EC476 Contracts and Organizations, Part III: Lecture 4 Leonardo Felli 32L.G.06 2 February 2015
Benjamin Cardozo — 1921 “Law never is , but is always about to be. It is realized only when embodied in a judgment, and in being realized, expires. There are no such things as rules or principles: there are only isolated dooms. [...] [...] No doubt the ideal system, if it were attainable, would be a code at once so flexible and so minute, as to supply in advance for every conceivable situation the just and fitting rule. But life is too complex to bring the attainment of this ideal within the compass of human powers”. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 2 / 45
Common Law — 1066-1189 The English system of Common Law , originally pure Case Law was established during the 11 th or 12 th centuries. In particular it was spread at the beginning of the reign of William the Conqueror , 1066. It was fully established by the end of the reign of Henry II , 1189. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 3 / 45
Justinian — AD 529 537 years earlier — Justinian had quite a different idea of what the Law ought to be. The “Corpus Juris Civilis” in English translation adds up to 5,818 pages. Table VIII — Law VIII — Where a road runs in a straight line, it shall be eight feet, and where it curves, it shall be sixteen feet in width. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 4 / 45
Code Napol´ eon — 1804 ◮ “By virtue of its simplicity, my one code was the source of more good in France than all the laws which preceded me.” (Bas-relief in Les Invalides, Paris.) ◮ The Code Napol´ eon (renamed the Civil Code) was promulgated in 1804. ◮ The Code Napoleon has served as the model for the codes of law of more than twenty nations. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 5 / 45
Law of the Italian Republic — AD 2000 If the birth takes place during a railway trip, the declaration must be rendered to the railroad officer responsible for the train, who will draw a transcript of verbal declarations, as prescribed for birth certificates. Said railroad officer will hand over the transcript to the head of the railroad station where the train next stops. The head of such station will transmit the documents to the local registrar’s office to be appropriately recorded. This is Article 40 of the regulations for registrar’s offices, issued as Decree Number 393 of November 3rd 2000 of the President of the Republic of Italy. Regulations issued to ensure the streamlining of procedures, as prescribed by Article 2, comma 12, of Law Number 15 of May 1997 of the Republic of Italy. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 6 / 45
Motivation ◮ There is a large empirical literature that shows that legal origin matters (La Porta, Lopez-de-Silanes, Shleifer, and Vishny 1997,1998, 1999, 2002, La Porta, Lopez-de-Silanes and Shleifer 2005, etc.) known as Law and Finance . ◮ Identify a stylized model of both Case Law and Statute Law. ◮ Compare the two systems and provide conditions under which one legal system dominates the other. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 7 / 45
Stylized differences between legal systems ◮ Statute Law is a legislator-made Law: judges apply the statute. ◮ In the Case Law, there is (implicit) delegation of the law-making power to judges. ◮ In Case-law we have the rule of precedent (stare decisis) that commits future judges to the decisions of past judges, but not in Statute Law. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 8 / 45
A Big Caveat ◮ Can we reinterpret this comparison in terms of Civil Law vs. Common Law? ◮ To some extent, clearly yes (at least historically) ... but this is controversial (Hatfield, 2006, Whitman 2006). ◮ Common Law countries have accumulated a lot of statutes through time. ◮ In Civil Law judges have some leeway as well and precedents play some role (especially in Germany). Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 9 / 45
The Question ◮ Is the pragmatism of Case Law simply always superior to the rigidity of Statute Law? ◮ Are there universes in which Statute Law is instead superior? ◮ Or is it the case that the ascent of Case Law is like a scientific discovery? ◮ It just was not known before the 11 th or 12 th century, and those who discovered it and started using it became unambiguously better off. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 10 / 45
Case Law vs Statute Law: A First Answer ◮ Premise: “[...] life is too complex [...]” Laws are bound to be Incomplete (impossible to fully describe/conceive ex-ante). ◮ Leaving things to the Courts is a way to delay the decisions to when more detailed information is available: ex-post. ◮ What are the Courts’ objectives? They are “ruling over others” so we should be sure they have “social welfare” in mind. ◮ If the Courts’ motives are “right” then the Case Law regime ought to be superior. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 11 / 45
Punch-Line ◮ In some cases Statute Law is instead superior. ◮ This is because the Case Law advantage — ex-post decisions — may also be a disadvantage. ◮ Case Law Courts may suffer from time inconsistency (present bias) due to the timing of their decisions. ◮ In a dynamic framework this time-inconsistency problem is unavoidable. ◮ When cases are sufficiently homogeneous, the draw-backs of incompleteness (Statute Law) are outweighed by the costs of time-inconsistency (Case Law). Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 12 / 45
Laws ◮ With “fully contingent” (complete) Laws, “[...] a code at once so flexible and so minute, as to supply in advance for every conceivabe situation the just and fitting rule [...]” the Statute Law is clearly the ideal regime. ◮ “[...] But life is too complex [...]” hence laws are not flexible, at least not as much as Courts decisions that occur after the fact and hence can depend on the details of the realized contingency. ◮ Statutes are incomplete laws: fix rules that do not depend on the realized contingencies. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 13 / 45
Time Inconsistent Courts: Examples ◮ Patent policy: wide breadth is optimal ex ante to give incentives, but inefficient ex post. ◮ Investor Protection: ex ante borrowers are in favor of strong investor protection to have cheap credit, but not ex post. ◮ Disclosure: Court’s decision may induce the parties to disclose their private information at the ex-ante stage at the cost of preventing profitable ex-post trades. ◮ Three strikes you are out: long Sentences deters crime ex ante. Ex post, the deterrent effect does not play any role. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 14 / 45
Preliminaries ◮ Infinite-period-lived Courts and sets of one-period-lived parties. ◮ Courts can either take a weak decision ( W ) or a tough decision ( T ). ◮ Parties take private decisions based on the Court’s expected ruling (in equilibrium, perfect foresight). ◮ Two states of natures : the complex state C (with prob. ρ ) and the simple state S (with prob. 1 − ρ ). Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 15 / 45
Simple Environment S , probability (1 − ρ ) ◮ Π denotes Court’s ex-ante payoffs (social welfare), � Π denotes Court’s ex-post payoffs. ◮ In environment S it is optimal for the Court to choose W ex-ante: Π( S , T ) Π( S , W ) < ◮ In environment S it is also optimal for the Court to choose W ex post: � � Π( S , T ) Π( S , W ) < ◮ Clearly in this environment there exists no time inconsistency. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 16 / 45
Complex Environment C , probability ρ ◮ In environment C it is optimal for the Court to commit ex-ante to choose T Π( C , T ) > Π( C , W ) ◮ However, ex post, after private decisions have been made, it is optimal for the Court to choose W � � Π( C , T ) Π( C , W ) < ◮ This is the source of the Court’s time inconsistency. ◮ The present-bias temptation is therefore Π( C , W ) − � � Π( C , T ) > 0 . Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 17 / 45
Setup ◮ At the beginning of each period Nature: ◮ determines whether the environment is C or S with probability ρ , 1 − ρ , ◮ in the Case Law regime draws ℓ S and ℓ C (more below) ◮ The common discount factor of the Legislator and the Court is δ < 1 (chance that the same case occurs next period). Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 18 / 45
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