Law and Economics

ISSN: 2582-3655

Author: Yashvi Jain & Purvi Chaturvedi


The following paper deals with the two intertwined subjects and their analysis in regard to their relationship. During the course of the paper, it can be understood that law and economics have a mutually dependent relationship as both deal with different aspects of human behavior. Through the paper the same can be traced that with the help of different principles of economics and their applicability in law. The paper also talks about various fields of law and their effect on economics.

1.       Introduction

Law and Economics being different sides of the same coin, lay the essential foundation of the efficient functioning of the modern society we inhabit today, and each complements the other in numerous ways than one.

The idea of applying economic conceptions to gain a better understanding of the law is older than the current program, which goes back to the late 1950s. Key perceptions of law and economics can already be found in the writings of the Scottish Enlightenment thinkers. The Historical School and the Institutionalist School, active on both sides of the Atlantic between roughly 1830 and 1930, had aims parallel to the current law and economics movement. During the 1960s and 1970s, the Chicago approach to law and economics reigned supreme. [1] After the critical debates in the United States between 1976 and 1983, other approaches came to the forefront. Of these, the neo-institutionalist approach and the Austrian approach, both corresponding to schools within economics proper, are worth observing. Law and Economics have gradually found its way to countries outside the United States. From the mid-1970s, it reached the other English-speaking countries, and gradually paved its way to the global fraternity thereafter. The economic analysis of law, or law and economics, may be defined as ‘the application of economic theory and econometric approaches to examine the formation, structure, processes, and impact of law and legal institutions.

It explicitly considers legal institutions not as given outside the economic system but as variables within it, and looks at the effects of changing one or more of them upon other elements of the system. In the economic analysis of law, legal institutions are treated not as fixed outside the economic system, but as belonging to the choices to be explained. Law and Economics are therefore perceived, not as two separate entities or fields, but as one complete subject matter, found to be of growing importance and application throughout the world. 

2.      Economics as a Science

Economics, which is considered to be one of the most widely applicable social science that explains human behaviour, has grown in opportunity and scoperelatively slowly up to the 19th century, but at an accelerating rate since then. Today it has many of the features of a language. It has linguistic origins, grammatical guidelines, good and bad constructions, dialects and a range of vocabulary which evolves, develops and changes over time.[2] It has quite a widespread role to play in various contexts, particularly in explaining agricultural and environmental problems. A basic example could be its contribution to the improvement of policies for the efficient targeting of agricultural subsidies, the regulation, and control of pollution and the depletion of natural resources.[3]Economics discusses the concepts, principles, and models that deal with how the market process works, and endeavors to explain how wealth is created and distributed in communities and cultures. It states how people allocate resources that are scarce and have many alternative uses and other such matters that arise in dealing with human wants and their satisfaction.

The structure of rules which a certain country or community addresses and recognizes as regulating the actions of its members and which it may implement by the imposition of penalties is recognized as- law. It establishes that an understanding of the nature and role of law is of significant importance to all who are interested in change in society. Change in policies is generally and customarily implemented through law and the legal processes of society, at times leading and at times following change.[4]

3.      The interdependence of the Subjects

The interdependence of the two is inevitable and is evident in a variety of day-to-day phenomena we face as individuals and also as members of society. As law influences economics, economics also influences law. Economics forms the basis of the study of law. It forms the foundation and center of the study which in turn helps in efficient governance, reflecting the socio-economic ethos of the country in particular and the world in general. The two subjects and their interdependence enable the country to run smoothly.  Law and economics stress that markets are more efficient than courts. And as economics provides a more logical and objective angle to law, it aids in the making of better and more efficient laws and economic policies. The future of Law and Economics lies in some sort of shared and mutual relationship. It lies not in making law submissive, docile or subservient to economics, but in using the analytical strength of economic theory in conjunction with the empirical understandings into people’s wishes that the legal system gives. So collectively, both theory and practice will become better able to serve our wants and needs.[5]

3.1 Analysis of the Interdependence

Economic analysis of law is usually divided into two subfields: positive and normative. Law and economics, with its positive economic analysis, seeks to explain the performance of legislators, prosecutors, judges, and bureaucrats. The model of rational choice, which underlies much of modern economics, demonstrated to be very useful for explaining (and predicting) how people act under various legal limitations and will be further deliberated upon in the essay.  The positive analysis informs the normative branch of the discipline about possible outcomes. If the effects of divergent legal rules and institutions are recognized, the normative analyst will be able to discern efficient rules from those that are inefficient and formulate reform proposals to increase the efficiency of the law. Positive law and economics’ uses economic examination to predict the effects of various legal rules. So, for example, a positive economic examination of tort law would predict the effects of a strict liability rule contrasted with the effects of a negligence rule. Positive law and economics have also at times supposed to explain the development of legal rules, for example, the common law of torts, in terms of their economic ability and efficiency. Whereas, normative law and economics go one step additional and makes policy recommendations based on the economic concerns of various policies. The key concept for normative economic analysis is efficiency, in particular, allocative efficiency. Furthermore, Law & Economics has the ability to improve the worth of the legal system. In the last decades, extraordinary literature has developed, showing the strength of both positive and normative economic analysis in various areas of law.

We now examine examples and look at how law and economics are interconnected disciplines that require the assistance of the other to make the country function smoothly and incorporate better governance.

A very basic example of how change is laws and taxes affect the economy can be the alcohol industry.  As a result of the change in laws regarding the consumption of alcohol, the demand, and supply of the products either increase or decrease. For example, if the government laws increase the age for the consumption of alcohol, the consumption of the product decreases which further results in the decrease of production. It further affects the alcohol industries and their revenue which directly affects the GDP of the country. Another example could be the change in the tax rate laws which directly affect the GDP of the country. A case study that shows the practical implications of the Law on Economics is the Demonetisation Act of India. The demonetization in 1978 was introduced by an ordinance, which was then replaced by the High Denomination Bank Notes (Demonetisation) Act, 1978. The Supreme Court emphasized that the time limit imposed for exchange of the high denomination notes was necessary in order to cease their circulation as early as possible.[6] Demonetization in 2016 significantly slowed down the economy’s growth and brought about massive effects, both negative and positive, in the economy.

The testimony to the elementary nature of the relationship between the two disciplines can be shown through the ten basic principles of economics and how they relate to law and the legal structure.

4.      Economic Principles and Law

  • One of the major aspects of Law and Economics is based on the basic economic principle that ‘People respond to incentives.’ An incentive can be a prospective punishment (negative) or a reward (positive), which induces people to act a certain way in response to the action under consideration. Under the criminal justice system, the concept of deterrence acts as a discouraging factor which is line with the economic principle of incentives. It ensures that adequate punishment is given which deters the guilty. It also guarantees that other people get discouraged to perform the same action by instilling in them the fear of consequences.[7] Since rational people make a decision by analysing the cost and benefits of any situation, they organically tend to respond to incentives whether positive or negative, such as punishments which impart fear in them. [8]

This principle is essential in analysing the functioning of markets. To cite a very basic example, consider two goods – X and Y, which are substitutes of each other. If the price of good X rises, people will shift to consuming more of good Y, thus reducing their consumption of good X since the cost of consuming good X is much more. On the other hand, the producers will shift to producing more of good X than Y, as the benefit of producing the former is now higher. In the first case, a rise in the price of good X incentivizes consumers to shift to good Y, while it incentivises producers to increase their production of good X. This exhibits how the responses of people interacting in a formalized market set up get altered due to incentives.

The same argument can be taken further and linked to legal rules and laws. The judgment of these is made by analyzing their establishment of the structure of incentives and the resulting consequences of people’s altered behavior in response to those incentives. A fundamental example of this can be how policy makers decide the structure of various tax laws. If they intend for people to drive smaller and more fuel-efficient vehicles, encourage activities like carpooling or increase the use of public transportation in lieu of the private ones, an appropriately higher taxon fuel (such as gasoline) is in order. A more complex to explain the same phenomenon in legal terms can be the Tort Law.[9]

For instance, the reason for damage payments in tort law is not to reimburse the injured parties; rather, it is to recommend an incentive for probable injurers to initiate effective and competent measures. This is done to elude bringing about a tort, in a cost justified fashion. The assumption that law and economics as a subject share with other subjects are that the individuals are rational and respond to incentives. As observed in our everyday lives, when the punishment for an act rises, the population will undertake a smaller amount of that act. Law and economics are more probable than other divisions or subdivisions of legal examination, to use empirical or statistical approaches to calculate the extent of these responses to incentives.[10]

  • The economic principle – ‘people face trade-offs’ might seem like a purely economic phenomenon on face value but can actually be used to explain the logic behind a wide variety of legal phenomena as well. What this principle means in generic terms is, that while making any decision, people face trading off of one goal against the other, given the choices. This principle can be perceived both, from an individualistic as well as a societal point of view. A relevant example pertaining to recent times would be a trade-off between a cleaner environment and a higher income level, as faced by modern society. Environment protection laws which endeavor to ensure a better and healthier environment, require firms to use eco- friendly production methods, thereby raising their costs of production. Higher production costs are most likely to translate into a cut down of profit margins by the firm, a decrease in labor wages, or a higher market price of the product. Hence, it is pretty evident how a cleaner environment and better health comes at the cost of lower income levels of the producers, the workers as well as the consumers. [11]

In the sphere of normative law and economics, efficiency is one of the bedrock ideas, and this principle leads us to an essential concept known as ‘Pareto efficiency’. It is a collective concept of efficiency used by both law and economics scholars. When resources are put to their optimum usage, pareto efficiency then refers to an economic situation where one individual cannot be made better off, without making the other individual worse off.[12] Put another way, any equilibrium which is attained when both the individuals making a decision by facing relevant trade-offs are at their optimum satisfaction levels (in the way resources have been allocated between them), such that further trade between them would make either of them worse off, in order to make the other one better-off, is known as a pareto efficient equilibrium. Hence, a legal rule is Pareto efficient if it could not be altered so as to make one person better off without making another person worse off.

However, a major ordeal that makes Pareto efficiency a limited normative concept, is the assumption of no negative externalities. Externalities play a significant role in the field of legal policy. Coming back to the example of environmental laws stated previously, this argument becomes visibly valid. A firm producing say, air or water pollution will lead to adverse health effects on the people and other living organisms living in close proximity to the firm. This is a case of a negative externality, which is caused by the action (production) undertaken by the firm. This negative externality produced by the action of the firm prevents the market from attaining Pareto-efficiency because any action which makes even one person worse-off implies that the outcome is not Pareto efficient. Such normative outcomes of economic analysis in the case of externalities can be explained by the Kaldor-Hicks technique. A legal rule is Kaldor-Hicks efficient if it could be made Pareto efficient by some parties compensating others as to offset their loss. According to this technique, the market is unable to reach a Pareto-efficient outcome in the case of environmental pollution because of very high transactional costs as in the case of pollution which adversely affects such a large number of individuals in the society, that the possibility of bargaining gets ruled out due to impracticability. Paradoxically, if we assume a scenario with no transactional costs, and assume that the ones affected by the externality would be compensated for their loss, then the Pareto-efficient outcome in such a case would be Kaldor-Hicks efficient. [13]

A direct legal example that works on the concept of pareto – efficiency is the case of mutually beneficial contracts. A contract is known as a mutually beneficial or pareto-efficient one if it cannot be modified so as to raise the well-being or the expected utility of each of the parties to it.

  • Economics assumes that people are rational and think at the margin. Coming, therefore, to the fundamental economic principle which states – ‘Rational people think at the margin’, this principle points out at the basic human instinct that given the opportunities people have, they tend to purposefully make decisions in a way which enables them to achieve their objectives in the best possible way. Thinking at the margin implies that people make a decision by comparing marginal costs and marginal benefits of an action. Only if the marginal benefit exceeds the marginal cost, will the individual find it beneficial to undertake that particular action? Law and economics, with its positive economic analysis, seeks to explain the performance of legislators, prosecutors, judges, and bureaucrats.

The model of rational choice, which underlies much of modern economics, demonstrated to be very useful for explaining (and predicting) how people act under various legal limitations. The model of rational choice or the rational choice theory refers to the school of thought which explains the behaviour of a society as a cumulative behaviour of individuals, based on rationality. According to this theory, individuals make rational choices in line with their personal preferences – an extension of the economic principle stated above. In the field of economics, this theory is increasingly used to formulate hypotheses about market and consumer behaviour, and also forms the basis to examine a broad spectrum of legal decisions. The reason why the theory of rational choice is an appropriate model for legal decision making lies in the fact that most of the legal decisions are market-like choices. This can be claimed on the basis that different legal rules create some kind of legal prices implicitly, on certain kinds of behaviours, to which legal decision-makers in turn conform their behaviour. This is very similar to how consumers and producers conform their behaviours to different prices in a market setting. An appropriate example can be the case of monetary sanctions known as ‘compensatory money damages’, imposed by law, ‘on those individuals who unjustifiably interfere with another’s property, breach a contract, or accidentally injure another person or his property. These money amounts may be taken to be the ‘prices’ of engaging in certain kinds of behaviour, such as a failure to take due care or to perform a contractual obligation.’[14]

  • In the economic analysis of the law of contracts (as based on the model of rational choice), one must understand the need for negotiation between two rational individuals. The economic concept of rational individuals enables them to make selections based on their choices and self-interest. For two individuals to make a single agreement decided mutually, an instrument to balance both their self-interests is required, which maybe be contradictory to one another. The law of contract enables the parties of the contract to decide, discuss, deliberate and reach a point of conclusion where the interest and choices of either of the parties is not compromised. The law of contract ensures the mutual interest of the involved parties by promising a beneficial and consensual deal between them. It also promises a positive transaction cost to both the parties, thus, balancing both their interest and upholding the rational choices of the individuals.

Another example of the rational choice theory being applied to legal decision making can be the famous Becker model, which guides the decision-making behaviour of a criminal to commit a crime. ‘Becker hypothesized that criminals are rational calculators and that, therefore, they made their decisions about compliance with criminal law on the basis of a comparison of the expected costs and benefits of criminal and legal activity.’[15]Thus, the Becker model claims that the crime will be committed by the rational criminal only if the expected benefits of the crime exceed the expected costs of committing it.

5.      Relationship between the two disciplines

While we have extensively explored the interdependence between law and economics, it is important to analyze the effect of the two disciplines to a large extent. The presence of the close relationship between law and economy retains the state standing both nationally and internationally. In this respect, the biggest danger that the state may face is economic improbability. A state in such an uncertainty cannot assure the economic activity with laws and regulations. It cannot determine the legal framework or may face a variation in strategies that may set the development of the country back. Therefore, establishing the necessary legal framework is of great significance for the development of global markets. These markets are governed by the trade laws essentially managed by international bodies such as the World Trade Organization. Trade being an important aspect of any economy, it requires national and international laws regulating the same. The United Nation accepts the underlying principle concerning human rights as the rule of law, and that the World Bank sees it as a necessary precondition of economic and social progress. This clearly manifests the strong and fundamental relationship between economics and law.

Throughout the course of the essay, we successfully traced how law as a subject is closely related to economics as a science. The logical base of economics helps the implementation of law and law governs most of the economic principles in the country. Law and economics are interdependent and their application together is used in many walks of life. The law-making is based on the socio-economic ethos of the country. It is dependent on the population and demography of a nation. Economics helps in determining the same through various tools of data collection and assimilation. Only with the given data can the law be framed and the people of a country can be governed. This clearly shows the level of interdependence between the two subjects.

Private law assists individuals and groups who are agreeable to enter into agreements in a free market, public law seeks to correct the outcomes of a free market system by means of economic and social Economists themselves should be well-versed about the legal environment in which economic activities must be conducted, while lawyers should be aware of the economic effects of current legal rules and the expected outcome under a different legal regime.

The basic principles of economics like the principle of rational choices, theory of trade-offs and the concept of incentives are closely associated and related to various laws. Namely – the law of torts which is essentially a civil law works with the principle of incentives, law of contracts which is basically a lawful agreement between two parties and is interlinked with the principles of rational choices. The various aspects of law such as trade laws, public laws, environment laws and criminal laws are related to and implemented with the help of economics.

6.      Conclusion

Law and economics work towards making the implementation of the subjects more efficient. Without the interdependence of the subjects on one another, law and economics wouldn’t be as dynamic as they are. Law essentially, governs the conduct of individuals and the society and Economics deals with the problems of limited resources and their use by the individuals. There two disciplines and intertwined and cannot be looked at distinctly different from one another. Thus, law & Economics meshes together two of society’s central and fundamental social constructs into one subject. Law and Economics work towards sanctioning a multi-faceted study of significant problems which exist in each subject.

[1]EjanMackaay, History of Law and Economics,

[2]UNDERSTANDING ECONOMICS, (last visited June 15, 2019).

[3]ECONOMICS DEFINITION, (last visited June 15, 2019).

[4]Robert F Meagher and David Silverstein, Law and Social Change, (2019)

[5]Guido Calabresi, “The Relationship between Law and Economics” (Jan. 26, 2019),

[6]Jenny Gesley, “FALQs: Demonitisation in India” ( Apr. 27, 2017),



[9]LAW AND ECONOMICSBY PAUL H. RUBIN, visited June 15, 2019).

[10]Richard A. Posner William M. Landes ,The Positive Economic Theory of Tort Law, (1980)

[11]Id, at 8.

[12]DEFINITION OF ‘PARETO’S EFFICIENCY’, visited June 15, 2019).

[13] Lawrence B Solum, “Legal Theory Lexicon: Efficiency, Pareto, and Kaldor-Hicks” (May 2 , 2010),

[14]Thomas S. Ulen, Rational Choice Theory in Law and Economics (1999),

[15]Id, at 4.


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