Constrained Optimization: Corporate Law and the Maximization of Social Welfare

Constrained Optimization: Corporate Law and the Maximization of Social Welfare

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How ought judges to decide cases? One answer, often associated with the economic analysis of law, asserts that judges ought to choose legal rules that are efficient or that maximize “wealth.” This claim, which stirred great controversy in the late 1970s and early 1980s, has largely subsided into the background in areas outside of corporate and commercial law. Within corporate and commercial law, however, academic legal discussion has increasingly adopted an economic perspective. The academic debate in the area of corporate and commercial law has thus largely focused not on whether the courts should pursue efficiency but on how the courts should promote this aim. Should any legal rules impose mandatory obligations on parties? What default rules are best? What is the optimal structure of priority rules in bankruptcy? The discrepancy in the intellectual histories of efficiency as a judicial goal in corporate and commercial law and in the law more generally has some justification. The arguments against the general claim have less force against the claim restricted to corporate and commercial law. The argument for instance that law ought to pursue various conceptions of fairness has less force in the realm of corporate and commercial law, where transactions are at arm's lengths between well-informed parties, each of whom seeks to maximize its profit. More importantly, a reasonably straightforward institutional defense of the efficiency claim in corporate and commercial law can be mounted. Briefly, it has the following elements. Law serves many objectives, but the promotion of the well-being of citizens is a central concern of law and legal institutions. This social concern has at least two aspects. First, society cares about the distribution of well-being among its citizens. Second, it cares about the general level of well-being. An institutional justification of wealth maximization (or efficiency) as a goal of corporate and commercial law then must establish that the pursuit of distributional (and other) goals ought to be institutionally divorced from the pursuit of increasing the general level of well-being. Kaplow and Shavell have argued that the distributional goals of society are better (i.e., more efficiently) advanced through redistributive taxation and social welfare programs than through corporate and commercial law. Basically, they show that any redistribution achieved through an inefficient rule of tort law (or, by implication, an inefficient contract or property rule) can be accomplished with less distortion through a redistributive tax scheme coupled with an efficient rule of tort law. The decrease in distortion implies that everyone could be made better off under the redistributive tax (and efficient tort rule) than under the redistributive (but inefficient) rule of torts. This argument thus supports a claim that the redistributive aims of law ought to be accomplished through legal institutions that are distinct from the institutions that maximize the general level of well-being. To increase the level of well-being of citizens society must structure incentives for individual actors appropriately. It has two tools available: the imposition of primary obligations and the structuring of enabling regimes such as corporate and commercial law that harness the initiative and information of individuals. Certain obstacles to the enhancement of well-being, such as the costs of environmental degradation, are best handled through the imposition of primary obligations, i.e., by setting “prices” to economic actors appropriately. Put differently, the rules governing corporate governance, contract, and bankruptcy can be formulated without attention to externalities; these problems are adequately dealt with in separate bodies of law. Finally, the self-interest of individuals pursuing their own aims within well-functioning markets will ensure that welfare is maximized. Corporate and commercial law, then, should simply provide a structure in which markets will function smoothly. This argument seems both unproblematic and compelling. A conception of corporate and commercial law unconnected to increasing the general level of well-being is completely implausible. A conception that required legislatures and courts to balance every social value when society formulates or applies rules governing corporate and commercial conduct seems equally implausible. Furthermore, the division of labor among bodies of law that this argument assumes has strong intuitive appeal; it conforms to the interpretive inclinations of most lawyers. The intuitive appeal of the argument, however, does not substitute for secure analytic foundations. This chapter reconsiders the normative foundations of corporate and commercial law. It raises three problems with the pursuit of efficiency or wealth maximization through corporate and commercial law. First, the chapter observes that the most efficient rule, or the wealth-maximizing rule, is always relative to some decision and to specified constraints. The best rule in a world of complete information, for example, may not be best in worlds with asymmetric information. Second, wealth maximization only provides an appropriate proxy for well-being under special conditions; these conditions need not always hold even in the context of corporate and commercial law. Third, the logic of maximization of well-being under uncertainty conceals as yet unsolved difficulties. The discussion proceeds as follows. Part II investigates the concept of efficiency relative to a decision and to constraints. In particular, it emphasizes complexities introduced by various information structures. Part III turns to wealth maximization. It first connects this concept to the underlying goal of promoting well-being. It then investigates the extent to which wealth maximization implements the concept of maximization of well-being. Part III closes by linking the more specific aims of corporate and commercial law to wealth maximization. Part IV offers some concluding speculations on how these foundational problems alter the conception of corporate and commercial law.

Source Publication

The Jurisprudential Foundations of Corporate and Commercial Law

Source Editors/Authors

Jody S. Kraus, Steven D. Walt

Publication Date

2000

Constrained Optimization: Corporate Law and the Maximization of Social Welfare

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