Behavioral Law & Economics

When the concept of law and economics came into existence, behavioral economics was a central point of contact. The Coase theorem is the foundation of law and economics. According to the theorem, the outcome is not affected by allocation of legal rights to one party or another if transaction costs are sufficiently low because when the transaction costs are low, the parties are expected to bargain to the efficient outcome under either legal regime.

The Coase theorem’s claim about the domain within which normative analysis of legal rules – whether one set of rules is preferable to another or the reverse – is actually relevant and central to law and economics.

Daniel Kahneman, Jack L. Knetsch, and Richard H. Thaler came out with a study using Cornell University mugs, and the results were direct contravention of the Coase theorem. They referred to this as the endowment effect – the refusal to give up an entitlement one holds initially even though one would not have been willing to pay to acquire that entitlement had one not held it initially. The endowment effect showed that Coase theorem’s prediction of equivalent outcomes, regardless of the initial entitlement, no longer holds. This plays an important role in drafting of legal rules.

Law and economics tries to assess the desirability of actual and proposed legal rules. For this purpose, the endowment effect is more suited than the Coase theorem. In the presence of endowment effect, the value attached to a legal entitlement varies based on the initial assignment of the entitlement.

Context plays an important role in the occurrence of endowment effect. Prior to the Cornell University mugs study, there were many studies which concluded that the Coase theorem was empirically robust in a set of domains. In all these studies, the value of each possible outcome was directly specified in dollar terms by the researchers. These studies found that if the transaction costs are sufficiently low and people are told specifically what each outcome is worth to them, they will generally find their way to a value-maximizing outcome. The Cornell University mugs study proved that if people are not told about the value of the outcome, the results of the earlier studies would be different.

The study of behavioral law and economics examines human limits to means-end rationality. The endowment effect plays an important role in behavioral law and economics. Other features of behavioral economics also pay an important role. Unbounded rationality, unbounded willpower, and unbounded self-interest are considered to be normal traits of humans. For studying behavioral law and economics, humans must be viewed as departing from traditional economic assumptions in three distinct manners: bounded rationality, bounded willpower, and bounded self-interest. The legal system can be influenced by the results of such studies. Using behavioral law and economics, courts can adjust legal reasoning and conclusions accordingly and legislators can design more effective laws.

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