Law and economics remains the most successful example of intellectual arbitrage in the history of corporate jurisprudence. It is virtually impossible to find serious corporate law scholarship that is not informed by economic analysis. Even those corporate law scholars who reject economic analysis spend much of their time responding to those who practice it.
As with any model claiming predictive power, law and economics rests on a theory of human behavior. Specifically, neoclassical economics is premised on rational choice theory, which posits decisionmakers who are autonomous individuals who make rational choices that maximize their satisfactions. Critics of the law and economics school have long complained that rational choice is, at best, an incomplete account of human behavior. The traditional law and economics response to this complaint is that rationality is simply an abstraction developed as a useful model of predicting the behavior of large numbers of people and, as such, does not purport to describe real people embedded in a real social order. Until quite recently, moreover, empirical research tended to confirm that the rational choice model of human behavior is a good first approximation of how large numbers of people are likely to behave in exchange transactions.
Over the last 10-15 years, however, a new school of economic analysis has emerged that challenges the rational choice model precisely on its predictive power. Empirical and laboratory work by cognitive psychologists and experimental economists has identified a growing number of anomalies in which behavior appears to systematically depart from that predicted by rational choice. A good example is the so-called status quo bias: All else being equal, decisionmakers favor maintaining the status quo rather than switching to some alternative state. The status quo bias can lead to market failure where decisionmakers’ preference for the status quo perpetuates suboptimal practices.
My thoughts on this topic were prompted by hearing my colleague Russell Korobkin -- a member of the Volokh Conspiracy (albeit a rarely seen one) -- give a presentation to a faculty workshop on behavioral economic analysis of form contracts; his presentation was based on an excellent paper, by the way, which he has posted to SSRN. (Strongly recommended.) I got to thinking some more about behavioral economics after having lunch last Friday with my colleague Victor Fleischer of A Taxing Blog. Behavioral economics is something of the flavor of the month in legal education, especially on the part of those with an ideological disposition against the free market connotations of neoclassical economic analysis. After a brief flirtation with it myself, I have become much more skeptical, for the reasons developed at length in the Extended Post below.
Empirical demonstrations of this decisionmaking bias have focused on the so-called endowment effect. Subjects commonly place a higher monetary value on items they own than on those that they do not own, even if the two items have the same market value. Accordingly, subjects must be paid more to give up something than they would be willing to pay to acquire the same object. The classic demonstration of the endowment effect variant of the status quo bias was a laboratory experiment in which students were initially endowed either with a coffee mug or six dollars cash. Mug holders were asked to identify the minimum amount they would accept to sell the mug, while cash holders were asked to specify the maximum amount they would be willing to pay to purchase a mug. Subjects were told that a market-clearing price would be determined and trades executed between mug holders willing to accept that amount and cash holders willing to pay that price. It turned out that the price demanded by mug holders was about twice that cash holders were willing to pay, so that very few trades took place.
I do not deny that there is considerable empirical evidence for the endowment effect and the status quo bias. More generally, I also do not deny that behavioral economics is a potentially useful tool that any legal scholar should have in his toolkit. As the Economist explained:
[I]f the endowment effect is real, people's economic decisions are fundamentally different from what economists have assumed. The implications of this are profound. To take one example, the Coase theorem, which argues that initial allocations of wealth do not matter as long as markets allow people to trade their stakes—the rationale for government auctions of everything from radio spectrum to mobile-telephone licences—would no longer be valid. To take another, although economists have shown that you need only a few sharp traders for prices in financial (and other) markets to become efficient, the volume of trade with an endowment effect will be below what it might be without one.
But it is one that must be used cautiously; too many legal scholars are using it far too glibly. Consider, for example, the evidence that the endowment effect appears to vanish when people do not physically possess the commodity in question. Subjects trading tokens or vouchers demonstrate only a weak endowment effect. Because capital market transactions more closely resemble the token or vouchers context then experiments involving physical possession of a tangible commodity, for example, these results call into question the extent to which one can rely on the endowment effect as evidence of a capital market failure. [Update: Korobkin passed on one of his articles, which presents a more nuanced account of this evidence. The money quote is "Money itself does not create an endowment effect, but the effect does appear to exist for financial instruments that are valued only for the money they are worth (i.e., have no intrinsic value themselves) if the value of the instrument is uncertain. These results suggest that securities and other financial instruments can create an endowment effect even though they are held as stores of wealth rather than for their intrinsic or 'use' value." The Endowment Effect and Legal Analysis, 97 Northwestern University Law Review 1227, 1236-37 (2003). Is not clear to me, however, why the results Korobkin discusses are not better characterized as mere risk aversion as opposed to an endowment effect.]
More important, in light of the above update, as the Economist also reported, there is emerging evidence that market actors can learn their way out of biases like the endowment effect:
John List, an economist at the University of Maryland, recently tested the existence of the endowment effect in a new way. Instead of using callow students, he went to a real market with traders of varying degrees of experience: a sports-card exchange, one of many such, where Americans trade pictures of their favourite athletes. There, traders dealing in hundreds of cards mix with browsers who might buy only one.
List found:
[E]vidence for an endowment effect—but also that long experience as a card trader spilled over into his experimental mug-and-chocolate market. Only novices, like the students in earlier experiments, tended to be swayed by what they had been given. This implies that prospect theory can capture the behaviour of inexperienced people, of which the world has many in all sorts of markets. But experienced buyers or sellers in well-established markets get over their psychological “flaws”. They can even transfer their trading skills from one market to another. The neoclassicals, it seems, have scored a point.
I would add a different, but I think equally significant reservation: The claim that law can correct market failures caused by decisionmaking biases or cognitive errors treats regulators as exogenous to the system. Once the state is endogenized, however, regulators must be treated as actors with their own systematic decisionmaking biases. It thus becomes evident that behavioral economics loops back on itself as a justification for legal intervention. Public choice theory provides still another reason market failure is not a sufficient justification for government intervention. Again, the problem is one of treating an endogenous factor as exogenous. A welfare economics model that posits legal intervention as a solution to market failure ignores the fact that regulators are themselves actors with their own self-interested motivations.
In sum, there is a strong temptation to use behavioral economics too glibly. Advocates of government intervention are akways tempted to jump from positing the status quo bias, citing the coffee mug experiments, to an assertion that the government needs to shake up the status quo, without demonstrating that the bias is truly valid in the specific setting at hand. In addition, a certain degree of skepticism about the power of law to effect social change seems warranted. Indeed, behavioral economics itself offers additional reasons to doubt the capacity of law as agent for social change. Finally, one cannot justify government intervention without asking whether the case for it survives endogenizing the state.
You can read an even more extended version of my argument, with application to the longstanding debate over mandatory disclosure in securities regulation, in my article Mandatory Disclosure: A Behavioral Analysis, 68 University of Cincinnati Law Review 1023 (2000).
