On January 2, 2007, Dean Henry Manne published a column in the WSJ regarding corporate democracy.  In this column, Manne takes a stab at shareholder voting and corporate democracy.  Manne maintains that shareholder activists are deluding themselves with the phrase “corporate democracy” in that only the controlling s/h have and will ever have a true voice in corporate matters (such that there never will be any “corporate democracy” as a practical matter).  It appears that Manne takes the position that corporate “democracy” does not and should not exist; shareholder activists misunderstand the shareholder vote from a “big picture perspective;” and there are other alternatives to a full shareholder vote. 

Professor Steve Bainbridge’s commented on Manne’s column, noting that “[a]ll in all, it’s a brilliant spanking of the shareholder activists, which I highly commend to your attention.”  As a token radical shareholder primacist, I have to say that I felt more befuddled after reading Manne’s comments than “spanked.” 

Setting aside any discussion of cumulative voting, Manne’s column left me wondering how he accounted for investor confidence.  Manne notes that, instead of holding meetings at which shareholders exercise their vote, one could (in theory) appoint a trustee to survey the controlling block to see who they want in leadership.  Yet it is unclear to me how Manne accounts for investors who pack up their money and walk away when denied a vote.  Adam Smith and the OPM concern:  it seems to me that voting is at least a small indication to shareholders that those managing their money are recognizing an accountability to the investors.  I have to believe that that impacts investor confidence, so how does Manne account for the longer term loss of investor confidence? 

Additionally, “shareholder democracy” serves the purpose of signaling to directors whether shareholders are displeased.  For example, assume at a 1995 annual meeting that 19% of the Disney shareholders withheld their vote for Eisner as director.  Obviously Eisner would still be elected by a 81% vote, but my position would be that the 19% vote was useful because it conveyed to Disney management that investors had perhaps lost their confidence in Eisner’s ability to serve as a director.  This would mean that Disney management would have time (hopefully) to change things to avoid the 19% of displeased shareholders pulling their money out of Disney.  If investors have no voice and no sense that management takes note of their views, will there not be some sort of loss of confidence, reluctance to invest, and related market adjustments? 

Manne might say “calling for a full vote was a big waste of time - the 19% block was always going to be stuck with the course charted by the 81%.  And if the complaining 19% pulled their money out of Disney stock such that the stock price slips, professional investors would snap up the Disney stock on the fall such that it would rebound.”  

But does that reply – the market will right itself - fully account for the costs of the market righting itself?  How do L&E wonks like Manne completely account for the true, long-term cost of noisy trading when it is hard to identify what the market would have done in the absence of such?  Assume that noisy trading weeds out certain investors with a weak stomach, how much is the market losing in transactional costs or capital market strength (long term) with a volatile market?  Even if Manne assumes that the market will right itself, what are both the direct and the indirect costs of the market righting itself via a relatively large Disney minority shareholder exodus and extra market noise?  It is unclear to me how Manne accounts for those things.

So says Eugene Volokh, so it must be true.  This strikes me as a wonderful hire for my alma mater and a big loss for Chicago.  Congrats to UCLA and to Professor Lichtman.

From the Milton Friedman Day website:

Dr. Milton Friedman was perhaps the most influential economist of the 20th Century, and the impact of his ideas will extend far into the future. To honor the man, January 29th is declared as Milton Friedman Day – a celebration of the economist’s positive impact on American life and business, and the spread of the benefits of free markets to nations around the globe. Milton Friedman Day will include a host of activities, including a “Day of National Debate” at universities across the country, a live online discussion on The Economist’s Free Exchange blog, and the premiere of the PBS special, “The Power of Choice: The Life and Ideas of Milton Friedman” (check local listings), among other events.

Here is a list of events associated with Milton Friedman Day.

The tentative recommendations of the Antitrust Modernization Committee are out, and include Commissioner vote counts for various propositions. The recommendations largely take the form of propositions that the AMC Commissioners joined, did not join, or were undetermined. Here are a few that caught my eye on an initial read-through (note that 2-5 apply to merger analysis).

1. A price above marginal cost, by itself, does not suggest market power in a
   relevant antitrust market. Firms with low marginal costs but large fixed
   costs, particularly for research and development and other innovative
   activity, may need to price significantly above marginal costs simply to
   earn a competitive return in the long run.
2. No substantial changes to merger enforcement policy are necessary to account for
   industries in which innovation, intellectual property, and technological change are
   central features (Commissioner Delrahim did not join, Commissioner Valentine undetermined).
3. The agencies should increase the weight they place on certain types of
   efficiencies. For example, the agencies and courts should give greater
   credit for fixed-cost efficiencies, particularly in dynamic, innovation driven
   industries where marginal costs are low relative to typical prices (five commissioners did not join).
4. The agencies should update the Merger Guidelines to explain more
   extensively how they evaluate the potential impact of a merger on
   innovation (five commissioners do not join)
5. The agencies should update the Merger Guidelines to include an
   explanation of how the agencies evaluate non-horizontal mergers (two commissioners do not join).
6. In particular, the existing standards regarding bundling, as expressed in cases such
   as LePage’s, may prohibit conduct that is procompetitive or competitively neutral
   and thus these standards may actually harm long-term consumer welfare (Commissioner Shenefield does not join).
7. Congress should repeal the Robinson-Patman Act in its entirety (two commissioners do not join).
8. Congress should not legislatively amend Section 2 of the Sherman Act. Standards
   currently employed by U.S. courts for determining whether single-firm conduct is
   unlawfully exclusionary are generally appropriate. Although it is possible to
   disagree with the decisions of particular cases, in general, the courts have
   appropriately recognized that vigorous competition, the aggressive pursuit of
   business objectives, and the realization of efficiencies not available to competitors
   are generally not improper, even for a “dominant” firm and even where
   competitors might be disadvantaged.

There is a lot to digest in the AMC recommendations. My overall impression is that the recommendations are quite sensible all the way around. I am particularly interested in the support for guidelines on innovation and non-horizontal mergers, though there is apparently less support for the former. The 1984 Merger Guidelines may provide a hint as to what non-horizontal merger guidelines might look like, though there have been a number of developments in the economic analysis of vertical contractual restraints and mergers since then (both theoretically and empirically) and so a new set of guidelines might look very different. Guidelines for innovation mergers might be very useful in terms of transparency, but my first reaction is that I don’t know quite what they would say. While it is clear that the AMC believes that innovation effects should “count” for merger analysis, and I agree, it seems like there is still much to learn about the basic economic forces at work with mergers involving innovation effects both theoretically and empirically. All of this is putting aside issues associated with how one might engage in the necessary welfare tradeoffs that might arise between say, higher prices and greater innovation from a particular merger. It seems like there is a threshhold level of knowledge that is necessary prior to drafting a set of Guidelines committing to a particular analytical approach that is sure to influence how federal courts handle these issues.

In any event, the AMC recommendations are well worth reading and are likely to spark a good deal of discussion in antitrust circles in the coming months and years. Looking forward, it will also be interesting to compare and contrast the AMC recommendations regarding monopolization and vertical conduct (see, e.g., 6-8 above) with any consensus that emerges from the FTC/DOJ Section 2 hearings.

Bill Henderson has a nice post on Chief Justice Roberts’ claim that judicial pay has reached the point of creating a “constitutional crisis.” Lots of bloggers (see, e.g., my colleague Ilya Somin at VC) have made the point that they are not impressed with the data the Chief has mustered in favor the assertion that the quality of the federal bench is likely to suffer as the gap between judicial pay and pay in private practice widens (or that a shift in composition of the federal bench towards fewer lawyers from private practice is a demonstrably bad thing, much less constitutional crisis). Most of this discussion has involved pointing out weaknesses in the Chief’s empirical evidence in support of his claim and some educated guesswork about the relevant elasticities of supply for high quality judicial candidates with respect to pay.  Though I think it it is very difficult to say something meaningful about these elasticities without data.

In any event, I think Bill’s post adds something new by attempting to reframe the debate a bit and raising some issues I had not thought about in relation to the Chief Justice’s plea for more compensation.  The first is that federal judges make much higher salaries than their state counterparts and so, as Bill writes, “it appears that we also have several dozen ‘constitutional cris[es]’ at the state level.” Second, Bil notes that while Am Law 50 partner and CLO salaries have grown dramatically as of late, both federal judiciary and solo/ small firm compensation has not done nearly as well. Bill asks why this gap in pay does not trigger the same sorts of concern over the independence of lawyers more generally?

These are both interesting points. With respect to state court judges, I presume that Chief Justice Roberts (if confronted with the data) would be more than happy to advocate for higher salaries in state court as well. But Bill is certainly right that if a gap in judicial / private pay creates constitutional crisis, we may be in the middle of more crises than we knew!  With respect to the plight of the solo/small firm practitioner, however, I’m not sure I follow what Bill is getting at. One obvious difference between judicial pay and practitioner pay is that the latter is set in the market in response to economic forces rather than by Congress in response to political forces. In other words, if the market sets much higher compensation levels for big law lawyers than solo practitioners — this is a valuable signal about the best use of lawyerly resources. In that setting, it is difficult to understand the sense in which these attorneys are underpaid, or why the gap would be problematic at all.
Third, Bill writes that:

“district and appellate judges working in large metropolitan areas will likely live in smaller homes or endure longer commutes. And the Judge’s kids may have to apply for loans to pay for college or law school, including federal Stafford loans, which are the lifeblood of higher education. In other words, their problems will be more like 98% of the American electorate, albeit still very much at the high end. Why is this a “constitutional crisis”? Some of us might call it “sensible policy.”"

While I think that my prior is to agree with Bill’s punchline (and the position taken by most bloggers I’ve read) that this is not a constitutional crisis, I’m not quite sure that I agree with this third point. It depends who is on the margin doesn’t it?  And that depends, again, on the relevant elasticities. One possibility is that in expensive metropolitan areas the marginal candidate will be the one Bill describes. It is also quite possible that the marginal candidate in such areas is sufficiently wealthy such that the pay cut in going to the federal bench has little effect on the family’s financial well-being (though the Luttig examples suggests the former certainly does occur).  In any event, my point is only that it is really hard to talk about prospective changes in the composition of the pool of candidates without better data than we have (and are likely to have given the nature of these decisions) on candidates.

The FTC announced this week perhaps its best decision since . . . well, ever: 

Chairman Deborah Platt Majoras today announced the appointment of Professor Joshua Wright to the newly created position of Scholar-In-Residence in the Bureau of Competition of the Federal Trade Commission. With this new position, the Commission will invite an academic expert on the law and economics of antitrust to join the Commission to work closely with the Bureau of Competition’s investigative and policy staffs. The program will help ensure that the Commission has the benefit of the latest and best thinking on competition issues as it undertakes its enforcement agenda.

This is a great honor for Josh and a powerful affirmation of the exceptional quality of his scholarship.  Moreover, it can only be good for the rest of us:  Josh is the youthful embodiment of the UCLA School (e.g., Armen Alchian, Harold Demsetz and Ben Klein (also collectively known as Josh’s dissertation committee)), a school of thought whose continued influence in antitrust policy brings both incomparable analysis and much-needed humility to bear on the regulatory enterprise.

Congratulations, Josh!

A few weeks ago, I suggested that Belvi’s antitrust suit against Starbucks is weak and ought to be dismissed.

This report in today’s Seattle Times further strengthens the case for dismissal. Competition in the Seattle market for espresso is apparently more intense than Belvi’s complaint would have us believe!

In November of 2006, the Delaware Supreme Court issued an opinion in Stone v. Ritter dealing with a director’s fiduciary duties in cases where the complaining plaintiff-shareholder is maintaing that her directors did not sufficiently monitor their corporate charge. (I refer to these “oversight” cases loosely as “asleep at the wheel” cases.) There has been some excellent blogging on the topic by Eric Chiappinelli, Gordon Smith, and  Steve Bainbridge.  Though I was in the middle of moving such that I could not blog in the middle of that wonderful Ritter blog-fest, I am now ready to stake my blogging ground on Ritter.

Stone v. Ritter was an oversight case, in which the complaining shareholders maintained that the directors of AmSouth failed to maintain a sufficient monitoring and reporting program such that red flags (in this case pertaining to banking law violations) could be detected by the board. This, the shareholders maintained, was a violation of the directors’ fiduciary duties. The chancery court dismissed the plaintiff-shareholders’ claims, and the Delaware Supreme Court affirmed, saying “In the absence of red flags, good faith in the context of oversight must be measured by the directors’ actions ‘to assure a reasonable information and reporting system exists’. . . .”

What the court also says about the duty of loyalty, however, is more interesting to me that the good faith references.  The en banc panel says: “[T]he fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith. As the Court of Chancery aptly put it in Guttman, “[a] director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation’s best interest.”

Enter Lyman Johnson and his article “After Enron: Remembering Loyalty Discourse in Corporate Law,” 28 Del. J. Corp. L. 27 (2003). In that article, Professor Johnson takes the position that “loyalty” in the context of a director’s “duty of loyalty” should be interpreted the same way the word is interpreted in daily life. Being loyal, as that term is normally used, covers conduct that we corporate law folk have always tried to finagle under the “duty of care.” We should expect directors to be loyal in the same way we expect others be loyal. That is to say, if I ask my loyal friend, Monica, to vote for me for state senate, I envision that Monica, my loyal friend, would march to the polling place and vote for me. How loyal is my friend if, after work, she decides on the spur of the moment and with no prior plans instead to go to “happy hour” somewhere?  Can I say “Monica is a loyal friend?” She is not a loyal friend, is she? It is not that she is a traitor. Rather, she is just not loyal.  I cannot look at Monica up on her stool at the bar for happy hour, not having voted for me, and say “Now THERE is a loyal friend.  That Monica is loyal.”

In his article, Lyman references “Christ’s famous charge to His apostle Peter to ‘take care of my sheep.’” If Peter is the loyal apostle, he will affirmatively care for the flock. If he is loyal. Not if he is “acting in good faith” or “acting with due care.” If he is truly a loyal disciple, he will affirmatively do whatever is needed to “take care of [the] sheep.” That, Lyman Johnson maintains, is what loyalty means.  Loyalty is that broad.  Asking if the actor is loyal subsumes the care and good faith inquiries.

Back to Ritter:  “[T]he fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith. As the Court of Chancery aptly put it in Guttman, “[a] director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation’s best interest.”

With that language, it is almost as though the Delaware Supreme Court taking a position that is totally consistent with Professor Johnson’s very broad position on what “loyalty” in the phrase “duty of loyalty” should mean. To breach the duty of loyalty, the actor does not need a conflict of interest. Simply failing to act in “the good faith belief that her actions are in the corporation’s best interest” is enough. Simply failing to be “loyal,” as that term is used in common parlance, is enough.

I like that.

Consumer Reports has recalled a study of rear-facing infant car seats that claimed that many seats failed crash tests using standards tougher than the National Highway Safety Traffic Administration’s. Apparently, NHSTA contacted Consumer Reports after reading the study and concluded that:

“The organization’s data show its side-impact tests were actually conducted under conditions that would represent being struck in excess of 70 mph, twice as fast as the group claimed. When NHTSA tested the same child seats in conditions representing the 38.5 mph conditions claimed by Consumer Reports, the seats stayed in their bases as they should, instead of failing dramatically.”

Dubner and Levitt have this story double-covered at Freakonomics. Levitt offers important advice to groups interesting in testing the efficacy of car seats: compare the performance of car seats to standard safety seats for children (or in the case of non-infant car seats, adult seat belts).

Shubha Ghosh, of the Antitrust & Competition Policy Blog, is predicting that the Supreme Court will not overrule the 1911 Dr. Miles decision, which holds that “vertical minimum resale price maintenance” (i.e., a manufacturer’s imposition of minimum resale price for his goods) is per se illegal. Ghosh explains:

[T]he grant of cert in Leegin is not surprising. Whether the Court will overrule Dr. Miles is another matter. My sense is that Dr. Miles is superprecedent, to quote the Chief Justice, in the area of antitrust, and I do not see much academic or practitioner pressure to overturn the 1911 decision. Furthermore, the argument has been to distinguish maximum from minimum resale price maintenance with the per se rule making sense in the latter case but not in the former.

I must respectfully disagree.

Contrary to Ghosh’s suggestion, Dr. Miles has been the subject of gobs of academic criticism, primarily because it ignores the substantial procompetitive benefits vertical minimum price-fixing may confer (most notably, the elimination of free riding among dealers). Moreover, as I explain in this post, the set of circumstances in which minimum resale price maintenance may be anticompetitive is both narrow and fairly easy to identify, suggesting that a more probing rule of reason analysis is appropriate.

I will eat my hat if the Court does not overrule Dr. Miles.

Ghosh’s post does, though, raise an excellent question: What is the proper role of stare decisis in antitrust jurisprudence, particularly that related to Section 1 of the Sherman Act?

For the uninitiated, Section 1 prohibits contracts that “unreasonably” restrain trade. To determine whether a restraint is reasonable, courts typically employ a “rule of reason” whereby they look at things like market structure and the nature of the restraint to assess the restraint’s effect on competition. For some trade-restraining practices, though, no significant investigation is required because the courts have had enough experience with the practices to know that they are nearly always output-reducing. Those practices are said to be “per se” illegal, and they are condemned automatically. Naked price-fixing by competitors, for example, is per se illegal.

In general, courts apply the per se rule only after they have had enough experience with a practice to conclude that the practice is almost always output-reducing. As the Court stated in the Topco decision, “It is only after considerable experience with certain business relationships that courts classify them as per se violations….” Thus, the courts should begin analyzing practices under the rule of reason and proceed to the abbreviated per se rule only after having determined — based on significant experience — that the practice at issue is nearly always anticompetitive.

When the Court does decide that per se treatment is appropriate, stare decisis considerations (i.e., the fact that the practice at issue has received rule of reason treatment in the past) are irrelevant. That’s exactly how it should be, for the entire point of this method of analysis is that the judicial inquiry into reasonableness should be only as probing as required. As the Court explained in the California Dental decision, “What is required … is an enquiry meet for the case, looking to the circumstances, details, and logic of a restraint. The object is to see whether the experience of the market has been so clear, or necessarily will be, that a confident conclusion about the principal tendency of a restriction will follow from a quick (or at least quicker) look, in place of a more sedulous one.”

But what role should stare decisis play when the Court determines after lots of experience, academic analysis, etc. that the per se rule is too restrictive — i.e., that a practice once deemed per se illegal is, in fact, procompetitive in many situations? Unfortunately, the Court has in the past considered itself to be “bound” by stare decisis concerns. Take tying, for example. Most academics agree that the practice, once condemned under the now-discredited leverage theory, may be procompetitive or competitively neutral in many situations and ought to be judged under the rule of reason. In the 1984 Jefferson Parish decision, though, the Court declined to jettison the outmoded per se rule against tying, announcing that “[i]t is far too late in the history of our antitrust jurisprudence to question the proposition that certain tying arrangements pose an unacceptable risk of stifling competition and therefore are unreasonable ‘per se.’” In other words, the Court found itself bound by stare decisis.

This asymmetric approach to stare decisis (ignore the doctrine when moving from the rule of reason to a per se rule, but honor it when pressed to move in the opposite direction), is troubling. As Prof. Hovenkamp recently pointed out in The Antitrust Enterprise: Principle and Execution (pp. 118-19):

Stare decisis has effectively created a ratchet effect for the per se rule, permitting courts to move in one direction but not the other. But knowledge about the competitive effects of business practices must be regarded as a two-way street. Just as increased judicial experience with a practice can lead judges to conclude that it is virtually always anti-competitive and can be disapproved after a truncated inquiry, judicial experience can also reveal the opposite.

To alleviate this unfortunate ratchet effect, Hovenkamp wisely argues that courts should afford stare decisis treatment to judgments regarding the method of analyzing restraints and not to individual conclusions about the reasonableness of particular restraints.

It will be interesting to see what the Court does with Dr. Miles. As noted, I’m almost sure the precedent will be overruled. Hopefully, the Court will also use the occasion to rethink the Jefferson Parish approach to stare decisis. We really don’t need anymore antitrust superprecedents.

“I am very sorry to report that your Social Security number was among the 28,600 illegally retrieved.  This does not mean that you are the victim of identity theft or that we have evidence of your Social Security number being misused. And it is important to know that the database does not include banking or credit card information or driver’s license numbers.”  Sweet.

Becker and Posner take on “libertarian paternalism” this week. The entries are both worth reading, especially for the parts where these co-bloggers disagree. Here are my favorite passages from each.  First, Posner attempts to distinguish his previous defense of the NYC trans-fat ban from good old-fashioned paternalism:

It might seem that the good could be produced just by competition-impelled advertising by restaurants that do not use trans fats. But such a suggestion ignores the difference between disseminating and absorbing information. If you have a peanut allergy, and the label on a package of cake mix says that the mix contains peanut oil, you know not to buy it; the cost of absorbing the information on the label is trivial. But if you are told that a restaurant does not use trans fats in its meals, determining the significance of that information to you would require you to undertake a substantial research project. You would have to learn about trans fats, somehow estimate the total amount of trans fats that you consume every year, estimate the amount of trans fats in the restaurant meals you consume relative to your total consumption of trans fats, and assess the significance of that consumption in relation to other risk factors that you have or don’t have for heart disease. Few people have the time for such research, or the background knowledge that would enable them to conduct it competently. Given that trans fats have close substitutes in both taste and cost, it is not unrealistic to suppose that the vast majority of people would if consulted delegate to government the decision whether to ban trans fats.

A few thoughts about this distinction. I don’t find it too persuasive because it proves too much. The “consumer ignornance” argument Posner offers goes something like the following. Consumers do not value the disclosure sufficiently because the cost of absorbing the information (in terms of time, calculation, estimation, etc.) is prohibitive. Because of the these costs, which appear to boil down to the complexity of the calculation involved, we cannot trust competition to generate the optimal level of trans-fats consumption.

But doesn’t this argument apply to all sorts of transactions? Is the literature on trans-fats and their long-term health effects all that different on these grounds from smoking, wine, red meat, soda, coffee, potato chips, or credit cards (and credit card consumers appear to be behaving quite rationally in their own interest)? The food items are not types where the costs of absorbing the information is “trivial” like the peanut oil label for the consumer with a peanut allergy. Instead, consumers frequently make tradeoffs associated with long-term health effects that appear to be quite complicated. And the rush of producers going trans-fat free without government intervention suggests at least that consumers are indeed responding to evidence of the harm from trans-fats. Becker’s response to Posner’s previous trans-fat post also contains citations to a literature suggesting that consumers respond rapidly to health news.
And from Becker:

Classical arguments for libertarianism do not assume that adults never make mistakes, always know their interests, or even are able always to act on their interests when they know them. Rather, it assumes that adults very typically know their own interests better than government officials, professors, or anyone else–I will come back to this. In addition, the classical libertarian case partly rests on a presumption that being able to make mistakes through having the right to make one’s own choices leads in the long run to more self-reliant, competent, and independent individuals. It has been observed, for example, that prisoners often lose the ability to make choices for themselves after spending many years in prison where life is rigidly regulated.

The more times this point is made the better. It is not enough to justify paternalistic intervention (soft, hard, libertarian, or otherwise) simply to show that consumers make mistakes. The burden of proof is to demonstrate that the government can make better choices for the individual than can the individual. In accounting for the long run costs of paternalism, we must also be mindful of dynamic effects that are likely to follow from paternalistic decision-making before intervening (on this last point, see Klick and Mitchell in the Minnesota L. Rev., or more recently Ed Glaeser’s essay on Paternalism and Psychology).

Last Friday was the first day of my Business Organizations class. We began with two articles that have profoundly influenced my thinking about the world in general and the business world in particular. To inaugurate the new semester, I thought I’d take a moment and pay tribute to the insights in those articles (and solicit first day ideas from other business law profs!).

The first piece is F.A. Hayek’s The Use of Knowledge in Society. The article, written at a time when socialism was all the rage among the intelligentsia, pointed out the fundamental flaw in the socialist system. The problem Hayek highlighted was not the much-discussed motivational problem (i.e., why create wealth when the government is going to take it from you and give it to someone else?) but was instead an informational problem: how can economic planners allocate resources to their highest and best uses, and thereby maximize wealth, when the planners are not privy to the time- and space-specific information that determines what those uses are? In Hayek’s words:

The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given” resources — if “given” is taken to mean given to a single mind which deliberately solves the problem set by these “data.” It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.

The solution to this problem, Hayek argued, is the price mechanism, which he dubbed a “marvel.” Indeed it is. Market prices incorporate gobs of information and quickly process it to produce a single metric that tells consumers and producers precisely what they need to know: whether they should increase their production/consumption or cut back on it.

Suppose, for example, that you own an oil well and can select the level at which you produce oil. You pick up the morning newspaper and read four headlines: (1) “Unrest Worsens in the Middle East”; (2) “Huge Oil Reserve Discovered Off Coast of New Jersey”; (3) “New Senate Leadership Refuses to Budge on ANWR Drilling”; and (4) “GM Announces Plans to Switch Production from SUVs to Hybrids.” What should you do??? Well, headlines (1) and (3) would suggest that oil supplies are going to be tightening, so you should increase production; headlines (2) and (4) suggest just the opposite. What you really need to know is the expected magnitude of each of these effects (and all the others related to oil supply and demand). Fortunately for you, though, you need not spend all day scouring the newswires for oil-related information and estimating the significance of each datum. All you need to do is look at the price of oil, which tells you the best guess of millions of folks about whether or not we need more oil. This is utterly amazing. In Hayek’s words:

The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. … The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction. … I have deliberately used the word “marvel” to shock the reader out of the complacency with which we often take the working of this mechanism for granted. I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.

The bottom line for Hayek, then, is that resources are most efficiently allocated not by centralized planners but by the “man on the spot” responding to the information inherent in market prices.

Enter Professor Coase. In The Nature of the Firm, he observed that this is absolutely not what we see in business organizations: “Outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur/coordinator, who directs production.” Thus, “the distinguishing mark of the firm is the supersession of the price mechanism.” Business organizations are, in short, little islands of socialism in which Hayek’s beloved price mechanism is “superseded.”

So why do these “islands of conscious power” emerge? Because there are costs to using the market to allocate resources — most notably, transactions costs. Suppose, for example, that you want to start a catering business. You could minimize your labor costs by going down to the unemployment office every day and hiring, for the day, the laborers you’d need to fill that day’s orders. By taking that tack, you could pay the lowest wages possible (since your workers’ next best option would be unemployment), and you could ensure that you didn’t have any idle laborers (since you could hire only as many folks as you’d need to fill that day’s orders). But of course you wouldn’t do that because it would be extremely costly to engage in this process day after day. Instead, you’d hire some folks for the long term, accepting the possibility that you’ll probably have some periods of employee idleness. Business organizations emerge, then, as means of economizing on transactions costs. They will grow until the degree to which they reduce transactions costs is exceeded by the efficiency losses they create (e.g., the costs of idle resources, the agency costs that inevitably result when managers command resources they do not own).

This conception of the firm as a construction designed to minimize costs has profound implications for the law of business organizations. It also shows us how transactional lawyers can create wealth (as opposed to merely redistributing it, as lawyers often do). If the nature of the firm is as Coase describes, then the law should treat business organizations as no more than cost-minimizing nexuses of contracts between the suppliers of capital, managerial talent, and labor. This suggests (1) that the law should provide some “off-the-rack” nexuses of contracts that would appear to reflect the needs of large classes of business entities, and (2) that these various off-the-rack collections of contracts should be freely tailorable by business planners. Transactional lawyers can add value, then, by tailoring these off-the-rack contracts to meet their clients’ specific needs.

[Interestingly, Henry Manne has recently suggested that business planners might want to create Hayekian price mechanisms within the firm in order to enhance the quality of information available to managers. His fascinating short paper Hayek, Virtual Markets, and the Dog that Did Not Bark suggests how planners might choose to authorize insider trading (or internal prediction markets) in order to provide managers with the information-revealing benefit of prices.]

That’s the nutshell version of the first day of my Bus Orgs class. I’d be most interested in hearing what other law profs do to introduce this subject.

Michael Abramowicz over at Concurring Opinions has an interesting post about the ongoing litigation between economists John Lott and Steven Levitt. Lott’s suit alleges that Levitt defamed him in his recent book Freakonomics by suggesting that Lott’s research on the relation between guns and crime could not be “replicated” by other scholars and in a subsequent email to an economist suggesting that Lott had paid $15,000 to the Journal of Law & Economics to publish in a special issue a series of articles supporting Lott’s views on guns. This week, a federal district court in Chicago granted Levitt’s motion to dismiss the claim concerning the statement in Freakonomics but denied his motion to dismiss the claim concerning the email.

Abramowicz suggests in his post that Lott’s “potential damages are almost certainly low” and that this case “though not technically frivolous” is “of a type that our legal system does not handle well” and “a vexatious use of the legal system, because the cost of bringing the claim seems much larger than any plausible reputational damage to Lott.”

Leaving the merits of the dispute aside, my question is this: if the cost of bringing the claim is really much larger than any damages that Lott may recover, then why is Lott pursuing the case? Isn’t Lott’s pursuit of the case strong evidence that he believes he could recover more than his costs?

Moreover, if indeed the claim is worth less than the cost of litigating it, why is Levitt vigorously defending the suit? Why have he and HarperCollins (his publisher) spent so much money disputing liability (e.g., by filing the motion to dismiss) rather than simply relaxing, knowing that damages won’t be very high? Isn’t it just as “vexatious” to dispute a vexatious claim as it is to assert one?

The answer, I think, is that defamation suits implicate subjective nonpecuniary interests that are difficult for courts to value. The formal legal remedies available in such cases are thus usually undercompensatory and pale in comparison to the reputational effects of winning or losing. While the financial stakes may be low, more is at stake than simply the money. The case is about reputation, not money. Hence the current legal quagmire. Even a generous financial settlement is therefore not likely to satisfy Mr. Lott, and by the same token an admission of having made a false statement is not something that Mr. Levitt would likely consider offering.

Here’s my suggestion for the most efficient way to end the dispute: in exchange for Lott’s agreement to dismiss the suit with prejudice, Levitt could agree to issue a statement not admitting to having defamed Lott but rather simply saying that he respects John Lott’s intellect and his work as an economist even though he remains skeptical about Lott’s work on guns and crime.

Hopefully a settlement along these lines is in the works, especially now that HarperCollins is out of the case and Levitt will have to start paying his lawyers out of his own pocket. But then again, settlement of the case would deprive bloggers of an interesting topic about which to comment!