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Relation between Economics and Law Essay

The study of Law without the knowledge of other related social sciences i.e., Political theory, Sociology and Economics, etc, is incomplete. In any law curriculum the study of Economics and Law and their interaction is increasingly found necessary.

As Law influence Economics, Economics also influence Law. As a matter of fact Economics forms the basis of the study of Law. Economics reflects the socio-economic ethos of the country in particular and world in general. It becomes out of date and misleading if the Economic ethos change. But it was proved to be wrong by Dalton. The organisation, industrial structure and performance have changed in the thirty years. E.g.: policy goals, policy instrument, Economic institutions.

Economics derives its aims and objectives from the study of man and must derive at least a large part of its methodology from a study of Nature. Legal Economics is a vital part in understanding the interactional dimension of Law and Economics, i.e., how modern Economics can be used to illuminate a number of legal problems. It is not sufficiently realised that the economic analysis can aid our understanding of the Law and how economic factors limit and shape the operation of crime control and legal systems. Economic considerations have varied and widespread effects on the costs and benefits that prospective offenders may expect from crime, on decisions to litigate or to settle out to court, on the significance of legal costs the practical problems of legal administration and the provision of legal services. Law and legal policy help to determine the behaviour of the economy. There are extensive legal constraints on the allocation and the distribution of resources and on labour and housing markets.

The social functions of Law are broadly classified into three:

(1) Encouraging good behaviour and discouraging bad behaviour.

(2) Facilitating the people to transactions among themselves in organised legal system.

(3) Distributing and re-distributing goods and services to the people.

Law normally enters the scene in two guises; as public law, and as private law. The range extent of state intervention depends on the socio-economic ethos of each country. Western countries for a long time believed in laissez faire position, i.e. State interference in the economy will lead to misallocation of resources, economic inefficiency and a net wealth loss. Areas of law such as contact, tort and consumer protection legislations have obvious effects on financial dealings.

In this changing scenario, there is need for guidance on the economic policy decisions by the legislature and courts which are increasingly involved with policy questions. Policy making courts need a behavioural theory of predict responses to change in Law and to evaluate these responses systematically according to normative standard.

Ours is a market-oriented economy based on private enterprise. This implies two conditions- first, that all property can be privately owned and second, that people are economically free, i.e. subject to obedience to the law, they are free to use their time and means as they like. This is however, subject to the laws and regulations made by the society for the general good, otherwise it will lead to social cost.

The classical economists, such as Adam Smith and his followers Marshall, Ricardo, Marthus, etc, believed that in a market economy perfect competition operates and through price mechanism (invisible hand) supply and demand of goods and services will reach equilibrium. Therefore, any interference in the market mechanism by the State will lead to economic waste and result in the economic inefficiency. Perfect competition operates only if the following conditions are satisfied:

(1) Too many buyers and sellers,. They are price-takers and not price-givers;

(2) Full knowledge of the products transacted in the market;

(3) Homogeneity of products (product differentiation is not possible); and

(4) Nil or negligible transaction costs.

However, due to rapid economic development after the Industrial Revolution, the conditions mentioned above did not operate resulting in World Depression and complete collapse of the market system (in 1930’s). In these circumstances, J.M. Keynes, a well known economist propounded a new theory. He said the invisible hand relied upon by classical economists had developed arthritis and the visible hand of the Government was needed to correct the malady. He, therefore, advocated limited State intervention to correct the defects in the market mechanism so that the market operations can be revived and equilibrium achieved. He had faith in the market oriented economy. Later it was realised by the welfare and the third world economists that limited State intervention will not work and full intervention is necessary for the following reasons:

(1) Steady increase in the divergence between private goods and social goods, i.e., economic development results in rapid industrialisation which in turn increases the tempo of urbanisation.

(2) Rise of monopolies lead to distortion of the price system in the market economy through manipulation of supply of products and selling standard products, etc.

(3) Rise of advertisement and propaganda

(4) Steady increase in the divergence between private cost and social cost.

Therefore, the introduction of a number of laws to protect environmental pollution (air, water and sound) has become necessary. The second feature of the market economy is the protection of property. Possession and ownership of property has been justified in economic theory because it is productive and contributes to economic growth. Propery rights are one of the incentives for efficient resource use. If there are no property rights, only common rights, then economic behaviour takes a new form.

Due to technological revolution and growth, the intangible, aspects of property surfaced and they had to be protected for economic development. Therefore, the definition of property has been widened to include not only physical property but also the intellectual property (i.e. goodwill, patents, copyright, etc). This wider definition of the property is attractive to economists and predates modern work on Demand Theory which in fact focuses on the characteristics of a ‘goods’ rather than the ‘goods’ it.

The third feature of the market economy is contract. Under the classical concepts, contract between the two parties are binding and no third party can interfere. This, of course is subject to the exceptions provided in the Contract Act (i.e. contact by minors, lunatics, idiots, etc. Contracts obtained by fraud, coercion, undue influence are all void contacts).

In India the sanctity of contract has been given go-by. The Supreme Court in many cases held that court can interfere in the contractual relations. For e.g., Justice Hidayatullah held that: “Social justice is not based on contractual relations and is not to be enforced on the principles of contract of service. It is something outside these principles, and is invoked to do justice without a contract to back it.”

The right to personal security under the welfare State has been given more social interpretation which includes:

(1) the right of the worker to be protected against the risk of sickness, unemployment and old age,

(2) his right to be protected by social insurance, and

(3) His right to enjoy the necessary services of Government loosely called ‘Social Services’.

Another area in contract law which made inroads in the concept of ‘sanctity
of contract’ is consumer protection law inasmuch as changed role in freedom of contact is viewed as one of the foundations of a well organised society. Broadly, there are four reasons for the use of consumer protection laws:

(1) The doctrine of ‘caveat emptor’ does not make sense in the modern world since information is asymmetrically distributed.

(2) The free market system does not lead to optional use of resources.

(3) The value judgement implicit in the “devil take the hindmost” attitude to the parting of money from a fool is now much less widely held.

The economic consequences of consumer protection laws are- the legislation produces a different outcome with respect to resource allocation, prices and income distribution to that which would otherwise occur, and it results in the companies’ devoting more resources to quality control or even withdraw from some markets resulting in higher market prices and different resource allocation.


The marrying of Economics and Law is not new. According to Posner, much of the common law can be explained in economic terms and all branches of common and statue law has been examined in the light of this theory. Empirical research has proved that law has developed according to the economic structure of the country. Economic analysis is part and parcel of several law courses. Besides, there are many courses directly on Economics and Law (Legal Economics).

At present it is probably fair to say that most lawyers find it quite difficult to see how they can make use of or even sense of such of the work done by economists on law… however, there are increasing signs of legal writers taking explicit account of economic arguments. There remains however considerable scope for further work on bridging the gaps between the disciplines. The high flown values that legal principles express are examined by legal economists in the light of their efficiency and their social effect and not just their self defined moral content.

WHAT IS LAW? : In layman’s language law is the definition and enforcement of ‘social norms’.

WHY LAW? : To maintain ‘socio-economic equilibrium’ in the society. If viewed in the static sense, then the preservation of the existing rights in the society is the purpose of the law. That is why positive law defines and defends existing rights in the society. There are three models followed by the non communist countries, i.e.

(1) Pure capitalist model in a market economy where the State plays no role and market forces decide how the market operates

(2) Mixed Economy model with capitalist orientation, where state plays a minor role, corrects failures in the market operations and leaves the rest to the market forces, and

(3) Mixed economy with socialist orientation, where the State plays a major role, i.e., interferes in the market operations not only to correct market failures but also to social justice, not because states are richer, but people have a different concept and expectations from the State.

The economic analysis of law is concerned with ‘efficiency’, i.e. rational allocation of scarce resources with lest cost to attain maximum satisfaction. In law, people are concerned with justice only and not about its cost. If there is conflict between efficiency and justice, the nature of trade-offs can be illuminated by economic analysis and since the attainment of justice involves the use of resources, the economic approach can contribute to normative discussions by providing information on the costs of justice.

Use of Economics does not predict the impact of law, but to describe and explain the law-to provide it with an economic rationale.

The third important feature of economic analysis of law is the resurgence of Neo-Institutional Approach by making not the transaction, the basic unit of analysis.


(1) It is Taxonomical. It lists a set of economically relevant categories that are useful for examining the law;

(2) It is more micro-analytical. It focuses on the details of the environment in which the transaction takes place and suggests an empirical approach that requires the collection and compilation of relevant data;

(3) It rejects market equilibrium analysis and instead places emphasis on the adaptation to disequilibrium; and

(4) It investigates specifically institutional phenomena and uses these to develop conceptual categories.

Our Constitution works on an economic system and not in vacuum. Ours is a market oriented economy where efficiency is the sole criterion and it has no place for a non economic input like social justice. Thus, there is a conflict between equality and efficiency. In a market economy where efficiency is the sole criterion, law plays a vital role in determining the efficiency of the economic activity it regulates. A law is ‘good’ if it guarantees and promotes economic efficiency and ‘bad’ if it impedes or disrupts it.

The common criticism levelled against this approach is that by concentrating only on efficiency, it ignores justice in the sense that market system by encouraging efficiency, tolerates inequality of income and wealth resulting in unequal distribution of economic opportunity, thus violating the core objectives of our Constitution. However, there is a second meaning of justice i.e. in a world of scarce resources, waste or misuse of resources is considered as immoral and good law can prevent the misuse of resources and achieve efficiency and justice. In this approach, both are complementary. As Posner observes, ‘the demand for justice is not independent of its price’.

A major contribution of economics is the framework that it gives the lawyer systematically to evaluate legal policy, reveal important trade-offs and interrelationships between legal goals and trace through the probable effects, costs and benefits of different laws. The economic approach not only provides an integrated treatment of the side effects but been responsible for drawing attention to the more subtle and hitherto unrecognised effects. Another contribution of economic analysis of law is that it treats legal rules as a system of incentives and disincentives which influences the actions of potential litigants.

The law is seen as guiding the behaviour of groups or individuals and on the assumption of economic rationality the economic model is able to predict the direction of the response. Thus the economists tend to focus on the general effects of law such as the impact on trading behaviour of different contract remedies. This emphasis differs significantly from the way most lawyers are accustomed with grievances and of resolving individual disputes peacefully, fairly and consistently with legal doctrine.

Law has also influenced socio-economic policies. “Laws and legal policy help to determine behaviour of the economy. In this context, Prof Barker observes that, “If Economic factors and economic interests have partly determined the legal framework, it is even more true that law has furnished the whole general framework of rules within which and under which the factors and interests of economics have had to work”. Legal Reform Legislations, Trust Law, Abolition of Bonded Labour (Art 23(1) of the Constitution), etc. are classical examples of how law has influenced the economic behaviour in the market economy.

Legal constraints on the allocation and distribution of resources and on labour and housing markets which affect the economic activities in the market. These aspects have become vital in the globalisation of the economy and revival of the markets with privatisation as the focal point. Prof Paul Burrow said that, “Economics and Law can provide insights in places where traditional legal analysis fails to penetrate”. It is essentially nature of the two disciplines that makes us optimistic that collaboration between lawyers and economists will be increasingly fruitful in the future.


The first topic of our study on the Economic Analysis of Law will be Tort Law because torts were one of the first bodies of Common Law to which formal economic models were applied.

The broad features of tort law are:

(1) It deals with civil offences only, i.e. trespass, nuisance, defamation, economic loss, etc.

(2) it is judge-made law and therefore is flexible (unlike criminal law)

(3) Tort Law aims at compensation as opposed to criminal prosecution which aims at punishment.

There are three elements in torts:

(a) Breach of duty owned to the plaintiff by the defendant;

(b) Harm suffered by the plaintiff; and

(c) The breach being the immediate or proximate cause of the harm.

Breach of duty must give rise to measurable damages, valued in terms of money or moneys’ worth.

The four possible bases of the action for damages are:

(a) Appeasement;

(b) Justice;

(c) Deterrence; and

(d) Compensation.

(1) APPEASEMENT: The objectives of both tort and criminal laws are to encourage good behaviour and discourage bad behaviour. The victim receives money as appeasement and he is pleased that aggressor is discomfited by being made to pay. By this means, the victim is induced to let off stream ‘within the law rather than outside it’.

(2) JUSTICE: two variants of this theory are:

(a) The principle of Ethical Retribution: the pavement of compensation is an evil for the offender and that justice requires that he should suffer this evil.

(b) The Principle of Ethical Compensation: this looks from the point of the victim. The payment of compensation is a benefit to the victim of the wrong and justice requires that he should receive compensation.

(3) DETERRANCE: the action in tort is a “judicial parable” designed to control the future conduct of the community in general. According to Austin, the proximate end of evil action is redress to the injured party; but its remote and paramount end is the same as that of the criminal sanction, the presentation of the offences generally.

(4) COMPENSATION: Compensatory or reparative theory demands that one who has caused injury to another must make good the damage whether he was at fault or not. It justifies strict liability.

Be that as it may, we are concerned as students of Legal Economics with economic efficiency objectives of tort law. Before that we will discuss briefly the legal objectives of tort. Holmes and later others are of the opinion that tort law has no interests in shifting the loss from the victim of an accident to others unless this serves some special objective, ranging from vindication, preserving the peace by ‘buying off’ the victims, desire to retaliate, ethical retribution, compensation and deterrence the connected question is whether Common Law imposes liability for failure to resume. This concept has been rejected as not practicable since it is difficult to set limits of social interference with individual liberty.

ECONOMIC EFFICIENCY: it is not concerned with morality or social purpose, etc, as in legal objectives of tort liability. It requires the minimisation of three costs:

(a) The losses due to accidents;

(b) The cost of preventing the accidents; and

(c) The costs of administering a system of accidental law.

In the light of the above discussion, we can safely conclude that the Tort Law, in India, is out of date, costly and reliefs meagre. As a result, it is economically inefficient, apart from special injustice caused to many of the victims of civil offences.


In a market oriented economy, the core concepts are property and contacts. These are basically, economic concepts, but law regulates them, contracts are devices for facilitating trade and economising costs of making transactions. By trading in promises for future delivery, traders can reduce uncertainty about the future. This requires adequate legal safeguards so that both the parties to the contract are secure and pan their activities accordingly.

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