend Taxation’, 44 National Tax Journal, 497-509. Zodrow, George R. and Mieszkowski, Peter (1986), ‘Pigou, Tiebout, Property Taxation, and the Underprovision of Public Goods’, 19 Journal of Urban Economics, 356-370. Zucker, D. (1983), ‘Note: MCA, Inc. v. United States: Judicial Recognition of the Separate Interests Theory’, 5 Journal of International Law and Business, 680 ff.

6110 OPTIMAL TECHNIQUES OF REDISTRIBUTION Christopher Curran Associate Professor, Emory University Department of Economics © Copyright 1999 Christopher Curran

Abstract Legal scholars have often argued that a legal system in providing a ‘level playing field’ for consumers and producers should be designed to help in society’s efforts to achieve an optimal distribution of income. This chapter reviews research by law and economics scholars that challenges this premise. Using neoclassical welfare economics most of these scholars conclude that there exists a taxation scheme that achieves a desired income distribution and is preferred by all members of society to any plan for redistributing income using the legal system. An implication of this research is that economic efficiency and not fairness is the appropriate criteria for evaluating any legal rule. JEL classification: K0, H2 Keywords: Income Redistribution, Taxation

1. Introduction In this chapter we examine the issue of whether income redistribution goals are more efficiently achieved by using the tax system or by incorporating these goals into the design and implementation of a legal system. As stated, this question takes as given that some amount of income redistribution is desirable and ignores the extensive literature on (1) the desirability of income redistribution and (2) the effectiveness of income redistribution in combating poverty. While the problem that remains - that of developing the most cost effective method of achieving the desired income distribution - has a strong production flavor, the answer has important implications both for the study and practice of law. If the arguments of Kaplow and Shavell (1994) and others are correct, then law and economics scholars should adopt their suggestion that ‘it is appropriate for economic analysis of legal rules to focus on efficiency and to ignore the distribution of income in offering normative judgments’ (Kaplow and Shavell, 1994, p. 677). If their analysis is flawed or if, as some authors suggest, traditional neoclassical economics models contain serious deficiencies, then the arguments of Calabresi (1991), Kronman (1980), Kennedy (1982) and Arlen (1992) that the courts should consider income distribution when evaluating legal rules have merit. 301

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2. Two Lines of Research It is not unusual for legal scholars to assume that courts ought to be concerned with the proper distribution of income. Indeed, given that allowing the courts to consider issues of income distribution in judging cases will increase the demand for the services of lawyers and the legal system, it would be surprising if legal scholars were unanimous in concluding that courts ought to ignore the implications of legal policies on the income distribution (see, for example, Polinsky and Shavell, 1991). Moreover, Friedman’s (1981) and Lott’s (1987) papers imply that a court should consider a party’s wealth when that consideration leads to optimal deterrence. Rather than reviewing all of this literature, this chapter focuses on articles directly addressing the issue of whether it is more efficient to use the legal system or taxation to redistribute income. Heavy reliance on neoclassical economic theory and (usually) mathematical models characterizes the articles contributing to this discussion.

3. Related Literature While Shavell (1981) is the first law and economics scholar to address the issue of the most efficient way to redistribute income, his arguments draw directly from the optimal taxation literature of the 1970s. (See Auerbach, 1985, and Stiglitz, 1985, for thorough reviews of the optimal taxation literature and Drèze and Stern, 1985, for a review of the cost-benefit literature.) Shavell acknowledges his particular intellectual debt to two articles in this literature. In the first, Mirrlees (1971) demonstrates that commodities whose demand are independent of income should not be taxed (with a fixed per unit tax) when there is an optimal income taxation system in place. In the second, Hylland and Zeckhauser (1979, p. 266) demonstrate that ‘in the optimal arrangement, distributional objectives are achieved through the tax system alone’. Moreover, Hylland and Zeckhauser conclude that, in the presence of the optimal income tax, government programs should be adopted based purely on efficiency criteria. Shavell’s 1981 paper reaches a conclusion that echoes that of Hylland and Zeckhauser. In particular, Shavell (1981, p. 414) argues that ‘despite imperfect ability to redistribute income through taxation, everyone would strictly prefer that legal rules be chosen only on the basis of their efficiency’.

4. Legal Scholarship The conclusions of Shavell (1981) are contrary to those made by earlier legal scholars. Scholars such as Ackerman (1973), Kennedy (1976), Michelman

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(1978), and Kronman (1980) argue that an important role of legal institutions is to redistribute income. Indeed, Kronman (1980, p. 510) argues that the choice between using the legal system and using taxation to redistribute income depends on ‘contextual considerations that are likely to vary from one situation to the next’. Kronman suggests that all of the alleged problems with using courts to redistribute income are equally likely to be problems with taxation. For instance, critics of using the courts to redistribute income claim that there is no reason to believe that judges can correctly assess the distributional consequences of any particular decision. Kronman counters that difficulty in applying egalitarian rules in individual cases does not mean that we cannot use egalitarian principles when designing the legal system. To the claim that the legal system should ‘remain neutral between the aims and activities of its citizens’ (Kronman, 1980, p. 502), Kronman responds that taxation is no more neutral than are the courts and the relative neutrality of the two methods of redistributing income is an empirical issue. Kronman responds in a similar manner to claims that regulation is more injurious to its intended beneficiaries and is more expensive to administer than is taxation by asserting that these are empirical issues than cannot be resolved through the use of theory alone, a conclusion not supported by Shavell (1981).

5. Shavell Forgotten Not only does Shavell’s research offer conclusions contrary to earlier research, it appears to have been ignored by legal scholars during the ten years following its publication. Calabresi (1991), Donohue (1989), Ellis (1982) and Kennedy (1982) all discuss the role of the legal system in achieving the proper distribution of income without mentioning Shavell’s 1981 seminal article. Abraham and Jeffries (1989), who argue that information about a defendant’s wealth should not be considered in determining punitive awards, do not reference Shavell. In their defense, the connection of Shavell’s conclusion to the issue that Abraham and Jeffries discuss is not obvious. Abraham and Jeffries argue that the consideration of a defendant’s wealth is not germane to the issue of punitive damages and invites jury speculation about issues about which they have no information. They argue that traditional arguments that the legal system needs punitive damages in order to deter individuals from inflicting harm for personal satisfaction and to neutralize the effects of underenforcement are incorrect. While Abraham and Jeffries do not point out the connection, their arguments echo those of both Hylland and Zeckhauser (1979) and Shavell (1981) that distributional goals are best achieved through the tax system while government programs - including legal regulation - should ignore distributional goals in favor of efficiency criteria. Thus, by Hylland and Zeckhauser’s and Shavell’s logic one would consider the defendant’s wealth

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only in cases wealth is correlated with deterrence, a conclusion that matches Abraham and Jeffries’ result.

6. Shavell Remembered Arlen (1992) appears to be the first author to acknowledge Shavell’s 1981 article. While the model that Shavell develops assumes that people are risk neutral, he points out that his results are independent of this assumption. Arlen argues, incorrectly it turns out, that Shavell’s conclusions do not hold when individuals are risk averse. The most recent contributions to this literature are in direct response to what Kaplow and Shavell (1994) and Miceli and Segerson (1995) perceive as a general misunderstanding of Shavell’s 1981 article by legal scholars, including Arlen (1992). In what follows, we discuss Shavell (1981) and Kaplow and Shavell (1994) together because of the similarities in the two articles. We then review Miceli and Segerson (1995). Since the model in Miceli and Segerson (1995) corrects and places Arlen’s results in the context of the Shavell model, we include Arlen (1992) in this discussion.

7. Shavell’s Analysis The arguments in Shavell (1981) and Kaplow and Shavell (1994) are essentially identical. These authors argue that all efforts to redistribute income be these efforts through the legal system or through the tax system - distort work efforts (see Hausman, 1981, for an empirical justification of this point). Redistributing income through the legal system creates additional inefficiencies in the activities affected by the legal rules. Thus, we should be able to construct a new tax schedule that we can combine with efficient legal rules that will have the same distortions of work effort but none of the inefficiencies that arise when we use the legal system to redistribute income.

8. Achieving a Desired Income Distribution Since this result is key, we consider it here in some detail. Shavell (1981) and Kaplow and Shavell (1994) assume that individuals are risk neutral maximizers of expected utility, which is equal to their income net of taxes, expected liability costs, expected damages, and the costs of work effort and care taking. The tax schedule is a function of income while the expected liability and damages are functions of the level of care taken by the individual. In order to simplify the analysis, these authors assume that (1) an individual’s income is a linear

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function of his work effort and (2) in the aggregate the government returns all taxes collected. Following existing literature, they define the efficient level of care as that care level that minimizes sum of the total costs of care and the expected accident costs. As Shavell (1981, p. 416) and Kaplow and Shavell (1994, p. 678) note, the level of care that is efficient is independent of an individual’s income. These authors show that we can replace any regime having an inefficient legal rule and a tax schedule with a regime with an efficient legal rule and a properly modified tax schedule that raises the same level of taxes. More importantly, they also show that all members of society prefer the regime with the efficient legal rule.

9. Modification of the Tax Schedule The modification to the tax schedule under the inefficient legal rule offers some insight into what drives these results. The modified tax schedule is equal to the tax schedule in the inefficient regime plus the total accident costs in the inefficient regime minus the total accident costs in the efficient regime (see Kaplow and Shavell, 1994, p. 678). Substitution of the new tax schedule into the expected utility function yields the results that the expected utility is the same in the efficient regime (with the modified tax schedule) as it is in the inefficient regime. Moreover, this new tax schedule yields a greater level of revenue. Remember that the modified tax schedule is equal to the old tax schedule plus the efficiency savings that come from switching to the efficient legal rule. Thus, if we rebate these savings uniformly to the population in the form of a lump sum (negative) tax, no-one’s incentive to work is affected and everyone is better off by the amount of the rebate in taxes.

10. Other Reasons for Using the Tax System to Achieve Distributional Goals Kaplow and Shavell (1994, pp. 674-676) offer several other, more traditional reasons for favoring the use of the tax system over the legal system to redistribute income. First, the tax system can allocate the impact of income redistribution on all of the rich and all of the poor. By contrast, using the legal system to redistribute income yields haphazard results. The legal system can only affect those individuals involved in a lawsuit. Moreover, in many cases consumer response is bound to mute or completely negate efforts to use the courts to redistribute income. For instance, individuals bound by contracts will adjust prices to take account of efforts by the courts to redistribute income. Similarly, corporations may well be able to pass on to consumers the income redistribution efforts by the courts. Second, Kaplow and Shavell (1994, p. 675)

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argue that claims that the legal system should be involved in income redistribution efforts because the political system is unable to achieve the ideal amount of income redistribution do not stand close examination. In particular, the legal system operates under the influence of the politicians and there is no reason to believe that efforts by the courts to redistribute income in ways not intended by the politicians will escape their scrutiny. Thus, Kaplow and Shavell (1994, p. 677) conclude that their analysis ‘suggests that it is appropriate for economic analysis of legal rules to focus on efficiency and to ignore the distribution of income in offering normative judgments’.

11. A General Model Miceli and Segerson (1995) offer the most complete analysis of the issue of role of income distribution in setting efficient levels of care. These authors analyze the role of risk aversion in the Shavell (1981) and Kaplow and Shavell (1994) model. In doing so, they correct and reconcile Arlen’s (1992) results with the other models. Miceli and Segerson argue that of the three potential optimal choice criteria - Pareto efficiency, the Pareto criterion, and aggregate welfare Pareto efficiency is the proper one to use. They define Pareto efficiency by the following choice problem: Max Ui subject to Uv U ov (1) where Ui is the utility level of the injurer, Uv is the utility level of victim, and U ov is some arbitrarily fixed level of utility for the victim. The Pareto criterion has the same definition as (1), except that U ov is set equal to the victim’s original utility level, U( W ov ). Finally, aggregate welfare is the solution to the following choice problem: Max Ui + Uv(2) is where some weight placed on the victim’s utility. Miceli and Segerson (1995, p. 194) illustrate the three concepts with the utility possibilities frontier (UPF) shown in Figure 1. The UPF contains all of the Pareto optimal points. As illustrated in Figure 1, the Pareto criterion and the aggregate welfare each pick points that are subsets of the Pareto optimal points. The authors prefer to use Pareto optimality as their choice criterion for two reasons. First, unlike the other concepts, Pareto optimality does not involve interpersonal comparisons of utility. Second, we can specify any income distribution by varying U ov .

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Figure 1 The utility possibility curve (UPC) for injurer and victim

12. Definition of Terms Miceli and Segerson (1995, p. 197) define P(X) to be the probability of an accident (where P' > and P'' < 0); X, the injurer’s care level; m, the damages that the victim suffers if there is an accident; Wi and Wv, the injurer’s and victim’s preaccident wealth levels, respectively; D, the damages paid by the injurer in case of an accident; and T, a (positive or negative) transfer from the injurer to the victim that occurs independent of whether an accident occurs. As Miceli and Segerson (1995, p. 197) note, the addition of the variable T allows them to ‘decouple distribution and cost minimization issues’. They then split the analysis into two distinct parts. In the first they derive the first-best care levels while in the second they analyze the ability of various liability rules to give individuals the incentives necessary to take these first-best care levels.

13. Efficient Care Standards Miceli and Segerson (1995) show that in the presence of fully working insurance markets, the first-best care standards are independent of both injurer’s and victim’s wealth levels as long as the policymaker is free to choose the care standard and the amount of the transfer, T. Only in the case where the policymaker can only set the care standard is the care standard a function of the injurer’s wealth. For instance, Arlen (1992) implicitly assumes in her analysis that the amount of the transfer, T, and the amount of damages, D, are preset such that T = D = 0. Figure 2 illustrates the case when the policymaker can only set the care standard. The solid curve labeled UPF1 is the utility

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possibilities frontier that faces the policymaker who is free to set the care standard and the amount of the transfer. Since the policymaker’s choice set is restricted, the utility possibilities frontier available to the policy maker who can only set the care standard must lie inside the unrestricted UPF at all points except the point where T and D by coincidence equal the levels that would occur in the unrestricted case. In Figure 2 the dashed line labeled UPF2 represents the restricted UPF, while point A represents the one point where T and D equal the values they would have in the unrestricted case. Clearly, there exist solutions on UPF1 where both the victim and the injurer can achieve higher utility levels than they can on the restricted UPF2. Figure 2 Restricted and unrestricted utility possibility curves

14. Efficiency of the Legal Rules By choosing appropriate liability rules society attempts to induce injurers to take the efficient level of care. The potential success of society in achieving this goal while concurrently attempting to reach an ideal distribution of income depends on the number of policy tools available to the policy makers. Miceli and Segerson (1995, pp. 200-202) analyze the efficiency of strict liability and negligence under various assumptions about the choice variables available to the policy makers. As they note, the efficient care level solves Max Ui subject to Uv U ov and X maximized Ui(3) given the liability rule. Miceli and Segerson demonstrate that, when policymakers can set the care standard X, the damage award D, and the transfer from the injurer to the victim T, both strict liability and negligence rules are efficient. The reason for this result is that the policy makers have three tools - X, D, and T - with which to achieve three goals income distribution, cost minimization and efficient incentives for the injurer.

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Thus, the policy makers can set X to minimize total social cost, D to give the injurer the proper incentives, and T to redistribute income, resulting in society attaining a point somewhere on UPF1, as shown in Figure 2. In contrast, if one or two of the three control instruments are not available to the policymakers, then society can achieve the three goals only by coincidence.

15. An Existence Theorem The results presented by Shavell (1981), Miceli and Segerson (1995) and Kaplow and Shavell (1994) comprise an existence theorem - if society decides to redistribute income, there exists a tax schedule for redistributing income that everyone prefers to any other way of redistributing income, including the use of legal rules or institutions. As Kaplow and Shavell (1994, p. 675) note, the importance of this result to legal scholars is that it demonstrates that it is appropriate to evaluate legal rules only on the basis of efficiency criteria.

Bibliography on Optimal Techniques of Redistribution (6110) Abraham, Kenneth S. and Jeffries, John C. Jr (1989), ‘Punitive Damages and the Rule of Law: The Role of Defendant’s Wealth’, 28 Journal of Legal Studies, 415-425. Ackerman, Bruce (1973), ‘Regulating Slum Housing Markets on Behalf of the Poor: Of Housing Codes, Housing Subsidies and Income Redistribution Policy’, 80 Yale Law Journal, 1093-1197. Arlen, Jennifer H. (1992), ‘Should Defendants’ Wealth Matter?’, 21 Journal of Legal Studies, 413-429. Hylland, Aanund and Zeckhauser, Richard (1979), ‘Distributional Objectives Should Affect Taxes but Not Program Choice or Design’, 81 Scandinavian Journal of Economics, 264-284. Kaplow, Louis and Shavell, Steven (1994), ‘Why the Legal System is Less Efficient than the Income Tax in Redistributing Income’, 23 Journal of Legal Studies, 667-681. Miceli, Thomas J. and Segerson, Kathleen (1995), ‘Defining Efficient Care: The Role of Income Distribution’, 24 Journal of Legal Studies, 189-208. Shavell, Steven (1981), ‘A Note on Efficiency vs. Distributional Equity in Legal Rulemaking: Should Distributional Equity Matter Given Optimal Income Taxation?’, 71 American Economic Review, 414-418.

Other References Auerbach, Alan J. (1985), ‘The Theory of Excess Burden and Optimal Taxation’, in Auerbach, Alan J. and Feldstein, Martin (eds), Handbook of Public Economics, Amsterdam, Elsevier Science Publishers B.V. (North Holland), 61-127.

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Calabresi, Guido (1991), ‘The Pointlessness of Pareto: Carrying Coase Further’, 100 Yale Law Journal, 1211-1237. Donohue, John J. III (1989), ‘Diverting the Coasean River: Incentive Schemes to Reduce Unemployment Spells’, 99 Yale Law Journal, 549-609. Drèze, Jean and Stern, Nicholas (1985), ‘The Theory of Cost-Benefit Analysis’, in Auerbach, Alan J. and Feldstein, Martin (eds), Handbook of Public Economics, Amsterdam, Elsevier Science Publishers B.V. (North Holland), 909-989. Ellis, Dorsey D., Jr (1982), ‘Fairness and Efficiency in the Law of Punitive Damages’, 56 Southern California Law Review, 1-78. Friedman, David D. (1981), ‘Reflections on Optimal Punishment, or: Should the Rich Pay Higher Fines’, 3 Research in Law and Economics, 185-205. Hausman, Jerry A. (1981), ‘Labor Supply’, in Aaron, Henry J. and Pechman, Joseph A. (eds) How Taxes Affect Economic Behavior, Washington, DC, Brookings Institution, 27-72. Kennedy, Duncan (1976), ‘Form and Substance in Private Law Adjudication’, 89 Harvard Law Journal, 1685-1778. Kennedy, Duncan (1982), ‘Distributive and Paternalist Motives in Contract and Tort Law, with Special Reference to Compulsory terms and Unequal Bargaining Power’, 41 Maryland Law Review, 563-658. Kronman, Anthony T. (1980), ‘Contract Law and Distributive Justice’, 89 Yale Law Journal, 472-511. Lott, John R., Jr. (1987), ‘Should the Wealthy Be Able to “Buy Justice?”’, 95 Journal of Political Economy, 1307-1316. Michelman, Frank I. (1978), ‘Norms and Normativity in the Economic Theory of the Law’, 62 Minnesota Law Review, 1015-1048. Mirrlees, J.A. (1971), ‘An Exploration in the Theory of Optimum Income Taxation’, 38 Review of Economic Studies, 175-208. Polinsky, A. Mitchell and Shavell, Steven (1991), ‘A Note on Optimal Fines When Wealth Varies Among Individuals’, 81 American Economic Review, 618-621. Shavell, Steven (1982), ‘On Liability and Insurance’, 13 Bell Journal of Economics, 120-132. Stiglitz, Joseph E. (1985), ‘Pareto Efficient and Optimal Taxation and the New New Welfare Economics’, in Auerbach, Alan J. and Feldstein, Martin (ed.) Handbook of Public Economics, Amsterdam, Elsevier Science Publishers B.V. (North Holland), 991-1042.

6120 PENSIONS Koen Algoed and Frans Spinnewyn University of Leuven © Copyright 1999 Koen Algoed and Frans Spinnewyn

Abstract This chapter discusses the different pension systems. Pension systems are a means of transferring purchasing power from the working phase to the retirement phase of the life cycle. Formal pension systems are organised in two ways. In the funded or the capital-reserve system, the agents save to accumulate a fund which finances an annuity to the survivors. In the pay-as-you-go system, the payment of the pensions to the retired population are financed by the contributions of the working population. It is shown that capital-reserve systems and pay-as-you-go systems, two variants of providing retirement income, may yield the same outcome or may yield allocations differing only in their second order effects. Capital-reserve systems are superior to pay-as-you-go systems in the definition of the future rights of the retired population. Pay-as-you-go systems are better suited to redistribute the burden of major shocks among the working generations and the retired generations. Reforms fixing the individual rights of the retired population conditional on the state of the economy and the record of individual contributions are desirable. Alternatively, adapting the tax status of funded pension plans to the state of the economy in a well-defined way could improve the risksharing properties of the capital-reserve system. JEL classification: H55 Keywords: Overlapping Generations, Pay-as-you-go, Capital Reserve, Aaron’s Rule, Social Risk

1. Saving for Retirement Old-age pension plans are a means of transferring purchasing power from the working phase to the retirement phase of the life cycle. The wages earned while working constitute a claim on the output of the economy. By refraining from consuming part of this claim, output can be devoted to investment or consumption of collective goods.. The contributions to a pension fund are an example. Through the pension fund, these financial means are lent to firms for the acquisition of capital assets or to the 311

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government for providing collective goods. In this way, the retired population derives a claim on the output of the economy, either by sharing in the income appropriated by the capital owners or by sharing in the taxes levied by the government to service the debt. This income finances consumption after retirement. Alternatively, working children can share their claim on the output of the economy with their retired parents. In this way, the parents are given the opportunity to satisfy their consumption needs after retirement. In the extended family, the children care for their parents in the hope of being cared for by their children in old age. On a broader scale, in a formal pension plan part of the wages earned by the working population are transferred to the retired population. In this way, the retired generation obtains a claim on the output of the economy even when they are no longer involved in the production process. Like private saving, old-age pension plans therefore smooth consumption over the life cycle. However, the transfer of purchasing power in a pension plan is conditional on the survival after retirement. Formal pension plans covering large populations redistribute income from the short-lived to the long-lived. In addition to the transfer of purchasing power, formal pension plans offer insurance against longevity. Old-age pensions insure against the risk that the retiree will outlive the amount saved for the provision of retirement income (Bodie, 1990a). In this way, those who have contributed for a pension but die before or live only for a short while after retirement contribute to and increase the retirement income of those who are blessed with a long life. The rate of return for the survivors in a pension plan exceeds the rate of return on saving, the difference being equal to the mortality rate. The reason is that the rights of those who die are transferred to the survivors. Restricting transfers to the survivors is motivated by the fact that only the survivors still have consumption needs. In contrast, the wealth accumulated through saving is bequeathed to the heirs. Due to the stochastic nature of the length of life, the bequest at the time of death has a random component. Using the techniques of insurance, formal pension plans can control for this random component. The exchanges between the young and the old generation are therefore better defined in the formal pension plans than in the extended family.

2. The Capital-Reserve System and the Pay-As-You-Go-System Formal pension plans are organised in two ways. In the funded or the capital-reserve system, the agents save to accumulate a fund which finances an annuity to the survivors. At each point of time, the accumulated fund of a cohort of agents together with the contributions which are still due from the

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surviving members of the cohort before retirement, will meet the future pension rights of the survivors in the cohort. In the pay-as-you-go system, the payment of the pensions to the retired population are financed by the contributions of the working population. When the former exceed the latter, the accounts are balanced either by a subsidy of the government financed by taxes or by running down reserves. A pay-as-you-go system can therefore be viewed as a plan of transfer payments from the working population to the retired population. The contributions made while working, provide the agent with a right to receive a pension while retired. From this description, it is concluded that the distinguishing feature between the capital-reserve system and the pay-as-you-go system is the redistribution of income between generations which takes place in the latter but not in the former (Verbon, 1989; Marchand and Pestieau, 1991). However, this conclusion needs the following qualifications. First, workers, capital owners and the taxing authorities have competing claims on the output. Depending on the organisation of the pension plan and the definition of the pension rights, the income of the retired population will depend on the solution of this basic conflict. If the pensions are linked to the income of the working population, as in the pay-as-you-go system, the old-age pensioners gain from an increase in the wage bill. But the interests diverge when both parties bargain over the share of the wage bill accruing to the old-age pensioners. If the pensions are linked to the income of the capital owners, as in the capital-reserve system, then the working generation increases its share at the expense of the retired generation. Second, the transfers between generations in the formal pension plans are complemented by voluntary transfers or bequests. Abstracting from uncertainties, differences in transfer payments between young and old in the pension plans will be offset by changes in the bequests. This neutrality theorem of Barro (1974) is a variant of Ricardian equivalence of government fiscal actions and is based on the life cycle model of savings (Modigliani and Brumberg, 1954). In this model, a consumption profile has the discounted sum of lifetime after-tax income as one of its arguments. Two after-tax income profiles with the same present value result in the same consumption profile. Two pension plans leading to two different profiles of after-tax income but with the same present value do not change consumption. If consumption does not change, investment and the capital formation are not affected by the choice of the pension plan. Barro’s neutrality result has been criticised by the fact that it may require negative bequests at the individual level in order to establish the neutrality of public actions. This will be the case when at the collective level the burden to the future generations of servicing the public debt is low.

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3. Equivalence of Pension Systems Under Certainty In the comparison of formal pension plans, consider an environment without uncertainty apart from the risk of longevity. In the capital-reserve system, the contributions to a pension plan grow with the interest rate which is linked to the marginal productivity of capital. Samuelson (1958) and Aaron (1966) have shown that the contributions to the pay-as-you-go system also earn a return which is composed of the growth rate of the population (Samuelson’s ‘biological’ rate of interest) and the growth rate of wages. Equivalence on the Golden Rule Path Assume that in the capital-reserve system, the age profile of contributions and benefits of any two succeeding generations are obtained from each other by a parallel vertical shift reflecting the growth rate of wages. It then follows that in the steady state the two systems are equivalent if the interest rate is equal to the sum of population and wage growth rates. This can be established as follows. In the capital-reserve system, the capital which has been accumulated during the working life is equal to the discounted future liability of the pension fund at the date of retirement. Consider a pay-as-you-go system in which contributions and benefits of each individual are equal to those of the capital-reserve system. Compare in the pay-as-you-go system the own contributions of the retiring generation when they started working and the current contributions of the youngest generation. The contributions of the youngest generation have increased at a rate equal to the sum of the growth rate of the population and the growth rate of wages for a period equal to the length of the working life. By assumption, this sum is equal to the rate of interest. It follows that the current contribution of the youngest generation in the pay-as-you-go system is equal to the capitalized value of the contributions of the retiring generation as young workers in the capital-reserve system. By shortening the period for which they were contributing each time by one year, the same holds for each of the older working generations. Similarly, for each of the retired generations, the total transfer payments in the pay-as-you-go system are equal to the present value of the future transfer payments of the pension funds when the current retiring generation will be of the same age. In the pay-as-you-go-system, the older retired generations are less numerous and have a lower pension reflecting the lower wage earned in their working life. By assumption, the sum of these effects is matched by the effect of discounting the future liability of the pension fund in the capital-reserve system. Since at the retirement date, the capitalised contributions are equal to the present value of the liabilities in the capital-reserve system, it follows that the pay-as-you-go system which mimics the capital-reserve system breaks even.

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If the interest rate is equal to the growth rate, the economy is at the golden rule. At the golden rule the consumption per head is maximised. The consumption per head is obtained as the difference between the production per head and the investment per head needed to keep the capital-labour ratio constant. The labour force is measured in efficiency units. Consumption per head is then a function of the capital-labour ratio. There is over-accumulation if the capital-labour ratio in the steady state is larger than the ratio in the golden rule. The golden rule is Pareto superior to any steady state with over-accumulation. This is established as follows. Let the capital stock fall by delaying investment until the capital-labour ratio has fallen to the one in the golden rule. Without investment, the consumption of the generations living in the transition can be increased. In the new steady state satisfying the golden rule, the consumption is larger than in the steady state with over-accumulation. The government debt is adjusted to obtain equality between private financial wealth and the sum of the government debt and the value of the capital stock. There is under-accumulation if the capital-labour ratio in the steady state is smaller than the ratio in the golden rule. In this case, one cannot increase the capital-labour ratio without decreasing the consumption of the generations living in the transition. The steady state with under-accumulation is therefore Pareto efficient. Equivalence off the Golden Rule Path Restricting the analysis to Pareto-efficient situations, we conclude that the rate of return on saving in the capital-reserve system is at least as large as the one in the pay-as-you-go system. By and large, the interest rate has always exceeded the growth rate of the economy. From Aaron (1966) to Feldstein (1976), economists as well as politicians have concluded that for that reason the capital-reserve system is more efficient than the pay-as-you-go system. In this comparison, it is implicitly assumed that government debt is the same in the two systems. In an economy with lump-sum taxation, the equivalence of the two systems is re-established when in the pay-as-you-go system the government debt is reduced by an appropriate amount (Bewley, 1981; Myles, 1995). The argument is based on the life-cycle model stating that the consumption profile is unaffected by a change in the after-tax income profile which does not change its present value. When compared to the capital-reserve system, the pay-as-you-go system has higher taxes before retirement but lower taxes after retirement. If the interest rate exceeds the growth rate of the economy, the two systems yield the same consumption profile for an average tax rate which is larger in the capital-reserve system than in the pay-as-you-go system. The tax rate is increased in the

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capital-reserve system by increasing the taxes needed to service a larger government debt. The same conclusion is obtained when it is assumed that the pay-as-you-go system mimics the capital-reserve system. If the interest rate exceeds the growth rate of the economy, it follows from the previous discussion that per retiring agent the contributions of the working generations in the pay-as-you-go system fall short of his or her accumulated savings in the capital-reserve system. The transfer payments to the retired generations in the pay-as-you-go system exceed the present value of the future liability to a retiring agent in the capital-reserve system. From the equality of the accumulated savings and the present value of future liabilities at the retirement date in the capital-reserve system, it follows that the pay-as-you-go system runs a deficit. When the government subsidy needed to restore the balance is equal to the tax saving from a lower government debt, the two systems are equivalent. The conversion of a pay-as-you-go system to a capital-reserve system shows that, ceteris paribus, the government debt must be larger in the latter than in the former (Townley, 1981; Breyer, 1989; Verbon, 1989). In the transition period, the retired generations receive pension payments equivalent to those they would have received for the fraction of their working life that they contributed under the old system. No generation is therefore sacrificed. The gap needed to compensate these generations is closed by an increase in government debt which is taken up by the pension funds. But then, after the transition period, no generation will benefit from the higher rate of return of the capital-reserve system. The government subsidy which was needed under the pay-as-you-go system is replaced by an increase in the average tax rate to service the larger debt. Although a consensus on the issue of the performance of pension systems has not been reached, we conclude that investment needed to raise the capital stock in a state of under-accumulation can be achieved only by reducing aggregate consumption at the outset. Consider an environment without uncertainty and without distortionary taxation. For a given rate of interest, the utility-maximising consumption profile is chosen within the intertemporal budget of each generation. An increase in the capital stock requires a higher investment rate and, therefore, an adjustment in the consumption profile. An adjustment of an optimal consumption profile is possible only by decreasing the lifetime utility. It then follows that increasing the capital stock is impossible unless at least one generation is made worse off. From this conclusion it does not follow that the different definition of the rights of pensioners in the capital-reserve system and in the pay-as-you-go system is unimportant. The definition of the rights in each of the systems

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and in their variants determines the risk borne by the retirees and the risk sharing between the agents in the economy. In addition, the allocation of pension rights provide different incentives to contribute to a pension system affecting both the level of contributions and the choice of the retirement age. Finally, market imperfections in the form of asymmetric information on survival risks, transaction costs, myopia and free riding must be taken into account.

4. Pension as Retirement Income Insurance Through contributions during the working years, pension plans are designed to protect an economic agent against economic insecurity in retirement. In addition to the longevity risk, the following major sources of retirement income risk can be distinguished (Bodie, 1990a; Disney, 1996). First, the replacement rate inadequacy reflects the risk that the retiree is unable to maintain the same standard of living after retiring as during the pre-retirement years. Consumption is smoothed by linking the pension to some measure of final earnings and the years of service. Occupational pensions of the ‘defined benefit’ form and pensions of civil servants belong to this type. In contrast, personal pensions of the ‘defined contribution’ form depend on the total contributions and investment earnings of the accumulation in the account of the employee. Capital market uncertainty reflects the risk that the retirement income will be inadequate because of poor performance of the capital market. Inflation risk affects the purchasing power of retirement savings. Pay-as-you-go systems are insulated from these two previous sources of risk, since the pension benefits are related to the contributions of the wage earners. Wage income fluctuates less than rental incomes and wages are adjusted to inflation. Finally, by the time the retirement age is reached, the individual risks that either the social insurance provisions in the pay-as-you-go system or the tax status of the pensions in the capital-reserve system have been changed. In defining the rights of the retiree in an optimal pension plan, the reduction of economic insecurity in one direction will imply greater economic insecurity in another direction. The reason is that aggregate production varies from year to year so that the uncertainty on the production side must somehow be reflected on the consumption side. If none of the pension plans dominates the others, agents may participate in pension plans of different types and, in addition, accumulate private wealth for retirement. In particular, human capital and housing property are a hedge against inflation risk (Feldstein, 1983; Summers, 1983). The choice between the various pension instruments and private saving can be described using the

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theory of portfolio selection (Augier, Chaveau and Loupias, 1995). The retirement income in the capital-reserve system depends on the stochastic rate of return of investments in physical capital and the tax status of pension plans. For the retirement income in the pay-as-you-go system, the stochastic rate of return depends on the wage growth, on the population growth and on changing social security provisions. The choice of the mix depends on the expected return and the systematic risk of each alternative. A pension plan with a greater exposure to economic insecurity will compensate the participant with a larger rate of return.

5. Optimal Risk Sharing The final appraisal of the efficiency of a mix of pension instruments should depend on its potential to eliminate idiosyncratic risks at the individual level (Borch, 1962; Fisher, 1983; Townsend, 1994). Optimal risk sharing is achieved when changing consumption levels of individuals living at the same time can be explained by changes in their aggregate endowment. Other peculiarities, in particular whether an individual is retired or not, should have no further explaining power. As a result, the individual consumption levels should move together with the aggregate endowment. Otherwise, a reallocation of endowments is welfare improving. Consider an individual or a small group of individuals with a high income when the income of others is low in a bad state and with a low income when the income of others is high in a good state. Then this group should give to the others in the bad state in return for a gift in the good state. When chosen appropriately, such a reallocation which gives to everybody an income which is lower in the bad state than in the good state is welfare improving for risk averse agents. Everybody’s income as a donor exceeds his or her income as a beneficiary in the reallocation of the endowments. The marginal cost of giving is therefore less than the marginal gain of receiving. From the perspective of optimal risk sharing, the income received by the old age pensioners and the income of the working population should move together. For this reason, Musgrave (1981) proposed a pension plan which determines old-age pensions as a fixed proportion of labour income per worker. Assume that workers transfer a fixed proportion of their income to old-age pensioners, that the ratio of old-age pensioners to workers is constant over time and that the share of labour income in total income is fixed. This definition of pension rights in a pay-as-you-go system is well suited to achieve optimal risk sharing when the growth rate of income is uncertain.

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Note that in a capital-reserve system, capital market risk and inflation risk could be eliminated by the government issuing bonds with a risk-free real rate of return. But from the perspective of optimal risk sharing, insulating the retired population from economic insecurity by shifting aggregate risk completely to the working population is inappropriate. Instead, Merton (1983a) proposed the issuing of bonds with a rate of return linked to the growth rate of per capita consumption. If wages and consumption are perfectly correlated, the proposals of Musgrave and Merton are equivalent. By the equality of the accumulated savings and the present value of future liabilities within each cohort at the time of retirement, the capital-reserve system excludes intergenerational transfers. In contrast, intergenerational transfers required by optimal risk sharing can take place in a pay-as-you-go system operating under a softer budget constraint. It is not guaranteed that the opportunities of a softer budget constraint will be used to improve intergenerational risk sharing. The government may yield to the demands of pressure groups which oppose the welfare improving adjustments. But the risk of government failure in the process of intergenerational risk sharing does not imply that the Pareto inefficient status quo without intergenerational transfers is the best choice. The previous argument in favour of the pay-as-you-go system takes the tax status of pension plans as given. However, the tax status of pension plans has redistributive consequences. By choosing an appropriate tax status and by adjusting taxation to the state of the economy, a capital-reserve system may improve intergenerational risk sharing as well.

6. Limits to Insurance Moral Hazard The link between the benefits of the retiree and the contributions in the working period affects the willingness to contribute in a pension scheme. The high fertility rates in the informal pension schemes is an example. A mandatory pay-as-you-go system which offers a basic (flat rate) pension financed by a payroll tax implies a distortionary tax affecting the choice of the labour input. With distortionary taxes, the pay-as-you-go system and the capital-reserve system may no longer be equivalent (Breyer, 1989; Homberg, 1990; Breyer and Straub, 1993). This conclusion depends on the level of government debt in each of the systems and on the distortionary effects of taxes needed to service the debt. In addition, if one wants to guarantee a minimum income to the retired belonging to the lower income classes for redistributive purposes, then these transfer payments have to be financed by distortionary taxes. Finally, the rights of the pensioners can be defined

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proportionally to the contributions and to the years of service in the pay-as-you-go system as well as in the capital-reserve system. Linking retirement income to the years of service raises problems in the case of early retirement. The optimal retirement date will vary both with the disutility of working and with the worker’s productivity at an older age. Since the latter depends on a variety of random factors, from an insurance point of view it is desirable to adjust the retirement date accordingly without changing retirement income. But since the factors determining the retirement date cannot be measured in an objective way, early retirement demanded by the worker or induced by the employer will result in abuses. In the second best, the retirement income should therefore depend on the years of service (Diamond and Mirrlees, 1986). Adverse Selection Like any insurance contract, pension plans face the problem of adverse selection arising from the asymmetric information about the survival probability. Individuals who privately know that their survival probability is below average may prefer to save in assets instead of life insurance. For them, the rate of return on life insurance is lower since the terms of life insurance policies are based on the average survival probability of the particular group to which the insurance policy is sold. Since the individuals with a lower survival probability do not buy life insurance, the cost to the others increases. The unattractive annuity rates prevent the full development of a market for annuities. Adverse selection can be circumvented by compulsory schemes, in which good and bad risks are pooled (Eckstein, Eichenbaum and Peled, 1985). Employer pension plans and publicly organized pension plans are examples.

7. The Arguments for Publicly Organised Pension Plans The arguments for state intervention in the provision of retirement income are income redistribution, market failures, paternalism and efficiency (Diamond, 1977). Pay-as-you-go systems, unlike capital-reserve systems, usually need the authority of a government. In comparing the relative performance of each system, the need for government intervention on the grounds of these arguments have already been dealt with. We add some comments. In the absence of mandatory social insurance, the lower income classes may not have an incentive to save for retirement income. Welfare assistance cares for people without income. People with a low income during their working life have therefore little to lose when they do not save for retirement income. Unless they accept a dramatic cut in their consumption as workers,

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they will be unable to increase their retirement income by retirement savings above the lost welfare benefit. This free-rider problem is resolved by a mandatory scheme. A redistributive public pension plan will reduce the cost to the low incomes and their willingness to participate in the labour market. In addition, people may be myopic and not save enough for retirement. Information on how much to save and where to invest the savings is costly to obtain. People may therefore accept the coercion of a mandated plan which provides the necessary discipline and offers a reasonable and trustworthy solution to an intricate problem. Adverse selection already requires pooling and does not leave much choice in tailoring a retirement policy to individual preferences. Many do not know or are unsure about their true preferences. The operating expenses of a public scheme are much lower than those of the life insurance industry with large selling costs. All these are additional arguments in favour of government intervention in the provision of retirement income.

8. The Demographic Problem Demographic ageing threatens the financial viability of pay-as-you-go systems. The creation of social security schemes operating on a pay-as-you-go basis in most European countries after the Second World War forced young generations to make transfers to aged generations with the promise of being refunded when their own retirement would come. This operation was easy in an environment of demographic and economic growth. The transfer from the young to the aged population is painful in the current setting with demographic ageing (Marchand and Pestiau, 1991). In order to bring the problem of demographic ageing in the right perspective, it is important to distinguish between the higher lifetime expectancy and the fall in fertility rates. Starting from the capital-reserve system, an increase in the survival probability after retirement requires higher contributions to provide adequate income after retirement for the same retirement age. The same carries over to the pay-as-you-go system. Without changing the contribution rate of the working generations, either the replacement rate must be reduced or the average retirement date has to be increased. The main causes of the falling activity rates of the aged are early retirement and the rise of unemployment among the aged. Changing early retirement incentives by penalising the retired who voluntarily quit the labour force or the firm which induces involuntary unemployment may be needed. But consumption smoothing and risk sharing requires adjustments in all the available instruments to achieve the equilibrium between contributions and liabilities in any pension system.

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As explained above, a fall in population growth will increase the deficit of the pay-as-you-go system which adjusts its contribution and replacement rates to those of a capital-reserve system operating in the same environment. Without corrective measures, this will increase the public debt in the pay-as-you-go-system. The fall in the labour force is due to the declining birth rate which run at high levels from 1946 to the mid 1960s. The fertility rate fell partly because of an increased female participation in the labour force. Since demographic changes are gradual and to some extent predictable many years in advance, it possible to plan ahead by smoothing the contribution rates and by building up reserves in the pay-as-you-go system (Hagemann and Nicoletti, 1989; Marchand and Pestieau, 1991). Transfer payments between countries experiencing differently paced demographic shocks or early repayment of the public debt in countries with large public debt are examples. But note that such measures can be taken in combination with alternative measures affecting the activity rates of the aged and the young in the population and the migration rates. In addition, a fall in the labour force will lower the costs of education of children unless fewer children are provided with more human capital. From the equality of the accumulated contributions and future liabilities of each retiring cohort, it is often claimed that a capital-reserve system offers better protection against demographic changes. But irrespective of the pension system, the dissaving of a large retiring generation exceeds the saving of the smaller succeeding generation. In the transition, the desired consumption claims may be satisfied only if the output is adjusted by changing the capital-labour ratio after an adjustment of the government debt. Otherwise, the income distribution problem between generations may cause inflation eroding the purchasing power of retirement income.

9. Concluding Remarks The basic conflict between the working generations and the retired generations in the division of output cannot be resolved in an easy way. The mode of financing retirement income will affect the outcome of this basic conflict. But, in evaluating the relative merits of each system, compensating effects should be taken into account. As has been shown, two variants of providing retirement income may yield the same outcome or may yield allocations differing only in their second order effects. Any reform of an existing pension scheme should therefore be modest in the setting of its goals. It should not disappoint people by promises which it cannot deliver because of unforeseen compensating effects. As a consequence, any reform should be gradual as well. Although the outcome may not differ very much

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in the long run after agents have adjusted their behaviour, the outcome may imply dramatic changes for the generations living in the transition to the new equilibrium as they are unable to adjust their behaviour. Capital-reserve systems are superior to pay-as-you-go systems in the definition of the future rights of the retired population. Although income security after retirement is desired by each individual, it is not optimal from the risk-sharing point of view to insulate one group of the population from the collective risks which have to be borne by the society as a whole and which have to be shared between generations. Pay-as-you-go systems are well suited to redistribute the burden of major shocks among the working generations and the retried generations. But reforms fixing the individual rights of the retired population conditional on the state of the economy and the record of individual contributions are desirable. Alternatively, adapting the tax status of funded pension plans to the state of the economy in a well-defined way could improve the risk-sharing properties of the capital-reserve system.

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Financial Aspects of the United States Pension System, Chicago, IL, University of Chicago Press. Modigliani, Franco and Brumberg (1954), ‘Utility Analysis and the Consumption Function: An Interpretation of Cross-section Data’, in Kurihana, K.K. (ed.), Post-Keynesian Economics, New Brunswick, NJ, Rutgers University Press. Musgrave, Richard A. (1981), ‘A Reappraisal of Social Security Financing’, in Skidmore, F. (ed.), Social Security Financing, Cambridge, MA, MIT Press. Myles, Gareth D. (1995), Public Economics, Cambridge, Cambridge University Press, 546 p. Peters, W. (1988), ‘A Pension Insurance Model in an Overlapping Generations Model’, 144 Journal of Institutional and Theoretical Economics, 813-830. Rea, Samuel A., Jr and James E. (1977), Pesando, Public and Private Pensions In Canada: An Economic Analysis, Toronto, University of Toronto Press. Ricardo-Campbell, Rita and Lazear, Adward P. (eds) (1988), Issues in Contemporary Retirement, Stanford, Hoover Institute Press, Stanford University, 427 p. Rothschild, Michael and Stiglitz, Joseph E. (1976), ‘Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information’, 90 Quarterly Journal of Economics, 629-649. Samuelson, Paul A. (1958), ‘An Exact Consumption-Loan Model of Interest With or Without the Social Contrivance of Money’, 66 Journal of Political Economy, 467-482. Samuelson, Paul A. (1975), ‘Optimum Social Security in a Life-cycle Growth Model’, 16 International Economic Review, 531-538. Schmahl, Winfried (ed.) (1989), Redefining the Process of Retirement: An International Perspective, London, Springer, 179 p. Schulenburg, J. Matthias Graf Von Der (1990), ‘Demographischer Wandel, intergenerationale Gerechtigkeit und Stabilität des Generationenvertrages (Demographic Change, Intergenerational Justice and Stability of the Contact Between Generations)’, in Gahlen, B., Hesse, H. And Ramser, H.J. (eds), Theorie und Politik der Sozialversicherung, Schriftenreihe des Wirtschaftswissenschaftlichen Seminars Ottobeuren Bd. 19, Tübingen, Mohr/Siebeck, 269-300. Schulenburg, J. Matthias Graf Von Der and Breyer, F. (1989), ‘Umlagefinanzierte Rentenversicherung bei abnehmender Bevölkerung unter den Bedingungen eines demokratischen Wahlmechanismus (Pension Insurance Financed by Contributions in Times of Decreasing Population Under the Conditions of a Democratic Election Mechanism)’, in Boettcher, Erik, Herder-Dorneich, Philipp and Schenk, Karl-Ernst (eds), Jahrbuch für Neue Politische Ökonomie, Tübingen, Mohr, 126-139. Smith, Sharon P. (1991), ‘Ending Mandatory Retirement in the Arts and Sciences’, 81 American Economic Review. Papers and Proceedings, 106-110. Solow, R.M. (1956), ‘A Contribution to the Theory of Economic Growth’, 70 Quarterly Journal of Economics, 65-94. Strauss, Peter J., Wolf, Robert G. and Shilling, Dana (1990), Aging and the Law, Chicago, Commerce Clearing House, 892 p. Summers, Lawrence H. (1983), ‘Observations on the Indexation of Old-age Pensions’, in Bodie, Z. and Shoven, J.B. (eds), Financial Aspects of the United States Pension System, Chicago, IL, University of Chicago Press.

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Townley, P.G.C. (1981), ‘Public Choice and the Social Insurance Paradox: A Note’, 14 Canadian Journal of Economics, 712-717. Townley, P.G.C. and Boadway, Robin W. (1988), ‘Social Security and the Failure of Annuity Markets’, 35 Journal of Public Economics, 75-96. Townsend, Robert M. (1994), ‘Risk and Insurance in Village India’, 3 Econometrica, 539-591. Verbon, Harrie A.A. (1985), ‘On the Independence of Financing Methods and Redistributive Aspects of Public Pensions’, 40 Public Finance, 280-289. Verbon, Harrie A.A. (1987), ‘On the Independence of Financing Methods and Redistributive Aspects of Public Pensions: Reply’, 42 Public Finance, 454-456. Verbon, Harrie A.A. (1988a), The Evolution of Public Pension Scemes, Berlin, Springer, 287 p. Verbon, Harrie A.A. (1988b), ‘Explaining Pay-as-you-go Financed Public Pensions’, 28 Economics Letters, 181-187. Verbon, Harrie A.A. and Van Winden, Frans A.A.M. (1986), ‘Public Pensions and Political Decision Making’, in Graf Von Der Schulenburg, J.-Matthias (ed.), Essays in Social Security Economics, Berlin, Springer, 32-53. Verbon, Harrie A.A. (1989), ‘Conversion Policies for Public Pension Plans in a small open Economy’, in Gustafsson, B.A. and Klevmarken, N.A. (ed.), The Political Economy of Social Security, Amsterdam, North-Holland. Viscusi, W. Kip (1979), Welfare for the Elderly: An Economic Analysis and Policy Prescription, New York, Wiley, 251 p. Wachter, Susan M. (ed.) (1988), Social Security and Private Pensions: Providing for Retirement in the Twenty-First Century, Lexington, MA, Lexington Books, 232 p. Wilson, C. (1977), ‘A Model of Insurance Markets with Incomplete Information’, 16 Journal of Economic Theory, 167-207. Woodford, M. (1989), Equilibrium Models of Endogenous Fluctuations: an Introduction, University of Chicago Discussion Paper. Yaari, M.E. (1964), ‘On the Consumer’s Lifetime Allocation Process’, 5 International Economic Review, 304-317. Yaari, M.E. (1965), ‘Uncertain Lifetime, Life Insurance, and the Theory of the Consumer’, 32 Review of Economic Studies, 137-150.

6200 TAKINGS Thomas J. Miceli and Kathleen Segerson Department of Economics University of Connecticut © Copyright 1999 Thomas J. Miceli and Kathleen Segerson

Abstract This chapter provides an overview of the law and economics literature on government takings of private property under eminent domain. The first part of the chapter addresses questions pertaining to physical acquisitions of property, including the meaning of the public use and just compensation requirements, and the impact of takings for development decisions of landowners. The second part of the chapter turns to the question of whether or when a land use regulation ever becomes so burdensome to the landowner as to require compensation under the takings clause. Regulations that cross this threshold are referred to as regulatory takings. The chapter first discusses the economic justification for government (public) control of externalities, and then considers factors that affect the compensation question, including the intent of the regulation, the impact of the regulation on the landowner, incentives for efficient land use, fairness considerations, and whether capitalization nullifies the need for compensation. JEL Classification: K11, K32, Q24 Keywords: Eminent Domain, Compensation, Regulatory Takings, Police Power, Land Use

1. Introduction This chapter provides an overview of the law and economics literature on government ‘takings’ through acquisition or regulation of private property. Unlike private individuals who must bargain with owners when they wish to acquire property, the government can acquire private property for public use without the owner’s consent provided that it pays just compensation. In the United States, this authority is granted by the ‘takings clause’ of the Fifth Amendment of the Constitution, which states: ‘nor shall private property be taken for public use, without just compensation’. In addition, nearly all state constitutions contain takings clauses (Fischel, 1995b, p. 180). The law and economics literature has addressed a number of issues relating to the government’s taking power, including the economic justification for the 328

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government’s power of eminent domain, the meaning of the public use and ‘just’ compensation requirements, and the implications of eminent domain for the land development decisions of property owners. In the first part of this chapter, we provide an overview of these issues and the related literature. In contrast to physical acquisitions or intrusions for which compensation is nearly always paid, government regulation of private property generally does not require compensation. Instead, it is viewed as a legitimate exercise of the government’s police power. There is a long-standing question, however, about whether or when a regulation ever becomes so burdensome to a property owner as to require compensation under the takings clause. Regulations that cross this threshold are referred to as ‘regulatory takings’. In the second part of this chapter, we review the law and economics literature on regulatory takings. We begin by discussing economic justifications for government regulation, and then turn to factors that affect the compensation question, including the nature of the government action and the impact of the regulation on landowners. We argue that various ‘rules’ for determining whether or not compensation should be paid, which appear at first to be different, are in fact consistent under certain conditions. We conclude by proposing compensation rules that balance the incentives of regulators against the incentives of landowners.

A. The Economics of Eminent Domain The Fifth Amendment to the US Constitution guarantees, in part, that the government shall not take private property for public use without paying ‘just compensation’. This seemingly straightforward protection of private property from arbitrary government seizure has generated a large literature attempting to interpret and justify its various components.

2. The Justification for Eminent Domain Eminent domain gives the government the power to acquire property from private individuals through non-consensual transfers. Thus, a private individual’s property is protected by a liability rule, rather than a property rule, vis-à-vis the government (Calabresi and Melamed, 1972). A common justification for this power is that it prevents individuals from refusing to sell their property to the government at a ‘reasonable’ price. This argument is faulty, however, because the subjective value an individual attaches to his or her property is worthy of protection in economic exchange - indeed, an important reason for protecting property by a property rule is to allow individuals to refuse transactions that do not make them better off (Posner, 1992, Ch. 3; Munch, 1976).

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Since subjective value is important, and property rules protect subjective value, there must be another justification for eminent domain. The answer is that, when the government is assembling a large amount of land to build a public project like a highway, individual owners whose land is necessary for the project acquire monopoly power in their dealing with the government. That is, they can hold out for prices in excess of their true (subjective) valuation of the land given that it would be costly, once the project is begun, for the government to seek alternative locations (Cohen, 1991). Although the government theoretically could solve this problem by acquiring all the necessary land prior to construction, it would be difficult to conceal the project as the pattern of acquisitions was revealed. Moreover, because the project is publicly funded, it usually is public knowledge well in advance due to the need to appropriate funds. Private developers assembling a large number of properties clearly face the same problem. One argument for why they do not have eminent domain power is that it would be easier for them to acquire the property while disguising their ultimate intent, for example, through the use of ‘dummy’ buyers. The real justification for eminent domain, then, is the need to prevent holdouts, which is a form of transactions cost. This justification is therefore a special case of the argument that property rules are desirable when transactions costs are low and liability rules are desirable when transaction costs are high (Calabresi and Melamed, 1972; Krier and Schwab, 1995; Kaplow and Shavell, 1996).

3. The Public Use Requirement The government’s eminent domain power is restricted by the public use requirement included in the Fifth Amendment (Merrill, 1986a; Paul 1987b; Rubenfeld, 1993; LaCroix and Rose, 1995). One interpretation of this requirement is that the government can only use its taking power to acquire property for the provision of public goods (Ulen, 1992). While this seems to be a natural interpretation of ‘public use’, the economic theory of public goods does not imply that acquiring the inputs for public goods creates a hold-out problem (Cornes and Sandler, 1986, Ch. 5; Cohen, 1991). While coerced contributions to the funding of public goods is necessitated by the free-rider problem, coerced acquisition of the resources used to produce them is not. Another interpretation of the public use requirement is that it is synonymous with the hold-out problem. This view, however, implies that private individuals faced with the hold-out problem also ought to have eminent domain power. Fischel (1995b, pp. 71-73) in fact suggests that private interests (for example, railroads) have often been granted the taking power by legislatures, and courts have been deferential (though not universally so) to this practice. Bouckaert and

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De Geest (1995) provide a transactions cost justification for private takings. Epstein (1985, Ch. 12) argues that the presence of a hold-out problem should be a necessary, but not sufficient condition for the public use limitation to be satisfied. In addition, some provision should be made to prevent private interests from acquiring all of the surplus from a forced sale. The basis for this additional requirement is that forced acquisitions with compensation set at market value prevent the owner of the acquired property from realizing both his subjective value, and a share of the gains from the sale (the value of the property in its proposed use minus the owner’s subjective value). To prevent this, Epstein proposes as the second prong of a two-pronged public use test something like the above public goods requirement in order to ensure that the gains from a forced sale accrue widely to the public rather than to a private interest endowed with taking power. Epstein does not, however, use this second prong to argue that private interests should never have taking power. Private interests can legitimately have taking power under Epstein’s public use test if, in addition to facing the hold-out problem, they make some effort to pay a share of the surplus from the taking to the victim of the taking. An example is the Mill Acts, which granted private individuals the right to erect dams for purposes of operating mills provided that they paid flooded upstream owners compensation equal to 150 percent of their market value. Note that this sharing of the surplus, while serving the interest of fairness, also helps to counteract the tendency to overtake under market value compensation (see the next section).

4. Just Compensation The Fifth Amendment allows the government to take private property for public use if it pays just compensation. Courts generally define just compensation to be ‘fair market value’. However, this amount almost certainly undercompensates landowners, possibly by a large amount, since owners do not generally view land and wealth as perfect substitutes, whereas market value compensates them as if they did. Fair market value is not only unfair to landowners, it also potentially leads to an excessive transfer of private property to public use because the government does not have to pay the true opportunity cost of the resources it acquires. (We pursue this point in more detail in the discussion of fiscal illusion below.) Thus, while the hold-out problem precludes the efficient assembly of property through market exchange, eminent domain with market value compensation potentially leads to too much assembly (Munch, 1976; Fischel, 1995a). Of course, the takings clause does not define just compensation to be fair market value, so it is not a necessary feature of eminent domain that it result

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in undercompensation. However, the problem with setting compensation equal to the owner’s true valuation is that this amount is unobservable, and owners would clearly have an incentive to overstate it (Knetsch and Borcherding, 1979). Thus, taking measurement costs into account, fair market value may be the best proxy for just compensation. A related issue, suggested by Epstein (1985, Ch. 18), is that money raised to finance compensation is a ‘taking’ from taxpayers for which they receive ‘inkind’ compensation in the form of benefits from the public project. Based on this insight, Fischel (1995b, p. 211) suggested that market value compensation may be the best way to balance ‘the undercompensation of the market-based rule against the greater loss incurred by higher taxes and [foregone] public works that full, consensual compensation would require’.

5. Eminent Domain and Land Use Incentives The feature of eminent domain that has drawn the most attention from economists, especially recently, is its impact on land use incentives. In particular, how does the possible threat of condemnation affect a landowner’s incentive to invest in developing his land? The first formal analysis of this question was by Blume, Rubinfeld and Shapiro (1984). The principal result that they derived (or at least the one that has received the most attention) was that full compensation for takings results in inefficient investment decisions by landowners while no compensation results in efficient incentives. Intuitively, compensation that is positively related to the value of the property, and hence the level of investment in that property, creates a moral hazard problem by providing the landowner insurance against the possibility of a taking. When a taking occurs, a social cost is incurred because an irreversible investment is lost. An efficient investment decision must therefore reflect the likelihood that this cost will be incurred (that is, the probability that a taking will occur). However, as is true of unlimited expectation damages for promisees in contract cases (Cooter, 1985), if the landowner is guaranteed full compensation, he will not incur any private loss if a taking occurs. Hence, he will ignore the possibility of a taking when making his investment decision and overinvest. Blume, Rubinfeld and Shapiro (1984) show that this overinvestment incentive can be eliminated by making the compensation lump-sum, that is, independent of the amount of investment in the property. Since lump-sum compensation is the same regardless of how much the landowner invests, increases in the level of investment lead to increased losses if a taking occurs. Thus, under lump-sum compensation the landowner is not fully insured and hence considers the possibility of a taking when making his investment decision. He thus chooses an efficient level of investment. Note that a special

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case of lump sum compensation is no compensation. Thus, Blume, Rubinfeld and Shapiro (1984) conclude that a rule of never paying compensation will lead to efficient landowner investment decisions. Kaplow (1986, 1992) has also endorsed the no compensation result for government takings, and more broadly for many forms of legal change that have distributional and allocative implications. Although no compensation is consistent with efficient land use incentives, several arguments have been made against it. The first and most common objection is that a rule of no compensation allows the government to acquire resources at no cost. This is not a problem if the government is unswervingly devoted to acquiring resources only when it is efficient to do so. Fischel and Shapiro (1988, 1989) refer to such a government as ‘Pigouvian’. However, modern public choice theory suggests that this is unlikely to be the case (Mueller, 1989). A more realistic view treats the government like any other economic agent who responds to economic incentives. If compensation is zero in this case, The resources under the control of the central authority will be perceived to be costless. The opportunity costs will be ignored, and land use regulation without compensation will lead to overproduction of environmental amenities .... (Johnson, 1977, p. 65)

Such a government is said to have ‘fiscal illusion’ (Blume, Rubinfeld and Shapiro (1984). In the current setting, this implies that the government will make its taking decision by comparing the benefit of the public good to the amount of compensation it must pay to the owners of the land that it takes. If it is not required to pay any compensation, it will tend to take property too often since it will view the taking as having positive benefits but no costs. Thus, a rule of zero compensation creates a moral hazard problem for the government. Full compensation can solve this problem and at the same time protect the rights of politically under-represented groups (Paul, 1987a; Epstein, 1985, 1995, Ch. 7; Burrows, 1991; Farber, 1992; Fischel, 1995b; and Yandle, 1995). As noted above, full compensation for takings results in inefficient investment because it allows landowners to ignore the social costs that result if a taking occurs. At the same time, full compensation is necessary to prevent overregulation by the government. In the presence of this trade-off, Fischel and Shapiro (1989) examined a compensation rule under which the level of compensation would be proportional to the value of the property, and they showed that the optimal (second-best) solution requires partial compensation. In contrast, Hermalin (1995) showed that the first-best outcome is attainable under a pair of compensation rules. Under the first, the government pays the landowner compensation equal to the social value of the taking. Note that this rule has the same effect as a property rule in that the owner receives

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compensation in excess of his value of the land (assuming that the taking is efficient), implying that the transfer is essentially consensual. The efficiency of this rule is thus consistent with the efficiency of property rules as discussed by Fischel and Shapiro (1988, p. 275). Under Hermalin’s second rule, the landowner has the option to buy back the land for a price equal to its social value. As noted above, actual compensation rules tie payment to the fair market value of the land to the owner rather than its value in public use, and owner’s do not ordinarily have a buy-back option. Thus both of Hermalin’s are purely normative in that they do not explain the actual practice of courts. Breach of contract remedies suggest yet another solution to the trade-off between moral hazard and fiscal illusion, namely, limit compensation to the full value of the land to the owner, evaluated not at the actual level of investment but rather at the efficient level of investment (Cooter, 1985; RoseAckerman, 1992). Note first that this rule will induce efficient behavior by the government because it requires full compensation. In addition, in equilibrium it will induce all landowners to choose an efficient level of investment because compensation is still lump-sum. Even when the government does not have fiscal illusion, there is an argument for paying compensation for takings if the likelihood of a taking depends on the value of the property (Miceli, 1991; Trefzger and Colwell, 1996). The model in Blume, Rubinfeld and Shapiro (1984) assumed that landowners view the probability of a taking as independent of their investment decision. However, in reality, the government may be less likely to take land that is more valuable in private use. For example, by taking undeveloped rather than developed land, it can reduce the social cost of the taking. If landowners anticipate that by increasing their investment in land they can reduce the chance that their land will be taken, they will adjust their investment decisions accordingly. To avoid this problem, Miceli (1991) shows that, even in the absence of fiscal illusion, compensation must be equal to the full value of the land at the optimal level of investment, net of any compensation tax. The intuition for this result is as follows. When the landowner expects zero compensation (or, generally, undercompensation), he will overinvest in order to reduce the probability of a taking. On the other hand, if he expects overcompensation he will underinvest in order to increase the probability of a taking. Only full compensation at the efficient level of investment eliminates these incentives to over- or underinvest. The question is whether landowners in fact view the probability of a taking as being a function of their level of investment. This is unlikely in the context of physical acquisitions of land, which rarely occur. Indeed, the probability of a physical taking is probably near zero for most landowners. However, government regulations preventing certain land uses such as zoning and

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environmental restrictions are widespread and generally apply to all plots in a given area. In that case, the probability of a land use restriction that reduces their property values is not necessarily small, and it may be possible for landowners to affect its magnitude by their land use decisions (Miceli and Segerson, 1996, Chs 7 and 8). Thus, this issue is likely to arise in the context of regulatory takings discussed below. The preceding discussion has shown that a compensation rule that pays landowners the full value of their land at the efficient level of investment results in both efficient investment in land and efficient takings decisions when the government has fiscal illusion. One problem with this rule is that it requires courts to be able to calculate the efficient level of investment, a task that may prove difficult in practice. However, this problem has not prevented courts from adopting rules in other areas of the law that require similar calculations. For example, negligence rules require calculation of due standards of care in accident settings (Landes and Posner, 1987, Ch. 4; Cooter and Ulen, 1988, Ch. 8; U.S. v. Carroll Towing, 159 F.2d 169 (1947)). Moreover, existing community standards for ‘normal’ land use can often provide a good proxy for efficient development levels (Fischel, 1985, Ch. 8). Two additional arguments against the no compensation result have been made in the literature. The first was by Michelman (1967) in perhaps the most influential article on takings to date. Michelman used a utilitarian standard for deciding, first, when a government should enact a taking, and second, when it should pay compensation. The standard is based on three factors: efficiency gains, demoralization costs, and settlement costs. Efficiency gains simply represent the social benefits minus the costs of a public project. A necessary condition for enactment of the project under Michelman’s standard is that the project generates efficiency gains. In addition to efficiency gains, Michelman introduced two types of costs. The first is the demoralization costs associated with non-payment of compensation. Demoralization costs represent the total of (1) the dollar value necessary to offset disutilities which accrue to losers and their sympathizers specifically from the realization that no compensation is offered, and (2) the present capitalized dollar value of lost future production (reflecting either impaired incentives or social unrest) caused by demoralization of uncompensated losers, their sympathizers, and other observers disturbed by the thought that they themselves may be subjected to similar treatment on some other occasion (Michelman, 1967, p. 1214). The second type of cost is the settlement (or transaction) costs associated with payment of compensation. Settlement costs represent ‘the dollar value of time, effort, and resources which would be required to reach compensation settlements adequate to avoid demoralization costs’ (Michelman, 1967, p. 1214). Michelman’s standard for compensation is that it should be paid if

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settlement costs are less than demoralization costs, and not paid if the reverse is true. Further, the public project should be enacted if and only if the efficiency gain exceeds the lower of the settlement and demoralization costs. Note that this standard is intermediate between the Pareto and Kaldor-Hicks criteria for efficiency. It is more permissive than Pareto since a project should be enacted without compensation if the efficiency gains exceed the demoralization costs and the demoralization costs are less than the settlement costs. However, it is less permissive than Kaldor-Hicks since even if there are efficiency gains, the project should not be enacted if those gains are less than the lower of the settlement and demoralization costs (Fischel and Shapiro, 1988, p. 280). The final argument against the no compensation result is based on the idea that compensation acts as a form of public insurance for risk-averse landowners against the possibility of government expropriation of their property (Blume and Rubinfeld, 1984, 1987; Rose-Ackerman, 1992). The need for public rather than private insurance is that moral hazard and adverse selection problems, and the infrequency of takings, prevent formation of a private insurance market for takings risk. Because of the administrative costs and incentive effects of compensation, however, it should only be paid when landowners are very risk-averse and losses are large.

B. Regulation and Takings Thus far we have focused on physical acquisitions of private property, which have been universally accepted by courts as compensable government takings. There has been much more controversy, however, both in the courts and in the academic literature, over government regulations that reduce private property values and the extent to which these should be compensable (Knetsch, 1983; Epstein, 1985; Paul, 1987a; Fischel, 1995b; and Yandle, 1995). Courts have generally granted the government broad powers to regulate private property in the interest of protecting public welfare. However, some government regulations can become so restrictive as to cause a substantial reduction in the value of private property. When this happens, courts have occasionally found the regulation to be a taking and ordered payment of compensation. The problem is to determine where to set the threshold that separates non-compensable regulations (police power actions) from compensable ones (regulatory takings). We begin our discussion of this question by considering the rationale for the existence of the government’s regulatory power. We then provide an overview of the issues that have arisen in trying to define a threshold for compensable regulatory actions.

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6. Justifications for Government Regulation One of the principal uses of the government’s regulatory power is in the context of externalities, or incompatible uses of property (Cornes and Sandler, 1986, Chs 3 and 4). There are, however, private (common law) remedies available for dealing with such incompatibilities. Thus, prior to addressing the question of whether the government should pay compensation for a regulation, we first need to answer the question of why government (public) intervention is economically justified at all. Trespass and nuisance are the principal common law remedies available to property owners faced with violations of their property rights. Trespass ordinarily allows owners to exclude, or enjoin, future intrusions regardless of the benefits to the intruder, whereas under nuisance law the court generally enjoins the intrusion or awards damages only after determining that the victim’s harm is substantial and the nuisance-creating activity is unreasonable (Keeton, et al., 1984, pp. 622-623). According to Merrill (1985), this distinction can be explained in terms of transactions costs. Specifically, when transactions costs between the intruder and the victim are low, trespass is the efficient remedy because it forces the parties to resolve the incompatibility through a voluntary transaction - a solution that guarantees a mutually beneficial outcome. When transactions costs are high, however, nuisance law is the appropriate remedy because the parties may be unable to resolve the dispute through bargaining. In that case, the court conducts a sort of costbenefit analysis before determining if the victim is entitled to relief. In a sense, the court coerces an efficient exchange (a ‘private taking’) or prohibits an inefficient one when bargaining is expected to fail. The case of Boomer v. Atlantic Cement (309 N.Y.S.2d 312 (1970)) illustrates this common law (private) approach to externalities. The preceding theory implies that private remedies initiated by the victim of an externality are available for both low and high transaction costs cases. The question then is where direct government regulation of externalities fits into this scheme. One answer is that if the external cost is dispersed across a large number of victims, then no one victim may have an incentive to seek a private remedy, even when the aggregate cost outweighs the benefit of the injurer’s activity. In that case, the government acts as an ‘agent’ of the victims by regulating the injurer’s activity directly. The government thereby overcomes a collective action problem among victims (Landes and Posner, 1987, Ch. 2). While many regulations are designed to address externality problems, government intervention can be justified on other grounds as well, such as protection of individual rights. For example, laws designed to protect the rights of disabled people, to guarantee free speech, or to ensure equal access or opportunity, can result in requirements that impose costs on property

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owners and reduce the value of private property. Alternatively, government regulation (such as public utility regulation) can arise in response to other market failures, including imperfect competition and imperfect information. Regulatory takings issues have arisen in these contexts as well. The preceding discussion identifies situations in which government regulation of private property may be justified, but it does not address the question of whether the landowner should be compensated for the resulting private loss. Although from an economic perspective the distinction between physical invasions and value-reducing regulations is not a meaningful one (Rose-Ackerman, 1992, p. 29), courts have routinely denied compensation for the latter (with some notable exceptions). In the following sections, we review the key issues relating to the question of when compensation should be paid for regulations that reduce the value of private property without physically acquiring it.

7. The Nature of the Government Action As noted, courts have historically granted governments wide powers to regulate without paying compensation, provided that the regulation somehow protects the public interest. This justification for non-payment of compensation thus focuses on the nature of the government action. 7.1 Regulation of ‘Harmful’ or ‘Noxious’ Uses An early case that established the nature of the government action as relevant for the compensation question is Mugler v. Kansas (123 U.S. 623 (1887)). The case concerned a law passed by the State of Kansas prohibiting the operation of breweries because they were public nuisances. The plaintiff argued that operation of his brewery predated the law, and further, that it did not constitute a nuisance. The Court nevertheless upheld the law based on the state’s right to regulate, without compensation, land uses that are injurious to public welfare. Specifically, the Court held that there is no taking if a regulation is aimed at preventing uses that are ‘injurious to the health, morals, or safety of the community’ (Mugler v. Kansas, 1887, 668-669). This argument has become known as the ‘noxious use’ doctrine and remains an important basis for government regulations under the police power. Concern with the nature of the government’s action was re-affirmed in Penn Central Transportation Co. v. City of New York (438 U.S. 104 (1978)). Echoing the noxious use doctrine from Mugler, the court noted that ‘in instances in which a state tribunal reasonably concluded that “the health, safety, morals, or general welfare” would be promoted by prohibiting particular contemplated uses of land, this court has upheld land-use

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regulations that destroyed or adversely affected recognized real property interests’ (Penn Central v. City of New York, 1978, p. 125). Thus, according to the Court, if the public benefit of the regulation is sufficiently large, it may not constitute a taking even when the landowner suffers a significant loss. Finally, in Lucas v. South Carolina Coastal Council (112 S. Ct. 2886 (1992)), the Court introduced a provision that would allow the government to avoid paying compensation if it could show that the activity a landowner planned to pursue would be prohibited under the state’s common law of nuisance. Thus, the Court recognized that government actions consistent with nuisance law are non-compensable. This provision of the Lucas decision is known as the ‘nuisance exception’. The academic literature has also looked to the nature of the government action to determine if a regulation should be compensable. Much of the literature is based on property rights principles. Property rights approaches to the takings question typically begin by implicitly defining a distribution of property rights that the law protects. If a government action deprives a property owner of a right protected by this distribution, compensation is due, whereas if it deprives him of an unprotected right, no compensation is due. The ‘harm-benefit’ rule exemplifies this approach (Fischel, 1985, pp. 154155). According to this rule, compensation is not due for regulations that prevent a landowner from imposing an external cost on society (for example, pollution), but compensation is due for regulations that compel the landowner to provide an external benefit (for example, open space). The underlying basis for this distinction is that landowners do not have the right to impose costs, but they do have the right to withhold conferral of benefits. Joseph Sax has offered two theories of takings that fall within this property rights approach. His first theory (Sax, 1964) argues that the government owes compensation when it acquires property rights for use as an enterprise - for example, when it provides a public good; but it does not owe compensation when it merely arbitrates private disputes - for example, when it regulates an externality. (Rose, 1983, advances a similar argument.) According to this view, regulatory takings for the most part fall within the category of noncompensable actions since, as noted above, they generally are aimed at preventing an external cost or correcting a market failure or inequity. Sax’s second theory (Sax, 1971) suggests that the government does not owe compensation for any action that involves the internalization of spillover effects (negative externalities). Bromley adopts a similar view, arguing that compensation for regulations that prevent externalities would represent ‘indemnification for an inability to continue to impose unwanted costs on others’ (Bromley, 1993, p. 677). Like the harm-benefit rule, this view is based on the idea that the law does not protect an individual’s property right when that right infringes on other individuals’ rights. Note that a similar delineation

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of property rights underlies the noxious use doctrine (Mercuro, 1992a, p. 3) and the Lucas nuisance exception. The nuisance exception is also a fundamental feature of Richard Epstein’s view of takings law (Epstein, 1985, Ch. 9, 1992; Epstein, et. al., 1992), which holds that landowners should generally receive compensation for regulations except when the offending land use would have been prohibited by the state’s common law of nuisance. Property rights approaches to the compensation question are not necessarily consistent with economic theory, especially those based on the harm-benefit approach. For example, it is well known that there does not exist a meaningful economic distinction between a harm imposed and a benefit conferred, given that a harm is equivalent to a foregone benefit, and a benefit is equivalent to an avoided harm (Coase, 1960; Fischel, 1985, p. 158). What is lacking is a ‘benchmark of neutral conduct’ for defining the threshold between harms and benefits (Michelman, 1967, p. 1197). The basis for harm-benefit rules can be made consistent with economic logic, however, by appealing to administrative, or transaction, costs as a way of identifying such a neutral point. 7.2 Standards of ‘Normal’ Behavior Fischel employs a transaction costs approach in proposing a rule based on a ‘normal behavior’ (Fischel, 1985, Ch. 8, 1995b; Ellickson, 1973, 1977). This rule resembles the harm-benefit rule in that it says that no compensation is due for regulations that prevent ‘subnormal’ land uses, but compensation is due for regulations that compel ‘super-normal’ land uses. The rule differs from the harm-benefit rule in that ‘normal’ behavior is defined according to local community standards based on what a landowner could reasonably expect to do with his land without government restriction. A reasonableness standard for land use thus replaces the arbitrary distinction between a harm and a benefit. The importance of transactions costs to this rule is that, by using normal behavior as the ‘zero compensation’ point, the transactions costs of compelling normal behavior are minimized. In particular, since most people will engage in normal behavior without state intervention, only a few transactions will be needed to fine those who engage in subnormal behavior and to compensate those who undertake supernormal behavior. Wittman (1984) uses a similar transactions cost approach to distinguish compensable from non-compensable regulations. He argues that administrative costs are minimized if compensation is paid only when the government acts inefficiently since ‘we would expect the government to act efficiently more often than not’ (Wittman, 1984, p. 74). In addition to minimizing transaction costs associated with paying compensation, Fischel’s normal behavior standard avoids what he views as a major problem with a rule that conditions compensation solely on the loss in value to the owner (the diminution of value rule) - namely, the possibility of paying compensation for regulations that restrict truly inappropriate land uses

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while imposing substantial losses on the landowner, for example, prohibiting pulp mills in residential neighborhoods. Fischel recognizes, however, the need to balance the costs of regulations against their benefits. He therefore argues that forcing ‘super-normal’ behavior on landowners need not require compensation if the benefits of the regulation exceed the cost to the private landowner and the transaction costs are excessive (Fischel, 1985, p. 165). Since the presumption is that requiring landowners to conform with social norms would generate benefits in excess of its costs, Fischel’s rule is essentially one of paying compensation for inefficient regulations and not paying compensation for efficient ones. To the extent that noxious uses and nuisances represent subnormal (inefficient) uses, non-compensation for regulation of these types of activities is consistent with Fischel’s and Wittman’s rules for minimizing transactions costs. Moreover, all of these rules are essentially versions of the harm-benefit approach to defining compensable regulations in that they rely on a distinction between ‘good’ and ‘bad’ behavior by the landowner, which in turn defines a threshold for determining compensation. Thus, while these various theories appear at first to be quite different, they are in fact consistent with each other when the thresholds are defined on the basis of economic principles. In addition, they are consistent with the threshold-based rules proposed by Miceli and Segerson (1994, 1996) (see Section 9 below). 7.3 The ‘Essential Nexus’ Requirement While the foregoing suggests that the nature of the government action can justify uncompensated regulations, courts have required that those actions must bear at least some relationship to the regulated land use. In particular, the doctrine of ‘unconstitutional conditions’ holds that ‘the government may not require a person to give up a constitutional right ... in exchange for a discretionary benefit conferred by the government where the property right sought has little or no reasonable relationship to the benefit’ (Dolan v. City of Tigard, 114 S.Ct. 2309, 2317 (1994)). This condition arises in takings cases when the government requires a landowner to dedicate some property to public use without just compensation in exchange for a permit to develop. In Nollan v. California Coastal Comm’n (438 U.S. 825 (1987)), the Court held that in order for a permit condition to be valid, there must exist an ‘essential nexus’ between the condition (that is, the required dedication of property) and the proposed development for which the permit is sought. The case concerned a state requirement that the Nollans allow public access to their beach in return for a permit to replace an existing beachfront bungalow with a three bedroom house. The State’s interest in imposing the condition of beach access was purportedly to counteract the fact that the larger house proposed by the Nollans would diminish the view of the ocean from the roadway. However,

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the Court held that the essential nexus requirement was not met in this case because access to the beach did not serve to enhance the view of the ocean from the road; that is, it did not counteract the impact of the proposed development. The Court re-examined this issue in Dolan v. City of Tigard (1994). While the Court reaffirmed the essential nexus requirement, it also found that mere existence of a nexus was not enough to validate the permit condition. In addition, ‘the degree of the exactions demanded [must] bear the required relationship to the impact of the petitioner’s proposed development’ (Dolan v. City of Tigard, 1994, p. 2318). The Court adopted a ‘rough proportionality’ test to assess this relationship. When the court applied this test to the facts of Dolan, it concluded that the government’s conditions did not bear the required ‘reasonable relationship’ to the impact of the proposed development. Miceli and Segerson (1996, Chapter 4) argue that the essential nexus requirement represents a generalized condition for determining whether or not a government regulation is efficient in cases where landowners have the ability to mitigate the external costs of their proposed development. The regulatory decision is assumed to have two separate components: first, the government decides whether or not to attach conditions to the permit if it is granted, and second, it decides whether or not to grant the permit given those conditions. In this context, the efficiency of the regulatory decision includes efficiency of both the decision of whether or not to grant the permit, and the efficiency of any conditions attached to the permit. The essential nexus and rough proportionality tests in combination can be viewed as an attempt to ensure the efficiency of the permit conditions. In contrast to Miceli and Segerson (1996), Innes (1995, 1997) argues that the essential nexus and proportionality requirements should not be applied in takings cases. He argues instead that the focus should be on providing equal protection to owners of similarly situated land (the equal protection requirement). This argument, however, is based on consideration of the incentives of landowners rather than the efficiency of the regulatory decision (see Section 8.3 below).

8. The Impact of the Regulation on the Landowner In addition to the nature of the government action, the other major factor used to evaluate regulatory takings cases is the impact of the regulation on the landowner. This criterion is best exemplified by Holmes’s diminution of value test.

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8.1 The Diminution of Value Test The impact of the regulation on the landowner was first advanced as a test for compensation in Pennsylvania Coal Co. v. Mahon (260 U.S. 393 (1922)), which is one of the most influential takings cases in US history. This case challenged a Pennsylvania statute, the Kohler Act, which prohibited coal companies from any mining that threatened the safety of surface owners due to cave-ins. The majority opinion, written by Justice Oliver Wendell Holmes, found the regulation to be a taking requiring compensation because it went ‘too far’ in reducing the landowner’s rights. Specifically, Holmes’s ruling provided that the government can regulate private property without compensation unless the regulation goes too far in diminishing the value of the property to the owner. This rule is thus referred to as the ‘diminution of value’ test. Holmes did not articulate a general test for establishing when a regulation had gone too far, however, leaving it instead to be determined on a case by case basis. Holmes’s ruling in Pennsylvania Coal marked a watershed in takings law because, prior to this case, takings were usually limited to physical acquisitions of property by the government; most efforts to obtain compensation for ‘mere regulations’ failed, due in large part to the noxious use doctrine (Friedman, 1986). The diminution of value test broke with this tradition by introducing the loss in value to the owner into the equation. It thus ‘put the police power on a continuum with the power of eminent domain’ (Mercuro, 1992a, p. 4). Holmes did not argue for a general rule of compensation because he recognized that the government ‘could hardly go on if to some extent values incident to property could not be diminished without paying for every such change in the law’ (Pennsylvania Coal v. Mahon, 1922, p. 413). At the same time, however, he acknowledged that a rule of no compensation for regulations would, given ‘the natural tendency of human nature’, result in overregulation until ‘at last private property disappear[ed]’. Thus, Holmes recognized the fundamental trade-off between the costs of compensation (a stifled government) and the benefits of compensation (protection of private property and a limitation of government excess): ‘The general rule at least is that while property may be regulated to a certain extent, if regulation goes too far it will be recognized as a taking’ (Pennsylvania Coal v. Mahon, 1922, p. 415). Most takings cases since Pennsylvania Coal have generally applied some form of Holmes’s diminution of value test. An example is the previously cited case of Lucas v. South Carolina Coastal Council (1992), which concerned a developer (Lucas) who had purchased two beachfront lots in South Carolina with the intent of developing them for residential use. Although development was permitted at the time Lucas purchased the lots, the State subsequently passed a law, the Beachfront Management Act, that prohibited development. Lucas acknowledged the state’s right to impose such a law, but he argued that it reduced the value of his property so much that it constituted a taking for

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which compensation was due. The South Carolina Supreme Court ruled in favor of the State, based on the broad regulatory powers that have been granted to state and local governments. However, the US Supreme Court reversed the decision and found that compensation was due. Environmental groups had feared such a decision in the belief that the need to pay compensation would greatly reduce the ability of governments to protect the environment against the unrestrained actions of private property owners. However, the decision in Lucas awarded compensation on narrow grounds. In particular, the Court found that compensation was due because ‘when the owner of real property has been called upon to sacrifice all economically beneficial uses in the name of the common good, that is to leave his property economically idle, he has suffered a taking’ (Lucas v. S. Carolina Coastal Council, 1992, p. 2895). Thus, the Court found that the regulation had clearly crossed the threshold set by the diminution of value test and that a taking had therefore occurred. However, the opinion offered no guidance as to the exact location of the threshold. While the diminution of value test has been widely applied, it has been criticized on efficiency grounds. As noted above, for example, if only the loss in property value is considered when deciding whether to compensate, then the resulting outcome may be inefficient since the benefit of the regulation will not be balanced against the cost (the loss in private property value) (Fischel, 1985, pp. 156-157). Similarly, if compensation is not required when the reduction in property value is small, then a government that considers only actual cost outlays rather than social costs, that is, a government with fiscal illusion, will view such regulations as costless and thus overregulate. If some balancing between these two effects is to take place, as proposed in the original Holmes ruling, then a standard for deciding when a regulation has gone ‘too far’ must be available. We will propose such a standard below. 8.2 Investment-Backed Expectations In Penn Central Transportation Co. v. City of New York (1978), the US Supreme Court faced the question of whether the City of New York could prevent the owners of Grand Central Terminal from erecting an office tower over the terminal by declaring it an historical landmark. The Court held that it could without being obliged to pay compensation. In reaching its decision, the Court identified several factors to be weighed in determining whether a regulation constitutes a taking, including the nature of the government action and the economic impact of the regulation on the claimant. The former reflects the noxious use doctrine from Mugler and the latter the diminution of value rule from Pennsylvania Coal. While Holmes did not offer any criterion for determining when a regulation goes too far under the diminution of value rule,

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the Penn Central court did. Specifically, the Court said that a regulation ‘may so frustrate distinct investment-backed expectations as to amount to a taking’ (Penn Central v. City of New York, 1978, p. 127), whereas it is not a taking if it does ‘not interfere with interests that [are] sufficiently bound up with reasonable expectations of the claimant to constitute “property” for 5th amendment purposes’ (Penn Central v. City of New York, 1978, pp. 124-125). Thus, a relevant factor for determining whether a regulation requires compensation is whether the regulation interferes with distinct investmentbacked expectations by the claimant. Justice Brennan’s majority opinion in the Penn Central case relied heavily on Michelman’s (1967) view that, in order for a landowner to put his land to productive use, he must have a reasonable expectation of being allowed to retain the fruits of his investment (Mandelker, 1987, pp. 10-13). Nevertheless, Michelman asserts that compensation is not due in every case of investmentbacked expectations (Michelman, 1967, p. 1213). For example, compensation would not be due if demoralization costs are low and settlement costs are high (see the discussion of Michelman above). Miceli and Segerson (1996, Ch. 7) also argue that a rule of paying compensation if and only if the landowner’s expectations are investmentbacked will be inefficient. In particular, they show that it can lead to overinvestment. However, they also show that efficient land use decisions will be made under a ‘good faith’ rule based on ‘reasonable’ (efficient) land use decisions. In particular, in the event of a regulation, such a rule would require compensation for landowners who acted in good faith, either by investing when it was efficient to do so or not investing when investment was inefficient, and it would not require compensation for those who did not act in good faith (Mandelker, 1987). 8.3 Singling Out and Equal Protection An additional factor identified in the Penn Central case for determining when a taking occurs was proposed by Justice Rehnquist in a dissenting opinion. This factor concerns whether the government action applies to a broad class of landowners or whether it ‘singles out’ individuals. Rehnquist noted that ‘Even where the government prohibits a noninjurious use, the court has ruled that a taking does not take place if the prohibition applies over a broad cross section of land and thereby “secure[s] an average reciprocity of advantage”’ (Penn Central v. City of New York (1978, p. 147), Rehnquist dissent, quoting from Pennsylvania Coal v. Mahon (1922, p. 415)). In contrast, regulations that single-out landowners are more likely to be judged a taking according to this criterion. In Agins v. Tiburon (447 U.S. 255 (1980)), the Court similarly held that a landowner subject to a zoning ordinance ‘will share with other owners the benefits and burdens of the city’s exercise of its police power. In assessing

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the fairness of the zoning ordinances, these benefits must be considered along with any diminution in market value that the appellants might suffer’ (Agins v. Tiburon, 1980, p. 262). Even Epstein (1995, pp. 134-137), who argues generally in favor of compensation, recognizes that regulations that spread benefits and costs over the same population offer in-kind compensation. The singling out criterion also forms the basis for Michelman’s (1967) proposed fairness standard for compensation: A decision not to compensate is not unfair as long as the disappointed claimant ought to be able to appreciate how such decisions might fit into a consistent practice which holds forth a lesser long run risk to people like him than would any consistent practice which is naturally suggested by the opposite decision. (p. 1223)

Such a rule can be defended by a ‘veil of ignorance’ argument that legitimizes rules that people would have approved prior to learning of their actual position in society (Rawls, 1971, pp. 136-142; Posner, 1980). This rule prevents landowners from being singled out to bear costs for society as a whole, as when a single landowner is compelled to give up his property without compensation to provide a public good (Rose-Ackerman, 1992). At the same time, it allows uncompensated regulations that potentially apply equally to all landowners, such as broadly-based zoning laws. Such a rule therefore depends on the extent to which a regulation applies to few versus many landowners. Singling out can also occur when compensation is not paid for restrictions that are placed on undeveloped land if comparable developed land is exempted from the restriction, that is, when there is not ‘equal protection’ for developed and undeveloped land. In addition to the fairness implications of an equal protection requirement, it can also have efficiency effects. Specifically, because it is often efficient for the government to take undeveloped land before developed land, uncompensated takings can provide an incentive for landowners to develop ‘too early’ in an effort to reduce the likelihood that their land will be taken (Innes, 1995, 1997). For example, a developer might begin construction in an effort to beat an anticipated downzoning (Dana, 1995). This is consistent with the result discussed above that zero compensation will not be efficient if landowners can influence the probability of a taking (Miceli, 1991; Miceli and Segerson, 1996, Chs 7 and 8). Compensating owners of undeveloped land that is taken, or affording equal protection to both developed and undeveloped land, can offset the incentive for premature development (Innes, 1995; Miceli and Segerson, 1996, Ch. 8). Thus, such a rule can achieve both equity and efficiency objectives. However, Miceli and Segerson (1996, Ch. 8) show that, while equal protection is sufficient for efficient incentives, it is not necessary. Other rules are capable of simultaneously satisfying efficiency and equity goals as well.

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In some cases, a developer will begin investing in a project only to find that a change in the zoning regulations prevents its completion. While recognizing that local governments need to have some freedom to revise their zoning laws in response to changing circumstances, landowners also need some protection of their sunk investments when a zoning change occurs (Mandelker, 1993, pp. 234-244; Kaplow, 1986). The courts have provided a basis for such protection in the form of ‘vested rights’. A vested right allows the landowner to proceed with the project despite the zoning change under certain conditions. In order for a landowner to acquire a vested right, he generally must have made a ‘substantial’ investment in the property in reliance on a valid building permit. In this sense, his expectations must be ‘investment-backed’ (see the related discussion above). How much investment is necessary to be deemed substantial is not clear. Generally courts engage in a balancing test that weighs the costs and benefits of the zoning change. For example, in addition to making substantial investments, the landowner must have acted in ‘good faith’ by not rushing the development process in an effort to beat an impending zoning change. More generally, the good faith test asks ‘whether a landowner’s conduct was consistent with how a reasonable property owner would have acted in the same circumstances’ (Mandelker, 1993, p. 239). Miceli and Segerson (1996, Chs 7 and 8) show that, if good faith or ‘reasonableness’ are judged on efficiency grounds, then a good faith rule can induce efficient land use decisions by awarding a vested right if development was efficient but not awarding one if development was not efficient. Note, however, that the threat to withhold a vested right if the landowner developed prematurely is only effective if the development is reversible - that is, only if the development process can be halted and the resulting external cost avoided or eliminated if the landowner developed inefficiently. This will not always be possible, as when a landowner harvests timber prematurely, or destroys wildlife in order to avoid the imposition of regulations aimed at preserving the habitat of an endangered species (a practice known as ‘shoot, shovel, and shut up’) (Epstein, 1995, p. 294). In such cases, it may be necessary to promise compensation for the threatened regulation in order to offset the incentive for preemptive development or destruction of wildlife and habitat. The magnitude of compensation cannot be too large, however, for then landowners may have an incentive to delay development inefficiently. One way to ensure efficient incentives is to condition the payment of compensation on efficiency of the landowner’s decision - that is, on whether his decision either to develop or to postpone development was efficient (Miceli and Segerson, 1996, Ch. 8) 8.4 The Role of Capitalization As noted above, an important factor in evaluating the fairness of a regulation is the extent to which it interferes with the landowner’s reasonable

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expectations. One issue that arises in this context is whether the threat of a regulation was known to the landowner when he first purchased the land. A frequent argument made against paying compensation for regulations is that when landowners purchased land subject to the threat of a regulation, they paid a price that discounted (or ‘capitalized’) the possibility of that regulation. Consequently, they have already received ‘implicit’ compensation (Posner, 1980). Although this argument owes much to Michelman (1967), courts understood it as far back as 1823 when, in the case of Callender v. Marsh (1 Pick. 417, 430 (1823)), the court said: ‘Those who purchase house lots ... are supposed to calculate the chance of [regulations]..., and as their purchase is always voluntary, they may indemnify themselves in the price of the lot which they buy.’ If the purchase price discounted (or capitalized) the threat of regulation, then the case for compensation is weakened because the landowner ‘got exactly what [he] meant to buy’. Michelman concludes that compensation in this case would be analogous to refunding the price of a losing lottery ticket (Michelman, 1967, p. 1238; Rose-Ackerman, 1992). This is a persuasive argument that has found its way into fairly recent judicial decisions defending rulings against compensation (HFH Ltd. v. Superior Court, 542 P.2d 237 (1975)). Several authors have suggested, however, that the capitalization argument against compensation is flawed (Epstein, 1985, pp. 151-158; Fischel, 1985, pp. 184-186; Fischel and Shapiro, 1988; Miceli and Segerson, 1996, Ch. 6). The reason is that, even if the purchaser had full knowledge of the threat of a regulation when he bought the land (and therefore paid a discounted price), the threat had to arise at some previous point in time, and the owner at that point suffered a capital loss. The only way that the original landowner is fully protected against this capital loss is if any subsequent owner who is regulated expects to receive full compensation, that is, compensation equal to the difference between the value of the property with and without the regulation. Compensation based on other measures, such as the purchase price of the land or reliance expenditures, will not eliminate landowner losses (or gains) even when capitalization occurs (Miceli and Segerson, 1996, Ch. 6).

9. Government Incentives versus Land Use Incentives The above discussion of land use incentives in the presence of a takings threat identified a moral hazard problem associated with compensation. Specifically, paying compensation for the full value of the confiscated land will generally lead to overinvestment by landowners. While this result was first demonstrated in the case of physical takings (Blume, Rubinfeld and Shapiro 1984), the basic logic applies to regulatory takings as well (Miceli and Segerson, 1996, Ch. 3). Specifically, with full compensation landowners will act as if they are fully

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insured against the risk of a regulation and hence will overinvest. To remedy this problem, compensation must be lump sum, or independent of the amount that was invested in the land. Since a special case of lump sum compensation is zero compensation, an implication of the Blume, Rubinfeld and Shapiro (1984) model is that zero compensation will lead to efficient land use decisions in the case of regulatory takings as well. If regulatory agencies have fiscal illusion, however, then a rule of no compensation potentially leads to excessive regulation (Epstein, 1985, Ch. 17; Johnson, 1977). This threat is especially severe for groups who are underrepresented in the political process or owners of immobile assets who cannot escape uncompensated regulations (Farber, 1992; Fischel, 1995a;Yandle, 1995). Hence, there is a potential trade-off between two effects: the moral hazard problem - which argues against compensation - and regulatory fiscal illusion - which argues for compensation. Miceli and Segerson (1994) explicitly examine the trade-off between moral hazard and fiscal illusion in the context of regulatory takings by considering a compensation rule that conditions the amount of compensation on whether or not the regulator acted in an efficient manner. They show that a rule under which compensation must be paid if and only if the government made an inefficient regulatory decision (the ‘ex post’ rule) will lead to efficient incentives not only for the regulator but also for the landowner. Under this rule, compensation is full when it is inefficient to impose the regulation ex post, but zero when it is efficient to impose the regulation ex post. This definition of the threshold for compensation induces the regulator to act efficiently because by doing so he can ‘avoid’ paying compensation. Moreover, since compensation is zero for efficient regulations, landowners will make the correct land use decisions as well. In light of this conclusion, Miceli and Segerson (1996, Ch. 5) argue that, under appropriate definitions of ‘noxious use’ and ‘nuisance’, the ex post rule is consistent with both the noxious use doctrine and the nuisance exception. In addition, it is consistent with Fischel’s (1985, Ch. 8) rule of paying compensation for inefficient regulations and not paying compensation for efficient ones (see the discussion above). Finally, it defines a threshold for determining when a regulation goes too far under the diminution of value test. While compensation under the ex post rule hinges on the nature of the government action, Miceli and Segerson (1994, 1996, Ch. 4) show that efficient incentives for both regulators and landowners can also be achieved under an alternative rule that determines compensation on the basis of the efficiency of the landowner’s decision (the ‘ex ante’ rule). Under this rule, compensation is paid if and only if the landowner made an efficient land use decision at the time the that the original investment was made. Note that both the ex post and ex ante rules induce efficiency by both parties for the same reason that negligence rules work in bilateral care accident cases (Landes and Posner, 1987, Ch. 4;

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Cooter and Ulen, 1988, Ch. 8). Specifically, they specify a threshold for one of the parties such that, by acting efficiently, that party can ‘avoid liability’. As a result, the other party bears ‘full liability’ in equilibrium and therefore also acts efficiently. Since Miceli and Segerson (1994, 1996, Ch. 4) identify two alternative rules that are efficient, factors other than efficiency can be used to choose between them. Two such factors are fairness and transactions costs. Fairness generally argues for payment of compensation in equilibrium (the ex ante rule), whereas transactions cost considerations argue against compensation (the ex post rule). Note that these options mirror Michelman’s (1967) comparison of demoralization and settlement costs for determining compensation. As noted above, Hermalin (1995) also proposed rules that solve the moral hazard and fiscal illusion problems in the context of full takings. However, in contrast to Hermalin’s proposals, the rules proposed by Miceli and Segerson permit attainment of the first-best outcome even when compensation is tied to the value of the land to the landowner, and the landowner does not have a buyback option. Thus, while both the Miceli-Segerson rules and those of Hermalin induce efficient behavior by both landowners and regulators, the former are more closely linked to actual takings law and hence have greater positive significance. Fischel and Shapiro (1989) also proposed a resolution to the trade-off between moral hazard and fiscal illusion in the context of a constitutional choice (veil of ignorance) model. They concluded that partial compensation for regulations optimally balances the costs of these two problems. However, a partial compensation rule only achieves a second-best solution. In addition, it fails to explain actual decisions of courts, which typically award either zero or full compensation. Note, however, that to the extent that compensation is based on fair market value, which is often less than the subjective value of the property (see Section 4 above), courts might in fact be awarding partial compensation for takings that are found to be compensable. Under this form of partial compensation, the rules proposed by Miceli and Segerson (1994, 1996) would yield second-best outcomes as well.

Acknowledgements We acknowledge the very helpful comments of two reviewers.

Bibliography on Takings (6200) Adelstein, Richard P. (1974), ‘Just Compensation and the Assassin’s Bequest: A Utilitarian Approach’, 122 University of Pennsylvania Law Review, 1012-1032. Baxter, W. and Altree, L. (1972), ‘Legal Aspects of Airport Noise’, 15 Journal of Law and

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Other References Calabresi, Guido and Melamed, A. Douglas (1972), ‘Property Rules, Liability Rules, and Inalienability: One View of the Cathedral’, 85 Harvard Law Review, 1089-1128. Coase, Ronald H. (1960), ‘The Problem of Social Cost’, 3 Journal of Law and Economics, 1-44. Cooter, Robert D. (1985), ‘Unity in Tort, Contract, and Property: The Model of Precaution’, 73 California Law Review, 1-51. Cooter Robert D. and Ulen, Tom (1988), Law and Economics, New York, Harper Collins.

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Gantner, Manfred (1988), ‘Öffentliche (De-)Regulierung im Zusammenhang mit der österreichischen Post- und Telegraphenverwaltung (Public Deregulation of Postal Serevices)’, 8 Finanzwissenschaftliche Diskussionsreihe. Gantner, Manfred (ed.) (1991), Handbuch des öffentlichen Haushaltswesens (The Handbook of Public Budgeting), Vienna, Manz, 416 p. Gantner, Manfred (ed.) (1994), Budgetausgliederung - Fluch(t) oder Segen? (Budgetary Disembodyment - Vice or Virtue?), Vienna, Manz, 232 p. Garcia Villarejo, Salinas, Avelino and Sánchez, Javier (1993), Manual de Hacienda Pública general y de España (Public Treasury Manual), Madrid, Tecnos. Geelhoed, L.A. (1993), ‘Deregulering, Herregulering en Zelfregulering (Deregulation, Re-regulation and Selfregulation)’, in Eijlander, Ph. (ed.), Government and Selfregulation, Deventer, W.E.J. Tjeenk Willink, 33-51. Gimeno Ullastres, Juan A., La Situación de las Facultades de Derecho y Económicas: Análisis y Propuestas (Analysis and Proposals for Law and Economics Schools), Secretaría de Estado de Universidades e Investigación, Ministerio de Educación y Ciencia, 67 p. Gimeno Ullastres, Juan A. and Ruiz Huerta, Jesús, ‘Los Costes de los Servicios Universitarios (The Cost of Universities)’, in X (ed.), La Financiación de la Enseñanza Superior, Madrid, Consejo de Universidades, 181-209. Ginsburg, Douglas H. and Demuth, Christopher C. (1986), ‘White House Review of Agency Rulemaking’, 99 Harvard Law Review, 1075 ff. Greene, Kenneth V. and Moulton, George D. (1986), ‘Municipal Employee Residency Requirement Statutes: An Economic Analysis’, 9 Research in Law and Economics, 185-204. Greenstein, Shane (1993), ‘Procedural Rules and Procurement Regulations: Complexity Creates Tradeoffs’, 9 Journal of Law, Economics, and Organization, 159-180. Grossekettler, Heinz (1984), ‘Verwaltungsstrukturpolitik (Public Administration Structure Policy)’, in Ewers, H.-J. and Schuster (ed.), Probleme der Ordnungs- und Strukturpolitik, Göttingen, Vandenhoeck & Ruprecht, 16-51. Hackney, James R., Jr (1988), ‘A Proposal for State Funding of Municipal Tort Liability’, 98 Yale Law Journal, 389-407. Harmathy, Attila (1980), ‘Allami Támogatások Jogi Kérdéseiröl (Legal Questions on State Subsidies)’, 1 Allam- és Jogtudomány, 33-61. Harmathy, Attila (1983), Szerzödések, Allamigazgatás, Gazdaságirányitás (Contract, Administration, Business Governing), Budapest, Akadémiai Kiadó, 210 p. Hill, Jeffrey S. and Brazier, James E. (1991), ‘Constraining Administrative Decisions: A Critical Examination of the Structure and Process Hypothesis’, 7 Journal of Law, Economics, and Organization, 373-400. Hondius, E.H., Schippers, Joop J. and Siegers, Jacques J. (1991), Rechtseconomie en Recht. Kennismaking met een Vakgebied in Opkomst (Law and Economics: Introduction to a Growing Field of Science), Zwolle, Tjeenk Willink, 201 p. Howard, Philip K. (1994), The Death of Common Sense: How Law is Suffocating America, New York, Random House, 202 p.

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7000 CIVIL PROCEDURE: GENERAL Bruce H. Kobayashi and Jeffrey S. Parker Associate Professor of Law and Professor of Law George Mason University School of Law © Copyright 1999 Bruce H. Kobayashi and Jeffrey S. Parker

Abstract The economic analysis of civil litigation has focused on the action of the litigants and on the effects of substantive and procedural rules on their behavior. This chapter focuses on the economic analysis of procedural rules and how these rules alter the incentives of the litigants to file, settle and litigate disputes. Such procedural rules affect the private costs and benefits of litigation through altering the net expected value and loss faced by the plaintiff and defendant. Procedural rules also affect the social costs and benefits of litigation by affecting the both the direct and error costs of litigation. The analysis in the chapter is organized around the US Federal Rules of Civil Procedure, and in reverse chronological order to reflect the economic analyses use of backwards induction to examine civil litigation. Topics examined in depth include sequencing rules, rules that affect the capitalization of litigation over parties and claims, the rules of discovery, and juries. JEL classification: K4, K40 K41 Keywords: Civil Procedure, Civil Litigation, Settlement, Trials

1. Introduction The economic analysis of civil litigation, following upon the pioneering work of Landes (1971), Gould (1973), and Posner (1973), has proven to be a fruitful area. Economic analyses of litigation have focused both upon the actions of parties in civil litigation and upon the effects of substantive and procedural rules on the litigants’ behavior (see Cooter and Rubinfeld, 1989, for a previous survey of the field). This chapter focuses on the economic analysis of procedural rules. Papers in this field generally have examined the effects procedural rules have on error costs and the direct costs of litigation. The length of the reference list annexed to this chapter indicates the extent of academic interest in studying the economic effects of procedural rules, and the consequences of alterations to those rules. 1

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2. Organizing Framework The organizing framework for this chapter generally follows the US Federal Rules of Civil Procedure (FRCP). The FRCP, as supplemented by statutory and decisional standards concerning the jurisdiction of courts and the preclusive effects of judgments, regulate most aspects of the civil litigation process, from the general statement of the purpose of the rules to the particularized standards regarding process, pleadings, lawyer sanctions, discovery, the allocation of legal costs, the relationship between multiple parties (including the regulation and certification of class actions), motions, trials and judgments. Since their promulgation in 1938, the FRCP have provided generally uniform rules for the conduct of litigation in the US Federal courts, and similar rules have been adopted in a majority of American states (for a comparison of federal and state procedural rules, see Oakley and Coon, 1986). In addition, the Federal Rules have been frequently revised, and the process of rulemaking itself has become a topic for economic and legal analysis. However, we do not discuss the rules and related topics in numerical order. Rather, because the economic analysis of litigation must be forward looking, and thus proceed using backwards induction, our chapter is organized in reverse chronological order.

3. Topics Covered Topics reviewed in depth in this chapter include sequencing rules, rules that affect the capitalization of litigation over parties and claims, the rules of discovery, and juries. Related areas not addressed in detail in this chapter are treated in other chapters of this volume and earlier volumes. These areas include: other areas of civil procedure, including fee shifting (7300), the litigation/settlement decision (7400) and class actions (7600); the organization of the courts, including jurisdictional issues (7100-7200); criminal procedure (7700); the economics of crime and punishment (8000-8600); arbitration and the private enforcement of law (7500); bankruptcy proceedings (7800); legal error, rules versus standards, and accuracy in adjudication (Volume I, 790), punitive damages (Volume II, 3700), the computing of damages, including the allocations of damages via contribution and indemnity rules (Volume II, 3500); and the production of legal rules and precedent (9000-9900). In addition, issues relating to evidence and information in litigation, including the rules of discovery, attorney client privilege, and advice for litigation, are examined in a companion section on evidence (7900).

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4. The Economic Analysis of Procedural Rules Economic analyses of procedural rules generally have proceeded within Posner’s (1973) framework, which conceives the purpose of such rules to be the minimization of the sum of error costs and direct costs. See also Tullock (1975) and Posner (1992) for a general analysis of procedure. Consistent with this framework, Rule 1 of the FRCP directs that the rules be construed and administered to secure the just, speedy, and inexpensive determination of every action. Economic analyses of procedural rules focus on the effect such rules have on the incentives of potential and actual litigants. Thus, the economic analysis of procedural rules must begin with an economic model of litigation.

5. The Economic Model of Litigation The basic economic model of litigation has two parties, a plaintiff (p) that has a potential claim against the defendant (d). The plaintiff’s estimate of the net expected value (NEV) of the claim equals his estimate of the probability (P) that he or she will prevail (Pp) multiplied by the expected award (Dp), net of the marginal costs to the plaintiff of proceeding to the next stage of litigation (Cp). The defendant’s objective function for estimating expected loss (EL) is developed in parallel fashion, as equaling the defendant’s estimate of the probability the plaintiff will prevail (Pd) times the expected award (Dd) plus the defendant’s marginal costs of proceeding to the next stage of litigation (Cd). In the more developed models, several of the variables may be endogenously determined. For example, both litigants’ selections of C may affect their estimates of the outcome, and one litigant’s choice of C may affect the other litigant’s estimate of its own cost of proceeding to the next stage. Most analyses use sequencing models, for which the definition of marginal cost given in the text is the most general case. In the most basic models, this cost is conceptualized as the marginal cost of ‘trial’ over ‘settlement’, though obviously it can be generalized to any of the multiple stages of litigation, and can refer to cooperative, decisional, or unilateral withdrawal outcomes, as developed by Cornell (1990). In processes without discrete formal stages, such as the American discovery process and some Continental trial processes, the most general case will be continuous updating of NEV and EL as each new item of information (for example, each witness or investigation) becomes available. In addition, the litigants can be influenced by effects external to the current litigation - for example, by the precedential or preclusive effects of the judgment in the current litigation on future litigation. In such cases, a current plaintiff’s judgment will produce an external gain to the plaintiff (Gp) while the

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defendant will suffer external loss (Ld). Likewise, a defendant’s judgment will produce external gain (Gd) while the plaintiff will suffer an external loss (Lp). The NEV and EL are the primary determinants of the incentives given to litigants in the economic model, including the amount of effort expended during litigation, the trial/settlement decision, the decision to file a suit, and the decision to avoid behavior that would give rise to legal liability. Because procedural rules alter the NEV and EL, these rules will have a central role in determining litigation incentives and outcomes. Because decisions made at earlier stages of litigation are dependent upon the parties’ expectations of the outcomes (and their own and opposing parties’ decisions) during later stages of the litigation, economic analysis begins from the last stage of trial and judgment, and proceeds by backward induction. Thus, we list and discuss topics in reverse chronological order.

6. Trial Courts The last stage of a civil litigation in the court of first instance is the trial and judgment (Cooter and Rubinfeld, 1990). This discussion suppresses the possibility of appellate review, which in the US federal system is governed by a separate set of Federal Rules of Appellate Procedure. Appellate review in the United States is concerned primarily with the correction of legal error and secondarily with factual error. For a discussion of the economic analysis of those topics, see Volume I, Chapter 0790 in this volume.

7. The Choice Between Judge and Jury Trials Trials and judgments are governed by Sections VI and VII of the FRCP (Rules 38-63). Subject to certain motions for the court to set aside the verdict (Rule 50) or order a new trial (Rule 59), judgment is entered as given by the factual findings and legal conclusions of a judge (see Rule 52) or the verdict of a jury (Rule 58). The federal rules allow any party to demand a trial by jury of any issue triable as a matter of federal constitutional right by a jury (Rule 38). Although most American states also provide by state law or constitution for a right to trial by jury in some or all cases, the state courts generally are not bound by the federal constitutional right to jury trial, except in certain cases where they are adjudicating federal claims for which federal law requires a right to jury trial. Rule 39 allows the parties in these cases also to have a trial by the court, by joint consent. Gay, et al. (1989) examine the choice between judge and jury under the assumption that juries are ‘noisier’ adjudicators than judges. Clermont and Eisenberg (1992) examine empirically whether the choice

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of judge versus jury produces differing verdicts in product liability cases tried under state law, finding that - contrary to the popular belief - judges, not juries, are more generous to plaintiffs. Further, they do not find that these results are explained by selection bias. In addition to explicit choices by the parties, several of the Rules allow the judge to exercise certain powers even when the case is tried by jury. Rule 49 allows the court to require a jury to return a special verdict, which involves explicit findings upon each of several elements of the claim at issue rather than allowing the jury to return the more common general verdict (see Lombadero, 1996; James, Hazard and Leubsdorf, 1992, p. 377). Rule 50 provides for judgment as a matter of law, which can be used by the judge to preempt or overrule a jury upon the determination that, after being fully heard, there is no legally sufficient basis for a reasonable jury to find for a party on an issue (see McLauchlan, 1973). Rule 56 provides for an equivalent ruling in the pretrial stage by summary judgment, on the basis of pretrial discovery material and written submissions by the parties (see McLauchlan, 1977), and Rule 12 permits a judgment as a matter of law at the earlier pleading stage, in cases where the plaintiff’s claim is legally deficient on its face.

8. Jury Structure and Decision Rule The rules also regulate the size and decision rule used by civil juries, as well as the process through which jurors are selected. Rule 48 specifies that, unless the parties otherwise stipulate, a civil jury shall be not fewer than six nor more than twelve, and that the verdict shall be unanimous. Economic analyses of jury decision making include an examination of how juries process information (Klevorick, Rothschild and Winship, 1984; Froeb and Kobayashi, 1996), and the effect of jury size and alternative decision rules (Klevorick and Rothschild, 1979). Finally, Rule 47 (as supplemented by federal statutes) controls the selection of jurors, including the procedures for examination of jurors during the selection process, and the use of peremptory challenges (see, for example, Schwartz and Schwartz, 1996).

9. Litigation Expenditures A separate literature has bypassed explicit consideration of the jury versus judge decision-making process by modeling the outcome of a trial as being determined by the litigants’ expenditures on litigation. The most common model of litigation expenditures is where the both litigants expend resources to alter the probability of prevailing (see Posner, 1973; Goodman, 1978; Tullock,

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1980; Wittman, 1988; Katz, 1988; Hay, 1995; Kobayashi and Lott, 1996). That is, in these models, the marginal cost of future litigation stages Cp and Cd (usually conceptualized as ‘trial versus settlement’) are endogenous choice variables that determine the probability that the plaintiff will prevail P(Cp,Cd). The equilibrium amounts of litigation expenditures depend upon the relative stakes of the parties, and upon the relative merits of the case. The litigation expenditures and probability determined by solving for the Nash equilibria are used as the expected values for earlier stages of litigation. Other articles have examined the relationship between the burden of evidence or decision standard and litigation expenditures. In these models, litigation expenditures that allow a litigant to meet the burden of proof or decision standard serve as a costly signal of liability (see, for example, Rubinfeld and Sappington, 1987).

10. The Trial/Settlement Decision The major decision preceding commencement of a trial is the decision whether to settle the case or proceed to trial. The relative magnitudes of the plaintiff’s NEV and the defendant’s EL are the primary determinants of whether a case settles or whether trial occurs. As noted above, this modeling can be generalized to any stage preceding a decision by the court, or a further commitment to incur litigation expense. Under risk neutrality, the NEV sets the plaintiff’s minimum acceptable settlement offer and the EL the defendant’s maximum settlement bid. In the absence of lawyer-client agency costs, a sufficient (but not necessary) condition for litigation is the perceived absence of a bargaining range, which occurs when the plaintiff’s minimum acceptable offer is greater than the defendant’s maximum bid, that is, NEV > EL, or equivalently: Pp(Dp + Gp + Lp) ! Pd(Dd + Ld +Gd) + Gd ! Lp > Cp + Cd

( 1 ) The above condition identifies two reasons why parties choose to forego settlement and proceed to trial. The first is based on prediction failure. The second is based on consideration of external effects, specifically precedential or preclusive effects of the current litigation on future litigation.

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A. The Optimism Model 11. The Prediction Failure Model Under the simplifying assumptions that the litigants have symmetric stakes (Dp = Dd = D) and that there are no external effects (Ld = Lp = Gd = Gp = 0), the condition for trial rather than settlement reduces to the following expression: (Pp ! Pd)D > Cp + Cd (2) This condition illustrates the optimism model of litigation. In such a model, settlement fails to occur because of prediction failure - that is, settlement fails because the parties have mutually inconsistent and relatively optimistic estimates of the probability that the plaintiff will prevail (that is, Pp > Pd). The litigants’ erroneous predictions lead them to behave as if there were no room for a mutually beneficial settlement.

12. The Priest-Klein Selection Model Economists also have modeled the process through which such mutually inconsistent and optimistic predictions are generated. The Priest and Klein (1984) model of case selection is based on the optimism model, and has two major hypotheses. The first and more general hypothesis is that the cases selected for trial are not representative of the population of disputes. Specifically, under the assumptions of symmetric stakes and specific distributional assumptions about the litigants’ estimates of P (specifically that each litigant’s estimate of P is an independent draw from a unimodal distribution centered around the true P), the basic Priest-Klein model predicts that a disproportionate number of cases selected for trial will come from cases that are close to the decision standard. The second hypothesis is a specific prediction for observed case outcomes in the limiting case where the litigants accurately estimate P. Priest and Klein show that under these circumstances the distribution of filed cases around the decision standard becomes approximately symmetric, and the generated plaintiff win rate approximately equals 50 percent. A large number of articles have examined the limiting prediction of a 50 percent win rate, and have presented evidence where the win rate differs from 50 percent. See, for example, Priest (1985), Wittman (1985), Ramsayer and Nakazato (1989), Eisenberg (1990), Hylton (1993), Thomas (1995), Waldfogel (1995), Shavell (1996). See Kessler, Meites and Miller (1996) and Kobayashi (1996) for recent surveys of the literature. While generally rejecting the specific fifty percent hypothesis, this evidence may simply reflect the fact that the

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assumptions underlying the limiting case do not hold. Further, empirical studies examining the more general predictions of the Priest-Klein model have found evidence consistent with model (see Kobayashi, 1996).

13. Settlement Failure and Discovery Because the prediction failure model predicts settlement failure because litigants lack information at the time of the final trial/settlement decision, it suggests procedural reforms aimed at increasing pre-trial information. The management of pre-trial information is addressed in Section V of the FRCP (Rules 26-37). The primary rule is Rule 26, which contains the general provisions governing civil discovery. Under Rule 26, litigants are required to respond to requests for information by the adverse party, on the theory that such requests and responses would increase pre-trial information and increase settlement and accuracy in adjudication. However, economic models of discovery have pointed out several problems with the rules. First, the rules shift the costs of gathering information from the requesting to the responding party, and thereby introduce both a potential moral-hazard problem and strategic behavior into the demand for pretrial discovery. Because the costs of responding to a discovery request are, in many cases, larger that the cost of making a request, this externalization predicts that parties will request information well past the point where the marginal value of information outweighs the marginal costs of gathering the information. In addition, the process of discovery can decrease, rather than increase, settlement by making parties more optimistic (see Cooter and Rubinfeld, 1994). Finally, discovery can potentially decrease the amount of information in litigation by providing disincentives for the production and retention of information that might be subject to extensive legal discovery (see Kobayashi, Parker and Ribstein, 1996; see also Hay, 1994 and Sobel, 1989).

14. Amendments to the Discovery Rules The perceived problems of ‘overdiscovery’ predicted by the economic model of litigation have been addressed in several amendments to the discovery rules. In 1983, Rule 26(b) was amended to embody an explicit cost-benefit test that could be applied by the judge to limit discovery. At that same time FRCP 16 was amended to expand the judge’s power to manage the pretrial process in general. However, the economic model suggests that these managerial solutions may be inferior to forcing each litigant to internalize the costs of its own information requests, or at least to pay for the marginal cost of extensive discovery requests (Cooter and Rubinfeld, 1994).

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In 1993, Rule 26 was further amended, again in response to concerns regarding litigants’ overinvestment in discovery activity. However, the major change to the rules was to institute a regime of initial disclosures to be made without any request for information from the adverse party (see FRCP Rule 26a; Brazil, 1978; Schwarzer, 1989; Cooter and Rubinfeld, 1995). Applying the economic model, this change is likely to make matters worse. To the extent that cost-shifting is the source of ‘discovery abuse’, these rules exacerbate the problem by allowing the requesting party to externalize the costs of both requesting and responding to requests for information. This effect is magnified by abandonment of code pleading in favor of the broad notice pleading rules contained in the FRCP (Section III, Rules 7-15; see Epstein, 1973a, 1973b, 1974, 1986; Posner, 1973; Katz, 1990; Bone, 1997). Further, to the extent that this rule moves the costs of pretrial discovery into an earlier phase of the litigation, this may have the effect of increasing total costs, and decreasing the marginal costs of trial over settlement. The 1993 amendment was subject to a local option in US federal districts, which has reduced some of the effects of the rule change. Empirical analysis has shown that the busiest federal districts have opted out of the new rule (Kobayashi, Parker and Ribstein, 1996).

B. The External Effects Model 15. External Effects Relative optimism is not the only way in which to generate the absence of a perceived bargaining range. The existence of external effects can cause litigation to occur even if the parties to the litigation agree on the likely outcome of the case. Examples of external effects include the precedential and preclusive effect of litigation, both of which serve to affect litigants’ prospects in future cases (see Galanter, 1974; Rubin, 1977; Che and Yi, 1993 and Kobayashi, 1996; see also Landes and Posner, 1979; Blume and Rubinfeld, 1982; Priest, 1987, 1980; Cooter, 1987; Galanter, 1987). For a more complete discussion of precedent and legal change, see Chapters (9000-9900) of this volume. To illustrate this point, consider the case with symmetric stakes and where the litigants agree on the probability the plaintiff will prevail, that is, Pp = Pd = P. According to the simple optimism model, such a case will settle in order to save the costs of a trial. However, even under these assumptions, litigation may be generated if the current case has implications for future behavior of the litigants involved. The NEV of the lawsuit to the plaintiff equals P(D +Gp) !(1 ! P)Lp ! Cp, and the defendant’s EL = P(D+Ld) !(1 ! P)Gd + Cd. The condition for litigation NEV > EL becomes:

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P(Gp ! Ld) + (1 ! P)(Gd ! Lp) > Cd + Cp

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(3)

Condition (3) shows that, even when the prospective outcome of a trial is agreed upon by the parties, trials can be generated when the external gains to the winning litigant outweigh the external losses to the losing litigant. In contrast to the sources of trial in the prediction failure and settlement failure models (where information costs prevent litigants from achieving a settlement within an existing bargaining range), external effects cause trials by preventing the existence of a bargaining range due to asymmetries in external effects. Because no mutually beneficial bargain is foregone, these trials are not a failure. In fact, the existence of external effects focuses on the positive and valuable rulemaking function of trials.

16. External Effects and Procedural Rules The model of trial based on external effects also suggests the relevance of a different set of procedural rules - one that focuses on the effects of litigation on future claims and third parties. The FRCP addresses the packaging of claims and parties generally in Rules 13-14 and 17-25. These rules serve as inclusive packaging devices, which operate by giving litigants incentives and opportunities to join parties and claims in order to internalize external effects and to achieve economies of scale in litigation. They include the permissive joinder rules (Rule 18-20), impleader (Rule 14), interpleader (Rule 22), intervention (Rule 24), the rule governing counterclaims (Rule 13), and the rule governing class actions (Rule 23). For an economic analysis of counterclaims, see Landes (1994). For a discussion of various aspects of class actions, see Dam (1975), Rosenfeld (1976), Bernstein (1978), Friedman (1996), and Chapter 7600 of this volume.

17. Common Law Packaging Rules A second major category of packaging rules include the common law rules of precedent, or stare decisis, and the rules of preclusion, or the law of res judicata. The common law rules of res judicata include the doctrines of claim preclusion (also known as merger and bar) and issue preclusion (also known as collateral estoppel). Under the rule of claim preclusion, parties or their privies (that is, predecessors or successors in interest) are precluded from relitigating issues that were or could have been raised in the first action (see, for example, Kobayashi, 1996; Landes and Posner, 1994). Claim preclusion prevents the splitting of claims based on the same out-of-court transaction, thus functioning as mandatory joinder-of-claims rules by their prospective effect on

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future litigation. In contrast, issue preclusion (collateral estoppel) is limited to issues that were actually litigated, actually decided, and necessary to the judgment in the first case. In addition, while application of claim preclusion is generally limited symmetrically to persons who were either parties or successors to parties on both sides of the initial litigation, collateral estoppel can operate non-symmetrically, or, as it is termed in legal doctrine, non-mutually, in the sense that collateral estoppel can operate in favor of strangers to the first action, but can operate against only parties or their successors (see Spurr, 1991; Hay, 1993). The existence of non-party preclusion has led to the attempted use of settlement conditioned on vacatur (the eradication of a prior public decision) as a means to eliminate the effect of preclusion (see Fisch, 1991).

18. Offensive Non-Mutual Collateral Estoppel To see the effect of the application of non-mutual collateral estoppel, consider the case where a single defendant faces two different plaintiffs sequentially. Suppose for simplicity that both cases turn on a single issue that determines the outcome. First consider offensive collateral estoppel. If the first plaintiff prevails against the defendant, the defendant is precluded from relitigating the decisive issue against the second plaintiff. Thus, a loss in the first case results in the loss of both cases, and the external effect Ld = (1 ! P)D. In contrast, a win by the defendant against the first plaintiff does not preclude the second plaintiff from relitigating the issue, if the second plaintiff is neither a party nor a privy to the first action. Thus, the only effect on the second litigation would be the precedential gain Gd = (dP D), where dP equals the change in P in the second litigation. If there are no novel issues of law, this gain is likely to be close to zero. And under the assumption that the plaintiffs are not repeat litigants, Lp = Gp = 0. Substituting into the condition for litigation (equation (3)) yields: (1 ! P)D(dP ! P) > Cd + Cp (4) If the precedential change dP is close to zero, condition (4) is unlikely to be satisfied. Thus, there will be little incentive to take such cases to trial. This incentive for settlement has led some to object to offensive non-mutual collateral estoppel on the grounds that such a rule will allow plaintiffs to repeatedly extract large settlements from a common defendant. However, the total effect on settlement amounts from such a rule is unclear (see Hay, 1993). First, the effect of estoppel causes the repeat litigant to capitalize all future litigation into the first litigation. This increase in the stakes causes the repeat litigant to spend a larger amount of resources when he goes to trial. This has

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the effect of lowering P, thus moving the bottom of the bargaining range downward. Further, the repeat litigant is likely to take a harder bargaining stance in the first litigation by anticipating its effects on future litigation.

19. Defensive Non-Mutual Collateral Estoppel In contrast, consider the use of defensive non-mutual collateral estoppel with multiple plaintiffs. Again, assume that Lp = Gp = 0. Now Ld = dP D and Gd = PD. Substitution into the condition for litigation (equation (3)) yields: PD ((1 ! P) ! dP) > Cd + Cp (5) In contrast to the rule of offensive non-mutual collateral estoppel with multiple plaintiffs, such a rule increases the likelihood of litigation. In addition, use of such a rule would apply preclusion against a non-party that was represented by a party in the first litigation with low relative stakes, which may increase legal error and increase the amount of litigation (see Spurr, 1991). Thus, the court’s rejection of the latter rule because of due process concerns is consistent with the predictions of economic analysis.

C. The Bargaining Failure Model and Asymmetric Information 20. Bargaining Failure Even within the basic optimism model of litigation, condition (2) is not a necessary condition for litigation. Even if a positive bargaining range is perceived to exist, the parties may fail to settle due to bargaining failure (see, for example, Cooter, Marks and Mnookin, 1982; Gross and Syverud, 1991; Shavell, 1993) or due to the existence of asymmetric information (see, for example, P’ng, 1983, 1987; Bebchuk, 1984; Schweizer, 1989; Spier, 1992, 1994b; Daughety and Reinganum, 1993; Froeb, 1993; Wang, Kim and Yi, 1994). In the former case the litigants fail to agree on a specific bargain even if both litigants agree that a positive bargaining range exists. In the latter case, trials are a necessary cost of avoiding adverse selection problems. In both of these cases, the potential for costly trials represents a calculated cost of strategic behavior aimed at obtaining a better expected settlement.

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21. Bargaining Failure and Procedural Rules The existence of asymmetric information in litigation again points to the discovery rules (see the discussion in Part B, above). In addition, economists have examined procedural rules that would increase the incentives for settlement. Under FRCP Rule 68, the defendant can make an offer of judgment. If this offer is not accepted by the plaintiff, and the subsequent judgment is less favorable to the plaintiff, the plaintiff is responsible for the defendant’s costs after making the offer (see Miller, 1986; Anderson, 1994; Anderson and Rowe, 1996; Chung, 1996). However, liberal and early use of Rule 68 is limited by the requirement that the defendant offer not merely settlement but judgment, which can have a preclusive effect in subsequent litigation. Further, under the current rules, it does not allow the plaintiff to recover marginal fees (although many statutes provide for one way fee recovery by plaintiffs). In addition, economists have analyzed contractual settlement devices such as settlement escrows (see, for example, Gertner and Miller, 1995), and the use of mediation and arbitration techniques (see Shavell, 1995).

D. Lawyer-Client and Client-Client Agency Costs 22. Lawyer-Client Agency Costs Finally, trials can be generated due to agency costs between lawyer and client and by agency problems between co-interested clients. A large literature has modeled the consequence of attorney compensation arrangements that give rise to the agency problems in settlement (see, for example, Miller, 1987). Articles examining the incentive effects of contingent fees include, Clermont and Currivan, 1978; Danzon (1983); Lynk (1990, 1994); Miceli and Segerson (1991); Thomason (1991); Dana and Spier (1993); Rubinfeld and Scotchmer (1993); Miceli (1994); Watts (1994); Hay (1996, 1997). Potential solutions to such problems include enforcement of ethical rules or the use of reputational mechanisms (see Gilson and Mnookin, 1984; Smith and Cox, 1985; Yang, 1996).

23. Contribution, Indemnity and Agreements with Multiple Defendants Similarly, litigation and settlement are affected by the rules which allocate liability among multiple defendants. These include the rules of contribution and indemnity (see Easterbrook, Landes, and Posner, 1980; Landes and Posner, 1980; Hause, 1989; Kornhauser and Revesz, 1989, 1990, 1994; Klerman, 1996) and agreements between plaintiffs and defendants (see Bernstein and Klerman,

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1995).

E. Effect of the Decision to File a Suit and the Decision to Avoid a Lawsuit 24. Incentives to Avoid Litigation Finally, the NEV and the EL provide incentives during the earlier stages of litigation. The EL, discounted by the probability that a suit will be filed and by the likelihood of settlement, provides deterrence of and incentives for avoidance of behavior subject to legal liability (Polinsky and Rubinfeld, 1988a, 1988b; Cooter and Rubinfeld, 1989; see also Ordover, 1978, 1981, and Hylton, 1990).

25. The Decision to File a Lawsuit Similarly, the NEV of a lawsuit is a primary determinant of whether or not a plaintiff chooses to file a suit. While many analyses of litigation limit their examination of legal claims to those whose NEV is positive, this is not a necessary condition for a suit to be filed. Negative NEV suits may also be filed in order to extract a settlement, and such strategies can be successful when the threat to litigate is credible (see Rosenberg and Shavell, 1985; Nalebuff, 1987; Bebchuk, 1988, 1996; Katz, 1990; Klein, 1990; Miceli, 1993; and Bone, 1997). For general analyses of the relationship between the cost of litigation and private and social incentive to bring a suit, see Schwartz and Tullock (1975); Priest (1982); Shavell (1982b); Menell (1983); Trubek, et al. (1983), Kaplow (1986); Rose-Ackerman and Geistfeld (1987); Hazard (1989); Williams and Williams (1994).

26. The Role of Sequencing of and Exit from Litigation Perhaps one of the most salient features of the FRCP, and one that has been only recently addressed by the economics literature, is the effect of the rules on the timing and sequencing of litigation. While many economic models treat litigation as a timeless decision, the procedural rules lay out a sequence of events that determine how litigation will proceed over time. The timing and sequence of litigation has been shown to have important implications for the NEV of a lawsuit and the behavior of litigants. For example, the ability of litigants to sequentially litigate motions or to separate liability and damage phases of trials have been shown to affect both the cost of litigation and the value of the litigation if litigants are allowed to

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exit. Sequencing with easy exit increases the ‘option’ value of litigation by allowing plaintiffs to avoid conditional negative NEV outcomes by exiting the litigation (see Cornell, 1990; Landes, 1993; Chen, Chien and Chu, 1997). In addition, the ability to take motions sequentially can affect the credibility of negative expected value suits (Bebchuk, 1996). Under the FRCP, exit is controlled by Rule 41. Under Rule 41, the plaintiff can unilaterally dismiss an action without order of the court at any time before the adverse party answers. After this, dismissal requires mutual stipulation by all parties, or an order of the court. The application of Rule 41 is a prime example of the tension between the ex ante and ex post effects of procedural rules. Ex post, it is unlikely that a defendant will prevent a plaintiff from abandoning a claim. However, the willingness of the court or the adverse party to allow the plaintiff to easily exit the litigation may be the primary reason the suit was filed in the first place.

27. Lawyer Sanctions The FRCP address this inability to commit through Rule 11, which allows the court to impose sanctions on parties and their attorneys for filing frivolous suits. This rule addresses the commitment problem by allowing the motion for sanctions to survive the dismissal or mooting or the original claim. Thus, Rule 11 allows the motion for sanction to survive as separate action with the sanctions as the incentive to litigate. Economic analyses of sanctions under Rule 11 include Kobayashi and Parker (1993); Polinsky and Rubinfeld (1993); Bebchuk and Chang (1996); and Bone (1997). However, recent amendments to Rule 11 may have reduced the value of Rule 11 as a commitment device. In the 1993 Amendments to the FRCP, the rules were amended to allow the a litigant twenty-one days to withdraw his pleading upon being served with a Rule 11 motion by the adverse litigant. In essence, the new rules allows for free exit, and thus weaken the commitment and deterrent effect of the rules. While the amendments to Rule 11 were designed in large part to decrease the volume of ‘satellite’ litigation over alleged Rule 11 violations, the effect of the rule change may be to increase the number of filed cases, the rate of Rule 11 challenges, and total litigation costs (Kobayashi and Parker, 1993).

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28. Fee Shifting Economists have also examined the use of two-way fee shifting (often referred to in America as the ‘English’ rule, in contrast with the general ‘American’ rule that each party bears its own fees, regardless of outcome) to deter low or negative value lawsuits. Because two-way fee shifting imposes extra costs on the losing party, it disproportionately affects low probability lawsuits (see Shavell, 1982a). However, the FRCP has not incorporated two-way shifting of fees and costs, and state experiments have not proven successful or long lived (see Snyder and Hughes, 1990; Hughes and Snyder, 1995). In addition, almost all fee-shifting statutes require the imposition of a judgment. Thus, the use of fee shifting would not necessarily reduce the option value of litigation. That is, if exit is routinely allowed prior to judgment, fee shifting will not serve as a deterrent. Indeed, to the extent that two-way fee shifting would increase the variance in final outcomes, use of such a system would increase the option value of litigation, and thereby increase the supply of filed cases (Cornell, 1990). For a more complete discussion of fee shifting, see Chapter 7300 of this volume. See also, Dewees, Prichard and Trebilcock (1981); Braeutigam, Owen and Panzar (1984); Reinganum and Wilde (1986); Bowles (1987); Katz (1987); Plott (1987); Donohue (1991); Graville (1993); Spier (1994a), and Katz and Beckner (1995).

F. Procedural Rulemaking 29. The Process of Procedural Rulemaking Finally, both the process of procedural rulemaking and the adversarial system itself have been the subject of economic analyses. Indeed, the controversy over the relative merits of party-controlled adversarial presentation and a more ‘managerial’ system of litigation was at the heart of the controversial amendments to the discovery rules, and has been the subject of debate in the academic literature (see McChesney, 1979; Tullock, 1980, 1988; Langbein, 1985). For a recent report of experimental results, see Block and Parker (1996). For a public choice treatment of the common law of procedural rules, see Macey (1994). The controversy over the recent amendments to Rule 11 and 26a have drawn attention to the process through which the rules are revised (see Kobayashi and Parker, 1993; Kobayashi, 1996), and have highlighted the lack of empirical evidence on the performance of procedural rules and systems (see, for example, Galanter, 1983; Walker, 1994). Indeed, the amendment to Rule 26a, which allows individual district courts to opt-out of the discovery rules, the Civil Justice Reform Act of 1990, which encouraged local variations in each

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district, and variation in local Federal Court rules and state court rules all provide substantial challenges to the traditional centralized system of rule making that existed in the federal system prior to 1990 (see Kobayashi, Parker and Ribstein, 1996; Solimine and Pacheco, 1997; and Subrin, 1989).

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Empiricism’, 77 Cornell Law Review, 1124-1187. Cooter, Robert D. (1987), ‘Why Litigants Disagree: A Comment on George Priest’s “Measuring Legal Change”’, 3 Journal of Law, Economics and Organization, 227-234. Cooter, Robert D. and Rubinfeld, Daniel L. (1989), ‘Economic Analysis of Legal Disputes and Their Resolution’, 27 Journal of Economic Literature, 1067-1097; reprinted in Richard A. Posner and Francesco Parisi (eds) (1996), Law and Economics, Edward Elgar. Cooter, Robert D. and Rubinfeld, Daniel L. (1990), ‘Trial Courts: An Economic Perspective’ 24 Law and Society Review, 533-548. Cooter, Robert D. and Rubinfeld, Daniel L. (1994), ‘An Economic Model of Legal Discovery’, 23 Journal of Legal Studies, 435-463. Cooter, Robert D. and Rubinfeld, Daniel L. (1995), ‘Reforming to New Discovery Rules’, 84 Georgetown Law Journal, 61-89. Cooter, Robert D., Marks, Stephen and Mnookin, Robert (1982), ‘Bargaining in the Shadow of the Law: A Testable Model of Strategic Behavior’, 11 Journal of Legal Studies, 225-251. Cornell, Bradford (1990), ‘The Incentive to Sue: An Option Pricing Approach’ 19 Journal of Legal Studies, 173-187. Dam, Kenneth W. (1975), ‘Class Actions: Efficiency, Compensation, Deterrence, and Conflict of Interest’, 4 Journal of Legal Studies, 47-73. Dana, James D., and Spier, Kathryn E. (1993), ‘Expertise and Contingent Fees: The Role of Asymmetric Information in Attorney Compensation’, 9 Journal of Law, Economics and Organization, 349-367. Danzon, Patricia M. (1983), ‘Contingency Fees for Person Injury Litigation’, 14 Bell Journal of Economics, 213-224. Danzon, Patricia, M. and Lillard, Lee (1983), ‘Settlement Out of Court: The Disposition of Medical Malpractice Claims’, 12 Journal of Legal Studies, 345-377. Daughety, Andrew F. and Reinganum, Jennifer F. (1993), ‘Endogenous Sequencing in Models of Settlement and Litigation’, 9 Journal of Law, Economics, and Organization, 314-348. Dewees, Donald N., Prichard, J. Robert S. and Trebilcock, Michael J. (1981), ‘An Economics Analysis of Cost and Fee Rules for Class Actions’, 10 Journal of Legal Studies, 155-185. Donohue, III, John J. (1991), ‘The Effects of Fee Shifting on the Settlement Rate: Theoretical Observations on Costs, Conflicts and Contingency Fees’, 54 Law and Contemporary Problems, 195-222. Easterbrook, Frank H., Landes, William M. and Posner, Richard A. (1980), ‘Contribution among Antitrust Defendants: A Legal and Economic Analysis’, 23 Journal of Law and Economics, 331-370. Eisenberg, Theodore (1990), ‘Testing the Selection Effect: A New Theoretical Framework with Empirical Tests’, 19 Journal of Legal Studies, 337-358. Epstein, Richard A. (1973a), ‘A Theory of Strict Liability’, 2 Journal of Legal Studies, 151-204. Epstein, Richard A. (1973b), ‘Pleadings and Presumptions’, 40 University of Chicago Law Review, 556-582. Epstein, Richard A. (1974), ‘Defenses and Subsequent Pleas in a System of Strict Liability’, 3 Journal of Legal Studies, 165-216. Epstein, Richard A. (1986), ‘The Temporal Dimension in Tort Law’, 53 University of Chicago Law Review, 1175-1218. Fisch, Jill E.(1991), ‘Rewriting History: The Propriety of Eradicating Prior Decisional Law Through

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Settlement Conditioned on Vacatur’, 76 Cornell Law Review, 589-642. Friedman, David D. (1996), ‘More Justice for Less Money’, 39 Journal of Law and Economics, 211-240. Froeb, Luke M. (1993), ‘The Adverse Selection of Cases for Trial’, 13 International Review of Law and Economics, 317-324. Froeb, Luke M. and Kobayashi, Bruce H. (1996), ‘Naive, Biased, Yet Bayesian: Can Juries Interpret Selectively Produced Evidence?’, 12 Journal of Law, Economics and Organization, 257-276. Galanter, Marc (1974), ‘Why the “Haves” Come Out Ahead: Speculations on the Limits of Legal Change’, 9 Law and Society Review, 95-160. Galanter, Marc (1983), ‘Reading the Landscape of Disputes: What We Know and Don’t Know (And Think We Know) About our Allegedly Contentious and Litigious Society’, 31 UCLA Law Review, 4-71. Galanter, Marc (1987), ‘Conceptualizing Legal Change and its Effects: A Comment on George Priest’s ‘Measuring Legal Change’‘, 3 Journal of Law, Economics and Organization, 235-242. Gay, Gerald D., Grace, Martin F., Kale, Jayrant R. and Noe, Thomas H.(1989), ‘Noisy Juries and the Choice of Trial Mode in a Sequential Signalling Game: Theory and Evidence’, 20 RAND Journal of Economics, 196-213. Gertner, Robert H. and Miller, Geoffrey P. (1995), ‘Settlement Escrows’, 24 Journal of Legal Studies, 87-122. Gilson, Ronald and Mnookin, R. (1984), ‘Disputing through Agents: Cooperation and Conflict Between Lawyers in Litigation’, 94 Columbia Law Review, 509-566. Goodman, John C. (1978), ‘An Economic Theory of the Evolution of the Common Law’, 7 Journal of Legal Studies, 393-406. Gould, John P. (1973), ‘The Economics of Legal Conflicts’, 2 Journal of Legal Studies, 279-300. Graville, H.S.E. (1993), ‘The Efficiency Implications of Cost Shifting Rules’, 13 International Review of Law and Economics, 3-18. Gross, Samuel R. (1987), ‘The American Advantage: The Value of Inefficient Litigation’,85 Michigan Law Review, 734-757. Gross, Samuel R. and Syverud, K.D. (1991), ‘Getting to No: A Study of Settlement Negotiations and the Selections of Cases for Trial’, 90 Michigan Law Review, 319-393. Hause, J.C. (1989), ‘Indemnity, Settlement, and Litigation, or I’ll be Suing You’, 18 Journal of Legal Studies, 157-179. Hay, Bruce L. (1993), ‘Some Settlement Effects of Preclusion’, 1993 University of Illinois Law Review, 21-51. Hay, Bruce L. (1994), ‘Civil Discovery: Its Effects and Optimal Scope’, 23 Journal of Legal Studies, 481-515. Hay, Bruce L. (1995), ‘Effort, Information, Settlement, Trial’, 24 Journal of Legal Studies, 29-62. Hay, Bruce L. (1996), ‘Contingent Fees and Agency Costs’, 25 Journal of Legal Studies, 503-533. Hay, Bruce L. (1997), ‘Optimal Contingent Fees in a World of Settlement’, 26 Journal of Legal Studies, 259-278. Hazard, Geoffrey C., Jr (1989), ‘Authority in the Dock’, 69 Boston University Law Review, 469-476. Hughes, James W. and Snyder, Edward A. (1995), ‘Litigation and Settlement under the English and

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American Rules: Theory and Evidence’, 38 Journal of Law and Economics, 225-250. Hylton, Keith N. (1990), ‘The Influence of Litigation Costs on Deterrence under Strict Liability and under Negligence’, 10 International Review of Law and Economics, 161-171. Hylton, Keith N. (1993), ‘Asymmetric Information and the Selection of Cases for Litigation’, 22 Journal of Legal Studies, 187-210. James, Fleming, Hazard, Geoffrey C. and Leubsdorf, J. (1992), Civil Procedure, Boston, Little Brown. Kaplow, Louis (1986), ‘Private versus Social Costs in Bringing Suit’, 15 Journal of Legal Studies, 371-385. Katz, Avery (1987), ‘Measuring the Demand for Litigation: Is the English Rule Really Cheaper?’ 3 Journal of Law, Economics and Organization, 143-176. Katz, Avery (1988), ‘Judicial Decisionmaking and Litigation Expenditure’, 8 International Review of Law and Economics, 127-143. Katz, Avery (1990), ‘The Effect of Frivolous Lawsuits on the Settlement of Litigation’, 10 International Review of Law and Economics, 3-27. Katz, Avery and Beckner, Clinton F. (1995), ‘The Incentive Effects of Litigation Fee Shifting when Legal Standards are Uncertain’, 15 International Review of Law and Economics, 205-224. Kessler, Daniel, Meites, Thomas and Miller, Geoffrey (1996), ‘Explaining Deviations from the Fifty-Percent Rule: A Multimodal Approach to the Selection of Cases for Litigation’, 25 Journal of Legal Studies, 233-260. Klein, Cristopher C. (1990), ‘Predation in the Courts: Legal Versus Economic Analysis in Sham Litigation Cases’, 10 International Review of Law and Economics, 29-40. Klerman, Daniel (1996), ‘Settling Multidefendant Lawsuits: The Advantage of Conditional Setoff Rules’, 25 Journal of Legal Studies, 445-462. Klevorick, Alan, and Michael Rothschild (1979), ‘A Model of the Jury Decisionmaking Process’, 8 Journal of Legal Studies, 141-164. Klevorick, Alan, Rothschild, Michael and Winship, C. (1984), ‘Information Processing and Jury Decision Making’, 23 Journal of Public Economics, 141-164. Kobayashi, Bruce H. (1996), ‘Case Selection, External Effects, and the Trial/Settlement Decision’, in Anderson, David A. (ed.), Dispute Resolution: Bridging the Settlement Gap, Greenwood, JAI Press, 17-49. Kobayashi, Bruce H. and Lott, John R., Jr (1996), ‘In Defense of Criminal Defense Expenditures and Plea Bargaining’, 16 International Review of Law and Economics, 397-416. Kobayashi, Bruce H. and Parker, Jeffrey S. (1993), ‘No Armistice at 11: A Commentary on the Supreme Court’s 1993 Amendments to Rule 11 of the Federal Rules of Civil Procedure’, 3 Supreme Court Economic Review, 93-152. Kobayashi, Bruce H., Parker, Jeffrey S. and Ribstein, Larry E. (1996), ‘The Process of Procedural Reform: Centralized Uniformity versus Local Experimentation’, George Mason University School of Law Working Paper. Kornhauser, Lewis, and Revesz, Richard (1989), ‘Sharing Damages Among Multiple Tortfeasors’, 98 Yale Law Journal, 831-884. Kornhauser, Louis and Revesz, Richard (1990), ‘Apportioning Damages among Potentially Insolvent Actors’, 19 Journal of Legal Studies, 617-651. Kornhauser, Lewis and Revesz, Richard (1994), ‘Multi-Defendant Settlements: The Impact of Joint and

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Several Liability’, 23 Journal of Legal Studies, 41-76. Landes, William M. (1971), ‘An Economic Analysis of the Courts’, 14 Journal of Law and Economics, 61-107. Landes, William M. (1993), ‘Sequential versus Unitary Trials: An Economic Analysis’, 22 Journal of Legal Studies, 99-134. Landes, William M. (1994), ‘Counterclaims: An Economic Analysis’, 14 International Review of Law and Economics, 235-244. Landes, William M. and Posner, Richard A. (1979), ‘Adjudication as a Private Good’, 8 Journal of Legal Studies, 235-284. Landes, William M. and Posner, Richard A. (1980), ‘Joint and Multiple Tortfeasors: An Economic Analysis’, 9 Journal of Legal Studies, 517-555. Landes, William M. and Posner, Richard A. (1994), ‘The Economics of Anticipatory Adjudication’, 23 Journal of Legal Studies, 683-719. Langbein, John H. (1985), ‘The German Advantage in Civil Procedure’, 52 University of Chicago Law Review, 823-866. Lombardero, David A. (1996), ‘Do Special Verdicts Improve the Structure of Jury Decision Making’, 36 Jurimetrics Journal, 275-324. Lynk, William J. (1990), ‘The Courts and the Market: An Economic Analysis of Contingent Fees in Class-Action Litigation’, 19 Journal of Legal Studies, 247-260. Lynk, William J. (1994), ‘The Courts and the Plaintiffs’ Bar: Awarding the Attorney’s Fee in Class-Action Litigation’, 23 Journal of Legal Studies, 185-210. McChesney, Fred S. (1979), ‘On the Procedural Superiority of a Civil Law System’, 30 Kyklos, 507-510. McLauchlan, William P. (1973), ‘An Empirical Study of Civil Procedure: Directed Verdicts and Judgments Notwithstanding Verdict’, 2 Journal of Legal Studies, 459-468. McLauchlan, William P. (1977), ‘An Empirical Study of the Federal Summary Judgment Rule’, 6 Journal of Legal Studies, 427-459. Macey, Jonathan R. (1994), ‘Judicial Preferences, Public Choice, and the Rules of Procedure’, 23 Journal of Legal Studies, 627-646. Menell, Peter S. (1983), ‘A Note on Private versus Social Incentive to Sue in a Costly Legal System’, 12 Journal of Legal Studies, 41-52. Miceli, Thomas J. (1993), ‘Optimal Deterrence of Nuisance Suits by Repeat Defendants’, 13 International Review of Law and Economics, 135-144. Miceli, Thomas J. (1994), ‘Do Contingent Fees Promote Excessive Litigation?’, 23 Journal of Legal Studies, 211-224. Miceli, Thomas J. and Segerson, Kathleen (1991), ‘Contingent Fees for Lawyers: The Impact on Litigation and Accident Prevention’, 20 Journal of Legal Studies, 381-399. Miller, Geoffrey P. (1986), ‘An Economic Analysis of Rule 68’, 15 Journal of Legal Studies, 93-125. Miller, Geoffrey P. (1987), ‘Some Agency Problems is Settlement’, 16 Journal of Legal Studies, 189-215. Nalebuff, Barry (1987), ‘Credible Pretrial Negotiation’, 18 RAND Journal of Economics, 198-210. Oakley, John B. and Coon, Arthur F. (1986), ‘The Federal Rules in State Courts: A Survey of State Court Systems and Civil Procedure’, 61 Washington Law Review, 1367-1427. Ordover, Janusz A. (1978), ‘Costly Litigation in the Model of Single Activity Accidents’, 7 Journal of Legal Studies, 243-261. Ordover, Janusz A. (1981), ‘On the Consequences of Costly Litigation in the Model of Single Activity

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Accidents: Some New Results’, 10 Journal of Legal Studies, 269-291. Perloff, Jeffrey, Rubinfeld, Daniel L. and Ruud, P. (1996), ‘Antitrust Settlements and Trial Outcomes’, 78 Review of Economics and Statistics, 401 ff. Plott, Charles R. (1987), ‘Legal Fees: A Comparison of the American and English Rules’, 3 Journal of Law, Economics, and Organization, 185-193. P’ng, Ivan P.L. (1983), ‘Strategic Behavior in Suit, Settlement, and Trial’, 14 Bell Journal of Economics, 539-550. P’ng, Ivan P.L. (1987), ‘Litigation, Liability, and Incentives for Care’, 34 Journal of Public Economics, 61-85. Polinsky, A. Mitchell and Rubinfeld, Daniel L. (1988a), ‘The Deterrent Effects of Settlements and Trials’, 8 International Review of Law and Economics, 109-116. Polinsky, A. Mitchell and Rubinfeld, Daniel L. (1988b), ‘The Welfare Implications of Costly Litigation for the Level of Liability’, 17 Journal of Legal Studies, 151-164. Polinsky, A. Mitchell and Rubinfeld, Daniel L. (1993), ‘Sanctioning Frivolous Suits: An Economic Analysis’, 82 Georgetown Law Journal, 397-435. Posner, Richard A. (1973), ‘An Economic Approach to Legal Procedure and Judicial Administration’, 2 Journal of Legal Studies, 399-458. Posner, Richard A. (1992), The Economic Analysis of Law, 4th edn, Boston, Little Brown. Priest, George L. (1980), ‘The Selective Characteristics of Litigation’, 9 Journal of Legal Studies, 399-422. Priest, George L. (1982), ‘Regulating the Content and Volume of Litigation: An Economic Analysis’, 1 Supreme Court Economic Review, 163-183. Priest, George L. (1985), ‘Reexamining the Selection Hypothesis: Learning from Wittman’s Mistakes’, 14 Journal of Legal Studies, 215-243. Priest, George L. (1987), ‘Measuring Legal Change’, 3 Journal of Law, Economics and Organization, 193-226. Priest, George L. and Klein, Benjamin (1984), ‘The Selection of Disputes for Litigation’, 13 Journal of Legal Studies, 1-55. Ramsayer, J. Mark and Nakazato, M. (1989), ‘The Rational Litigant: Settlement Amounts and Verdict Rates in Japan’, 18 Journal of Legal Studies, 263-290. Reinganum, Jennifer F. and Wilde, Louis L. (1986), ‘Settlement, Litigation and the Allocation of Legal Costs’, 17 RAND Journal of Economics, 555-566. Rose-Ackerman, Susan and Geistfeld, Mark (1987), ‘The Divergence between Social and Private Incentives to Sue: A Comment on Shavell, Menell, and Kaplow’, 16 Journal of Legal Studies, 483-491. Rosenberg, David and Shavell, Steven (1985), ‘A Model in Which Suits are Brought for Their Nuisance Value’, 5 International Review of Law and Economics, 3-13. Rosenfeld, Andrew (1976), ‘An Empirical Test of Class-Action Settlement’, 5 Journal of Legal Studies, 113-120. Rubin, Paul H. (1977), ‘Why is the Common Law Efficient?’, 6 Journal of Legal Studies, 51-63. Rubinfeld, Daniel L. and Sappington, David E.M. (1987), ‘Efficient Awards and Standards of Proof in Judicial Proceedings’, 18 RAND Journal of Economics, 308-315. Rubinfeld, Daniel L. and Scotchmer, Suzanne (1993), ‘Contingent Fees for Attorneys: An Economic Analysis’, 24 RAND Journal of Economics, 343-356. Schwartz, Edward P. and Schwartz, Warren F. (1996), ‘The Challenge of Peremptory Challenges’, 12 Journal of Law, Economics, and Organization, 325-360.

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Schwartz, Warren F. and Tullock, Gordon (1975), ‘The Costs of a Legal System’, 4 Journal of Legal Studies, 75-82. Schwarzer, William W. (1989), ‘The Federal Rules, The Adversary Process, and Discovery Reform’, 50 University of Pittsburgh Law Review, 703-723. Schweizer, Urs (1989), ‘Litigation and Settlement under Two-Sided Incomplete Information’, 56 Review of Economic Studies, 163-178. Shavell, Steven (1982a), ‘Suit, Settlement, and Trial: A Theoretical Analysis Under Alternative Methods for the Allocation of Legal Costs’, 11 Journal of Legal Studies, 55-81. Shavell, Steven (1982b), ‘The Social versus the Private Incentive to Bring Suit in a Costly Legal System’, 11 Journal of Legal Studies, 333-339. Shavell, Steven (1993), ‘Suits versus Settlement when Parties Seek Nonmonetary Judgments’, 22 Journal of Legal Studies, 1-13. Shavell, Steven (1995), ‘Alternative Dispute Resolution: An Economic Analysis’, 24 Journal of Legal Studies, 1-28. Shavell, Steven (1996), ‘Any Frequency of Plaintiff Victory is Possible’, 25 Journal of Legal Studies, 493-501. Smith, Janet K. and Cox, Steven R. (1985), ‘The Pricing of Legal Services: A Contractual Solution to the Problem of Bilateral Opportunism’, 14 Journal of Legal Studies, 167-183. Snyder, Edward A. and Hughes, James W. (1990), ‘The English Rule for Allocating Legal Costs: Evidence Confronts Theory’, 6 Journal of Law, Economics and Organization, 345-380. Sobel, Joel (1989), ‘An Analysis of Discovery Rules’, 52 Law and Contemporary Problems, 133-159. Solomine, Michael E. and Pacheco, Bryan (1997), ‘State Court Regulation of Offers of Judgement and its Lessons for Federal Practice’, 13 Ohio State Journal on Dispute Resolution, 51-78. Spier, Kathryn E. (1992), ‘The Dynamics of Pretrial Negotiation’, 59 Review of Economic Studies, 93-108. Spier, Kathryn E. (1994a), ‘Pretrial Bargaining and the Design of Fee-Shifting Rules’, 25 RAND Journal of Economics, 197-214. Spier, Kathryn E. (1994b), ‘Settlement, Bargaining, and the Design of Damage Awards’, 10 Journal of Law, Economics, and Organization, 84-95. Spurr, Stephen J. (1991), ‘An Economic Analysis of Collateral Estoppel’, 11 International Review of Law and Economics, 47-61. Subrin, Stephen N. (1989), ‘Local Rules, and State Rules: Uniformity, Divergence and Emerging Procedural Patterns’, 137 University of Pennsylvania Law Review, 1999-2051. Thomas, Robert E. (1995), ‘The Trial Selection Hypothesis without the 50 Percent Rule: Some Experimental Evidence’, 24 Journal of Legal Studies, 209-228. Thomason, Terry (1991), ‘Are Attorneys Paid What They’re Worth? Contingent Fees and the Settlement Process’, 20 Journal of Legal Studies, 187-223. Trubek, David M., Sarat, Austin, Felstiner, William L.F., Kritzer, Herbert M. and Grossman, Joel B. (1983), ‘The Cost of Ordinary Litigation’, 31 UCLA Law Review, 72-127. Tullock, Gordon (1975), ‘On Effective Organization of Trials’, 28 Kyklos, 745-762. Tullock, Gordon (1980), Trials on Trial: The Pure Theory of Legal Procedure, New York, Columbia University Press. Tullock, Gordon (1988), ‘Defending the Napoleontic Code over the Common Law’, 2 Research in Law and Policy Studies, 3-27.

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Waldfogel, Joel (1995), ‘The Selection Hypothesis and the Relationship Between Trial and Plaintiff Victory’, 103 Journal of Political Economy, 229-260. Walker, Laurens (1994), ‘Avoiding Surprise from Federal Civil Rule Making: The Role of Economic Analysis’, 23 Journal of Legal Studies, 569-593. Wang, Gyu Ho, Kim, Jeong-Yoo and Yi, Jong-Goo (1994), ‘Litigation and Pretrial Negotiation under Incomplete Information’, 10 Journal of Law, Economics and Organization, 187-200. Watts, Alison (1994), ‘Bargaining Through an Expert Attorney’, 10 Journal of Law, Economics and Organization, 168-186. Williams, Philip L. and Williams, Ross A. (1994), ‘The Cost of Civil Litigation: An Empirical Study’, 14 International Review of Law and Economics, 73-86. Wittman, Donald (1988), ‘Dispute Resolution, Bargaining, and the Selection of Cases for Trial: A Study in the Generation of Biased and Unbiased Data’, 17 Journal of Legal Studies, 313-352. Wittman, Donald (1985), ‘Is the Selection of Cases for Trial Biased?’, 14 Journal of Legal Studies, 185-214. Yang, Bill Z. (1996), ‘Litigation, Experimentation, and Reputation’, 16 International Review of Law and Economics, 503-521.

Other References Adams, Michael (1981), Ökonomische Analyse des Zivilprozesses (Economic Analysis of Civil Procedure), Königstein/Ts, Athenäum, 130 ff. Adams, Michael (1983), ‘Eine wohlfahrtstheoretische Analyse des Zivilprozesses und der Rechtsschutzversicherungen (An Economic Analysis of Civil Procedure and Legal Aid Insurance)’, 139 Zeitschrift für Schweizerisches Recht, 187-208. Adams, Michael (1986), ‘Der Zivilproze als Folge strategischen Verhaltens’ (On Civil Procedure as a Consequence of Strategic Behavior)’, 7 Zeitschrift für Rechtssoziologie, 212-225. Alexander, Janet Cooper (1994), ‘Judges’ Self Interest and Procedural Rules: Comment’, 23 Journal of Legal Studies, 647-665. Bone, Robert G. (1994), ‘The Empirical Turn in Procedural Rule Making: Comment’, 23 Journal of Legal Studies, 595-613. Bowles, Roger A. (1981), ‘Economic Aspects of Legal Procedure’, in Burrows, Paul and Veljanovski, Cento G. (eds), The Economic Approach to Law, London, Butterworths, 191-209. Broder, Josef M. (1978), ‘Citizen Participation in Michigan District Courts’, in Randall, Allan (ed.), Citizen Participation in Natural Resource Decision Making, North Central Research Strategy Committee for Natural Resources, Department of Agricultural Economics, University of Kentucky. Reprinted in Samuels, Warren J. and Schmid, A. Allen (eds) (1981), Law and Economics: An Institutional Perspective, Boston, Nijhoff, 166-178. Brown, John Prather (1985), ‘Alternatives to the Present System of Litigation for Personal Injury’, in Baily, Mary Ann and Cikins, Warren I. (eds), The Effects of Litigation on Health Care Costs, Washington, Brookings Institution, 69-79. Carrington, Paul D. (1979), ‘Adjudication as a Private Good: A Comment’, 8 Journal of Legal

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Studies, 303-317. Carroll, Sidney L. and Gaston, Robert J. (1981), ‘A Note on the Quality of Legal Services: Peer Review and Disciplinary Service’, 3 Research in Law and Economics, 251- 260. Chiorazzi, Michael et al. (1988), ‘Empirical Studies in Civil Procedure: A Selected Annotated Bibliography’, 51 Law and Contemporary Problems, 87-207. Conference (1987), ‘Conference on the Law and Economics of Procedure’, 3 Journal of Law, Economics, and Organization, 143-372. Cooper, Edward H. (1994), ‘Discovery Cost Allocation: Comment’, 23 Journal of Legal Studies, 465-480. Cooter, Robert D. and Ulen, Tom (1989), Law and Economics (Scott Foresman, 1988; 2nd edition, 1996, Japanese translation by Prof. Shozo Ota, introduction by Prof. Koji Shimdo, published by Shoji-Homu. Davis, Otto A. (1979), ‘Public and Private Characteristics of a Legal Process: A Comment’, 8 Journal of Legal Studies, 285-293. Denzau, Arthur (1979), ‘Litigation Expenditures as Private Determinants of Judicial Decisions: A Comment’, 8 Journal of Legal Studies, 295-302. Getman, Julius G. (1974), ‘A Critique of the Report of the Shreveport Experiment’, 3 Journal of Legal Studies, 487-497. Goldberg, Victor P. (ed.) (1979), ‘Discussion by Seminar Participants’, 8 Journal of Legal Studies, 323-398. Huang, Peter H. and Wu, Ho Mou (1992), ‘Emotional Responses in Litigation’, 12 International Review of Law and Economics, 31-44. Linder, Douglas O. (1989), ‘Some Doubts Concerning the Selection Hypothesis of George Priest’, 37 University of Kansas Law Review, 319-347. Miller, Geoffrey P. (1977), Note, Aldinger v. Howard and Pendent Jurisdiction, 77 Columbia Law Review, 127-152. Miller, Arthur R. (1984), ‘The Adversary System: Dinosaur or Phoenix’, 69 Minnesota Law Review, 1-37. Miller, Geoffrey P. (1989), ‘Comment: Some Thoughts on the Equilibrium Hypothesis’, 69 Boston University Law Review, 561-568. Miller, Geoffrey P. (1994), ‘Economic Analysis of Civil Procedure: Introduction’, 23 Journal of Legal Studies, 303-306. Nederlands Juristen Blad (1990), Rechtshulp anno 1990, Special Issue, (a number of articles). Nederlands Juristen Blad, (1987), Tussen Kwaliteit en Efficiency in de Rechtspraak (Between Quality and Efficiency in Case Law), Special Issue (a number of articles). Polinsky, A. Mitchell and Che, Yeon-Koo (1991), ‘Decoupling Liability: Optimal Incentives for Care and Litigation’, 22 RAND Journal of Economics, 562-570. Posner, Richard A. (1988), ‘Comment: Responding to Gordon Tullock’, 2 Research in Law and Policy Studies, 29-33. Rowe, Thomas D., Jr (1994), ‘Repealing the Law of Unintended Consequences? Comment’, 23 Journal of Legal Studies, 615-626. Sarokin, H. Lee (1989), ‘A Comment on Geoffrey Hazard’s Authority in the Dock’, 69 Boston University Law Review, 477-479. Schwarzer, William W (1988), ‘Rule 11 Revisited’, 101 Harvard Law Review, 1013-1025. Shavell, Steven (1989), ‘The Sharing of Information Prior to Settlement of Litigation’, 20 RAND Journal of Economics, 183-195. Symposium (1987), ‘Conference on the Law and Economics of Procedure’, 3 Journal of Law, Economics, and Organization, 143-447.

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Symposium (1989), ‘Issues in Civil Procedure: Advancing the Dialogue’, 69 Boston University Law Review, 467-779. White, Lawrence J. (1988), ‘Litigation and Economic Incentives’, 11 Research in Law and Economics, 73-90. Yeazell, Stephen C. (1989), ‘The Salience of Salience: A Comment on Professor Hazard’s Authority in the Dock’, 69 Boston University Law Review, 481-486.

7100 JUDICIAL ORGANIZATION AND ADMINISTRATION Lewis A. Kornhauser Professor of Law, New York University School of Law © Copyright 1999 Lewis A. Kornhauser

Abstract This chapter surveys the economic literature on the functions and structure of courts. Issues concerning appellate courts and collegiality are addressed in a companion chapter. JEL classification: K4 Keywords: Judicial Administration, Court Organization, Judges, Adjudication

1. Introduction Economic analyses of substantive legal rules generally suppress the adjudication of factual and legal disputes that a legal rule might engender. The nature of adjudication, however, will influence greatly both the content of the substantive law and the costs of dispute resolution. An understanding of the structure of adjudication is thus central to an understanding of the effects of legal rules on behavior and on the identification of socially desirable legal rules. In addition, adjudication is a complex task implemented through institutions that vary across time and jurisdiction. The structure of adjudication and questions of judicial organization and administration thus present a rich field of study in their own right. These two approaches to the study of judicial organization raise different, though equally interesting, questions. As yet, no unitary theory has developed to explain the structure of adjudication. The initial economic analyses of these institutions have raised several important questions: (1) What are the functions of adjudication? (2) Why is adjudication public rather than private? (3) Should there be only one system of courts or should there be many? (4) What is the relation among courts, legislature and executive? (5) How do we explain the organizational features of courts such as their jurisdiction and their hierarchical relation? The questions presented by judicial organization and administration are contiguous with those presented by appeal and supreme courts. I adopt a somewhat arbitrary division of topics and relegate discussions of the reasons for appeal, explanations of hierarchy and collegiality to Chapter 7200 Appeal and Supreme Courts. 27

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2. The Functions of Courts 2.1 What Do Courts Do? Adjudication resolves disputes. Dispute resolution itself consists of at least four different tasks. First, courts must determine the facts of the dispute. Second, they apply the law to those facts. Third, the court may, in some instances, enforce its judgment against one of the parties. Finally, in some instances, the court may have to compel one or more of the parties to submit to the jurisdiction of the court. In some legal systems, the judicial function is limited to these four tasks; in others, courts also make law. In civil law theory, for example, courts simply apply the law announced by legislatures to resolve disputes. Legal theorists in common law countries, by contrast, resolve disputes through the application of law but also promulgate new legal rules; courts thus play a lawmaking function as well. This difference between civil and common law perceptions of adjudication, as well as various structural differences between the two systems, presents a challenge to economic analysts which has yet to be answered. 2.2 Public vs. Private Adjudication Adjudication is commonly considered a quintessential function of government. In recent years, however, there has been a substantial privatization of at least some of these functions through a growing use of arbitration and other ‘private judges’. This phenomenon has prompted scholars to study the extent to which government must supply judicial functions. Landes and Posner (1979) provide one of the earliest inquiries into the choice between private and public provision of adjudicatory services. Working within a common law framework, they identify the judicial functions as both dispute resolution and rule generation. They argue that only the dispute resolution function is suitable for (partial) privatization. Some public provision of dispute resolution might be necessary because (1) enforcement of judgments might require public authority and (2) in some instances, public authority may be necessary to compel one or more parties to submit the dispute to adjudication in the first place. A private market in adjudicatory services, however, would meet all other requirements of a dispute resolution system. They argue that a competitive market would produce competent and impartial judges because both qualities would be necessary to induce all parties to a dispute to consent to adjudication of their dispute by a given judge. Cooter (1983) offers a similar argument. Landes and Posner, however, argue that private provision of rules will not, in general, be desirable. Rule generation is a public good and a private judge who announces a rule will not capture all the benefits that the announcement of a rule creates. Therefore, in a system of private adjudication, rules will be

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undersupplied. In addition, competing judges may generate competing sets of rules. They do not, however, explain why rules cannot be adequately supplied by legislatures. Shavell (1995) considers the choice of private dispute resolution in the context of an established public system of courts. He addresses two questions: why would parties resort to private dispute resolution? and when is it socially desirable? He distinguishes ex ante invocation of private dispute resolution, in which the parties agree prior to the emergence of a dispute to resort to private resolution of their dispute, from ex post invocation of it, in which the resort to these private methods occurs after the dispute arises. He argues that ex ante invocation is socially desirable for three reasons: (1) it may lower the costs and risks of dispute resolution; (2) it may create better incentives to perform because of the greater accuracy of private resolution; and (3) it may reduce the number of litigated disputes. He argues that ex post invocation of private dispute resolution is not desirable.

3. The General Organization of Courts 3.1 Judicial Motivation Economic models of judicial behavior and of court organization require an assumption concerning the motivations of judges. This requirement presents the central challenge to the economic analysis of courts. Several approaches have been adopted, most of which are surveyed here. A supplementary discussion that emphasizes a distinction between ‘team’ and ‘political’ models of judges appears in Chapter 7200 on Appeal and Supreme Courts. The literature has focused primarily on adjudication in common law jurisdictions. This focus has implied that lawmaking is the judicial function that has received the most motivational attention. In this context, the literature has advanced three different types of answers to the question of judicial motivation. First, one can assume that judges meet their obligations as articulated in some jurisprudential theory of adjudication. Put differently, judges ‘follow the law’. Team models, discussed in Section 2 of Chapter 7200 Appeals and Supreme Courts attempt to ground this adherence to norms in a more economic framework. Second, one can assume that judges seek to implement their own policy preferences subject to constraints such as review by other judges or by legislatures. This political model is discussed at greater length in Section 3 of Chapter 7200. Third, one may assume that, as in political models, judges act self-interestedly but define self-interest differently. The literature surveyed here has largely attempted to infer judicial motivation from the structure of incentives within which the judge works.

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Aranson (1990) surveys the political science literature that applies the spatial theory of voting to courts and compares it to law and economics approaches to judicial motivation. He suggests three competing views of judicial motivation. The first, that it is rule governed, parallels the first strand mentioned above and discussed at greater length in Section 2 of Chapter 7200. The second, that judicial motivation is rent redistributing, and the third, that it is wealth maximizing, describe systemic tendencies rather than the motivation of particular judges. One might understand ‘rent redistribution’ consistently with the political model discussed in Section 3 of Chapter 7200. Wealth maximization, by contrast, assumes that Posner’s claim that the common law maximizes wealth can be explained in terms of judicial success in pursuit of their common aim. Posner (1973) sketched an approach to the problem of identification of the preferences of judges. He assumed that judges were self-interested and then briefly examined different incentive structures from which he inferred the underlying preferences of the judges. In particular he compared the structure in many states in which judges lack life tenure and aspire to higher political office to the structure of the federal courts in the United States in which the judges have life tenure. These themes were developed in the subsequent literature. Landes and Posner (1980) argue that utility maximizing judges will primarily seek to maximize their power because their performance is too weakly linked to income and promotion for those concerns to have much effect on judicial behavior. They then adopt the number of times a judge is cited in other cases as a measure of his power. They then argue that judges with higher salaries and more secure tenure will have greater power (and hence be cited more often) because higher salaries both attract more competent judges and reduce the judge’s incentives to distort his decisions and because longer tenure reduces turnover and the influence of politics. They then provide an ingenious test of their hypotheses. They create two samples of common law appellate opinions rendered in 1950. First they looked at all 246 tort, contract and property cases decided by the federal appellate courts under their diversity jurisdiction. Second they drew a random sample of 241 tort, property or contract cases decided by state supreme courts in 1950. The number of cases drawn from a specific state matched the proportion of federal cases decided under the law of that state. They then compared the citation rates of state and federal decisions in the two systems. They found only weak support for their hypothesis concerning higher salary and more secure tenure. Federal decisions were more likely to be cited in the state supreme courts of ‘other’ states (that is, states other than the one of which the federal court applied the law) than the decisions of state courts. Cooter (1983) adopted a procedure similar to that of Landes and Posner (1979). He developed a theory of behavior of private judges and used that as a benchmark from which to infer the preferences of public judges. He argued that both public and private judges would care about their reputations among other

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judges and the bar. Higgins and Rubin (1980) addressed the concern for promotion somewhat more directly. They argued that judges have preferences over policy ‘discretion’ and wealth; these preferences are conditional on their age. They argue that a judge’s ability to satisfy her preferences are constrained in two ways. First, the reversal rate depends on the judge’s policy preferences and the policy preferences of the higher court. Second, wealth depends on the reversal rate (because that affects each judge’s prospect of promotion) and age. They then derive a test for the relative effects of discretion and wealth. They study two samples. The first sample consists of those active district court judges in the eighth federal circuit in 1974 who permitted the release of data on the total number of cases they decided in 1973 and 1974. The second sample consisted of all active district court judges in the fifth federal circuit in 1966. They found that neither age nor seniority explained the reversal rates of the eighth circuit judges. They did find however that the estimated parameter on reversal rate had the predicted sign and was significant at the 10 percent level in a logit estimation of the probability of being promoted. Greenberg and Haley (1986) argue, contrary to the conventional wisdom in general and to Posner (1985) in particular, that low judicial salaries are socially desirable because they signal a greater willingness to accept the non-pecuniary benefits of the judiciary; moreover, they argue that individuals who derive greater non-pecuniary benefits from judging make better judges. Elder (1987) identifies two distinct mechanisms for monitoring judges: political and administrative mechanisms. These mechanisms create different incentives so that one should observe different behaviors in systems with different monitoring mechanisms. Without specifying the judicial objective function precisely, he nevertheless argues that judges deciding criminal cases will produce more trial verdicts under political monitoring than they would under administrative monitoring. He then tests this claim on 1977 data drawn from state criminal courts in 247 districts in seven states. His parameter estimates are consistent with his hypothesis. Cohen (1992) followed up Elder’s approach. He argued that Elder implicitly assumed that each judge sought to maximize his preferences defined in terms of minimizing his workload and his reversal rate. He argues that these preferences also imply that, when the penalty range increases, a judge will increase the penalty of those defendants who request a trial more than they increase the penalty of those who plead guilty. He also argues that judges will be concerned about promotion and that this too will influence the pattern of sentencing. He then considers a sample that consists of all federal antitrust indictments from 1955 through 1980. In 1974, Congress increased the maximum penalties for antitrust violations from $50,000 to $100,000. He finds that promotion concerns are explanatory with respect to fines but not with respect to incarceration.

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Cohen (1991) exploited the data generated by a ‘natural experiment’ presented by the adoption of new sentencing guidelines by the United States federal courts. He examined 196 decisions by federal district courts that considered the constitutionality of the guidelines. He estimated a probit model of the probability of upholding the guidelines as a function of judicial ideology, caseload, promotion potential and the number of prior decisions for constitutionality. Promotion potential was measured by an index that reflected the (per district court judge) number of open seats on the appellate circuit. He found that the parameters on workload and promotion potential had the predicted sign and were highly significant. Katz (1988) adopts a behavioral approach. He assumes that judges decide cases on the basis of the arguments presented to it. Each party offers arguments in its favor and the court decides in favor of the plaintiff if the plaintiff’s arguments, in light of the ‘underlying’ (or, perhaps, ex ante) merits of the case, outweigh the defendant’s arguments and some random error. He then shows that, when cases are more evenly balanced ex ante, expenditures of each party on litigation rise; and, if judicial decision is more random or variable, each party’s expenditures fall. 3.2 Independence of the Judiciary Economic analysts have devoted much attention to explanations for, and implications of, ‘independent’ judiciaries. An independent judiciary is one that is free from external influence, primarily, political influence. This conception of independence is somewhat at odds with the ascription of a political motivation to judges themselves because independence is generally seen as guaranteeing a more ‘objective’ resolution of disputes. Though the literature has not attended much to this specific problem, there are suggestions that a more general model of constitutional structure might justify an independent branch of politically motivated judges. Most industrialized countries assert the independence of their judiciaries but the structures that guarantee independence differ greatly. In the federal system in the United States, for example, judges have life tenure and their (nominal) salaries cannot be decreased during their lifetime. In many states of the United States, however, judges serve for a term of years; moreover, in many states, they may be elected in either partisan or non-partisan elections. In both the state and federal systems, as in common law jurisdictions generally, judges are, however, drawn from the general bar. In many civil law countries by contrast, law graduates choose to enter practice or the judiciary at the outset of their career; a judicial bureaucracy then creates incentives for that judge. The insulation of that bureaucracy from ‘normal’ politics then determines the extent of judicial independence. This institutional variation across jurisdictions permits a comparative study of judicial independence. As a consequence, studies of

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independence, unlike studies in other areas of judicial organization, have been primarily comparative in nature. Landes and Posner (1975) offered the earliest discussion of independence. Their argument rests on the claim that an independent judiciary will, in statutory interpretation, enforce the original legislative understanding. Individual legislatures accede to this practice because they want to increase the time a statute prevails. Landes and Posner then claim that the degree of independence should increase with the size of the jurisdiction because larger jurisdictions provide broader scope for rent-seeking. They then attempt to test their theory on data concerning 97 statutes declared unconstitutional by the United States Supreme Court between 1789 and 1972. Ramseyer (1994) extends the analysis of Landes and Posner (1975) by drawing on a comparison of Japan and the United States. Ramseyer defines judicial independence as the extent to which politicians do not manipulate careers of sitting judges. He asks why some politicians provide an independent judiciary and others do not. He claims that a political structure will provide for an independent judiciary if (i) politicians believe that elections will continue indefinitely and (ii) politicians believe that their prospects of continued victory are low. He then does three case studies: the United States which satisfies both antecedent conditions and has an independent judiciary; contemporary Japan which satisfies the first condition but not the second and does not have an independent judiciary; and imperial Japan which satisfied condition (ii) but not condition (i) and did not have an independent judiciary. Cooter and Ginsburg (1996) also deploy comparative data to study the question of judicial independence. They work with a different conception of independence than Ramseyer. Ramseyer’s definition referred to the structure of appointment, pay, promotion and tenure in the judiciary. Cooter and Ginsburg have a more substantive view of independence; they look to the courts’ ability to make law that diverges from the views of the legislature. They argue that the degree of judicial independence will depend on both political and constitutional features of a society. In particular they argue that societies in which a cohesive party dominates politics will be less likely to have judicial independence. On the other hand, the more ‘legislative vetoes’ that the constitution builds into its political process the more independence the courts have. They then asked experts in comparative law to rank the daringness of the judiciary of various countries. They then regressed daringness on the number of vetoes and the duration of the governing coalition. Despite the small sample size, the parameters on both independent variables had the predicted sign and were statistically significant; moreover they explained a substantial part of the variance.

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3.3 Jurisdiction Case and controversy requirement Courts generally resolve disputes but the dispute must generally be, in some way, ‘live’ and ‘real’. In the United States, this requirement of the existence of a real dispute is embodied in the ‘case or controversy’ requirement of Article III of the Constitution. The requirement, however, is not a peculiarity of United States federal courts. With the exception of some constitutional courts, such as those of France and Germany, that have jurisdiction to issue opinions on the constitutionality of legislation prior to its enactment, most judicial systems require some similar trigger. Why should this be so? And who should be allowed to press a claim concerning a ‘real’ dispute? Jensen, Meckling and Holderness (1986) address this latter question of who should be allowed to press a claim in a live dispute. They argue for limited rules of standing because, they claim, a liberal standing rule increases the costs of engaging in any rule-governed transaction. Landes and Posner (1994) address the first question concerning the justification of a requirement of a concrete case to trigger the adjudicatory power. They extend a model of legal advice developed by Shavell (1988, 1992) and Kaplow and Shavell (1992) to investigate questions concerning the use of attorneys to the question the case or controversy requirement. They focus on the distinction between type 1 and type 2 error - the wrongful attribution of liability to defendants versus the wrongful excusal from liability of defendants. They argue that this distinction can be deployed to explain much of the observed pattern of exceptions to the case or controversy requirement. Specifically, they note that anticipatory adjudication, in violation of the concreteness requirement, increases both errors. They then examine in detail the institutions of declaratory judgments, res judicata, advisory opinions, and preliminary injunctions. Stearns (1995, 1996) argues that the case or controversy requirement serves to restrict the occurrence of cycling that plagues institutions of social choice. For a fuller discussion, see the section on collegiality in Chapter 7200. Specialized courts vs. courts of general jurisdiction Over what disputes should a court have jurisdiction to decide? Two methods for defining the subject matter jurisdiction of courts predominate. First, and most commonly, a court might have jurisdiction over any dispute that arises within a specified geographic area. Virtually all court systems consist primarily of these courts of general jurisdiction. Second, a court might have jurisdiction over disputes with a specified subject matter. Notice that these organizational patterns could be applied to courts of first instance (that find facts as well as apply law) only, to appellate courts only, or to both courts of first instance and to appellate courts. Moreover, in a system with specialized courts of first instance but appeal to

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courts of general jurisdiction, one could limit appeal to a single general court of jurisdiction or one could allocate non-exclusive jurisdiction to a number of appellate courts. In the United States, one may understand the administrative law structure as establishing administrative agencies as specialized courts to determine the facts and make initial legal rulings that are then appealed to courts of general jurisdictions. Thus most labor disputes, welfare disputes and immigration disputes are first heard in administrative agencies and then, if necessary, appealed to the federal courts of appeals. In these instances, each of the federal courts of appeal has jurisdiction to hear appeals from these specialized tribunals. Many environmental disputes, by contrast, may only be appealed to the US Court of Appeals for the DC Circuit. Finally, there are some specialized courts of appeal such as the tax court and the federal circuit for Court of Appeals for the Federal Circuit which has jurisdiction over patent and other intellectual property disputes. What is the appropriate way to allocate jurisdiction among courts? Posner (1985) argues that specialized appellate courts are likely to be more ideological than courts of general jurisdiction because judges on specialized courts are likely to be more focused on the subject matter of their jurisdiction and hence more likely to be sensitive, and responsive, to controversy. Revesz (1990) analyzes the desirability of vesting appellate authority over administrative agencies in specialized courts. His analysis emphasizes the effect of the nature of the appellate court’s jurisdiction on legislative ability to control agencies. He argues that review by specialized courts reduces the effectiveness of congressional delegation to administrative agencies. He develops a simple principal-agent model in which Congress is the principal and the administrative agency the agent. They have different policy preferences because commissioners in agencies have terms that do not correspond to the terms of the commissioners and because there may be a divergence in preferences between Congress and the President who appoints the head of many agencies. Congress has three mechanisms for the control of agencies: it may overrule particular decisions, it may exercise oversight through one or more committees, and it may alter the agency’s budget. Congress, however, might also use the courts to monitor the agency. Revesz argues that a court of general jurisdiction is a better monitor. 3.4 Court Congestion Comparative law scholars have often noted the variation in ‘litigiousness’ across countries. There is little economic literature that seeks to explain this cross-cultural variation but there is a substantial literature analyzing the causes of ‘congestion’ in the courts of one notably litigious society, the United States. Virtually every proposal to reduce court congestion in the United States federal courts recommends the abolition of diversity jurisdiction which grants

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federal courts the authority to resolve disputes between citizens of different states, even when they involve only questions of sate law. One justification for diversity is that it prevents discrimination against out-of-state residents. Goldman and Marks (1980) tested this claim by looking at two samples of attorneys drawn from the US District Court for the Northern District of Illinois in 1976. They randomly sampled 200 attorneys tied to specific questions and asked them their reasons for litigating in federal court. They had a 62 percent response rate. In addition they randomly sampled 205 attorneys from the law division of Cook County District Court in 1976; this court had a $15,000 amount a controversy minimum so that the cases within its jurisdiction were reasonably comparable to those within the jurisdiction of the federal court. This survey had only a 37 percent response rate. Only 40 percent of the attorneys in federal court listed local bias as a reason for choosing federal court. Attorneys drawn from state court cases were asked to consider a hypothetical case identical to the one litigated but in which their client was an out-of-state resident. Roughly 25 percent said they would file in federal court. Local bias thus had very little influence on the choice of forum. Noam (1981) attempts to assess the social cost of court congestion by calculating the effects of congestion on criminal sentences and then on the crime rate. He argues that plea bargain reached between prosecutor and defendant will depend on the caseload of the court. The higher the caseload per judge, the lower the average sentence. Moreover, he argues that the per capita crime rate is a function of the average sentence. Using simple specifications of these functional relations he derives an equation that represents the marginal effect of additional resources devoted to the criminal courts. He then estimates his equation using FBI data on crime rates for four types of crimes against property in the District of Columbia. This estimation yields very high marginal returns to increased investment in the court system.

4. Fact-Finding To resolve disputes, courts must determine the facts. A substantial portion of procedural rules govern the fact-finding process. Each of these rules influences the structure of the judicial system because each influences the cost of litigation relative to the cost of settlement and to self-help remedies. (The literature on evidence and the choice between settlement and litigation are summarized elsewhere in this volume.) Some procedural rules play a more central role in the organization of court systems. In this section, I examine the structure of trials and the use of juries, a characteristic element of many but not all court systems.

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4.1 Sequential vs. Unitary Trials Most disputes present more than one factual issue for resolution. Should these be resolved simultaneously or sequentially? In the United States, factual issues are generally resolved simultaneously, but often the question of liability and the question of remedy are decided sequentially, sometimes by different fact-finders. Landes (1993) presents the primary investigation of this issue. He modifies his own, early model of the choice between settlement and litigation (see Landes, 1971) to analyze several issues concerning the effect of trial structure on the settlement rate. The analysis rests on the insight that a sequential structure to the litigation reduces the expected cost of litigation. Hence, the plaintiff’s incentive to sue increases, which implies that the number of lawsuits will increase. Landes argues further that sequential trials reduce the probability of settlement because they narrow the range of acceptable settlements. 4.2 Juries Many legal systems divide the law-finding (or law-applying) and fact-finding functions of trial courts. These systems delegate fact-finding to a jury, generally a group of lay individuals chosen more or less randomly to decide one case. This procedure raises several questions. Jury selection Bowles (1980) compares the cost of jury trials in Britain to the cost of a system of fact-finding by a three-judge court. The cost of a jury trial consists primarily of the production foregone by persons serving on the jury. Bowles notes that high wage earners will attempt to avoid jury service more vigorously than low wage earners. He concludes that a jury trial will be less expensive if the cost of a judge is more than three times the cost of a juror. He does not, however, correct for the speed of the trial. Martin (1972) also estimates the social cost of the jury system in the United States. He first estimates the occupational distribution of jurors on the assumption that juror days of service are distributed identically to jurors. He then multiplied by the median daily wage rate for each occupation and estimated the social cost at $233 million ( $135 million) in 1958 dollars. He then compares the cost of two systems of jury selection: random selection and a ‘keyman’ procedure in which lists are constructed through consultation with community leaders. He finds that random selection is significantly less expensive because community leaders are more likely to draw jurors from high wage occupations than random selection. Finally Martin argues that voluntary service would reduce costs even further.

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Jury size and jury voting rules Models of jury size and the effects of jury voting rules must specify how juries deliberate and vote. Many models assume no deliberation. Moreover, until recently, the literature assumed that each juror voted conscientiously; her vote expressed her view of the guilt or innocence of the defendant. When one assumes in addition that each juror is more likely than not to decide correctly and that jurors’ judgments are independent of each other, the Condorcet jury theorem applies and one can easily show first, that a unanimity rule minimizes the probability of wrongful convictions; second, that majority rule maximizes the probability of a correct decision; and third, that, as the number of jurors increases, the probability of wrongful conviction under a unanimity rule decreases towards zero and the probability of a correct decision under majority rule increases towards one. Recently, however, analysts have introduced models of strategic voting by jurors and these models yield dramatically different results. Austen-Smith and Banks (1996) and Feddersen and Pesendorfer (1996) show how radically the assumption of strategic behavior by jurors undermines the Condorcet Jury Theorem. When a juror acts strategically, the information aggregation feature of the Condorcet Jury Theorem disappears because each juror now decides how to cast her vote in light only of those instances in which her vote will be pivotal. As a consequence, as Austen-Smith and Banks show clearly, a juror’s vote may not reveal her actual view concerning the case. Feddersen and Pesendorfer show, more dramatically, that the probability of wrongful conviction may be higher under a unanimity rule than under a different voting rule. These models raise important questions about the appropriate way in which to model juries. These questions parallel those presented in the study of collegial courts, discussed in Chapter 7200, where team models in which judges act in a fashion somewhat analogous to the assumption underlying the naive Condorcet Jury Theorem models contend with political models in which judges act strategically. In the United States, until the 1970s, juries typically consisted of twelve individuals and required unanimity to render a verdict. Then, the United States Supreme Court ruled that neither the number twelve nor unanimity were constitutionally required in state criminal proceedings. These decisions spurred research into the importance of these requirements. Klevorick and Rothschild (1979) provide a model of jury deliberation in order to determine whether non-unanimous juries or unanimous juries of fewer than twelve jurors would yield different verdicts than the ‘standard’, twelve-person unanimous jury. Their analysis uses a stationary Markov model to provide a dynamic model of the majority persuasion hypothesis, derived from Kalven and Zeisal (1966), that the final verdict is the same as the majority position on the first ballot. They offer both a discrete and continuous model of

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jury deliberation. The cores of the models are identical. The jurors enter the jury room with a view on the merits and cast an initial ballot. The vote then changes incrementally as time passes with one person changing her vote at each instant until unanimity is reached. The transition probabilities are given by the current vote: the probability of one more vote for the plaintiff equals the percentage of jurors who favor the plaintiff’s case. In this model one can calculate both the expected number of jury ballots until unanimity is reached (conditional on the initial vote) and the probability that a non-unanimous jury will agree with a unanimous one. Klevorick and Rothschild show that a move to a requirement of ten votes for judgment rather twelve always alters the probability of conviction by less than 0.0055. Their result, of course, depends critically on the manner in which majority pressure operates in the jury room. When they adopt a different assumption concerning transition probabilities, they calculate that the move to ten for judgment may lead to as many as 1/6 of the cases decided differently. Klevorick and Rothschild also show that this shift substantially reduces the expected number of ballots prior to judgment. Schwartz and Schwartz (1992, 1995, 1996) offer a somewhat different approach to jury decision making. The earliest paper addresses three questions concerning the decision rules of juries. First, why do juries fail to reach a verdict? Second, what verdict will a jury reach when it may convict for lesser included offenses or when multiple offenses are litigated simultaneously? Third, how, if at all, will the jury decision rule alter the charges filed by prosecutors? To this end, they assume that a defendant might be charged with any number of counts within some interval. They consider two regimes. In one the prosecutor chooses one count in the interval, and the jury must choose among three outcomes, conviction on that count, acquittal, or no decision. In the second regime, the prosecutor chooses two counts, one entailing a lesser punishment than the other, and the jury chooses among four outcomes, acquittal on both counts, conviction on the lesser count, conviction on the more severe count, or no decision. In the event of no decision, a retrial before a different jury occurs. Each jury consists of four people, chosen randomly from a population. Each potential juror is an expected utility maximizer, characterized by spatial ‘preferences’ for punishment of the defendant; that is, each juror has an ideal outcome that represents the crime for which she believes the defendant should be convicted. The simple model implies that a defendant always prefers a non-unanimous, super-majority rule to unanimity because his expected verdict is lower under the non-unanimous rule. This result occurs because, though the probability of conviction is greater under non-unanimity, the probability of acquittal rises more rapidly. When the jury may convict on a lesser included offense, the analysis is more complex and less clear-cut. Schwartz and Schwartz (1995) extend the analysis of their prior article in the context of the liability and punishment phases of capital offenses in the

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United States. They argue that the decision process for fact finding has three elements: the voting rule, the jury selection process, and the characterization of the set of outcomes among which the jury may choose. They argue that, in a multi-stage fact-finding process, the voting rule must be the same in each stage in order to avoid the jury at one stage nullifying the law governing the jury at a different stage. In addition, only reciprocal voting rules will avoid hung juries (where a rule is reciprocal if ‘conviction’ requires c of n votes then ‘acquittal’ requires n - c of n votes). Schwartz and Schwartz (1996) carries the argument of the prior two papers further. They argue that any voting rule should satisfy at least two properties: (1) it should be decisive; and (2) it should satisfy the ‘one person/one vote’ criterion. This second property does not eliminate any anonymous voting rule, whether majority, supermajority, or submajority. (Super and submajority rules would violate neutrality). The first criterion identifies majority rule as the unique decisive voting rule when there are only two possible outcomes. To satisfy the desire to minimize wrongful convictions that the unanimity rule is said to promote, Schwartz and Schwartz argue that the size of the jury should be increased perhaps to 15.

5. Concluding Remarks Economic analysis of judicial organization and administration, though it has greatly increased understanding, is only in its infancy. No question has received an exhaustive treatment and many have not been examined at all. This area suggests a multitude of comparative questions, most of which have not received any attention at all. They are ripe for analysis.

Bibliography on Judicial Organization and Administration (7100) Aranson, Peter H. (1990), ‘Models of Judicial Choice as Allocation and Distribution in Constitutional Law’, Brigham Young University Law Review, 794-826. Austen-Smith, David and Banks, Jeffrey S. (1996), ‘Information Aggregation, Rationality and the Condorcet Jury Theorem’, 90(1) American Political Science Review, 34-45. Backhaus, Jurgen (1992), ‘General Legislation and the Budget: Commentary’, 12 International Review of Law and Economics, 209-210. Barnard, David (1977), The Civil Court in Action, Butterworths, London, 350 ff. Bowles, Roger A. (1980), ‘Juries, Incentives and Self-Selection’, 20 British Journal of Criminology, 368-376. Brunet, Edward (1985), ‘Measuring the Costs of Civil Justice’, 83 Michigan Law Review, 916-938. Casper, Gerhard and Posner, Richard A. (1974), ‘A Study of the Supreme Court’s Caseload’, 3 Journal

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of Legal Studies, 339-375. Casper, Gerhard and Posner, Richard A. (1976), The Workload of the Supreme Court, Chicago, American Bar Foundation. Casper, Gerhard and Zeisel, Hans (1972), ‘Lay Judges in the German Criminal Courts’, 1 Journal of Legal Studies, 135-191. Cohen, Mark A. (1991), ‘Explaining Judicial Behavior or What’s ‘Unconstitutional’ about the Sentencing Commission?’, 7 Journal of Law, Economics, and Organization, 183-199. Cohen, Mark A. (1992), ‘The Motives of Judges: Empirical Evidence from Antitrust Sentencing’, 12 International Review of Law and Economics, 13-30. Cooter, Robert (1983), ‘The Objectives of Private and Public Judges’, 41 Public Choice, 107-132. Cooter, Robert and Ginsburg, Tom (1996), ‘Comparative Judicial Discretion: An Empirical Test of Economic Models’, 16 International Review of Law and Economics, 245-313. Ebner, P. (1982), Reducing Pretrial Delay... A Look at What State and Local Courts Are Doing to Break the Logjam, Santa Monica, Rand Institute of Civil Justice. Elder, Harold W. (1987), ‘Property Rights Structures and Criminal Courts: An Analysis of State Criminal Courts’, 7 International Review of Law and Economics, 21-32. Feddersen, Timothy J. and Pesendorfer, Wolfgang (1996), ‘Convicting the Innocent: The Inferiority of Unanimous Jury Verdicts’, Northwestern University Center for Mathematical Studies in Economics and Management Science Discussion Paper No. 1170. Feeley, Malcolm (1983), Court Reform on Trial: Why Simple Solutions Fail, New York, Basic Books, 251 ff. Flanagan, Robert J. (1987), Labor Relations and the Litigation Explosion, Washington, DC, Brookings Institution, 122 ff. Friedman, David (1979), ‘Private Creation and Enforcement of Law: A Historical Case’, 8 Journal of Legal Studies, 399-415. Galanter, Marc (1986), ‘The Day After the Litigation Explosion’, 46 Maryland Law Review, 3 ff. Gely, Rafael and Spiller, Pablo T. (1990), ‘A Rational Choice Theory of Supreme Court Statutory Decisions with Applications to the State Farm and Grove City Cases’, 6 Journal of Law, Economics, and Organization, 263-300. Gillespie, Robert W. (1976), ‘The Production of Court Services: An Analysis of Scale Effects and Other Factors’, 5 Journal of Legal Studies, 243-265. Goldman, Jerry, Hooper, Richard L. and Mahaffey, Judy (1976), ‘Caseload Forecasting Models for Federal District Courts’, 5 Journal of Legal Studies, 201-242. Goldman, Jerry and Marks, Kenneth S. (1980) ‘Diversity Jurisdiction and Local Bias: A Preliminary Empirical Inquiry, 9 Journal of Legal Studies, 93-104 Gravelle, Hugh S.E. (1983), ‘Judicial Review and Public Firms’, 3 International Review of Law and Economics, 187-205. Greenberg, Paul E. and Haley, James A. (1986), ‘The Role of the Compensation Structure in Enhancing Judicial Quality’, 15 Journal of Legal Studies, 417-426. Griffiths, J. (1991), ‘De Rechtbank als Fietsenfabriek’ (The Court as Bicycle Manufacturer)’, 66 Nederlands Juristenblad, 129-130, 445. Hazard, Geoffrey C., Jr (1965), ‘Rationing Justice’, 8 Journal of Law and Economics, 1-10. Higgins, Richard A. and Rubin, Paul H. (1980), ‘Judicial Discretion’, 9 Journal of Legal Studies,

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129-138. Jensen, Michael, Meckling, William H. and Holderness, Clifford (1986), ‘Analysis of Alternative Standing Doctrines’, 6 International Review of Law and Economics, 205-216. Kalven, Harry and Zeisal, Hans (1966), The American Jury, Boston, Little Brown. Kaplow, Louis and Shavell, Steven (1992), ‘Private vs Socially Optimal Provision of Ex Ante Legal Advice’, 8 Journal of Law Economics and Organization, 306-320. Karotkin, Drora (1994), ‘Effect of the Size of the Bench on the Correctness of Court Judgments: The Case of Israel’, 14 International Review of Law and Economics, 371-75. Katz, Avery (1988), ‘Judicial Decision Making and Litigation Expenditures’, 8 International Review of Law and Economics, 127-143. Klevorick, Alvin K. (1977), ‘Jury Composition: An Economic Approach’, in Siegan, Bernard H. (ed.), The Interactions of Economics and the Law, Lexington, Lexington Books. Klevorick, Alvin K. and Rothschild, Michael (1979), ‘A Model of the Jury Decision Process’, 8 Journal of Legal Studies, 141-164. Kornhauser, Lewis A. and Sager, Lawrence G. (1986), ‘Unpacking the Court’, 96 Yale Law Journal, 82-117. Landes, William M. (1971), ‘An Economic Analysis of the Courts’, 14 Journal of Law and Economics, 61-107. Landes, William M. (1993), ‘Sequential versus Unitary Trials: An Economic Analysis’, 22 Journal of Legal Studies, 99-134. Landes, William M. and Posner, Richard A. (1975), ‘The Independent Judiciary in an Interest Group Perspective’, 18 Journal of Law and Economics, 875 ff. Landes, William M. and Posner, Richard A. (1979), ‘Adjudication as a Private Good’, 8 Journal of Legal Studies, 235-284. Landes, William M. and Posner, Richard A. (1980), ‘Legal Change, Judicial Behavior and the Diversity Jurisdiction’, 9 Journal of Legal Studies, 367 ff. Landes, William M. and Posner, Richard A. (1994), ‘The Economics of Anticipatory Adjudication’, 23 Journal of Legal Studies, 683-720. Levin, Martin A. (1975), ‘Delay in Five Criminal Courts’, 4 Journal of Legal Studies, 83-131. Martin, Donald L. (1972), ‘The Economics of Jury Conscription’, 80 Journal of Political Economy, 680-702. Melumad, Nahum D. and Thoman, Lynda (1990), ‘On Auditors and the Courts in an Adverse Selection Setting’, 28 Journal of Accounting Research, 77-120. Miller, Arthur R. (1984), ‘The Adversary System: Dinosaur or Phoenix’, 69 Minnesota Law Review, 1-37. Miller, Geoffrey P. (1989), ‘Comment: Some Thoughts on the Equilibrium Hypothesis’, 69 Boston University Law Review, 561-568. Noam, Eli M. (1981), ‘A Cost-benefit Model of Criminal Courts’, 3 Research in Law and Economics, 173-183. Noll, Roger G. (1992), ‘Judicial Review and the Power of the Purse: Comment’, 12 International Review of Law and Economics, 211-13. Pastor, Santos (1990a), ‘Economìa de la Justicia (I) y (II)’ (Economics of the Judicature), 5 and 6 Revista de Economìa Pública. Pastor, Santos (1990b), ‘Economìa de la Justicia en España (The Spanish Courts and the Economic

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Analysis)’, Revista de Economìa, 4 ff. Pastor, Santos (1991), ‘Informe sobre la Litigación, Recursos y Acceso de los Cuidadanos a la Justicie’ (Report on Litigation, Courts Inputs and Access to Justice)’, In Ministerio De Justicia, Materiales para una Reforma Procesal, Madrid. Posner, Richard A. (1973), ‘An Economic Approach to Legal Procedure and Judicial Administration’, 2 Journal of Legal Studies, 399-458. Posner, Richard A. (1983), ‘Will the Federal Courts of Appeals Survive until 1984? An Essay on Delegation and Specialization of the Judicial Function’, 56 Southern California Law Review, 761-791. Posner, Richard A. (1984), ‘The Meaning of Judicial Self-Restraint’, 59 Indiana Law Journal, 1-24. Posner, Richard A. (1985), The Federal Courts: Crisis and Reform, Cambridge, Harvard University Press, 365 p. Posner, Richard A. (1986), ‘The Summary Jury Trial and Other Methods of Alternative Dispute Resolution: Some Cautionary Observations’, 53 University of Chicago Law Review, 366-393. Posner, Richard A. (1989), ‘Coping with the Caseload: A Comment on Magistrates and Masters’, 137 University of Pennsylvania Law Review, 2215-2218. Priest, George L. (1989), ‘Private Litigants and the Court Congestion Problem’, 69 Boston University Law Review, 527-559. Ramseyer, J. Mark (1994), ‘The Puzzling (In)dependence of Courts: A Comparative Approach’, 23 Journal of Legal Studies, 721-47. Revesz, Richard L. (1990), ‘Specialized Courts and the Administrative Lawmaking System’, 138 University of Pennsylvania Law Review, 1111 ff. Scheiner, Alan Howard (1991), ‘Judicial Assessment of Punitive Damages, the Seventh Amendment, and the Politics of Jury Power’, 91 Columbia Law Review, 142-226. Schwartz, Edward P. and Schwartz, Warren F. (1992), ‘Decision making by Juries Under Unanimity and Supermajority Voting Rules’, 80 Georgetown Law Journal, 775-907. Schwartz, Edward P. and Schwartz, Warren F. (1995), ‘Deciding Who Decides Who Dies: Capital Punishment as a Social Choice Problem’, 1 Legal Theory, 113-148. Schwartz, Edward P. and Schwartz, Warren F. (1996a), Simple Majority Rule for Criminal Jury Trials: The Verdict is Now In, manuscript. Schwartz, Edward P. and Schwartz, Warren F. (1996b), ‘The Challenge of Peremptory Challenges’, 12 Journal of Law, Economics and Organization, 325 ff. Shanley, Michael G. (1991), ‘The Distribution of Posttrial Adjustments to Jury Awards’, 20 Journal of Legal Studies, 463-481. Shavell, Steven (1988), ‘Legal Advice about Contemplated Acts: The Decision to Obtain Advice, Its Social Desirability, and Protection of Confidentiality’, 17 Journal of Legal Studies, 123-150. Shavell, Steven (1992), ‘Liability and the Incentive to Obtain Information about Risk’, 21 Journal of Legal Studies, 259-270. Shavell, Steven (1995), ‘Alternative Dispute Resolution: An Economic Analysis’, 24 Journal of Legal Studies, 1-28. Sociaal Cultureel Planbureau (1990), Doelmatig Rechtspreken (Efficient Administration of Justice), S.C.P. 88, ’s-Gravenhage, Staatsdrukkerij, 74 ff. Stearns, Maxwell (1995), ‘Standing Back from the Forest: Justiciability and Social Choice’, 83 California Law Review, 1309-1413.

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Stearns, Maxwell (1996), ‘How Outcome Voting Promotes Principled Issued Identification: A Reply to Professor John Rogers and Others’, 49 Vanderbilt Law Review, 1045-1067. Straussman, Jeffrey D. (1986), ‘Courts and Public Purse Strings: Have Portraits of Budgeting Missed Something?’, 4 Public Administration Review, 315-351.

7200 APPEAL AND SUPREME COURTS Lewis A. Kornhauser Professor of Law, New York University School of Law © Copyright 1999 Lewis A. Kornhauser

Abstract This chapter surveys the economic literature on judicial appeals and collegiality of courts. More general issues concerning judicial administration and court organization are surveyed in a companion chapter. JEL classification: K4 Keywords: Appellate Courts, Appeals, Adjudication, Supreme Courts

1. Introduction This chapter reviews the literature concerning several issues raised in the economic analysis of appeal and of supreme courts. These issues overlap those considered in Chapter 7100, Judicial Organization and Administration. Appellate courts in general and supreme courts in particular exist only in hierarchically organized court systems. Most of the literature has focused on courts in common law countries. Indeed, most models that extend beyond the simplest features of adjudication do so in the context of the political system of the United States. This review consequently shares the parochial focus of the literature. Analyses of appeal in civil law systems and in the context of different political systems would greatly advance understanding of the subject as they often present different institutional features. At least some civil law systems, for example, allow an appellate court to make an independent assessment of the facts of the case, a judgment denied common law courts. Similarly, the highest courts in some civil law jurisdictions hear substantially more cases than the highest courts in common law countries, a fact that may explain, or be explained by, differences in precedential practice and in the style and content of judicial opinions. 2. Explanations of Hierarchy Appeal, and supreme courts, only arise in court systems which are organized hierarchically. Why does hierarchy occur? Posner (1985) suggested that the primary function of a supreme court was law creation and the insurance of 45

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uniformity of application of law among the lower courts. In addition, he argued that, in the United States, concerns about unreviewable power implied that trial courts would be subject to some supervision. These ideas have not been much elaborated in the literature. Rather, two distinct research strategies have emerged from two different models of adjudication. The ‘team’ model assumes that all judges in the system share a common objective function - to maximize the number of ‘correct’ decisions rendered by the system. Hierarchy emerges because it somehow promotes the goal of error minimization. The ‘political’ (or ‘principal-agent’) model assumes that judges differ in their objective functions. Hierarchy arises in this model so that the small set of politically dominant judges can enforce their views on recalcitrant judges lower in the hierarchy. Kornhauser (1995) provides an informal team model that explicitly addresses the question of the optimal organization of n judges into a judicial system. Judges share the goal of minimizing the number of errors; the likelihood of a correct decision depends on the amount of effort the judge invests in deliberation on the case. Moreover, deliberation on a specific case also provides a signal about the correct resolution of ‘nearby’ cases. Because the court faces a resource constraint, the question of optimal organization of judges arises. Kornhauser argues that, in appropriate circumstances, a hierarchy will emerge in which there is (a) division of labor between trial judges who find facts and appellate judges who determine the law; and (b) strict vertical stare decisis so that lower court judges will always adhere to the decisions of higher court judges. Models of hierarchy that emphasize the need for consistency as in Rogers (1995) and Dorf (1995) are team models in which the ‘correct decision’ requires consistency.

3. Team Models of Error Correction Shavell (1995) is the earliest formal model of error correction. Shavell assumes that the state must decide first, whether to establish both trial and appellate courts or trial courts only; and second, how many resources to devote to each level of court that it establ