Private Law Theory

ABSTRACT
The fundamental originating principle of law and economics (‘L&E’) is that legal decisions should be (and are) based on maximizing efficiency. But L&E proponents do not define ‘efficiency’ as Pareto Efficiency – the way agreed to by most economists. A Pareto optimal condition is obtained when no one can be made better off without making someone worse off. Pareto Improvements are win-win changes where no losers exist. In the judicial system, however, there are always winners and losers, because under Article III § 2 of the Constitution a legal case does not exist unless there is a justiciable ‘case or controversy’ in need of resolution. Unable to use Pareto Efficiency, L&E scholars have been forced to adopt alternative definitions of efficiency. Most L&E scholars claim to define ‘efficiency’ based on the work of Kaldor and Hicks, but (perhaps unwittingly) instead use a definition of ‘efficiency’ derived from the 19th century idea of consumer surplus, which encompasses L&E notions such as ‘wealth maximization’, and ‘consumer welfare’ in antitrust. Neither of these alternative definitions is viable, however. Outside of L&E, the Kaldor-Hicks approach has long been recognized to be riddled with logical inconsistencies and ethical failures, and the surplus approach is even more deficient. Remarkably, virtually none of the numerous L&E textbooks even hint at such problems. Critically, all definitions of efficiency improvements in L&E are biased in favor of wealthy individuals or firms, because they are dependent on the status quo ante distribution of assets. Many L&E practitioners treat efficiency improvements instead as being objectively good, an error revealing that L&E is primarily motivated by its neoliberal policy agenda. This article makes three contributions to the L&E literature: (1) it explains that the Kaldor Test is different from the Hicks Test, and explains that this difference generates serious obstacles to using the ‘Potential Pareto’ approach to identify good public policy; (2) it shows that antitrust generally does not actually use the Kaldor-Hicks approaches, but rather the older approach of Alfred Marshall’s consumer surplus, and shows what is problematic about that approach; and (3) it shows that most L&E textbooks discuss none of the many problems of making social decisions using ‘Potential Pareto’ or consumer surplus criteria, evasion made possible by teaching the criteria in superficial ways.

Glick, Mark A and Lozada, Gabriel and Bush, Darren, Law and Economics Fallacies: What Modern Economics Really Says About the Definition of Efficiency and the Measurement of Welfare (August 11, 2024).