Principles of microeconomics (I)

Welcome to the study of economic analysis of law! If you can master the material in this chapter and the next one, you will find all the applications of economic principles in the remainder of this text straightforward. The approach to the shidy of law taken in this text, and in the research referred to below, represents the future of legal scholarship.

These first two chapters introduce some fundamental economic principles. The basic tools of price theory - supply and demand curves, and the like - are humble and deceptively simple, and it is easy to underestimate the power of these ideas. A lack of understanding of these principles often leads to the adoption of inefficient and sometimes disastrous policies - government subsidies of crops and inefficient films, protectionist policies in foreign trade, and the like. Outside the United States, of course, the ignorance of economics has resulted in mass starvation and blighted lives for millions living in poverty. Thus we can begin to appreciate the value of price theory by considering the consequences of making decisions without it.

In this chapter we will examine demand and supply curves, how price and the amount of the good sold are determined in a competitive market (with an application to the market for lawyers), elasticities, and the effects of government intervention in the market via taxes, subsidies or price controls. We develop these foundations of price theory only to the extent they are helpfiil for the analysis of law set forth in the chapters that follow. Readers who are familiar with price theory at the level of a college course in intermediate microeconomics may wish to skip the first two chapters, and proceed immediately to the chapter on an introduction to the legal system.

A basic principle: the fungibility of money

A good is “fungible” if units of the good are regarded as indistinguishable from one another, and thus freely exchangeable. Money is fungible. A’s $1 bill is for all practical purposes identical to B's SI bill. The idea of fungibility has important economic implications. Many state lotteries have been adopted in part because of political support resulting from promises made to the public that all net revenues of the lottery will be used only for public education. Suppose a state spends $500 million a year on its public schools, raising the funds from a property tax. The voters of the state approve a state lottery, relying on the promise that all net revenues of the lottery will be spent on public education. The lottery has $200 million in net revenues in its fust year, and all of it is spent on the public schools. Suppose, however, the state now takes $200 million of its property tax revenues that were previously spent on education, and spends them instead on road repairs. In this case the total spending on education has not increased; the problem is that money is fungible.

Now suppose that, without a lottery, the state would have continued to spend S500 million on public education. However, there is a lottery, and its net revenues for the year are S800 million, all of which must be spent on education. In this case the lottery actually increases spending on education by $300 million. Even though money is fungible, a restriction or earmark that causes expenditures to be greater than they would otherwise be does have an effect.

Let us return to the previous example, where the lottery raised $200 million specifically for public education, but total spending on schools ($500 million) did not increase at all. Do things like this really happen? As it dims out, it is unusual to find such extreme examples of fungibility. There have been a number of studies of the effect that earmarking funds for public education has on total educational spending. One study1 found that between 500 and 700 out of every dollar earmarked for education ends up in local school districts, notwithstanding the fungibility of money. Governments are usually not brazen enough to offset the additional funds completely. This has been attributed to the “flypaper effect,” i.e. the idea that money often sticks to the wall in the place where it is thrown. The idea is that government spending for a particular purpose, like public education, that has been promoted by an interest group, like the education lobby, tends to increase total expenditures for that purpose, because (1) the interest group will follow through to make sure the new funds that have been committed are not offset by an equal reduction of funds somewhere else, and (2) the government does not want to disappoint the interest group, because the interest group will then lose interest in supporting government programs. There is something like an implied contract that the government will not “double-cross” the interest group by reducing its spending to fully offset the new spending program that has been approved.

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