When transaction costs are low the more efficient remedy against harms to property rights is?

1In 1935, Frank Knight—whose predilection for a market economy is notorious—expressed his concerns and doubts about the possibility that honest individuals might survive the competitive process and reach powerful economic positions. The ‘Rockefeller capitalism’ in the United States exemplified how one could govern an economy and run an efficient economic empire without abiding perfectly with the law. More recently, the emergence of morally dubious individuals and Mafia infiltration into legitimate businesses have raised the issues of law neutrality in economics, of how to reconcile efficiency (economics) and justice (law), and appropriateness of protecting the interests of non-Mafiosi from this infiltration.

2Economics as a theoretical field can be split into two opposite traditions: the theory of market forces, and the theory of “the whole, its organization and control mechanisms” (Samuels, 1969, 68). This is also true of the specific field that questions the interface between law and economics. Coase (1960), the Coase Theorem (Stigler, 1966) and the ensuing literature on the subject serve as the basis for the division of the economic analysis of law (as part of the theory of market forces) and the old institutional view (theory of the whole) in which the market is part of a wider economic system. Coase (1960) indeed represents a turning point in the economic analysis of the relationship between law and economics (see Bazzoli, Kirat, 1997; Kirat, 1998). The paper, which deals with the problem of social cost and rejects the traditional Pigovian solution to externalities, had a wider impact than its original topic. On the one hand, it gave rise to New Institutional Economics, breaking with the legal-economic nexus approach, but focusing on the study of transaction costs. On the other hand, it opened the way to the enunciation of the Coase Theorem and to the property rights theory: the emphasis is on the absence of transaction costs, which allows private arrangements in order to solve incompatibilities in the use of rights. Rational individuals, thanks to voluntary market transactions, obtain efficient arrangements, irrespective of the initial legal delimitation of rights. Hence the assumption that the initial allocation of rights is neutral: the courts can choose a liability rule or not; with no transaction costs, their decision is neutral with respect to the achievement of a final efficient solution. In other words, the legal rule has no impact on the economic system if there are no transaction costs.

3I will demonstrate in this paper how the assumption of ‘law neutrality’ stemming from various interpretations of the Coase Theorem can be re-assessed as an attempt to disentangle the legal-economic nexus artificially (i.e., the idea that the economy is a function of law and law is a function of the economy), which actually serves to sever the nexus. This is a very restrictive view of the nature and function of law. The interactions of law and economics are replaced by a neutralisation of law in which economic analysis imposes its formal techniques and assumptions to shape the legal system.

4Therefore, in this paper, I first inquire into the true significance of what I call the assumption of ‘law neutrality’ in property rights theory. This assumption refers to the idea that the initial legal allocation of property rights has no impact upon the final and optimal allocation of resources: where does this assumption come from? I criticise it for being a result based on a static, market-oriented efficiency criterion. I also analyze it from an institutional viewpoint: is the neutrality of law acceptable and desirable if one considers that law and economics are two interpenetrating spheres?

5Because the assumption of law neutrality was based on a seminal paper by Coase (1960), I begin by revisiting this work from the perspective of this assumption. Here, I develop a global model by synthesising the entire content of Coase’s article (1960) into one question: when does the initial legal allocation of property rights matter? (Section 1). I then turn to the traditional account of the assumption of law neutrality. The Chicago School of economic analysis of law is the dominant proponent of this thesis, focusing on efficiency and on the necessity to minimize existing transaction costs. It shows that the assumption holds when transaction costs are absent. In case of positive transaction costs, the task of lawyers should be to minimize them in order to keep the initial allocation of rights neutral (Section 2). Next, I underline that although the emphasis is generally on the absence of transaction costs, assertions about the neutrality of law are rooted in an implicit condition: the differentiation between ‘who’ (the domain of law) and ‘what’ (the domain of economics). This split participates in the severing of the legal-economic nexus. By clarifying the existing interactions between law and economics, I also clarify the mechanisms whereby exclusively economic criteria are used in property rights theory to solve potential conflicts between the law and economics. I try to demonstrate that this process of neutralisation of the law is both artificial and unsatisfactory (Section 3). Finally, I illustrate the debate between the advocates of law neutrality (in favour of market forces) and their opponents (in favour of an institutional viewpoint on the subject) using the example of Mafia infiltration of legitimate businesses. My approach shows that the Chicago school is unable to tackle the problem of Mafia infiltration partly because of this assumption of law neutrality. Conversely, an approach based on an interdisciplinary dialogue between two interacting fields, rather than economisation of the legal field helps both understand the true problems raised by Mafia firms operating in legal activities, and propose operational legal solutions to tackle the problem at the root (Section 4).

1. Coase (1960) Revisited: Does the Initial Legal Allocation of Property Rights Matter?

6In fact, “The Problem of Social Cost” (1960) never explicitly referred to the issue of law neutrality. Rather, the assertion that the law is neutral (under certain hypotheses, which I will address later on) is the result of various interpretations of Coase (1960). Therefore, it seems necessary first of all to revisit this work from the perspective of law neutrality, although Coase never actually focused on this. The aim is to read Coase (1960) with one main question in mind: what is or might be the impact of the law on the economic system?

1.1. Coase (1960): private bargaining vs. legal rule?

• 1 That is to say: liability rule, tax on the polluter to offset the damage or even exclusion of the p (...)

7The analytic framework set out by Coase (1960) is much more complex than is generally portrayed in the ‘Coase Theorem.’ The intent, here, is to provide a more accurate account of the complexity of the original contribution. The aim of Coase’s paper (1960) was not to deal with the relation between law and economics but with externalities: “The paper is concerned with those actions of business firms which have harmful effects on others.” (Coase, 1960, 1) The ultimate goal was to demonstrate that the traditional Pigovian approach to social cost and negative externality1 is inappropriate. The focus was mainly on whether or not to apply a liability rule so as to make damaging businesses pay for any damage caused. Therefore Coase changed the viewpoint on the problem: the problem is reciprocal, he explained, it is not a matter of a damaging agent (call it A) and its victim, the damaged agent (call it B). A systematic liability rule would not solve the initial problem because “to avoid the harm to B would inflict harm on A” (Coase, 1960, 2). If the problem of social cost is reciprocal, then, the new question is: “should A be allowed to harm B or should B be allowed to harm A?” (Coase, 1960, 2) To answer this question, the value of what is obtained in each case must be compared to the value of what is sacrificed to obtain it. From an economic perspective, this means searching for the highest value of global production. Here, though incidentally, comes the issue of the impact of the law on the economic system: are the courts able—let alone willing—to calculate this when determining legal rights?

8The issue introduced by Coase (1960) with regard to the problem of social cost is the possibility and opportunity for A and B to bargain instead of resorting to the courts. Thanks to arithmetical examples, in a world in which the pricing system works smoothly (parts III & IV), Coase showed that even in the case of liability for damage, both A and B could benefit from bargaining. In fact, the bargaining option is limited to a specific case. For example, if the problem is between a farmer and a cattle raiser whose herd damages the farmer’s crops, the possibility for bargaining occurs “if receipts from the sale of the undamaged crop are less than the total costs of cultivating the damaged tract of land” (Coase, 1960, 3). In this case, the solution would be to leave the tract of land uncultivated. The loss would be less for the farmer, as it would be for the cattle-raiser in case of liability rule. Therefore, bargaining depends on the costs and gains of A and B. In Coase (1960), even in a world without transaction costs, the bargaining process is not always possible. But, whenever bargaining is possible, the result of the process is efficient because it maximises the value of total production.

9Coase (1960) is illustrated with many different cases and examples. One of them, which comes from Pigou (1920), is the well-known case of the railway which destroys crops on neighbouring lands because of the sparks from the engine. I will name A the railway causing the damage, and B the farmer suffering crop destruction. I have developed a global, comprehensive scheme that represents Coase’s reasoning. The starting point is obviously the situation determined by the initial legal allocation of rights—liability rule or no liability rule—which is taken as a given. The scheme is then built around these two ‘legal worlds’. Unlike the interpretations of Coase (1960), the two worlds described at the beginning of the paper are not a world with transaction costs and a world without transaction costs, but rather a world with and a world without liability rule. The question of existence of transaction costs comes as a second step. Based on these two criteria (type of legal rule and level of transaction costs), I obtain an inverted tree with different cases that are valued according to efficiency achievement.

10In a first scheme, I present a traditional situation—that is to say, a world in which law prevails—with two options: the existence or the absence of a liability rule. If there is a liability rule, it is applied, and the issue of transaction costs is not even raised. A pays for all damage caused to B and the costs (private and external) due to the railway are paid by their author. This means that the railway may choose to decrease its level of activity accordingly. However, as pointed out by Pigou (1920), this result is more efficient than the initial situation. If there is no liability rule, the problem raised by externality and market failure remains unsolved. But, if A and B are rational individuals, they may engage in a bargaining process. This is when the issue of transaction costs is raised. If transaction costs are too high, A and B will be precluded from bargaining and the economic system will be locked in the initial inefficient situation of market failure. If transaction costs are zero or low enough, A and B will bargain and the result will maximize the total production value efficiently.

Figure 1: The traditional situation

11The second scheme presents the complexity of Coase (1960). The departure point is unchanged: the law defines the initial allocation of rights (liability rule / no liability rule). But, in both worlds, the possibility of a bargaining process is contemplated. Therefore, the existence of transaction costs becomes fundamental.

12If there are no transaction costs, whatever the initial delimitation of rights, a bargaining process takes place and results in an efficient solution in terms of value of total production. Although the final solution is the same with or without liability rule, I underline the fact that in the first case, A pays B, whereas in the second case, B pays A. In global terms, this is irrelevant because of the maximization of production. At an individual level, however, it makes a difference for A and B to pay or to be paid. Independently from the efficiency criterion, one might think—for moral reasons—that identity matters because the polluted should not have to pay to reduce the level of the pollution suffered.

13In a world of positive transaction costs, the cost-benefit approach prevails. If the gain exceeds the cost, the bargaining process will take place too and lead to an efficient solution to the market failure. Conversely, excessive cost impedes any bargaining. Here, the dichotomy between the worlds with and without liability rule reappears. Without liability rule, A and B remain trapped in an inefficient situation and the conflicting situation remains unsolved. However if A is liable for all damages caused, B is relieved from the external costs incurred. The problem, according to Coase (1960) is that this compensation is not necessarily desirable: “The problem is whether it would be desirable to make the railway liable in conditions in which it is too expensive for such bargains to be made.” (Coase, 1960, 30) I refer to the result of the implementation of the liability rule as a “possibly inefficient solution” because there are cases where the solution is efficient and others where the solution is inefficient (for example, the number of trains circulating is reduced, decreasing the value of total production). Coase, once again using an arithmetical example, stresses that this is an example of inefficiency but never writes that State intervention and the compensation rule are always wrong from an efficiency point of view:

With these figures it is clear that it is better that the railway should not be liable for the damage it causes, thus enabling it to operate profitably. Of course, by altering the figures, it could be shown that there are other cases in which it would be desirable that the railway should be liable for the damage it causes. It is enough for my purpose to show that from an economic point of view, a situation in which there is "uncompensated damage done to surrounding woods by sparks from railway engines" is not necessarily undesirable. Whether it is desirable or not depends on the particular circumstances. (Coase, 1960, 33-34)

Figure 2 : The Coasean scheme

14On the whole, the initial delimitation of rights has an impact on the economic system if positive transaction costs impede bargaining between A and B. But the result is different depending on whether or not there is a liability rule. In the former case, the final result is possibly inefficient ; in the latter, it is inefficient.

1.2. Coase (1960): what is the relationship between law and economics?

15Even though, as I mentioned before, it is not a central theme of the paper, the question raised in this subsection is the following: what do we learn from Coase (1960) regarding the relationship between law and economics? I have identified four main points.

16First, the legal system is a necessary framework for the economic system. The economic system is not independent of the legal system because of the initial delimitation of rights (whether the damaging business is liable or not for any damage caused), and because it determines how market transactions might transfer and combine these rights. This initial delimitation is important because it shapes the resulting transactions but it is supposed to have no impact on the result of bargaining transactions if such transactions are possible:

It is necessary to know whether the damaging business is liable or not for damage caused since without the establishment of this initial delimitation of rights, there can be no market transactions to transfer and recombine them. But the ultimate result (which maximises the value of production) is independent of the legal position if the pricing system is assumed to work without cost. (Coase, 1960, 8)

17The initial delimitation of rights is necessary for the bargaining process to happen. It will also determine the respective positions of the parties towards private bargaining. For example, if there is a liability rule and the parties choose to negotiate, A will be in a weaker position and will be the one to pay for a fence, for example, in order to reduce the damage to the farmer’s crops. Conversely, if there is no liability rule, B will be in a weaker position and may be the one to pay A so that the latter reduces his production and the damage caused.

18Second, law and economics may not share the same objectives. Before Coase (1960), the negative externality problem was studied as a situation of conflict with damages, compensation rights and an injured party. The legal rule, in this case the liability rule, aims at solving a conflict that is not resolved by the market. Law and economics are not antagonistic; in the old institutionalism tradition, the legal rule is even necessary to establish a lasting and legitimate social order, which in turn helps the economic system to work smoothly. Coase (1960), by changing the problem of social cost into a problem of reciprocal nature, also changed—unwillingly—the relationship between law and economics. Legal rules can end up being in conflict with, or at least irrelevant to, the aims of the economic system: “The reasoning employed by the courts in determining legal rights will often seem strange to an economist because many of the factors on which the decision turns are, to an economist irrelevant.”(Coase, 1960, 15)

19The dichotomy between law and economics is clearer when Coase delineates the field of interest of each field: “...it has to be remembered that the immediate question faced by the courts is not what shall be done by whom but who has the legal right to do what.” (Coase, 1960, 15) This quotation shows that the issue of respective identity of the parties (‘who gets rights’) is a matter of interest for the courts, but not for the economists who are interested in the (efficient) use of resources (‘what to do with them’). I will return to this issue of the differentiation between ‘who’ and ‘what’ later on (see section 3).

20Third, in a world without transaction costs, private bargaining is to be preferred. The divergence between the economic and legal objectives can be corrected thanks to private bargaining:

It is always possible to modify by transactions on the legal market the initial legal delimitation of rights. And, of course, if such market transactions are costless, such a rearrangement of rights will always take place if it would lead to an increase in the value of production. (Coase, 1960, 15)

21This means that market transactions can undo what a legal rule has established. The conflict between court decisions and economists is solved in favour of the latter: economics prevails over law. Private bargaining can cancel the initial inefficient legal delimitation of rights.

22Fourth, in a world with positive transaction costs, the law might create inefficiency. Conversely if the costs of carrying out market transactions are taken into account, and if the increase in the value of production resulting from the rearrangement of rights is less than the costs incurred:

The initial delimitation of legal rights does have an effect on the efficiency with which the economic system operates. One arrangement of rights may bring about a greater value of production than any other. But unless this is the arrangement of rights established by the legal system, the costs of reaching the same result by altering and combining rights through the market may be so great that this optimal arrangement of rights, and the greater value of production which it would bring, may never be achieved. (Coase, 1960, 16)

23Transaction costs may impede the efficient rearrangement of rights. In this case, the initial delimitation of rights will determine the final mix of output and its value. There are different arrangements leading to different values of total production. To compare them and then select the best one, one has to choose a criterion (in this case, efficiency as the maximization of the value of total production) and establish a ranking according to this criterion. There are three configurations:

24First, being locked in the initial situation: nothing is done to correct the externality because on the legal side there is no liability rule, and on the economic side bargaining is impeded by transaction costs. This is a typical case of Pareto inefficiency.

• 2 This refers to the issue of complete information. By grounding my hypothesis in bilateral bargainin (...)

25Second, the rearrangement of rights by private bargaining: the absence of transaction costs permits the agents to exchange based on mutual agreement. A final efficient allocation of rights is possible if agents are aware that transactions are worthwhile.2 This is partly bound up with the degree of diffusion of information.

26Third, legal solution to the problem through the implementation of a liability rule: A compensates B for any damage caused. The efficiency of the final mix of output is uncertain. According to various empirical examples, it can or cannot be achieved.

27Therefore, the ranking between the three situations is incomplete. The second solution is always superior to the first. The third solution can be inferior or equal to the second. It is unclear whether for Coase (1960), the third solution is equivalent or superior to the first. In view of this uncertainty in the ranking, the conclusion is not that the choice of the liability rule is 1) always inappropriate; 2) always worse than the “no liability rule” option.

28The idea (which I will refer to as the assumption of law neutrality) that the initial delimitation of rights is neutral (that is to say, has no impact on the efficiency of the final mix of output) is traditionally associated with the absence of transaction costs. Some economists, relying on the dichotomy between the ‘ideal world of Coase’ and the ‘real world’ (Van den Bergh, 1988), argue that, in a world with positive transaction costs, law ceases to be neutral, meaning that it creates inefficient situations. The world with positive transaction costs is then considered as a homogeneous whole, whereas, as Coase (1960) clearly stated, the achievement of efficiency is conceivable and depends on the existence of a liability rule and its adequacy on a case-by-case basis, and on the level of existing transaction costs both in absolute and relative terms (i.e. compared to transactions gains).

29Since Stigler (1966) enunciated the Coase Theorem, transaction costs have generally been considered a restrictive criterion that limits the field of neutrality merely to the reallocation sphere: the neutrality of law appears to be achieved only through market transactions insofar as these transactions offset the inefficient mix of output imposed by an economically erroneous first allocation of rights. In this context, the question is whether we are still focusing on the neutrality of law rather than a market-prone process of economic neutralisation of the law. A paradoxical prevalence of exchange appears to be unavoidable to affirm the neutrality of the law. The focus on the ideal world of no transaction costs erases the question of the relationship between law and economics that existed albeit secondarily in Coase (1960), and changes the view on the subject: whereas Coase (1960) wanted to study the law in order to understand the functioning of economic systems, the property rights theory addresses what economic analysis can do for the discipline of law, thus putting it in a subordinate position. Nevertheless, both tend to misinterpret the function of law, explaining it in primarily economic terms (wealth maximisation, efficiency).

2. The Coase Theorem, the Invariance Proposition and the Disentangled Legal-Economic Nexus

30This section explains how these interpretations—the different statements of the Coase Theorem—have progressively led to the assumption of law neutrality as one aspect of the more global ‘invariance proposition’, which was coined by Coleman (1984) and inspired by the Coase Theorem (2.1). The process of disentanglement of the legal-economic nexus achieved by the Coase Theorem is then exemplified by focusing on the efficiency criterion (2.2) and on the zero transaction costs condition (2.3).

2.1. The Coase Theorem and the ‘invariance proposition’

31The idea that the law might be neutral stems from many formulations of the Coase Theorem. For example, Polinsky produced the following formulation of the Coase Theorem: “If transaction costs are zero the structure of the law does not matter because efficiency will result in any case” (Polinsky, 1974, 1665, my emphasis). Schwab wrote, “a change in [law] affects neither the efficiency of contracts nor the distribution of wealth between the parties” (1988, 242). Cooter and Ulen wrote, “when parties can bargain together and settle their disagreements by cooperation, their behaviour will be efficient regardless of the underlying rule of law” (Cooter, Ulen, 1988, 105, my emphasis). According to Regan, “in a world of perfect competition, perfect information, and zero transaction costs, the allocation of resources in the economy will be efficient and will be unaffected by legal rules regarding the initial impact of costs resulting from externalities” (Regan, 1972, 427, my emphasis). As already quoted in the first section, Coase himself stated, “It is necessary to know whether the damaging business is liable or not for damage caused since without the establishment of this initial delimitation of rights there can be no market transactions to transfer and recombine them. But the ultimate result (which maximises the value of production) is independent of the legal position if the pricing system is assumed to work without cost.” (Coase, 1960, 8, my emphasis)

32The typology established by Cooter (1987) exemplifies how the neutrality of law can commonly be seen as a result of the Coasean solution to externalities. Cooter (1987) identified three major ways to interpret “The Problem of Social Cost”:

33Firstly, in terms of free inter-individual bargaining: first allocation of rights has no impact on the achievement of an economically efficient situation in as much as such rights can freely be exchanged by rational individuals;

34Secondly, in terms of market failures: first allocation of rights has no impact on the achievement of an economically efficient situation from the moment the market for rights is perfectly competitive;

35Thirdly, in terms of positive transaction costs: first allocation of rights has no impact on the achievement of an economically efficient situation if transaction costs are inexistent.

36All three interpretations share a common feature: the economic impact of the original legal allocation of property rights. All of them also lead to a common idea: the assumption of law neutrality, even if it is subject to certain conditions. This means that the final—and efficient—mix of output is independent of the first initial allocation of property rights by the legal system in the economic ‘ideal world.’

2.2. The efficiency criterion: first step towards the disentanglement of the legal-economic nexus

37So far, I have only stressed that the neutrality of law is a relevant issue from an economic viewpoint; I still need to define more precisely the content of this neutrality, i.e. what it refers to. The meaningful criterion here is efficiency. More precisely, when stressing the importance of having rights clearly defined, Coase specified the kind of efficiency used as a reference: “...the ultimate result (which maximises the value of production) is independent of the legal position if the pricing system is assumed to work without cost.” (Coase, 1960, 8, my emphasis)

38In neoclassical economics, efficiency is defined as follows : the accepted solution to the externality problem must maximize the value of the final mix of output. In other words, the accepted solution corresponds to a situation in which agents would agree to maximize their joint profits as if they formed a single productive entity. It satisfies the Pareto criterion according to which optimality is not achieved if there is still a possible change of allocation that could make one member of the society better off and no other member worse off. For Coase (1960), the strict Pareto criterion is lessened and is complemented by the Kaldor-Hicks test : the comparison between what the winners win and what the losers lose.

39For Coase (1960), the final mix of output is not only efficient but is also unique and identical to a particular mix serving as a reference. This characteristic of uniqueness is typical of the refusal to take into account the extent to which efficiency is also bound up with distribution. It reveals a change in the methods of law and economics as a specific branch of analysis and places this notion of law neutrality within the field of the economic analysis of law as opposed to the previous German Historical and Institutional Schools and the Old Institutional branch of law and economics. Coase (1960) proposed a new way of comparing different social arrangements by adopting neoclassical tools such as the opportunity cost approach. Various formulations of the Coase Theorem have accentuated the divorce by giving a strictly neoclassical interpretation of Coase (1960), leaving the institutional issue of comparing social arrangements aside.

40Therefore, the focus on the efficiency criterion appears to be the first step in the process of disentangling the legal-economic nexus. Actually, instead of considering law and economics as two interpenetrating spheres, focusing merely on a static efficiency criterion imposes a market-grounded value regardless of what the legal objectives might be. It denies the collective dimension of property rights and their rules of allocation and reallocation. In particular, if one considers property rights as a tool granting access to economic opportunities, as in the approach developed by Commons, the Pareto criterion is unsatisfactory. An alternative criterion would be to measure improvements in terms of equality of opportunity for all when comparing two allocations of property rights. In this setting, the initial allocation of rights and, possibly, the legal control over reallocations of rights aim at exerting an influence on the capacity of individuals to take part in economic processes. It is thus part of the duty of the law and of lawyers to make choices in order to protect certain interests, to promote economic opportunities for some and limit the power of others, and to channel market forces by creating a power structure of a legal kind (Dugger, 1980, 212). This leads to an interpenetration of law and economics that the efficiency criterion alone is unable to assess. Ignoring power relationships, distribution, and the need for a ‘reasonable’—rather than efficient—framework of rules only contributes to a fictitious disentanglement of the legal-economic nexus.

2.3. The zero transaction cost condition: a second step towards the disentanglement of the legal-economic nexus

41Another condition is fundamental in the literature on the Coase Theorem and the invariance proposition: the absence or the low level of transaction costs.

42Stigler (1966) played an important role by indirectly accrediting the idea that zero transaction cost was the main situation to deal with when talking about law neutrality: in case of negative externality, with reciprocal costs and no transaction costs, the efficient solution to bargaining is independent of the initial allocation of rights, and private agreement is to be preferred to any other solution (like judicial or administrative solutions and internalisation). In a situation of incompatible uses of resources and under the conditions mentioned above, the initial allocation of property rights over these resources will not interfere in their final destination: the legal logic that dictates initial allocation of rights will not prevail over the economic logic that determines the single best way to use the resources. Posner extended this approach by incorporating the efficiency of civil law, arguing in a lecture summarising his work:

[T]he “Coase Theorem” holds that where market transaction costs are zero, the law’s initial assignment of rights is irrelevant to efficiency, since if the assignment is inefficient the parties will rectify it by a corrective transaction. There are two important corollaries. The first is that the law, to the extent interested in promoting economic efficiency, should try to minimize transaction costs, for example by clearly defining property rights, by making them readily transferable, and by creating cheap and effective remedies for breach of contract. The second corollary is that where, despite the law’s best efforts, market transaction costs remain high, the law should stimulate the market’s allocation of resources by assigning property rights to the highest-valued users. (Posner, 2002, 16)

43He turns the positive approach of Stigler (1966) into normative propositions. By doing so, he definitely places the discipline of law in a subordinate position with regard to economics: the law is a tool the purpose of which is to facilitate the smooth functioning of competitive markets.

44 De Meza summarised the issue as follows: “The starting point for Coase is that though the law establishes rights, it is bargaining that determines outcomes. If transacting is costless, gains from trade will be fully exploited and efficiency be achieved whatever the distribution of entitlements.” (De Meza, 1998, 270) This phrasing highlights the importance of transaction costs in the analysis of law neutrality.

45 Positive transaction costs may be an impediment to transactions that are considered to be the best mechanism (whether centralised, administrative or judicial) to achieve efficiency. Coase wrote:

[O]nce the costs of carrying out market transactions are taken into account it is clear that such a rearrangement of rights will only be undertaken when the increase in the value of production consequent upon the rearrangement is greater than the costs which would be involved in bringing it about…In these conditions the initial delimitation of legal rights does have an effect on the efficiency with which the economic system operates. (Coase, 1960, 15-16)

• 3 Although some economists have added other conditions such as complete information (Farell, 1987; My (...)
• 4 This statement can also be inverted: the Coase Theorem does not depend on the absence of transactio (...)

46In the case of zero transaction costs, transaction is always possible3 and there is no reason why efficiency should not be reached, as rational individuals will exchange until the maximum aggregate surplus is reached. The importance of the transaction costs criterion reveals an underlying assumption in the reasoning of Coase and his followers. On the one hand, it implicitly appears that economics and the law do not share the same objective: the objective of economics is clearly referred to as productive efficiency, but the objective of the law is not really exemplified or, according to Posner, has to ‘mimic the market’ (Posner, 1986, 16). On the other hand, in the approach inspired by Coase (1960), it is also implicit—though not proved—that transactions will ‘correct’ the economically erroneous first allocation; hence the importance of transaction costs and the (restrictive) limitation of law neutrality to a world without transaction costs.4

47Other economists have maintained this approach to the impact of law on economic activity but introducing some restrictions or conditions for its validity. In particular, applications of the Coasean approach to ‘game theory’ highlight the role of information in achieving efficiency, even in the case of low positive transaction costs. For example, Fudenberg and Tirole (1983) studied incomplete information and found that an aggregate surplus is maximised only if a fully informed party initially owns the item. Conversely, Farrell (1987) demonstrated that bargaining can allow an efficient result if information is complete. However, efficiency remains the criterion and the absence of transaction costs a condition of reference.

• 5 For an overview of critiques on the independency thesis, see Medema and Zerbe (2000).

48In contrast, some economists consider the invariance thesis (i.e. the independence of efficiency with regard to the initial allocation of property rights) to be very controversial. Their criticisms generally revolve around the Coasean hypothesis (1960) of no income effect.5 Other criticisms have been raised but are of lesser interest for the point I wish to make here. They principally revolve around (i) the number of participants involved in Coasean bargaining (see Olson, 1965); (ii) whether the bargaining process is simultaneous or iterated (as in Schlicht, 1996, 1997); or (iii) and whether the contractual relationship is bilateral or multilateral (see, for example, Hoffman, Spitzer, 1986).

49Coase stressed that the absence of transaction costs is a “very unrealistic assumption” (Coase, 1960, 15) which does not fit the “real world” at all. Nevertheless, the idea captivated the minds of law and economics scholars alike, spreading the conviction that, in a frictionless world, law would not matter and markets could solve problems efficiently. If true, this would negate the theory that “basic economic problems are considered to be a function of the institutions involved and not simply of market forces” (Samuels, 1969, 3-4). Once again, the literature following Coase (1960) widely contributed to the disentanglement of the legal-economic nexus assuming that economic transactions, if they are not hampered by high transaction costs, will undo the supposed ‘mistakes’ of the legal system.

3. Pushing the Disentanglement of the Legal-Economic Nexus Further: The Differentiation between ‘Who’ and ‘What’

50Although the emphasis is traditionally on the zero transaction cost condition, the assumption of law neutrality actually needs an implicit condition: the differentiation between ‘who’ and ‘what’. The initial legal allocation of property rights is neutral only if one considers that the personal characteristics of potential owners (‘who’) are irrelevant to the field of economics, and that the law does not have to protect certain interests and determine the balance of power. Demsetz reintroduced the question of who gets the property rights in 1988 and raised the ‘identity-of-owners’ issue. He pointed out that Coase (1960) avoided the question of variation of wealth distribution according to different possible bargaining situations (3.1). This criticism showed that in fact Coase (1959, 1960) rejected the question of identity of owners, leaving to the field of law questions regarding who has rights and who (the polluter or the polluted) pays whom (3.2). Far from being irrelevant to economists, the identity of owner issue seems a good way of reconnecting law and economics, redefining efficiency, and opposing the disentanglement of the legal-economic nexus (3.3).

3.1. Demsetz and the identity-of-owners problem

51This subsection introduces two new elements: (1) the comparison of consecutive states; (2) the personal characteristics of owners. Coase (1960) did not discuss these elements, but they are relevant to my discussion because they reintroduce the ‘who’ issue.

52 Demsetz (1988) elucidated the ‘identity-of-owners’ problem, integrating both of these elements and (very basically) connecting the comparison between consecutive states and the focus on the personal characteristics (consumption characteristics in this case) of owners. By discussing Coase’s (1960) efficiency argument, Demsetz demonstrated how the distributional issue unavoidably ensues from the Coasean solution to the problem of social cost, even though this is negated :

One may conclude from Coase’s reasoning that the identity of owners has no impact on resource allocation in a competitive setting in the absence of transaction costs if the affected parties play no significant role in the overall pattern of demands for goods. With positive transaction costs or with affected parties significantly impacting the pattern of demands for goods, the identity of owners affects the mix of output that is efficient, but does not alter the conclusion that each resulting mix of output is efficient when judged by the demands emanating from the wealth distribution associated with a particular specification of ownership. (Demsetz, 1988, 16)

53Any reallocation of rights implies an income effect among the transacting parties. Demsetz emphasised the consumption patterns of the two parties involved in the private agreement. Coase insisted that the final mix of output was not only efficient but also unique. This standpoint is implicitly equivalent to the assumption that cattle farmers and settlers share the same consumption function. In contrast, Demsetz (1988) assumed that cattle farmers and settlers do not share the same consumption function; consequently the final mix of output may remain efficient but will in no way remain identical.

54By recognising the multiplicity of efficient solutions and the contingency of any given efficient solution on the presumed structure of rights, Demsetz echoed the circularity of efficiency stressed by institutional law and economics, which is difficult for the Chicago School to handle. Schmid (1989) argued that the final mix of output that is termed ‘efficient’ is in fact efficient only with regard to the assumed initial structure of rights. This initial structure is precisely assessed in terms of identity. Samuels wrote: “Legal decisions or changes can be said to be efficient only from the point of view of the party whose interests are given effect through the identification and assignment of rights.” (Samuels, 1981, 154)

55The problem of identity-of-owners is fundamental because it provides a way of formulating the real, though missing, condition that allows the assertion of economic neutrality of law as defined with reference to Coase (i.e. efficiency and uniqueness).

3.2. Coase (1959) and the disconnection between ‘who’ (law) and ‘what’ (economics)

56Application of the distributional issue (‘who is to hold property rights’) introduces the implicit condition on which the Coasean assumption of law neutrality is based: the disconnection between ‘who’ and ‘what.’ Briefly, the task of defining and checking the identity of the holder of property rights is entirely left to the legal field; afterwards, the use that is made of the scarce resource belongs to the domain of economics. I refer to this condition as ‘implicit’ because it does not appear in Coase (1960), but in fact Coase did make this condition explicit in 1959:

Whether a newly discovered cave belongs to the man who discovered it, the man on whose land the entrance to the cave is located, or the man who owns the surface under which the cave is situated is no doubt dependent on the law of property. But the law merely determines the person with whom it is necessary to make a contract to obtain the use of the cave. Whether the cave is used for storing bank records, as a natural gas reservoir, or for growing mushrooms depends, not on the law of property, but on whether the bank, the natural gas corporation, or the mushroom concern will pay the most in order to be able to use the cave. (Coase, 1959, 25)

• 6 For Coase (1960), it is important to have well-defined and exogenous rights so that reallocations c (...)

57The two delineated fields cannot be superposed as a latent logic divides the fields of law and economics. This scission is temporarily sequential: the law comes first,6 then the allocation determined by law can in a way be ‘undone’ through economic mechanisms. In other words, for Coase (1960) the logic of economics usually prevails—if transaction costs are negligible—over legal logic, and free private agreements can undo the distributional efforts (or choices) achieved through first allocation of property rights.

• 7 Ethics refer to a set of values and virtues that can change in time and place. Here, I will mainly (...)

58Thanks to this differentiation between ‘who’ and ‘what,’ the issue of distribution can be set aside; it ceases to be relevant for economists, at least from a theoretical point of view. The world in which the law is neutral is in fact the juxtaposition of two separate incontrovertible worlds: distribution (including ethical7 concerns) is left to the world of law, and efficiency to the world of economics. From a Coasean perspective, the logic of economics (realm of efficiency) is not only perfectly distinct and disconnected from legal logic but will prevail in the end due to sequential reasoning. This explains the normative assumption, specific to the Chicago School, that everything must be done to smooth the path towards economic efficiency: as Posner phrased it, legal decisions must “mimic the market” and are valued according to their capacity to lower existing transaction costs.

3.3. The distributional issue or the non-neutrality of owner identity

59As we know, Coase’s (1960) goal was to criticise and go beyond the prevailing Pigouvian approach to the problem of externalities. Pigou articulated his solution to the problem of external damages around the concept of liability: externality implies the existence of a victim and an offender. Incidentally, this interpretation of the problem caused by social cost perfectly fits the legal analysis of liability for damage. In contrast, Coase shifted the externality issue from the field of liability (tort law) to the field of property (property law).

60Renouncing the two categories of victim and offender is one way to negate the distributional issue connected with the allocation of property rights. To borrow from Demsetz, it negates the identity-of-owners problem, but from an ethical and legal perspective. It also echoes Knight’s (1935) doubts about the capacity of the competitive process characterising a market economy to allow the emergence of ‘honest’ individuals in leading economic positions to the detriment of more dubious individuals.

61Efficiency can nevertheless be used as a dominant way to assess the various possible allocations of rights. Section 1.2 defined efficiency, in this context, as the achievement of a final mix of output that maximises the value of production. I also discussed how efficiency is not univocal, even for economists. Reducing it to one single dimension seems a drastic choice as this cannot encompass the full significance of the concept. In addition, it may be considered a specific definition, allowing the complete dismissal of any concerns about values (for instance, is making the polluter pay the polluted the same as making the polluted pay the polluter?).

62New-institutional authors such as Medema, Mercuro and Samuels have stressed that it would be erroneous to neglect the non-uniqueness of efficiency which can in no way be reduced to a single dimension. In particular, Samuels and Schmid asserted that “the concept of efficiency as separate from distribution is false” (Samuels and Schmid, 1981, 2). Efficiency can and should be defined as a multidimensional vector of characteristics, of which at least two can be named: the final mix of output (uphill) and the distribution of wealth (downhill). However, this multidimensionality makes it more difficult to assess the efficiency of final states of allocation.

63Another approach allows me to go beyond efficiency, or at least to try and reduce the gap between ethics (what is right) and efficiency. This approach requires redefining the significance of the assumption of law neutrality. Here, the law is defined positively; it cannot be viewed anymore as a hindrance to the economic logic of efficiency. The underlying idea is that distribution is a highly normative choice that cannot be freely undone by the workings of private agreements. Ethics must be part of the normative judgement that shapes the initial assignment of rights. At the level of first allocation, it is necessary to select which individuals will hold rights, knowing that this will determine the distribution of wealth. Then, for any successive reallocation some will gain and some will lose. These elements introduce biases into the definition of efficiency, as noted previously by Calabresi (1991) and others. Moreover, and this is more specifically our point here, from a legal perspective, it may be necessary to bar some individuals from both the allocational and the reallocational process. This is clearly the case for criminals; here, the law is not and should not be neutral.

4. Back to the Legal-Economic Nexus: The Mafia and Legitimate Businesses

64One can reinterpret the doubts expressed by Knight in two ways: by applying the Coasean definition of law neutrality, or by applying an institutional definition that goes beyond efficiency. If one looks at law neutrality from a Coasean perspective, it is in no way problematic that morally dubious individuals may emerge to the detriment of honest agents in a competitive environment if they make the most valuable use of their property rights. This idea may be expanded with reference to the possibility that the law may impede certain individuals—in this case, criminals—from acceding to property over productive entities: the infiltration of criminals within legitimate businesses is not an economic problem, if it complies with the efficiency criterion. In contrast, following Knight’s reasoning, the law would be considered neutral if it could allow simultaneously for efficiency and for the enrichment of the category of persons who abide by the social pact. In this section, I will first turn to the efficiency criterion applied to the Mafia and its legitimate businesses. Then, I will discuss the nature of exchange when a Mafioso faces a non-Mafioso. Lastly, I will show that, with the Mafia, the law has a role to play in order to avoid the establishment of a lasting Mafia order. It explains the need for patrimonial measures of prevention whose benefits are clear in terms of legal-economic nexus.

4.1. Efficiency applied to the Mafia: a misstatement of the problem

65The infiltration of legitimate businesses by the Mafia is one example of an economic problem that might be missed or misunderstood when adopting a Coase-Theorem-inspired perspective and the assumption of law neutrality. The existence of ‘Mafia firms’ (firms owned by Mafiosi but with a legal and declared purpose) has been asserted and studied by various scholars, and in particular Arlacchi (1983), Catanzaro (1988) and Gambetta (1992). For my purposes here, the following questions are important: In the presence of Mafiosi on the legal markets, can the efficiency criterion be sufficient to determine who is to own property rights? Can the law confine itself to mimicking the market when faced with criminal agents? Posner asked but did not definitively answer the question: “Should entry [of criminals] in legitimate businesses be encouraged or discouraged ?” (Posner, 1986, 224)

66If we let market forces work freely, legitimate businesses prove unable to deter Mafiosi from entering the market (by creating firms or, more usually, by taking over existing firms). Thanks to their easy access to liquid assets (Arlacchi, 1983, among others), Mafiosi have the capacity to pay and gain access to property rights over a productive entity. The completeness of the bundle of property rights, typical of market economies, warrants the transferability of such rights over productive entities from non-Mafiosi to Mafiosi.

67The issue of whether it is unethical to allow Mafiosi to infiltrate legitimate businesses (and thereby increase their own wealth) is beyond the scope of this paper. Instead, I will focus on the issue in terms of market functioning and efficiency. Economists and sociologists have studied the impact of the mafia on legal markets for the last three decades at least; they all agree that Mafiosi have a disruptive effect on the markets they enter. For example, in infiltrated economies, which have been called ‘economies of expulsion’ (Champeyrache, 2004), legal Mafia-owned firms tend to expropriate the non-Mafiosi and concentrate firms and power. The functioning of local economies in the presence of the Mafia is biased because the legal Mafia-infiltrated sector is integrated within a wider scheme including illegal activities: goods and money flow from illegal to legal activities and vice versa, blurring the frontiers between legal and illegal economies (Rey, 1993). Consequently, the attribution of property rights over productive entities to Mafiosi affects the size of both legal and illegal activities as well as entrepreneurship among both Mafiosi and non-Mafiosi. The distribution issue is not neutral—but this raises a new question: Is it separate from the efficiency issue or separate from it?

68The main issue here is that redistribution can be part of the efficiency issue, meaning that an economy or a society can become more efficient by taking into account distributive concerns. Zamagni (1993), following Franchetti (1876), raised the issue of the persistence of a ‘Mafia order’ in Sicily or, more generally, the existence of a stable Mafia equilibrium, arguing that the Mafia “constitutes a suboptimal solution to the Hobbesian problem of social order” (Zamagni, 1993, 135). In other words, infiltration of the market by the Mafia leads to a Pareto equilibrium compared to the natural state. The Rule of Law would also be a Pareto-superior solution. If we compare the Mafia order and the Rule of Law, the latter solution is strictly superior in terms of justice and efficiency but according to the Pareto criterion, they are both optimal compared to the natural state. From a Pareto perspective, once a Mafia order is established, no move towards the Rule of Law can be acceptable because some agents (the Mafiosi) would lose from such a move. Therefore, allowing the Mafiosi to infiltrate legitimate businesses contributes to the establishment of a Mafia order and locks the economy into an optimal framework: the status quo with the mafia, which is nonetheless a suboptimal solution compared to a situation in which the Mafia is not given the opportunity to enter legal markets.

4.2. The nature of exchange in the presence of the Mafia

69Mafia firms can reach efficiency. An economy infiltrated by the Mafia has no way of getting rid of the Mafiosi if only market forces operate. To avoid this situation, the law must forbid the Mafiosi to create legitimate businesses and prevent the transfer of property rights to Mafiosi. Thus the law must be non-neutral and, in certain cases, work to curb market forces to (somewhat paradoxically) protect the market itself. This means restoring the legal-economic nexus to its true meaning and usefulness.

70Coase (1960) and the subsequent interpretations of his article focused on the positive results of private bargaining between equal and powerless individuals. Therefore, in Coase’s mind the nature of the problem is ‘Pareto symmetric’ and it does not matter who compensates who. In the presence of the Mafia, such reasoning does not hold. The nature of exchange, identity matters and ethics are deeply modified. Mishan (1971, 24-25) already stressed that a conflict might be Pareto symmetric without being ethically symmetric. He took the example of a conflict between smokers and non-smokers and he depicted the approach which makes no economic distinction between rules which place the burden of the cost of pollution control on polluters and receptors as morally and ethically unacceptable. It does not matter if the law is in favour of the smokers or the non-smokers in terms of efficiency, but the question of who should pay matters from an ethical and a legal viewpoint. The argument is that the freedom of the polluters damages the welfare of others, whereas the freedom desired by those who want to live in clean surroundings does not, of itself, reduce the welfare of others. The same applies to relations between Mafiosi and non-Mafiosi in the legal economy. When Mafiosi operate in legitimate businesses, as already mentioned, they tend to expropriate non-Mafiosi and reduce their opportunity to take part in the economy, thereby reducing their welfare (Champeyrache, 2004).

71Mafiosi also benefit from the power accumulated by the criminal association. In bargaining situations occurring between a Mafioso and a non-Mafioso, there is a discrepancy in the nature of the exchange because what the exchange looks like formally differs from what it really is. Commons (1931) stressed the importance of the “personality of participants,” which he describes as “all the differences among individuals in their powers of inducement and their responses to inducements and sanctions” (Commons, 1931, 655). As stated in the Italian penal code (see article 416 bis), a Mafioso, as a member of the criminal association, benefits from a power of intimidation (forza di intimidazione) and of subjection (condizione di assoggettamento). Under these conditions, a bargaining transaction can de facto be the expression of coercion and power in favour of the Mafia. A cumulative number of transactions between Mafiosi and non-Mafiosi results in an increase in inequality of opportunity and in an increasingly unfair competition paradoxically achieved through the free working of unregulated market forces.

4.3. When the non-neutrality of law is required: a plea for the Rognoni-La Torre law

72‘Who’ matters and treating Mafiosi and non-Mafiosi as equals, free to bargain and reallocate property rights over productive entities might not impede the attainment of an optimal situation but certainly shapes the nature of efficiency. If the resolution of conflicts is left only to market forces, the reallocations of property rights—unregulated by law—will legitimate and reinforce the exercise of power by some individuals (Mafiosi) over others (non-Mafiosi). In turn, this will create a specific ‘efficiency path’ which consolidates the Mafia order mentioned above (see section 4.1).

73In order to avoid a situation in which an economy becomes trapped in a path that perpetuates the Mafia order and grants major opportunities to Mafiosi to the detriment of non-Mafiosi, the law has a role to play. Indeed, institutional changes are required to correct imbalances in power relationships and to correct injustice. In this setting, “The assignment of legal rights is one determinant of who has power and who is exposed to this power.” (Dawson, 1994, 36) The Rognoni-La Torre Law in Italy is part of this framework. Implemented in 1982 as a set of ‘patrimonial measures of prevention’, it allows the confiscation of patrimonies (including firms) accumulated by Mafiosi. When Mafiosi are already present in legitimate businesses, they can lose their assets. The aim is also to prevent Mafia infiltration so that the patrimonial measures are part of a larger scheme of legal provisions to impede Mafiosi from entering legal markets and establishing a long-lasting Mafia order. Symmetrically, the Rognoni-La Torre Law establishes that the interests of non-Mafiosi entrepreneurs have to be protected by law. The market on its own is unable to grant them such protection. It even tends to favour Mafiosi and consolidate their power, exposing non-Mafiosi to expropriation. Indeed, the Mafiosi use mutual property rights as a functioning principle (Champeyrache, 2012). Although, formally, the bundle of property rights remains complete, the Mafiosi modify the effective content of the bundle of rights, and in particular the effectiveness of the alienability right. The degree of alienability depends on who is the owner. Goods—and productive entities—are highly transferable from non-Mafiosi to Mafiosi hands. But goods belonging to Mafiosi cease de facto, although not de jure, to be alienable because Mafiosi usually ask for an excessive price when they sell. Empirically, once they are in Mafiosi hands, property rights are locked inside the Mafia network. Market forces are therefore unable to expel the Mafiosi. The latter create a ‘grey economy’ where their legitimate businesses and illegal activities are intertwined and generate incomes high enough to acquire and accumulate more property rights over legal firms. Market forces are also unable to protect individuals not affiliated with the Mafia in their pursuit of rightful economic opportunity. Only the law—thanks to devices such as the Rognoni-La Torre patrimonial measures—can re-establish an equality of opportunity, correct imbalances in power relationships between Mafiosi and non-Mafiosi, and thus correct injustice.

74The following chart summarises the contrast between the property approach and the institutional approach and the different response given to the problem raised by the Mafia’s infiltration of legitimate businesses.

Conclusion

75In this article, I have defined the meaning and the content of the Coase-inspired assumption of law neutrality. I have also criticised the property rights approach for its emphasis on the absence of transaction costs because it generates a biased and limiting representation of the relationship between law and economics. The Coase Theorem and its various interpretations dismiss the ‘real world’ of positive transaction costs and therefore take for granted the neutrality of the initial allocation of rights in the economic system. The function of law is not even discussed per se; it is assessed only in economic terms of efficiency. The zero transaction cost condition and the negation of the identity-of-owner problem actually lead to a process of law neutralisation, which is both artificial and unsatisfactory. As a consequence, setting aside the dichotomy between the ‘real world’ with transaction costs and the ‘ideal world’ without transaction costs restores the autonomy of law in economic analysis. Law is no longer subordinate. This revives the old institutionalism tradition and questions the almightiness of the efficiency criterion in standard economics. More globally, my intention is to show that instead of implicitly assuming a dichotomy between ‘who’ and ‘what,’ economists should reconnect these two elements into a global scheme and consider that the identity of owners is not neutral. This process would strongly challenge the basis for the traditional version of the assumption of law neutrality. It would also contribute to a more accurate definition of the role that is and should be devoted to the law, in particular, and of the interactions between law and economics, in general.

76I have tried to restore the disentangled legal-economic nexus and I have illustrated the case with the example of the Mafia infiltration of legitimate businesses. A comparison between the property rights theory and the legal-economic nexus approach shows that in order to understand the Mafia phenomenon and crack down on it, an institutional theory of organized crime is very much necessary. This theory would give a major role to institutions and to the interaction between law and economics. Institutions would have a more important role than simply minimizing transaction costs. Conversely, standard crime economics, based on opportunity costs as in Becker, or on efficiency calculus, is unable to handle the problem correctly because the market itself is unable to get rid of the Mafiosi.

The author would like to thank Mehrdad Vahabi, Jean-Sébastien Lenfant and two anonymous referees for their valuable comments and suggestions. Obviously, all the remaining errors are mine.

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