C. METHODOLOGY
II. F UNDAMENTAL ASSUMPTIONS OF THE ECONOMIC ANALYSIS OF LAW
3. Social choice theory
Assuming that the consequences of regulatory changes can be determined accu-rately, social choice theory offers different concepts that allow for a comparison of different market outcomes with regard to the socially preferable one.47 Yet, there is not one unique concept that yields the social optimum of a decision problem. Depending on the definition of criteria the optimum shall fulfill, different value judgments are made in social choice theories.48 The most important ones will be introduced briefly in the following sections:49
43 Richard A. Posner, Economic Analysis of Law (Boston: Little, Brown and Company, 1992), 4.
44 Hans-Bernd Schäfer and Claus Ott, The Economic Analysis of Civil Law (Cheltenham: Edward Elgar Publish-ing Limited, 2004), 52, 55.
45 With reference to Nobel Laureate John Harsanyi: Ibid, 54.
46 Richard A. Posner, Economic Analysis of Law (Boston: Little, Brown and Company, 1992), 4.
47 Hans-Bernd Schäfer and Claus Ott, The Economic Analysis of Civil Law (Cheltenham: Edward Elgar Publish-ing Limited, 2004), 20.
48 Ibid, 21.
49 Besides these two important criteria, a lot of other decision rules have been developed in the social sci-ences, e.g. the concept of utilitarianism going back to Jeremy Bentham. These alternative concepts, however, will not be discussed here because the following analysis is based on the widely accepted deckision rules pro-posed by Pareto and Kaldor-Hicks.
▪ The Pareto criterion (Pareto efficiency), and
▪ the Kaldor-Hicks criterion (Social welfare).
a) The Pareto criterion
Vilfredo Pareto was one of the first economists to study the comparison of different market outcomes.50 He formulated what took later on his name as the Pareto principle51:
“Consider two social states, x and y, each of which is a complete descrip-tion of the society and the situadescrip-tion of each individual in it. Then if each member of society prefers x to y or is indifferent between x and y and at least one member prefers x to y, then x is socially preferable to y. Social choices that fulfill this condition are known as Pareto superior or Pareto improvements.”52
The concept of Pareto allocative efficiency can be derived directly from this definition: A situation is Pareto efficient, if it is impossible to change the social status in order to make one person better off without making another individual in the society worse off.53 Hence, according to the definition of Pareto, only situations where no Pareto improvements are possible can be Pareto efficient.54 Yet, a Pareto efficient market outcome does not strin-gently describe a socially just one.55 Notably, Pareto efficiency does not reflect the distri-bution of welfare in society. Instead, an allocation of all goods and resources satisfies the conditions of the Pareto principle, even though this result is not considered a reasonable allocation.56 In the end, Pareto efficiency is a desirable end in social choice – yet, further criteria are needed to choose between different Pareto efficient allocations of one social state and ensure welfare distribution.57
50 Hal R. Varian, Intermediate Microeconomics (New York: W.W. Norton & Company, 2006), 15.
51 This refers to the term “Pareto principle” used as synonym for Pareto efficiency and should not be confused with the statistical phenomenon known as the “80-20 rule”.
52 Hans-Bernd Schäfer and Claus Ott, The Economic Analysis of Civil Law (Cheltenham: Edward Elgar Publish-ing Limited, 2004), 22.
53 Robert Cooter and Thomas Ulen, Law & Economics (Boston: Pearson Education, Inc., 2008), 17.
54 Hal R. Varian, Intermediate Microeconomics (New York: W.W. Norton & Company, 2006), 15.
55 Hans-Bernd Schäfer and Claus Ott, The Economic Analysis of Civil Law (Cheltenham: Edward Elgar Publish-ing Limited, 2004), 23.
56 Hal R. Varian, Intermediate Microeconomics (New York: W.W. Norton & Company, 2006), 613.
57 Ibid. Also Hans-Bernd Schäfer and Claus Ott, The Economic Analysis of Civil Law (Cheltenham: Edward Elgar Publishing Limited, 2004), 28-29.
Therefore, economists have been developing alternative concepts that allow for a distri-bution of welfare across people, the most important one being the Kaldor-Hicks criterion58 presented in the next subsection.
b) The Kaldor-Hicks criterion
In 1939, Nicholas Kaldor and John Hicks proposed an alternative decision rule. The criterion later named after its originators is the following:
“A social state x is distinguished from a social state y in that at least one member of the society prefers x to y and that at least one member prefers y to x. The social state x is superior to y if, and only if, those who prefer x can compensate those who prefer y so that they remain indifferent be-tween x and y and those who prefer x are still better off in x than in y.”59
In short, this decision rule prefers a social state over another if the benefitted group can virtually compensate the disadvantaged group and still have a net advantage.60 As the term “virtual” implies, the compensation does not actually have to be paid. The denomi-nation of the Kaldor-Hicks criterion as “potential Pareto superiority” illustrates this point precisely.61 Instead, the technique of cost-benefit-analysis can be applied:62 Adding the gains of all people in society and subtracting the accumulated losses from a change in social state yields a result that supports the change if it is positive, thus the benefits exceed the cost.63
The Kaldor-Hicks criterion, therefore, allows for the maximization of wealth of the society as a whole.64 This approach is the basis of the field of welfare economics and will be used in this work to compare the different market outcomes from an economic point of view.
The concept does not answer, however, questions of justice and ethical or social desira-bility with regard to the different market outcomes.65 Anyhow, consensus for a social con-tract under the Kaldor-Hicks criterion can be justified with the notion of general compen-sation: Even if there is no compensation paid in individual cases, society benefits from the
58 Robert Cooter and Thomas Ulen, Law & Economics (Boston: Pearson Education, Inc., 2008), 47.
59 Hans-Bernd Schäfer and Claus Ott, The Economic Analysis of Civil Law (Cheltenham: Edward Elgar Publish-ing Limited, 2004), 30.
60 Robert Cooter and Thomas Ulen, Law & Economics (Boston: Pearson Education, Inc., 2008), 47.
61 Richard A. Posner, Economic Analysis of Law (Boston: Little, Brown and Company, 1992), 14.
62 Robert Cooter and Thomas Ulen, Law & Economics (Boston: Pearson Education, Inc., 2008), 47.
63 Jonathan Gruber, Public Finance and Public Policy (New York: Worth Publishers, 2007), 202.
64 Hans-Bernd Schäfer and Claus Ott, The Economic Analysis of Civil Law (Cheltenham: Edward Elgar Publish-ing Limited, 2004), 31.
65 Richard A. Posner, Economic Analysis of Law (Boston: Little, Brown and Company, 1992), 14.
application of the Kaldor-Hicks criterion in the long run through a form of general com-pensation stemming from a higher level of wealth in this society. A higher level of wealth, consequentially, benefits all members of a society. Ultimately, the Kaldor-Hicks decision rule results in every individual decision being Pareto-superior.66
The analysis, therefore, does not pursue redistributive goals in the first place. Instead, the presented decision rules by Pareto and Kaldor-Hicks focus on efficient resource allocation in society in order to maximize the welfare of society as a whole. The restriction of the analysis to efficiency considerations is justified with the argument put forward by Cooter and Ulen (2008):67
▪ Imprecise targeting of redistribution by private legal rights,
▪ problems with the prediction of distributive effects of private law,
▪ high transaction costs from the redistribution through private law, and
▪ distortions of the economy from redistributions by private law.
For these reasons, private law is no desirable basis for the redistribution of wealth.68 How-ever, there are some limitations to this approach. The next section will highlight the weak-nesses and criticism to the methodology of the economic analysis of law.