Law and Economics Papers

Did Reform of Prudent Trust Investment Laws Change Trust Portfolio Allocation?

Max M. Schanzenbach et al. — Wed, 07 Dec 2005 11:38:24 PST

This paper investigates the effect of changes in state prudent trust investment laws on asset allocation in noncommercial trusts. The old prudent man rule favored “safe” investments

such as government bonds and disfavored “speculation” in stock. The new prudent investor rule, now widely adopted, relies on modern portfolio theory, freeing the trustee to invest based on risk and return objectives reasonably suited to the trust and in light of the composition of the trust portfolio as a whole. Using state- and institution-level panel data from 1986-1997, we find that after a state’s adoption of the new prudent investor rule, trust institutions held about 1.5 to 4.5 percentage points more stock at the expense of “safe” investments.

Accordingly, we conclude that trustees are sensitive to changes in trust fiduciary law. Even though trust investment laws are nominally default rules, such rules matter in the presence of

agency costs and unreliable judicial enforcement of opt outs.

Facilitating Scientific Research: Intellectual Property Rights and the Norms of Science - A Response to Rai and Eisenberg

Scott F. Kieff — Thu, 02 Jun 2005 09:40:22 PDT

Arti Rai's article in the Fall 1999 issue of the Northwestern University Law Review explores the proper use of both legal rules and prescriptive norms to shape behavior in the basic biological research community. Rai's article builds upon the extensive work in this area by Rebecca Eisenberg, which first attained prominence through Eisenberg's article in the December 1987 issue of the Yale Law Journal. Eisenberg concludes that the use of patents in the area of basic biological research may frustrate central norms of the community. Rai prescribes concerted public and private action as the best tools for avoiding patents and the problems Eisenberg attributes to them. This essay responds to patent critics like Rai and Eisenberg by showing how patents are essential for promoting the central norms of the basic biological research community.

Counting Guns in Early America

James T. Lindgren et al. — Thu, 02 Jun 2005 09:40:21 PDT

The picture of gun ownership that emerges from these analyses directly contradicts the assertions of Michael Bellesiles in Arming America: The Origins of a National Gun Culture (2000). Contrary to Arming America's claims about probate inventories in 17th and 18th century America, there were high numbers of guns, guns were much more common than swords or other edge weapons, women in 1774 owned guns at rates (18%) higher than Bellesiles claimed men did in 1765-90 (14.7%), and 83-91% of gun-owning estates listed at least one gun that was not old or broken. The authors replicated all the portions of Bellesiles' published study where he both counted guns in probate inventories and cited sources containing inventories. They conclude that Bellesiles appears to have substantially misrecorded or misremembered the 17th and 18th century probate data he presents.

Real Time: Governing the Market After the Failure of Knowledge

Annelise Riles — Thu, 02 Jun 2005 09:40:20 PDT

This paper presents an ethnographic account of the work of bureaucrats at the Bank of Japan, Japan's central bank, as they engaged in the construction of a "real time" payments system. The paper aims to consider certain shared dimensions of the knowledge practices of late modern anthropologists and economic planners and the special challenges these pose to the study of modern knowledge. In particular, the paper focuses on the effects of the attraction of "self-sustaining systems" consisting of "two sides." It concludes that one central challenge of new ethnographic subjects such as global financial markets is to find ways of ethnographically apprehending dimensions of modern knowledge that do not present themselves as steps or elements in the construction or destruction of systems, or as phenomena that can be seen from two sides.

The Use of 'Most-Favored-Nation' Clauses in Settlement of Litigation

Kathryn E. Spier — Thu, 02 Jun 2005 09:40:18 PDT

Many settlement agreements in lawsuits involving either multiple plaintiffs or multiple defendants include so-called "most-favored-nation" clauses. If a defendant facing multiple claims, for example, settles with some plaintiffs early and settles with additional plaintiffs later for a greater amount, then the early settlers will receive the more favorable terms as well. These MFN provisions have been prominent in the recent MP3.com case, as well as tobacco litigation, class actions, and many antitrust lawsuits. This paper considers a defendant who is facing a large group of heterogeneous plaintiffs. Each plaintiff has private information about the (expected) award that he or she will receive should the case go to trial. MFN clauses are valuable because they commit the defendant not to raise his offer over time. This has two important effects. First, holding overall settlement rate fixed, MFNs encourage earlier settlement. Second, depending upon the distribution of plaintiff types, MFNs can either increase or decrease the overall settlement rate. Social welfare implications are discussed, and alternative theories, including the strategic use of MFNs to extract value from future plaintiffs, are explored.

Roundtable Discussion: Corporate Governance

William J. Carney et al. — Thu, 02 Jun 2005 09:40:16 PDT

This is a transcript of a roundtable discussion between Robert Pritzker of The Marmon Group, Inc., Vice-Chancellor Jack Jacobs of the Delaware Court of Chancery, and Law Professors William Carney, Richard Painter, and Robert Sitkoff, with Professor Carney serving as moderator. The general topic was corporate governance. Among other things the participants discussed the implications of information provided by Mr. Pritzker regarding Smith v. Van Gorkom. Mr. Pritzker stated that the $55 price and the one-week deadline were established by Jerry Van Gorkom, not the Pritzkers. Mr. Pritzker also described the terms and the motivations for the Pritzkers' contribution to the settlement. Finally, in addition to analysis of the Van Gorkom decision, the panel also discussed public and private boards of directors, the Caremark decision, and corporate charitable and political contributions. The roundtable was held under the auspices of the Theory Informs Business Practices Symposium at the Chicago-Kent College of Law on April 6, 2001.

Access to Networks: Economic and Constitutional Connections

Daniel F. Spulber et al. — Thu, 02 Jun 2005 09:40:14 PDT

A fundamental transformation is taking place in the basic approach to regulating network industries. Policy makers are in the process of abandoning their century-old commitment to rate regulation in favor of a new regulatory approach known as access regulation. Rather than controlling the price of outputs, the new approach focuses on compelling access to and mandating the price of inputs. Unfortunately, this shift in regulatory policy has not been met with an accompanying shift in the manner in which regulatory authorities regulate prices. Specifically, policy makers have continued to base rates on either historical or replacement cost. We argue that courts and policy makers have largely ignored the fact that this fundamental shift in regulatory approach demands an equally fundamental shift in the approach to setting prices. Economic theory suggests that regulatory authorities should base access prices on market prices. In addition, because compelled access to most telecommunications networks requires that competitors be permitted to place equipment on the network owner's property, access requirements constitute physical takings for which market-based compensation must be paid. Although the unavailability of market-based determinants once justified basing prices on some measure of cost, the shift in regulatory policy (especially when combined with the emergence of direct, facilities-based competition made possible by technological convergence) has caused the justifications for refusing to set rates on the basis of market prices to fall away. We then use these insights to analyze access pricing with respect to three emerging regulatory issues: (1) access to unbundled network elements mandated by the Telecommunications Act of 1996, (2) the access to utility poles compelled by the 19996 amendments to the Pole Attachments Act, and (3) open access to digital subscriber line (DSL) and cable modem networks providing high-speed broadband services.

Flouting the Law: Does Perceived Injustice Provoke General Non-Compliance?

Janice Nadler — Thu, 02 Jun 2005 09:40:10 PDT

What happens when people's common sense view of justice diverges from the sense of justice they see enshrined in particular legal rules and legal outcomes? In particular, does the perception of one particular law as unjust make people less likely to comply with unrelated laws? This article reports an experiment that empirically tested the Flouting Thesis - the idea that the perceived justice of one law can influence the intention to comply with unrelated laws. Participants who were exposed to laws they perceived as unjust were more willing, as a general matter, to flout unrelated laws, compared to participants exposed to laws perceived as just. This willingness to disobey extended far beyond the unjust law in question, resulting in participants expressing plans to flout unrelated laws in their everyday lives (such as traffic violations, petty theft, and copyright restrictions). Factors contributing to the relationship between perceived injustice and flouting include the role of law in American popular culture, the expressive function of the law in producing compliance, and unconscious psychological processes that underlie the diminished willingness to comply with the law.

An Agency Costs Theory of Trust Law

Robert H. Sitkoff — Thu, 02 Jun 2005 09:40:08 PDT

This Article develops an agency costs theory of the law of private trusts, focusing chiefly on donative trusts. The agency costs approach offers fresh insights into recurring problems in trust law including, among others, modification and termination, settlor standing, fiduciary litigation, trust-investment law and the duty of impartiality, trustee removal, the role of so-called trust protectors, and spendthrift trusts. The normative claim is that the law should minimize the agency costs inherent in locating managerial authority with the trustee and the residual claim with the beneficiaries, but only to the extent that doing so is consistent with the ex ante instructions of the settlor. Accordingly, the use of the private trust triggers a temporal agency problem (whether the trustee will remain loyal to the settlor's original wishes) in addition to the usual agency problem that arises when risk-bearing and management are separated (whether the trustee/manager will act in the best interests of the beneficiaries/residual claimants). The positive claim is that, at least with respect to traditional doctrines, the law conforms to the suggested normative approach. This Article draws on the economics of the principal-agent problem and the theory of the firm, and it engages the ongoing debate about whether trust law is closer to property law or contract law. Although the analysis focuses on donative trusts, it should be amenable to extension in future work to commercial and charitable trusts.

Corporate Political Speech, Political Extortion, and the Competition for Corporate Charters

Robert H. Sitkoff — Thu, 02 Jun 2005 09:40:07 PDT

This article explores the policy bases for, and the political economy of, the law's long-standing discrimination against corporate political speech. This Article also explores the relevance of state law regulation of corporate political speech to the competition between the states for corporate charters. In the process, implications for the current political debate over soft money and the current academic debates over enacting an optional federal corporate takeover law regime and creating a securities law regulatory competition are noted. The underlying aim of this Article is to bring to bear on the relevant policy debates a shift in focus from the shareholder/manager agency relationship to the agency relationship between lawmakers and society. The Article draws on the contractarian view of the firm, the economic theory of regulation, and the study of public choice.

Symmetric Entrenchment: A Constitutional and Normative Theory

Michael B. Rappaport et al. — Thu, 02 Jun 2005 09:40:04 PDT

In this article, we defend the traditional rule that legislative entrenchment, the practice by which a legislature insulates ordinary statutes from repeal by a subsequent legislature, is both unconstitutional and normatively undesirable. A recent essay by Professors Eric Posner and Adrian Vermeule disputes this rule against legislative entrenchment and provides the occasion for our review of the issue. First, we argue that legislative entrenchment is unconstitutional, offering the first comprehensive defense of the proposition that the original meaning of the Constitution prohibits legislative entrenchments. We show that a combination of textual, historical, and structural arguments make a very compelling case against the constitutionality of legislative entrenchment. In particular, the Framers incorporated into the Constitution the traditional Anglo-American practice against legislative entrenchment, as evidenced by early comments by James Madison - comments that have not been previously discussed in this context. Moreover, legislative entrenchment essentially would allow Congress to use majority rule to pass constitutional amendments. On the normative issue, we offer a new theory of the appropriate scope of entrenchment: the theory of symmetric entrenchment. Under our theory, there is a strong presumption that only symmetric entrenchments - entrenchments that are enacted under the same supermajority rule that is needed to repeal them - are desirable. The presumption helps to distinguish desirable entrenchments that would improve upon government decisions from undesirable ones that simply involve legislatures protecting their existing preferences against future repeal. To be desirable entrenchments must generally be symmetric, because the supermajority rule that is applied to the enactment of entrenched measures would improve the quality of these measures and therefore compensate for the additional dangers that entrenchments pose. This theory steers a middle path between a strict majoritarian position, which would prohibit all legislative entrenchments, and a position that would allow legislative majorities to entrench measures.

On the Internal Contradictions of the Law of One Price

David D. Haddock et al. — Thu, 02 Jun 2005 09:39:59 PDT

The "law of one price" defines a market as the geographic area within which the same thing is sold for the same price at the same time, allowance being made for transportation costs. This paper shows that as usually stated the law of one price actually has two plausible interpretations. The law might mean that a market can be defined as the economic space wherein prices differ only by transportation costs. Alternatively, the law might mean that a market, once defined by some other criterion, will exhibit prices differing only by transportation costs. Under the first definition of the law, however, every production site is a market. Under the second definition, prices in fact do not differ by transportation costs. For market definition purposes, the law of one price is therefore either useless or wrong, depending on how it is interpreted.

Talking 'Bout My Antitrust Generation: Competition For and In the Field of Competition Law

Fred S. McChesney — Thu, 02 Jun 2005 09:39:57 PDT

Twenty-seven years ago I took my law-school antitrust course, from a fledgling assistant professor who had just left the Federal Trade Commission. My performance was adequate, earning one of the better grades in the course, but not spectacular. Unspectacular enough that afterwards the professor said it disappointed him. In retrospect, I think I under-performed because I was a soon-to-be economist as well as a budding lawyer. Like many people back then, I approached antitrust with a presumption that the gears of industrial-organization economics and antitrust law meshed more or less synchronously. But such a presumption was unwarranted, to say the least. As the course developed, it increasingly dawned that antitrust law, supposedly devoted to enhancing competition, was more a part of the problem than the solution. A few who had thought about all this longer had figured it out already. But for a callow law student at the time, it was difficult to mesh the economics of competition with "competition" law. I went into the exam conflicted, and evidently it showed. The conflicts today are fewer, thanks to a new brand of antitrust thinking that has developed and a new breed of antitrust enforcers that have arrived over the past generation. Often the new thinkers and enforcers are one and the same. The assistant professor who taught me antitrust is now the Chairman of the Federal Trade Commission, having written prolifically on both the Commission and antitrust law generally. Likewise, seminal scholars - also among my contemporaries and teaching colleagues - such as Frank Easterbrook, Richard Posner and Diane Wood - now as judges apply the new law that they espoused as academics. This article describes aspects of the evolution by which new antitrust rules have emerged to stimulate the salutary (if incomplete) rapprochement between economics and law in antitrust. In effect, the new rules have emerged from various types of competition, of two general sorts. To invoke Harold Demsetz's useful distinction, the competition has occurred in the field and for the field of antitrust. That is, the current generation has witnessed competition, first, as to which intellectual (including economic) paradigm animates antitrust law - competition for the field. As Section I details, competition for the field has included competition in the federal judiciary, some of that competition represented by acts of seeming judicial disobedience in antitrust. Thereafter, there has been considerable competition in the field, along lines to be described in section II, focusing on developments (some desirable, some not) in enforcement of the antitrust laws.

Why Wonder Bread Lost No Dough: Materiality, Settlements and the FTC's Ad Substantiation Program

Richard S. Higgins et al. — Thu, 02 Jun 2005 09:39:55 PDT

Previous studies (e.g., by Sam Peltzman) demonstrate the powerful share-value effects of Federal Trade Commission (FTC) actions against firms whose advertising the FTC claims violate the law. Curiously, however, when the FTC announces an investigation but simultaneous settlement of the case with the advertiser, no adverse impact results, an empirical finding thus far unexplained. This article uses a recent FTC action, in which the accused advertiser suffered no adverse equity impact, to explain that result. Many advertising messages challenged by the FTC are not material to consumers. If not - and especially when, as in the case discussed here, the advertiser had much earlier discontinued the advertising challenged - the advertiser predictably would not suffer. Econometric evidence supports the findings of no adverse impact, and of lack of materiality in the messages the FTC challenged.

Legal Negotiation and Communication Technology: How Small Talk Can Facilitate E-mail Dealmaking

Janice Nadler — Thu, 02 Jun 2005 09:39:53 PDT

E-mail recently has become a popular mode of communication for lawyers negotiating deals and conducting settlement discussions. But the obvious conveniences of e-mail as a negotiation medium can blind users to its pitfalls. The impoverished nature of the e-mail medium can lead to misunderstandings, sinister attributions, and ultimately, negotiation impasse. How can lawyers make use of the advantages of e-mail for negotiation while overcoming its disadvantages? One solution consists of a very simple insurance measure: small talk. In the empirical demonstration described in this Article, law students each negotiated a commercial transaction with another law student at a different university using e-mail as the mode of communication. Negotiators who engaged in a brief, getting-to-know-you phone conversation built substantial rapport that resulted in positive social and economic benefits for both parties. This initial small talk by telephone made subsequent e-mail interaction proceed more smoothly because the early creation of rapport helped the negotiators approach the negotiation with a more cooperative mental model, thereby trusting in each other's good intentions. This, in turn, led to a successful negotiation that concluded with a contract, and engendered positive feelings about one another and expectations of successful dealings in the future. By contrast, negotiators who did not engage in small talk were over four times more likely to reach an impasse, and ended up feeling resentful and angry about the negotiation. The Article concludes by discussing implications and recommendations for lawyers who use e-mail to negotiate.

Testing the Focal Point Theory of Legal Compliance: Expressive Influence in an Experimental Hawk/Dove Game

Richard H. McAdams et al. — Thu, 02 Jun 2005 09:39:51 PDT

Economic theories of legal compliance emphasize legal sanctions, while psychological and sociological theories stress the perceived legitimacy of law. Without disputing the importance of either mechanism, we test a third way that law affects behavior, an expressive theory that claims law influences behavior by creating a focal point around which individuals coordinate. The focal point theory makes three claims: (1) that the need for coordination is pervasive because "mixed motive" games involving coordination model common disputes; (2) that, in such games, any third-party cheap talk that calls the players' attention to a particular equilibrium tends to produce that equilibrium; and (3) that law, by publicly endorsing a particular equilibrium, tends to call the players' attention to that outcome. After explaining the first and third claim, we offer an experimental test of the second. Specifically, we investigated how various forms of third party cheap talk influence the behavior of subjects in a Hawk/Dove or Chicken game. Despite the players' conflicting interests, we found that messages highlighting one equilibrium tend to produce that outcome. This result emerged when the message was selected by an overtly random, mechanical process, and also when it was delivered by a third-party subject; the latter effect was significantly stronger than the former only when the subject speaker was selected by a merit-based process. These results suggest that, in certain circumstances, law generates compliance not only by sanctions and legitimacy, but also by facilitating coordination around a focal outcome.

Manufacturer Liability for Harms Caused by Consumers to Others

Bruce L. Hay et al. — Thu, 02 Jun 2005 09:39:49 PDT

This paper investigates whether manufacturers should be liable if consumers, through the use of a product, cause harm to others. If consumers have deep pockets then consumer-only liability is socially desirable. With consumer insolvency, however, consumer-only liability leads to inadequate consumer precautions, inadequate safety features, and excessive economic activity. With homogeneous insolvent consumers, the best rule is "residual-manufacturer liability" where the consumer bears primary responsibility and the manufacturer bears the shortfall in damages. When consumers' willingness-to-pay is correlated with social harm they cause then residual-manufacturer liability distorts the market quantity. When consumers differ in their wealth then residual-manufacturer liability creates an inefficient cross-subsidization and an overprovision of safety features. In both cases, consumer-only liability may be preferred to residual-manufacturer liability. Applications, including gun manufacturer liability, are discussed.

Irrelevant Internalities, Irrelevant Externalities, and Irrelevant Anxieties

David D. Haddock — Thu, 02 Jun 2005 09:39:47 PDT

Due to the high transaction cost that would be necessary for large numbers of people to negotiate with each other, even those who are sanguine about private markets become reserved when externalities affect large populations. The distinction between private and societal interest is well understood for pecuniary externalities, but neglect of Buchanan and Stubblebine's article Externality has left the same distinction widely unrecognized for non-pecuniary ones. If only a few parties on either side experience a relevant externality within Buchanan and Stubblebine's relevant/irrelevant distinction, private interactions can appropriately internalize costs and benefits across the entire population. Regardless of the perceptiveness of legal and cultural institutions in placing entitlements, and regardless of the level of transaction cost among the universe of the affected, a surprising number of externalities will readily fix themselves. The desirability of corrective intervention is much too easily conceded.

Trust Law, Corporate Law, and Capital Market Efficiency

Robert H. Sitkoff — Thu, 02 Jun 2005 09:39:46 PDT

In both the publicly-traded corporation and the private donative trust a crucial task is to minimize the agency costs that arise from the separation of risk-bearing and management. But where the law of corporate governance evolved in the shadow of capital-market checks on agency costs, trust governance did not. Thus, even more than that of close corporations, the law and study of private trusts offers an illuminating counterfactual - a control, as it were - for a playful thought experiment about the importance of capital market efficiency to the law and study of public corporations. The animating idea for this essay is that many of the differences on the agency costs frontier between the public corporation and the private donative trust can be roughly attributed to their relative positions in modern capital markets and the related disparity in their residual claimants' ease of exit. Among other things, this approach reveals a correlation between the trust law model and the views of corporate law scholars who doubt the ECMH and its implications for corporate governance. The essay also discusses the use of market data for assessing breach and damages in corporate and trust litigation and for empirical evaluation of theoretical scholarly analysis in both fields. More generally, comparison of the governance of the public corporation and the private donative trust brings into view the importance of relative price efficiency for the modern approach to corporate governance.

Existence Value and Federal Preservation Regulation

David A. Dana — Thu, 02 Jun 2005 09:39:43 PDT

Conventional economic and political theory predicts that the states will underregulate the degradation or destruction of natural resources within their borders when some or all of the resulting adverse effects fall outside their borders, that is, upon out-of-staters. Academic critics of the federalization of environmental law agree with this conventional view at an abstract level, but, in their view, only the physical effects of the destruction of a natural resource on out-of-staters should count as an interstate externality that can justify federal intervention. The federal courts may be moving toward an even narrower conception of what constitutes an environmental externality that can justify federal regulatory intervention - a conception in which the externality must entail interstate market effects in addition to interstate physical effects. This Article argues that a significant set of the interstate effects of natural resource degradation and destruction on the American populace cannot plausibly be classified as either physical or market effects: some, perhaps many, Americans lose some sense of well-being simply by virtue of the loss of the existence of wetlands, waterways, and other natural resources in states where they do not live. Existence values (or more precisely, the desire to prevent the loss of existence values) provide a powerful positive account of how the federal political process, despite concerted opposition by well-organized business interests, has at times come to restrict the degradation of natural spaces that few out-of-state residents are likely to ever visit or otherwise use. Existence values also provide a strong normative account of why such restrictions are, from a societal vantage, presumptively welfare-maximizing. Indeed, as explained in Part III of the Article, federal regulation is more likely to be necessary to maximize welfare in the context of interstate losses in existence value than in the context of interstate physical effects, such as air or water pollution crossing state lines. The principal claim of those who reject the use of existence values as a rationale for federal regulation is that existence values are nonmeasurable and hence unsuitable for consideration in public policy. As explored in Part IV of the Article, this empirical objection is inconsistent with the findings of contingent value (CV) surveys in which respondents have been asked how much they would be willing to pay for the preservation of one or more natural resources. The CV surveys completed to date, although admittedly imperfect as measurement devices, suggest significant values for the preservation of a range of natural resources. More important, the federal political process itself provides a comparative measure of the magnitude of the existence-value benefits of natural preservation (on the one hand) and the magnitude of the competing economic benefits associated with the degradation or destruction of natural settings (on the other). If anything, given the core insights of public choice theory and the structural supports in the federal political process for industries whose economic interests often run counter to natural preservation (e.g., the mining, timber, and oil industries), we should expect the federal political process to understate significantly the comparative magnitude of the existence-value benefits of natural preservation. The current literature also contains a non-empirical objection to existence values as a justification for federal regulation. The essence of this objection is that federal preservation regulation premised on existence value preferences is illegitimate because it violates the principles of respect for private property rights and distributive justice among communities. As explained in Part V of the Article, these principles, at best, support the claim that all sorts of government regulation - and not just federal regulation aimed at preserving natural resources - is illegitimate from a particular (and highly contestable) point of view. The normative defense of existence values and existence-value-driven regulation developed in Parts III-V provides a useful perspective from which to evaluate the current state of Commerce Clause doctrine. Commerce Clause doctrine has never formally recognized existence-value concerns as a basis for federal jurisdiction, and that is unlikely to change. However, certain doctrinal approaches to the Commerce Clause create room for regulation motivated by existence-value concerns, and others, such as the approach arguably endorsed by the majority in SWANCC, do not. If one accepts that federal regulation premised on existence-value concerns is presumptively welfare maximizing, then one must accept that Commerce Clause tests that preclude such regulation carry a substantial social cost. The normative defense of existence-value regulation also has implications for the choice between approaches to standing that facilitate citizen enforcement of regulations premised on existence-value concerns, and approaches, such as that endorsed by the majority in Lujan v. Defenders of Wildlife, that impede such enforcement.