Key assumptions of the invisible hand theorem

There are some key assumptions in the invisible hand theorem which we failed to make explicit earlier. Before we discuss these assumptions, it is important to note that they are sufficient rather than necessary conditions - in other words, relaxing the assumptions does not automatically mean that the invisible hand result will not hold. On the other hand, if the invisible hand result does not in fact hold and we observe some inefficiency in a market, it must be because one or more of the following assumptions do not hold. Thus, examining these assumptions provides us with some important insights into the role of the legal system in influencing economic outcomes and economic well-being.

As will be discussed further in Chapter 2, the normative approach to law and economics attempts to justify legal rules based on some normative consequentialist criterion (usually the efficiency criterion). This approach recognises that efficiency is a powerful and unifying concept. However, inefficiency of existing institutional or legal arrangements does not automatically justify government intervention, the alteration of an existing legal rule, or the imposition of a new legal rule. Outcomes under existing arrangements need to be carefully compared on a like basis with alternatives that are proposed. Failure to do so can lead to the 'nirvana fallacy', which Demsetz (1969) has explained as follows:

The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing 'imperfect' institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements. In practice, those who adopt the nirvana viewpoint seek to discover discrepancies between the ideal and the real and if discrepancies are found, they deduce that the real is inefficient. Users of the comparative institution approach attempt to assess which alternative real institutional arrangement seems best able to cope with the economic problem; practitioners of this approach may use an ideal norm to provide standards from which divergences are assessed for all practical alternatives of interest and select as efficient that alternative which seems most likely to minimize the divergence.2

Efficiency analysis which compares existing arrangements with some theoretically 'perfect' ideal set of institutional arrangements is an inappropriate framework for real world policy design. This book uses efficiency analysis as a unifying analytical concept to illustrate the kinds of costs and benefits that different legal rules can create. However, throughout the analysis, the nirvana fallacy should always be kept in mind. Like markets and the individuals who participate in those markets, regulatory agencies, policy institutions, courts and the legal system are not perfect and are not infallible. Legal rules and institutions are themselves subject the same kinds of failures that may affect markets (that is, imperfect knowledge, informational asymmetries, distorted incentives, and so on). It is important to realise that just as market failures exist and may indeed be pervasive, government and regulatory failures also exist.

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