The legal foundations of markets

The legal system and its rules and norms facilitate the formation of formal and informal markets on which voluntary, value-creating exchanges and resource movements can take place. As Coase (1991) notes, 'without the appropriate institutions no market economy of any significance is possible'. Just as understanding markets, the process of trade and the gains from trade are all central to understanding economics, understanding the role that legal rules and institutions play in facilitating economic exchange is a vital part of understanding of the very same phenomena.

Legal rules influence market outcomes by altering the incentives faced by individuals participating in the market process. Rules, remedies and punishments send 'price' signals to consumers and producers in the form of expected damages and other remedies (in the case of private law), or fines, imprisonment terms and other punishments such as the death penalty (in the case of public and criminal law). In an efficient legal system, legal rules, remedies and punishments maximise the net economic benefits of the market process.

Some legal institutions and rules are more important than others. Private property rights, contract law and accident law all play a vital part in market economies in influencing the efficiency or otherwise of resource allocation. Some legal rules can boost the gains from trade, some can hinder trade and detract from economic well-being, and some - very surprisingly - may be completely irrelevant for determining observed market outcomes.

The field of law and economics - the focus of this book - studies how the legal rules that govern interactions between individuals can affect market outcomes and the allocation of scarce resources, and how these rules alter individuals' incentives, well-being, and the gains from trade and specialisation. Law and economics focus on four separate but related propositions, all of which are explored in this book:1

  • 1. The Invisible Hand Theorem (also known as the First Fundamental Theorem of Welfare Economics): Under certain assumptions, competitive markets produce efficient outcomes.
  • 2. The Efficiency Version of the Coase Theorem: If transaction costs are sufficiently low and legal rights are well defined, legal conflicts (which would otherwise arise over uncompensated costs and benefits that are due to activities which generate external effects) are resolved in an efficient manner via mutually advantageous, voluntary exchange.
  • 3. The Economic Role of the Legal Rules (Normative Version): If

transaction costs are not sufficiently low, so that the conclusion of the Coase Theorem does not hold, then legal rules should be designed in such a way to ensure an efficient allocation of resources.

4. The Economic Role of Legal Rules (Positive Version): The system of legal rules developed under the common law (that is, the system of judge or court-made law which is based on precedent, as opposed to statute-based law) in fact evolves over time to ensure an efficient allocation of resources.

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