Evolution of Legal Systems

Emanuela Carbonara – University of BolognaESNIE23 May 2008

23 May 2008 ESNIE 2008 2

Outline

How do legal systems evolve? The economics of legal harmonization The evolution of legal systems

Does evolution favor efficiency? What is the effect of rule competition

on efficiency?

How Do Legal Systems Evolve?

23 May 2008 ESNIE 2008 3

23 May 2008 4

Market for Rules: The “Supply Side” States can

1. Enact new laws

2. Transplant rules from other legal systems

3. Harmonize/Unify

ESNIE 2008

23 May 2008 5

The Supply Side1. Follow - “mimic” legal rules from other

jurisdictions Import rules and adapt them to your existing

rules and culture2. Lead - “compete” with other legal systems

Produce rules more attractive to the global market• They become the rules most often chosen

in transnational commerce;• Firms incorporate in the jurisdiction with

the most “attractive” rules; Transaction costs (legal barriers) for

domestic firms are minimized• Examples: Delaware, “race-to-the-bottom

v. race-to-the-top”ESNIE 2008

23 May 2008 6

Market for Rules: The “Demand Side” Global market Economic agents demand :

Ability to choose between domestic and foreign law

Clear “choice-of-law” and “choice-of-forum” rules

Globalization demands harmonization of legal systemsIncreasing importance of transnational marketsElimination of the “border effect”

The WTO is pushing countries for faster harmonizationHarmonization benefits trade (Rodrik, 2004;

Turrini and Van Ypersele 2006)ESNIE 2008

23 May 2008 7

Legal Barriers

Estimates that transaction costs for advanced economies amount to 40% in ad-valorem termsOnly 5% is due to typical trade barriers

(Rodrik 2004) Turrini, van Ypersele (2006)

Study the “border effect” assuming it might be due to legal differences

Find striking result that even within a single country, trade between two regions is higher when subjected to the same court of appeal.

ESNIE 2008

23 May 2008 ESNIE 2008 8

Bridging the Legal Gap I1. Legal transplantation

countries import statutes and principles belonging to other legal systems

Unilateral (non co-operative) effort by one country Driven also by legal competition Example 1: The Turkish actual legal system was

established in the years 1924 - 1930. The various Codes were chosen from what were seen to be ‘the best’ in their field for various reasons. No single legal system served as the model. Civil law, the law of obligations and civil procedure from Switzerland, commercial law, maritime law and criminal procedure from Germany, criminal law from Italy and administrative law from France.

Example 2: Ninety seven percent of the draft of book 2 of the new Armenian civil code, Obligations, was taken straight from the Russian civil code.

23 May 2008 ESNIE 2008 9

Bridging the Legal Gap II Legal harmonization and unification

Countries bargain on a set of objectives, then each one amends its legal system to reach the chosen objectives

Coordinated multilateral effort Harmonization and unification differ for the degree

to which the gap between legal systems is actually reduced

With unification countries agree to adopt a unified set of rules, replacing their national rules

Examples of harmonization and unification are the “directives” and “regulations” approved by the Council of the EU• Directives “harmonize” by setting common goals

and standards• Regulations “unify” by replacing national laws

with common rules

23 May 2008 ESNIE 2008 10

The Costs of Legal Change

Countries have to change their legal systems costs of drafting a new law costs of learning foreign legal rules

Jurisprudence and doctrine become obsolete Courts and lawyers have to learn new legal

rules (application and interpretation problems)

Increase in uncertainty and litigation due to lack of legal precedents and doubts on the interpretation of the new law by courts.

23 May 2008 ESNIE 2008 11

The Costs of Legal Change II

Stronger impact of mandatory rules a reduced legal efficiency-enhancing lex shopping (Ribstein and Kobayashi, 1996)

Influence costs by lawyers and legal practitioners who lose their grip on the “supply of legal skills” (Ogus, 2002)

Political costs of change (reputation) Social costs (Legrand 1997)

Free riding incentives (Garoupa Ogus 2006)

23 May 2008 ESNIE 2008 12

The Costs of Legal Change III The “Transplant Effect” (Berkowitz,

Pistor and Richard 2003)Empirical study on 49 countries:

“countries that transplant the law have less legal order than “origins”, unless transplanted statutes that were close to the original law or where adapted.

The Economics Of Legal Harmonization

23 May 2008 13ESNIE 2008

23 May 2008 ESNIE 2008 14

Issues & Questions

Countries tend to resist to legal harmonization notwithstanding undeniable benefits

There are the costs of legal unificationAdaptation and switching costs

Would countries be willing to invest to reduce such costs to facilitate legal harmonization?

When legal unification occurs, do efficient rules prevail?

23 May 2008 ESNIE 2008 15

Legal Harmonization: The Model Carbonara and Parisi (2007) 2 countries, A and B, with different legal

systemsA has legal system aB has legal system b

a and b are equally efficient There are legal and commercial transactions

between A and B Legal differences between the legal systems

impose costs on A and B, reducing legal benefits from commercial transactions

Information is complete and symmetric

23 May 2008 ESNIE 2008 16

Legal Distance

D is the difference between a and b D= - xA- xB

Define = initial distance between a and b xj = distance-reducing effort by country j (j =A,

B) A and B know the value of D at each moment in

time With legal transplantation, countries choose xA and

xB simultaneously and non cooperatively given With legal harmonization, countries choose xA and

xB to maximize joint surplus. They bargain to share the surplus

23 May 2008 ESNIE 2008 17

Distance Reducing Effort

xA and xB are strategic substitutes The unilateral move of A towards B (or

vice-versa) reduces the incentives of B to move towards A. The optimal xA is decreasing in xB

Free riding Distance is always positive in equilibrium Distance is larger when countries

transplant

23 May 2008 ESNIE 2008 18

Countries Can Control Switching Costs 2 – stage game:

Adjustment costs are endogenous At stage 1, prior to the choice of x,

country A can change its adjustment cost• This requires a costly investment• Adjustment costs can be

decreased or increased At stage 2, A and B choose xA and xB

23 May 2008 ESNIE 2008 19

Effect of Changing Switching Costs Direct effect on welfare

higher adjustment costs increase resources needed to reduce legal distance

reduce welfare Strategic effect

higher adjustment costs reduce xA

by strategic substitutability xB increasesmore costs to reduce D are born by Bthis enhances A’s welfare

23 May 2008 ESNIE 2008 20

The Strategic Effect

If strategic effect dominatesA invests to increase m. switching costsprecommitment strategy to reduce own

ability to adapt to b in stage 2size of strategic effect depends on

reactivity of equilibrium xB (ultimately on B’s reaction function)• B’s adjustment costs• B’s costs of legal distance

23 May 2008 ESNIE 2008 21

Changing Adjustment Costs Raising some of the rules to the level of

constitutional rules, requiring supermajorities or aggravated procedures for their amendment

Recognizing specific rules as fundamental principles of the system, thus creating a strong presumption against their modifiability.

Introduce more complicated bureaucratic procedures and red tape or new institutions like committees or authorities They would strongly oppose change, increasing

political obstacles. Calling for a referendum to approve changes (like

those called in several EU countries to approve the new European Constitution).

23 May 2008 ESNIE 2008 22

Changing Costs and Cooperation In general, it can happen that A invests to

increase m. switching costs more when stage 2 is cooperativeB can be forced to increase xB to a larger

extent if stage 2 maximizes joint welfare There are cases where A invests to reduce

m. s. costs when stage 2 is non-cooperative and invests to increase m.s.costs when stage 2 is cooperative

These cases might result in less harmonization under cooperation paradox

23 May 2008 ESNIE 2008 23

Conclusions

Adjustment costs impede full transplantation

Harmonization increases legal uniformity but does not lead to unification

Countries may invest strategically to increase adjustment costs

Investment may well be higher when the second stage is cooperative, so that cooperation results in less harmonization

The Evolution Of Legal Systems

23 May 2008 ESNIE 2008 24

23 May 2008 25

Efficiency and the Evolution of Law Market-for-Rules Metaphors

Freedom of choice for applicable law leads to an expansion of the “size of the market” for legal rules.

Forum shopping and choice-of-law-rules enlarge the set of rules applicable to a transaction.

Efficiency Hypothesis -- Efficient rules should win the competition (Mattei, 1997, Ogus, 2002)Demand-Side Explanations: They are chosen

more often by private partiesSupply-Side Explanations: Legislators introduce

most often chosen rules in their national legal systems

This should induce the convergence of legal systems

ESNIE 2008

23 May 2008 ESNIE 2008 26

Evolution of Law and Path Dependency Diffusion of legal norms is path and history

dependent There are substantial network effects

If many countries adopt a rule, the gains from adopting it increase, independently of its efficiency

There is a “tilting point” (critical mass)Once the number of countries adopting a

given rule is high enough, all countries may switch to that rule

Due to the “critical mass effect”, an inefficient norm might become universally widespread

23 May 2008 ESNIE 2008 27

Coexistence of Legal Norms

If such critical mass is not reached, norms can coexist in the steady stateThis explains how legal families

originated

Assume the evolution of law follows a replicator – like/payoff monotonic dynamics

A Digression:Evolutionary Equilibria

23 May 2008 ESNIE 2008 28

23 May 2008 ESNIE 2008 29

A New Idea of Rationality We abandon the idea that players are

perfectly rational The strategy of an individual in its

interactions is predetermined by its phenotypeE.g. fight or retreat

A population is a mix of phenotypes: different pairs randomly selected from it will interact using different strategies

Individuals using strategies on average better suited for those interactions will have greater evolutionary success (fitness).

23 May 2008 ESNIE 2008 30

Biology Meets Economics

Individuals “inherit” one strategy to playCultural transmissionSocialisationBackground & educationPast experience

Different individuals “inherit” different strategies

Strategies (on average) more successful over the mix of strategies played in the population proliferate and are adopted by more & more players

23 May 2008 ESNIE 2008 31

Evolutionary Equilibrium

A strategy that cannot be upset by any successful invasion of another is part of an evolutionarily stable equilibrium (ESS).

Monomorphic and Polymorphic EquilibriaTwo or more strategies can be equally fit,

coexisting in certain proportionsThen the population is said to be

PolymorphicPolymorphism is a concept close to the

notion of mixed strategy.

23 May 2008 ESNIE 2008 32

ESS and Replicator Dynamics Replicators are entities (genes, strategies)

who can “copy” themselves, thus spreading in a population.

Replicator dynamics is the selection mechanism determining which of the potential replicators will grow at the expenses of “competitors”.

The rate of change of a replicator is assumed proportional to the difference between

a) The replicator’s current payoff;b) The current average payoff in the

population.

Competition And Efficiency

23 May 2008 ESNIE 2008 33

23 May 2008 34

A Model of Evolutionary Competition Carbonara and Parisi (2008): evolutionary

model of contract law with international trade and endogenous legal barriersBarriers depend on how widespread a rule

in the world and on the actual use of the rule in transactions

States face switching and adaptation costs when changing their law

States and economic agents are independent actors

Rules compete

ESNIE 2008

23 May 2008 35

Results1. “Victory” in rule competition is only

partially driven by strict efficiency.2. Relevance of network effects

Percentage of countries adopting the same rule;

Rules shared by the majority of commercial partners.

3. Choice-of-law rules play an important role: With more restrictive rules countries and

firms tend to go in the same directions With laxer rules the two processes can go

in different directions4. More competition not necessarily desirable?

ESNIE 2008

23 May 2008 36

The Model

There are two legal rules A and B Rule A is the “efficient” rule

It allows higher gains from trade when used in business contracts

Rule A and B compete Extent of rule competition is

determined by choice-of-law rules

ESNIE 2008

23 May 2008 37

Choice-of-Law Criteria

1. Choice-of-law clauses are validated according to a lois suppletive test Parties are not allowed to select a governing

law deviating from mandatory provisions of their legal system of origin

Rarely applied nowadays2. Choice-of-law clauses are validated according to a

substantial relationship test The chosen rule has to bear a close relationship

with the parties or with the object of their contract

3. Choice-of-law clauses are validated according to a ordre public test Parties are free to choose the law governing

their contract as long as non-derogable principles of their domestic legal system are not undermined

ESNIE 2008

23 May 2008 38

Modeling Choice-of-Law

1. Very restrictive: firms have no freedom to choose a rule different from the one adopted in their country of origin

2. (Semi) restrictive: freedom of choice in transnational contracts; domestic transactions subjected to national rules

3. Permissive (Free): firms are free to choose the legal rule they prefer, even for domestic transactions.

ESNIE 2008

23 May 2008 39

Countries

There are N countries In each country there are m (symmetric)

firms engaging in transnational trade Countries are symmetric but for the legal

rule they initially followAt time t, nt percent follow legal rule A

Countries can transplant a new ruleThey face switching costs

ESNIE 2008

23 May 2008 40

Firms Firms have transactions with national and

foreign parties The rule chosen by their country affects

firms’ transaction costs When choice-of-law is allowed firms choose

the rule governing their transactions with foreign parties

Using a rule different from their country’s one costs a firm >0 (application cost)At time t, xt percent use legal rule A (if

legal)

ESNIE 2008

23 May 2008 41

Trade

Firms are matched randomly in pairs A firm is matched

with a trading partner from A with probability n

with a trading partner from B with probability (1-n)

(0,1) measures the “legal barrier” When firms can choose foreign rules they

apply the efficient rule whenever possible

ESNIE 2008

The Dynamics in the Very Restrictive Choice-of-Law Regime

23 May 2008 ESNIE 2008 42

1

VA-VB>SCBA

VB-VA>SCAB

x

n

No Move Region

0

The Dynamics in the Restrictive Choice-of-Law Regime

23 May 2008 ESNIE 2008 43

a2

a1b1

b2

1 x

The Dynamics in the Liberal Choice-of-Law Regime

23 May 2008 ESNIE 2008 44

nxF(x) x

n

B

a1

c1

a2

b1

b2

(1,n° )

23 May 2008 45

An Equilibrium with Rule Coexistence…

where only one rule is used in transactions (A)

but all countries adopt the other rule Equilibrium evolutionarily stable iff

and low

ESNIE 2008

23 May 2008 46

Which Choice-of-Law Regime? Ideally, optimal regime

Should minimize costs of reduced international trade

Should favor selection of efficient rulesShould maximize speed of convergence to the

(efficient) steady stateShould minimize costs of the transition to the

(efficient) steady state Is it true that more permissive regimes have

better chances of achieving all the above goals? Are efficient rules more likely to “win the

competition” under a permissive choice-of-law regime?

ESNIE 2008

23 May 2008 47

Case I: The Very Restrictive Regime Wins! and are high Initial situation: a relatively high n but

relatively few firms use A Then

RR leads to steady state AR and F lead to steady state B

• Intuition high : too many firms should bear in order to use A, they contract using B.

ESNIE 2008

23 May 2008 48

Case II: Liberal Regimes Can Win! Again, and high Different initial conditions, low n and very

high x Result

R and RR lead to BF leads to A

• Intuition: lots of firms use A at the initial condition.

• Majority of contracts under F are written using A. Strategy A is very attractive to countries as it helps saving on “application" costs .

ESNIE 2008

23 May 2008 49

Competition Fails and are low

RR leads to steady state BR leads to steady state AF leads to steady state D

• Intuition low : strong incentive for firms to invest use A independent of their legal rule of origin

• low : the weight of the “border effect” is too high compared to the application cost increase trade at the least possible cost and let firms seek efficiency

ESNIE 2008

23 May 2008 50

Are Liberal Choice of Law Regimes Always Socially Efficient? A very restrictive regime by efficient

countries might speed up convergence to efficient rule

A very restrictive regime by inefficient countries is always harmful

No universal “superiority” of open choice of law regimes

ESNIE 2008