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Principles and Methods of Law and Economics
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  • Page extent: 394 pages
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 (ISBN-13: 9780521534116 | ISBN-10: 0521534119)

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PRINCIPLES AND METHODS OF LAW AND ECONOMICS

This is an introductory book that targets the reader who aspires to apply economic analysis but seeks a technical introduction to its mathematical techniques or a structured elaboration of its philosophical principles. It juxtaposes economic analysis with moral philosophy, political theory, egalitarianism, and other methodological principles. It then presents the details of methods, such as model building, derivatives, differential equations, statistical tests, and the use of computer programs.

Nicholas Georgakopoulos is Professor of Law at Indiana University School of Law. He received his master’s degree and doctorate from Harvard Law School, where he specialized in finance and the regulation of financial markets. His publications are cited prominently, including citations by the U.S. Supreme Court and the Securities Exchange Commission.





Principles and Methods of
Law and Economics

Basic Tools for Normative Reasoning


Nicholas L. Georgakopoulos
Indiana University





CAMBRIDGE UNIVERSITY PRESS
Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo

Cambridge University Press
40 West 20th Street, New York, NY 10011-4211, USA

www.cambridge.org
Information on this title: www.cambridge.org/9780521826815

© Nicholas L. Georgakopoulos 2005

This publication is in copyright. Subject to statutory exception
and to the provisions of relevant collective licensing agreements,
no reproduction of any part may take place without
the written permission of Cambridge University Press.

First published 2005

Printed in the United States of America

A catalog record for this publication is available from the British Library.

Library of Congress Cataloging in Publication Data

Georgakopoulos, Nicholas Leonidas.
Principles and methods of law and economics : basic tools
for normative reasoning / Nicholas L. Georgakopoulos.
p. cm.
Includes bibliographical references and index.
ISBN 0-521-82681-0 (hardcover) – ISBN 0-521-53411-9 (pbk.)
1. Law and economics. 2. Law–Methodology.
3. Economics–Mathematical models. I. Title.
K487.E3G46 2005
340 .11–dc22 2004029141

ISBN-13 978-0-521-82681-5 hardback
ISBN-10 0-521-82681-0 hardback

ISBN-13 978-0-521-53411-6 paperback
ISBN-10 0-521-53411-9 paperback

Cambridge University Press has no responsibility for
the persistence or accuracy of URLs for external or
third-party Internet Web sites referred to in this publication
and does not guarantee that any content on such
Web sites is, or will remain, accurate or appropriate.





In memory of my mother.
May justice and welfare end random violence.





Contents

Preface xiii
    INTRODUCTION: INNOVATION IN LEGAL THINKING 1
    A. Proposals, Consequences, and Ideals ● 1  
    B. Toward Scientific Analysis of Law ● 3  
    C. Bibliographical Note ● 7  
PART 1: PRINCIPLES
1.   FROM FORMAL LOGIC TO NORMATIVE REASONING 11
    A. Formal Deontic Logic ● 12  
    B. Formal Logic’s Failure in Normative Reasoning ● 13  
    C. The Informal Normative Syllogism ● 15  
       Proposals, Consequences, and Ideals in Normative Reasoning ● 16  
    D. Concluding Exercises ● 17  
    E. Bibliographical Note ● 19  
2.   SOCIAL WELFARE VERSUS MORAL PHILOSOPHY 20
    A. Ideals behind Law and Economics: Welfarism and Pragmatism ● 23  
    B. Juxtaposition with Other External Derivations of Ideals ● 25  
       i. Deriving Ideals from Existing Rules (Including Formalism) ● 25  
       ii. Rawls’ Contractarianism ● 26  
       iii. The Potential Equivalence of Derived Ideals and Preferences ● 27  
    C. Distinguishing Features of Economic Analysis ● 29  
       i. Avoidance of Moral Relativity ● 30  
       ii. Preference for Applications over Refinement of Principles ● 30  
       iii. Ubiquitous Importance of Incentives ● 30  
       iv. Treatment of Preferences as Objective ● 31  
       v. Lack Bias for Rule Proliferation ● 34  
       vi. Orientation Toward the Future ● 34  
    D. Concluding Exercises ● 35  
    E. Bibliographical Note ● 36  
3.   FROM POLITICAL PHILOSOPHY TO GAME THEORY 37
    A. Political Theory ● 38  
       i. Inefficiencies of Majority Rule ● 39  
       ii. Legal Process: Explaining the Administrative State ● 40  
       iii. Civic Republicanism ● 42  
       iv. Perfectionism ● 43  
    B. Voting System Design ● 44  
    C. Game Theory ● 50  
       i. Cooperation Games: Prisoner’s Dilemma ● 51  
       ii. Coordination Games: Driving Side ● 54  
       iii. Game Theory in Legal Scholarship ● 55  
    D. Social Norms ● 57  
    E. Bounded Rationality ● 59  
    F. Concluding Exercises ● 66  
    G. Bibliographical Note ● 70  
4.   THE IMPORTANCE OF DISTRIBUTION OF WEALTH 72
    A. Redistribute! ● 75  
    B. Do Not Redistribute! ● 79  
    C. Delegating Redistribution to Tax Policy ● 84  
    D. Concluding Exercises ● 89  
    E. Bibliographical Note ● 94  
5.   COASE AND LAW’S IRRELEVANCE 95
    A. Coasean Irrelevance ● 96  
    B. Normative Use ● 98  
       i. Revealing Imperfections ● 98  
       ii. An Example ● 99  
    C. Transaction Costs: The Usual Suspect ● 99  
       i. Vantage Point Makes Transaction Costs ● 103  
       ii. Innovations Transform Transaction Costs ● 104  
       iii. Litigation Costs: Transaction Cost or Not? ● 105  
       iv. Example: Increasing Social Gain from Private Litigation ● 105  
       v. Normative Implications for Litigation of the Analysis of Transaction Costs ● 107  
    D. Concluding Exercises ● 109  
    E. Bibliographical Note ● 111  
6.   MORE FAILURES OF COASEAN IRRELEVANCE 112
    A. Negotiation Holdouts ● 112  
    B. Systematic Errors ● 115  
    C. Risk Aversion ● 115  
       i. Imposing a Transaction Cost ● 118  
       ii. Substantive Solutions of Risk Aversion ● 118  
    D. Distribution ● 120  
    E. Concluding Exercises ● 121  
    F. Bibliographical Note ● 126  
PART 2: METHODS
7.   MATHEMATICAL MODELING 129
    A. Symbols, Functions, and Idioms ● 131  
    B. Simplification and the Model as a Premise ● 140  
    C. Modeling Applications ● 142  
       i. Modeling Negligence Law: Optimization ● 143  
       ii. Modeling the End of Affirmative Action: Differential Equations ● 146  
    D. Concluding Exercises ● 148  
    E. Bibliographical Note ● 152  
8.   CONFRONTING UNCERTAINTY: BASIC PROBABILITY THEORY 154
    A. Describing Randomness: Probability and Expectation ● 155  
    B. Mathematical Models of Expectation ● 159  
    C. Uncertain Uncertainty: Conditional Probability ● 161  
    D. Concluding Exercises ● 166  
    E. Bibliographical Note ● 174  
9.   ADVANCED PROBABILITY: DISTRIBUTIONS AS THE SHAPE OF RANDOMNESS 175
    A. The Shape of Randomness: Distribution Functions ● 176  
       i. Visual Comparison of Discrete and Continuous Distributions ● 177  
       ii. CDF and PDF: Features and Relations ● 178  
       iii. Truncated and Censored Distributions ● 181  
    B. The Normal Distribution ● 186  
    C. Concluding Exercise: Imperfect Enforcement ● 188  
    D. Bibliographical Note ● 196  
10.   HOW TO PRICE UNCERTAINTY: FINANCE 197
    A. Valuation in Perfect Markets ● 199  
       i. Known Rates: Discounting ● 199  
       ii. Risky Assets ● 203  
    B. Normative Implications of the CAPM ● 211  
       i. Financial Information ● 211  
       ii. Forecasts ● 212  
    C. Financial Market Microstructure: The Game-Theoretical Foundation of the CAPM ● 213  
    D. Normative Application of Microstructure: Insider Trading ● 214  
    E. Concluding Exercises ● 220  
    F. Bibliographical Note ● 224  
11.   FINANCE AND PROBABILITY: OPTIONS AND DERIVATIVES 225
    A. Option Pricing ● 227  
    B. Normative Implications of Option Pricing ● 234  
       i. Recipients of Fiduciary Obligation ● 235  
       ii. Automated Reorganizations via Options ● 236  
       iii. The Options Understanding of the New Value Exception ● 240  
    C. Concluding Exercises ● 244  
    D. Bibliographical Note ● 248  
12.   USING SPREADSHEETS 249
    A. The Basics ● 249  
       i. Obtaining Built-in Help about Functions ● 251  
       ii. Using the Function Wizard ● 253  
       iii. Categories of Built-in Functions ● 255  
       iv. Relative and Absolute References in Copying ● 258  
    B. Graphics ● 261  
       i. Chart Types ● 262  
       ii. Completing the Chart Wizard ● 265  
       iii. Manipulating Charts ● 267  
    C. Solving Equations ● 269  
       i. The Solver ● 269  
       ii. Goal Seek ● 270  
    D. Macros and User-Defined Functions ● 271  
       i. Recording a Macro ● 271  
       ii. Editing a Macro ● 273  
       iii. Assigning a Macro to a Graphic ● 274  
       iv. Entering a Function ● 274  
    E. Downloading and Combining Data ● 274  
       i. Data Files Separating Columns with Commas or Tabs ● 275  
       ii. Specifying the Type of Data ● 277  
       iii. Fixed-Width Data ● 278  
       iv. Combining Data ● 279  
    F. Concluding Exercises ● 280  
    G. Bibliographical Note ● 281  
13.   STATISTICS 283
    A. The Use of Statistics in Legal Thinking ● 284  
    B. Fundamentals: Descriptive Statistics and Distributions ● 287  
    C. Empirical Research ● 288  
       i. Basics: Comparing Data That Take Values and Data That Fall into Categories ● 289  
       ii. Determining Influences: Multiple Outcomes ● 298  
       iii. Determining Influences: Yes/No Outcomes ● 308  
       iv. Observations That Are Filtered by a Threshold ● 310  
    D. Concluding Exercises ● 311  
    E. Bibliographical Note ● 313  
14.   CONCLUSION: IMPORTING METHODOLOGICAL INNOVATIONS 315
    A. Cellular Automata ● 315  
    B. Fractals ● 317  
    C. Evolutionary Theory ● 320  
    D. To End ● 320  
    E. Bibliographical Note ● 321  
 
APPENDIX A: MEINHARD V. SALMON 249 N.Y. 458 (1928) 323
 
APPENDIX B: GLOSSARY 332
 
APPENDIX C: MATHEMATICA NOTEBOOKS 339
 
    A. Differential Equations in Law: The Effect of Terminating Affirmative Action ● 342  
       i. Determine the Participation in the Workforce ● 342  
       ii. Add the Initial Condition ● 343  
       iii. Manipulate the Exponent to See It Disappear ● 343  
       iv. The Long-Run Participation ● 344  
       v. The Composition of the Candidates ● 344  
       vi. Graphics ● 345  
    B. Derivation of the Normal Distribution ● 347  
       i. Derive the Normal Distribution as Gauss Did ● 347  
       ii. The Standard Normal Distribution ● 349  
       iii. Restating with Standard Deviation ● 349  
       iv. Restating with Average Deviation ● 350  
       iv. The Triangular Distribution ● 351  
    C. Application of Triangular Distribution: The Uncertain Apprehension of Speed Limit Violations ● 355  
    D. A Comparison of Insider Trading Regimes ● 360  
       i. Foundation ● 360  
       ii. Problem ● 361  
       iii. Solution: Statement ● 361  
       iv. Solution: Proof ● 362  
       v. Illustration of Price Path ● 365  
Index 369




Preface

This book breaks with several traditions of legal scholarship. Rather than focus on one topic, it seeks to show how broad the application of economic analysis of law can be. Rather than explain existing knowledge, it seeks to show how new methodologies develop. Rather than convey the safety of stability, it seeks comfort in the reality of change. My hope is that it will serve as an adequate introduction for ambitious readers who are eager to follow the bright tradition of innovative legal scholarship.

   I hope that this book, which is to a significant extent the result of this approach, helps to orient new jurists in an increasingly complex field. Several voices within the legal academy readily use new methods, expressing with deed their belief that the law of diminishing returns must apply to methodological efforts as well. This book owes much to those pioneers, too numerous to count. The breadth of this book cannot help but force a brevity that is unfair to every one of its topics.

   The overall shape of this book, however, is due to the extraordinary editor of Cambridge University Press, Finola O’Sullivan. She provided significant guidance toward an exciting target. Also very significant was the help of her colleagues at Cambridge University Press, John Berger and Scott Parris. Unusually deep is my gratitude to my dear colleague Daniel Cole at Indiana University Law School–Indianapolis. Also voluminous was the help of Andrew Klein and Stephen Utz. I have received great benefit from comments of John Armour, Judge Guido Calebresi, John Donohue, Peg Brinig, Judge Richard Posner, Mark Ramseyer, Eric Rasmusen, Steve Shavell, Peter Siegelman, Jay Weiser, and George Wright.

   I stress my gratitude to my numerous teachers, in temporal order: my parents and schoolteachers, my professors at the Athens University Law School, Greece; my professors at Harvard Law School, and particularly my doctorfather, Reinier Kraakman; my professors at Harvard Business School; my colleagues at the University of Connecticut and Indiana University, both in Indianapolis and in Bloomington; my co-authors of the second edition of Blumberg on Corporate Groups (Aspen, 2004); and, finally, the numerous presenters at the seminars that I have had the luck to attend in several schools, the law and economics seminar of Harvard Law School, the finance seminar of Harvard Business School, the faculty seminar of the University of Connecticut School of Law, the law and economics seminar at Yale Law School, which received me with unmatched hospitality; and the law and economics seminar at the Law School of the University of Chicago, as well as the presenters at the annual meetings of the American, Canadian, and European associations of law and economics. To all my professors and almost all the presenters I subjected to questioning and for the occasions that it may have crossed any boundaries, I apologize.

   Deep thanks to Liz and Vicki. No bounds have my thanks to my children, Lee and Dimitri. They taught me more than they think. They lost more of my time than I would have liked. Their forbearance is admirable. Their support is precious. They make magic daily and every day magical.


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