Emergence and construction of efficient rules in the legal system of German civil law

Intrmational

R&w

of‘lnw and Economics

(1993)

13, 285-302

Emergence and Construction of Efficient Rules in the Legal System of German Civil Law CLAUS OTT AND HANS-BERND

Fuculty of‘ Law II, University

of Hamburg,

SCHAFER

20146 Hamburg, Germav~y

Recent Critique of the Cost-Benefit Approach to Law In its most straightforward version the cost-benefit approach, as proposed by Posner,’ asks whether a new legal rule increases total wealth. Goods are valued at their current market prices. If these prices do not exist or are obviously distorted, proxies and shadow prices may be used.’ In a broader sense the cost-benefit approach can be extended to concepts other than wealth maximization, that is, utilitarian maximization, which includes aspects of distributional justice by using distributive weightings for the individual willingness to pay.” The cost-benefit approach to law is based on three assumptions, all three of which and especially the third one, are challenged by the current critique. 1. 2. The 3.

Consequrlltinli~sm: The legitimacy of a legal rule is to be evaluated quences for the members of the society. Wdfuri~~m:Out of all consequences only those that affect individual current

critique

is especially

Ol@rtivism”: It is in principle can assess the consequences by getting detailed enough changes.

directed

by its conseutility

matter.

against

possible that an outsider and uninvolved of a legal change on the utility or wealth information on corresponding utility

observer of people or wealth

The current critique of economic analysis is especially directed against objectivism. Apart from views taken by Hayek’ years ago, Schmidtchen, Kizzo, Sugden, de Alessi and Staaf, Ellickson, and Heiner and Cooter” have expressed doubts about the welfare economic cost-benefit analysis of norms. Kizzo’s critique is quite straightforward’: Suppose that two individuals, A and B, can both economically avoid an accident between them. A can avoid it by an expenditure on resources that has a disequilibrium market value of $50, while B can do the same by an expcnditure of $75 on ditf’erent resources that are also disequilibrium priced. Can we then say that social costs will be minimized if. liability is placed on A? We canIlot. II does not f’ollow that the social opportunity costs of A’s rc‘sourccs exceeds that of R.

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Such a legal analysis that places the liability on the cheaper cost avoider, and consequently concludes that accidents are then avoided at cheapest costs, is based on three assumptions, which Schmidtchen has named the tools trinity of maximization, equilibrium, and efficiencyH: 1. 2. 3.

Decision makers maximize wealth or leisure. Historical prices are taken as proxies for equilibrium as proxies for opportunity costs. The potential-Pareto criterion (Kaldor-Hicks-Skitowsky) criterion.

prices and historical

costs

is used as a normative

In the real world, however, runs the argument, historical prices as taken from the files of bookkeepers have nothing to do with equilibrium prices and are not indicators of wealth or utilities.” Only the owner, the buyer, or the seller of a resource knows in a situation of disequilibrium the value of a resource whose value may differ for any single individual. There is no bridge from historical prices to equilibrium prices and from there to welfare judgements. This conclusion even holds if one cotnpletely disregards the ef-fects of “wrong” equilibrium prices, such as monopoly prices or prices distorted by technical external effects. The maximization hypothesis of human behavior is also rejected by this critique, especially on the grounds that uncertainty prevents economic agents from maximizing. “’ This view is taken by adherents of the new evolutionary school of economics. Schmidtchen argues that the tool of the expected utility theory, which allows for maximizing in an uncertain world, does not solve the problem. Expected utility theory presupposes the knowledge of different future states to which the economic agents can attach probabilities such that their probability density is known. ‘The problem of uncertainty is seen, however, as being much deeper than suggested by the theory of expected utility, leading a decision maker to actions that are different from those predicted by a theory of maximizing behavior. ” The view is held that unccrtainty is much more likely to lead to rule-based rather than to maximizing behavior’” if a gap between the competence of an agent and the difficulty of the decision problem arises [(C-D) gap]. If this is the case the effect of changing rules, which must lead to changing behavior if agents are maximizing, cannot be predicted anymore. But even if the theory of expected utility were a correct description of individual behavior under uncertainty, the probability distribution of future events is purely subjective and not observable by any outside observer. It follows that in the absence of equilibrium and of maximization a judgement on whether or not a legal rule increases efficiency is impossible for an outside observer such as a judge. Consequences

Critics of the cost-benefit approach to law draw different conclusions. One is to reject the role of the judge as a “cognitive superman”‘” and to reduce the domain of public policy, especially that of the judiciary. Another view is to analyze conditions in which cooperative behavior emerges spontaneously in the form of customs, habits, or norms and to transform them into binding legal rules. Reduction of Role of Judiciary and Legislation If the welfare implication of a rule camrot properly be assessed, a possible consequence could be to allow damages to fall where they may-in tort law and contract

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enforcement, which reflects the true preferences of the parties, to the highest possible degree. “. . Instead of an elaborate system of negligence law, the courts could adopt a ‘let the damages fall where they may’ attitude in all but say, the most grotesque cases.“‘” If the benefits of a rule are unclear, this revolutionary proposal would at least save court and litigation costs.‘” Another consequence would be to apply specific performance rather than damage compensation in any case of breach of contract. As the proper assessments of damages are impossible in case of a breach of contract, the only efficient rule is then specific performance at whatever costs, whereas the theory of “efficient breach” has to be rejected as an objectivist fallacy. This view is taken by Alessi and Staff.“’ They take their argument to the extreme consequence, referring to the landmark case, ,Jncob 63 Yowzg Inc. v. Kent. Here a different brand of pipe than the one specified in the contract was installed in a house. To install the ordered pipe would have required tearing down and rebuilding portions of the house. The jury decided that the defects of the installed pipe were of “trivial and inappreciable importance” and denied specific performance. From a subjectivist point of view, this is an unjustified oejectivist judgement, unjustified because an external observer cannot possibly value the expectation of the buyer’s foregone alternatives. Especially, he cannot use market price differentials to do so. From this point of view, any theory of efficient breach of contract breaks down.

Structural Approach

ofAdjudicating

If, from a subjectivist point of view, the contract is the only genuine method of revealing individual preferences, the consequence could be to restrict the domain of regulation and public policy to the obvious or “most grotesque cases.“” Thus, it is obvious that regulating automobile traffic is more efficient than letting cars run on either side and direction on motor highways and waiting for a spontaneous order of traffic regulation to develop. But all in all this perspective results in a minimal state, which does little more than protect property rights and freedom of contract. An alternative view has recently been taken by making use of theorems and arguments of evolutionary economics and game theory. In the words of Schmidtchen, the judge as a maximizing cognitive superman is to be replaced by a “do-it-yourself method.“lx Conventions and rules are generated by individuals who live together and have no other choice than to cooperate in the long run. These social norms and conventions are conceptualized as strategies in noncooperative games that are intinitely repeated and in which future earnings are not heavily discounted.“’ These norms are 1. 2.

3. 4.

Basically self-enforced2”; to break them would lead to a net utility loss for most players. Not designed but rather the outcome of actions of individuals, who follow their own egoistic interests. They are, to use Hayek’s famous phrase, the result of human action but not of human design. Developed from certain regularities of behavior to conventions and from there to boni mores. Possibly transformed into legal norms by court decisions and extended to domains in which cooperation has not developed because, though they are in principle self-enforcing, for some players noncooperation pays out.

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Civil law under this perspective is seen as a compromise between the spontaneity of custom and the formality of legislation. According to Cooter, courts, instead of computing costs and benefits of rules, should transform social customs into legal rules if the structure of the game that produced the rule is such that it leads to efficiency. In his view empirical findings suggest these conditions: 1. 2.

The game is endlessly repeated or the probability point of time. Players do not heavily discount future earnings.

of repetition

is high at any

Under these conditions efficient solutions will arise spontaneously because opportunistic or defective behavior of a player can be so heavily sanctioned by the other players that it does not pay to play defectively.” Social Norms in German Civil Law Social Norms and Legal Rules in Adjudication Structural approach to ef@iency. The structural approach promises a way out of the dilemma. The way out, according to the structural approach, is to look for efficient solutions that have been established in social interaction. Instead of methodically constructing efficient rules by using efficiency criteria and weighing costs and benefits of alternative rules and decisions, the courts would better find efficient solutions indirectly by looking for social norms and enforcing such norms if they have emerged within cooperative structures.g’ Thus the interest of scholars is focusing again on social norms, and the old debate about the sources of law is revitalized. There is a long tradition to the view that social norms that have developed over a long period of time in a process of cultural evolution represent appropriate, well-balanced solutions of social problems and are superior to legal rules constructed and used as instruments of planning and public choice.23 In the following it will be shown which role social norms actually play in German civil law. Adoption ofsocial norms by law. There are two different ways in which social norms may become legal norms. The first is through customary law, the second through integration ofjudge-made law. Customary law is defined as a rule that is not codified, but predominantly observed by the members of the community, and that is held to be legally binding (inveterata consuetudo, opinio necessitatis).“’ A social norm may become customary law if it is a deeply rooted convention, supported by the general conviction that everybody has to submit to it. Customary law is recognized as a source of law by the German Civil Code (Art. 2 EG BGB). It is, however, closely linked to judge-made law, because unwritten rules are usually made manifest by court decisions, and the question of whether a certain rule of customary law exists will in most cases be settled by the authority of the courts. 2i In theory, rules of customary law exist without formal recognition by courts, but in practice norms are discovered as customary law only by adjudication. Alternatively, social norms may be integrated into law where codified law explicitly refers to social norms. In German Civil Law many blanket clauses refer to “boni mores” (public morals), to commercial and trade customs, to the “due level of care,” or to “common usage” or “conventions” (Verkehrssitte).‘” The legal status hereby attached to social norms varies; certain social norms rank on the same level as compulsory legal rules, whereas others have rele-

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Vance only for the interpretation of legal norms. Section 138 of the German Civil Code states that contracts that contravene public morals are regarded as void, and Section 1 of the Unfair Competition Act prohibits acts of competition that violate boni mores in business. On the other hand, Section 346 of the German Commercial Code states that trade customs are to be considered in regard to the meaning and consequences of acts in business interactions; this means that social norms are relevant for the interpretation of contracts, but they are not necessarily binding the court. Legal norms of this kind open the law for social norms. Again, the courts play a crucial role in the process of integrating social norms. This role, however, is not restricted to finding social norms and applying them, but includes elements of normative control. There is no automatic transformation of social norms into legal rules, even where legal rules explicitly refer to social norms. The first step itself is not always merely an act of fact finding. It may be relatively easy to identify a trade custom-for example, the conventional meaning of trade terms (cif, fob)-but it is quite different to decide whether certain expectations and conventions exist with regard to public morality-for instance, in business interactions. Here already.judicial discretion is involved. In the second step, the courts have to decide whether a social norm should be recognized and enforced, and in many cases this means selecting between contradicting social norms that are related to the same field of interaction. This is the step of normative control of social norms by the courts. Social norms and conventions are only accepted if they are regarded as being consistent with legal principles and values. The “due level of care,” as defined by courts, does take into account the level of care that is usually practiced in the community, and both are not necessarily identical. The due level of care may be higher or even lower than the level of care usually observed. The court has to define the level of care that is “required in social interaction” ( U 276 BGB). It is the competence and responsibility of the court to determine which precautions must be taken against certain risks, even if safety conventions exist in the community.” Normative control is also administered by courts in the case of boni mores. Social conventions about decent behavior do not, however, constitute public morals. They are recognized only if they are regarded as reflecting the sense of decency of fair and reasonable people2’ (Anstandsgefuhl aller billig und gerecht Denkenden). It is not the social norms actually observed in a certain community that are adopted, but only norms that-in the opinion of the,judge-are observed by “decent and reasonable” people. This is a normative, not an empirical, question. The judge does not look for existing social norms accepted by real persons, but for norms that would be accepted by ideal persons. Obviously the transformation of social norms into legal rules in such cases hardly distinguishes this from law making by judges; the difference between transforming social norms and making legal rules is fading away.

RoG of spontunrous order in civil law. The domain of spontaneous order in civil law is contract law, but even this statement needs some restriction. Contractual relations are to a large extent not established in an individual bargaining process but are preconditioned by a network of general terms and conditions imposed by one party upon the other. Again, legal control of such contractual regulations is necessary due to the market-for-lemons effect.‘” Outside this area, the realm of spontaneous order in civil law is restricted by the fact that the transformation of social norms must pass judicial control and thus becomes intermingled with judge-made law. Customary law

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plays almost no role at all in German civil law; it has been merged withJudge-made law.30 Blanket clauses referring to boni mores have substantially changed their function: The concept of public order has broadly replaced the search for preexisting social norms. Nevertheless, social norms and conventions play important roles as arguments in legal reasoning. As already mentioned, the courts will take into consideration standards of care actually practiced in the community when defining the due level of care in terms of negligence, but they are not regarded as legally binding. For instance, the Federal High Court (BGH) has ruled that radar must be used on a ship riding at anchor at high sea in low visibility, although it was found that this was neither prescribed by law nor practiced by sailors. 51 The convention not to use radar while riding at anchor, the court said, was a relict of a time of less progressive technology and could therefore not be accepted as indicating the due level of care. In other cases, the Court has recognized that safety standards elaborated and recommended by experts are especially suited to define the due level of care because they reflect the state of the art.““’ However, these safety norms are deliberately set up by a private agency and are the result of safety planning, not of spontaneous order.

Concept of Boni Mores-Public

Morals or Public Policy?

Blanket clause of boni mores in German civil law-a survey. There are two central norms in German civil law referring to boni mores (public morals). The first is Section 138 of the Civil Code, which states that a contract contravening public morals is held to be void. The other norm is Section 826 of the Civil Code, a general clause of tort law, which states that whoever causes damage to someone else intentionally and in a way that violates boni mores is held liable. Thus, violation of boni mores is sanctioned in contract law and in tort law. In addition, Section 1 of the Unfair Competition Act prohibits all acts of competition in business that contravene boni mores. All these norms are regarded as instruments to prevent the improper use of private autonomy. Private autonomy in civil law has to be restricted where its consequences are inconsistent with the basic legal and moral principles of the social order of the community. Boni mores in competition law-fundamental change. There has been a long-lasting debate about the actual meaning of boni mores in Section 1 of the Unfair Competition Act.“’ Originally, the intention of the legislators was to refer to generally accepted social norms or conventions about decent behavior in business. Unfair competition law was first enacted in 1896 and reenacted in 1906, when the boni-mores clause (Section 1) was added. At that time, reference was made to the expectations of honest businessmen that have developed in a long tradition as a spontaneous order in an open-end game of cooperating competitors. The function of the legal norm was mainly to enforce these social norms and conventions against deviant individual members of the profession.“” So far the doctrine of boni mores in competition law is entirely in accordance with the structural approach. But the doctrine has changed over the past century because the original concept was outdated by rapid change in marketing strategies. The development of norms through spontaneous order could not keep up with the dynamic innovations in marketing. The rule-making capacity of the evolutionary process was not sufficient. The other reason for the collapse of the former doctrine was a structural deficit. It was

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discovered that the structure of the game was different from that assumed originally. At the beginning of the century, unfair competition law was regarded as a matter of protection of competitors against disloyal behavior of other competitors, but later consumer protection emerged as an equally important aspect.3” Consumers, however, did not participate in the norm-producing game of the business community. Spillover effects to third parties result from such norms. For these reasons the idea of controlling unfair competition by transforming social norms into legal rules must be given up, and indeed has been given up by jurisdiction and eventually also by jurisprudence.“’ The original concept of boni mores in competition law has been replaced by the concept of public policy. The function of the boni-mores clause has changed. It is no more a transformation norm but must be regarded as a delegation norm. That means that by this norm rule-making authority is delegated to the courts.“x The question of how the courts handle this competence then arises. This fundamental change and its consequences may be discussed in a most controversial issue of unfair competition law concerning the question of whether predatory pricing should be regarded as a violation of boni mores in competition law and therefore prohibited. Selling selected items at prices that do not cover the costs of the seller is a strategy often used by large firms. For many years the lobby of small- and medium-sized retailers has strongly opposed this marketing strategy and has tried to induce legislative sanctions, with only partial success.39 The battle was continued before the courts, but the Federal High Court decided that underselling does not principally violate Section 1 of the Unfair Competition Act and consequently upheld this adjudication.“” In these cases, the court did not look for social norms or conventions regulating price battles in the business community but developed certain rules based upon its own philosophy of fair and workable competition. The arguments are

1. 2.

Underselling does not impose unfair restraints upon competitors but is generally a substantial element of effective competition. Underselling may become unfair competition if it is aimed at removing competitors from the market and if, as a consequence, competition on this market will cease to exist, or if it has to be expected that other competitors imitate this strategy to such an extent that disturbances of competition detrimental to public welfare would result.

In a case from 1983, the Court were bought by a retailer at the 99.00.“’ The court ruled that this Act, although it was admitted that to use this marketing strategy.

had to deal with the pricing of dry shavers, which price of DM loo-105 each and then sold at DM did not violate Section 1 of the Unfair Competition small- and medium-size retailers might not be able

Switch towards public policy. Analysis of these decisions proves that the courts are not looking to the business community for social norms regulating competition but are making rules in order to sustain competition. The way the court establishes a rule is via a public policy approach; the consequences of alternative decisions are reflected and then a choice is made. The criteria are mostly drawn from the concept of “competition by performance” (Leistungswettbewerb), not by obstruction (Behin-

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derungswettbewerb). 4’LThe boni mores in competition tural conditions of efficient competition.‘”

law are identical

to the struc-

Adjudication qf Trade Custom Domain of business rules of conduct. Section 346 of the German Commercial Code states that trade customs have to be considered among merchants with regard to the meaning and consequences of the acts and behavior. Trade customs are related to the meaning of certain abbreviations used in business, such as cif (cost, insurance, freight), fob (free on board), and dc or dip (cash resp. payment against documents), to allocate costs and risks. Trade customs of this kind are linguistic conventions among a certain professional community. Other trade customs are related to complementary contractual duties, such as restitution of packing material. Corresponding trade custom exists in Hamburg but not in Diisseldorf. Special trade customsthe Tegernseer customs-exist in the lumber business concerning warranty claims. Other examples of trade customs are conventions about the right to cancel hotel reservations. These customs are social norms that have developed spontaneously, and they are integrated into law in a manner described by scholars of the structural approach.-” These norms have to be found by the judge. This is implemented through the court’s investigation, and therefore the court will determine whether a certain trade custom exists by asking the Chamber of Commerce (for example), which in turn will ask its members. So far, the adjudication of trade customs may appear to function. The identification of trade customs is nevertheless in many cases not an act of simple fact finding, but a rather complex process, with results depending on how the question was put and who was asked. Apart from this, courts also apply a normative control in this area. This is shown in the following case. Rule of “cash against documents” and role of adjudication. In 1964, the Federal High Court had to decide a case in which the clause “cash against documents” was invo1ved.l” The plaintiff had sold 35 ts. of deep-frozen kangaroo legs to the defendant with the clause included in the contract: “Net Cash in London against Documents on arrival of Vessel in Hamburg. ” The cargo arrived at the Hamburg harbor before the documents were handed over to the buyer and was stored in a refrigerator stock. The buyer refused to fulfill the contract before he could examine the cargo. He argued that the term cash against documents did not make sense in a case where the shipment arrived before the documents were presented because the transaction would not be delayed by an examination of the quality of the goods previous to payment. It would be unfair of the seller to insist on “cash against documents” and to deny previous examination. ‘I‘he High Court of Frankfurt decided in favor of the defendant.“’ The court ruled that the term C&Z apinst documents loses its function once the cargo has arrived at its destination. The function of this clause is, according to the High Court, to accelerate trade transactions. Therefore, as long as the shipment is still on the way, payment must be made upon presentation of the documents and shall not be delayed until the buyer gains possession of the cargo. If the transaction is not delayed, possession cannot be refused, even if this was contrary to a convention in the trade community. A trade custom, the High Court argued, could only be recognized by the courts as long as it is reasonable.

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This decision was overruled by the Federal High Court. The Court held that the clause “cash against documents” expresses an international trade custom according to which the buyer has no right to examine the cargo before taking up the documents and making payment in exchange for the documents. The court argued that a strict interpretation of this clause was indicated because there were good reasons to refuse the buyer any control of the cargo even after arrival at its destination. The reasons are, as the court stated, to avoid frictions in international trade transactions. Banks would give credits to finance overseas trade only if they get securities in the form of documents that contain a title against the buyer for unconditional payment. If payment could be made dependent on previous control of the cargo by the buyer, this security for credit would be invalidated. This is a reasonable motive for the trade custom in question, the court argued, and therefore has to be considered when applying the clause. This controversy about a certain trade custom is symptomatic of the relevance of social norms in civil law. The courts involved in the “kangaroo case” did not restrict their adjudication to identif-ying a social norm-in this case, a convention about the content of the term cnsh ngainst documrnts-but discussed whether the clause did serve reasonable ends in the case to be decided. ‘rhe social norm was transformed into a legal rule only because the Federal High Court held that this was necessary to avoid detrimental effects on the working of trade transactions. This reflects a consequential used by the approach, not a structural approach, and the criteria and arguments Federal High Court could easily be translated into efficiency arguments.

Legal nature and rrleuanrr of princ$h ofpropu accounting. The legal nature of these principles is a much debated issue in accounting law.” Some authors hold that they are customary law. while others argue that they are to be regarded as social conventions. There is a long-lasting debate between scholars who favor a “deductive method” and others who favor an “inductive method.“” The “inductionists” argue that the principles of proper bookkeeping are unwritten conventions accepted and realized by honest members of the business community. These conventions-or social norms-can be identified by empirical research. ‘The-judge, so it is argued, does not have to make rules of proper accounting, but rather to find rules that have spontaneously developed in the business community. The “deductionists,” however, argue that these rules are to be established not by looking for empirical evidence, but “by thinking,” that is, by developing rules that are consistent with the purpose of accounting.“’ The debate about the legal nature of the principles of proper accounting illustrates very clearly the changing relation between social norms and legal rules in the development of law. This development confirms the theory of the structural approach, but at the same time proves that the structural approach does not explain the origin of- legal rules. At the beginning of the debate, principles of proper accounting were generally regarded as a common practice among merchants. In the Commercial Code from 1897, reference was made for the first time to “principles of proper accounting,” which were regarded as factual customs of merchants. The idea was that reasonable norms would evolve spontaneously in business life, out of the “inherent forces of society. ‘w’ This was closely connected with the historical and evolutionary approach to law and economy still prevailing in those times. It was widely believed that the

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economy would spontaneously produce its appropriate order and norms, and that state legislation should principally abstain from interference. This model of rule making, however, was never realized. Adjudication was not restricted to discovering and recognizing accounting customs in the business community but included normative control and correction of social norms. The accounting practices of real existing merchants did not count as much as those of respectable, honest, and ideal merchants. This fundamentally changes the approach: “The standard by which one would judge the accounting methods used in recording data and preparing financial statements should be that of what is “appropriate” or “reasonable” or “sound,” not what is generally accepted.“’ The concept of respectable and honest merchants is a model of how merchants should behave in the opinion of the ~judge, although they may not actually behave so. Thus, the development of legal rules is shifted to a normative level. Customs and practices of accounting, even if generally accepted in the business community, are not accepted by law unless they have passed the “filter of judicial control.” This filter of judicial control separates the inductive from the deductive approach because social norms passing this filter are substantially transformed. Whether accounting principles are “appropriate” or “reasonable” depends upon the legal functions of accounting. The judge, therefore, has to consider the consequences of a possible rule and to compare them with the legal ends of accounting. In most cases, the rule-making decision is a mixture of different elements: deduction of legal criteria of proper accounting, precedents, statements of experts, and reference to literature.52 Arguments used in this debate against the structural approach to adjudicate accounting norms are drawn from a “structural test” of the process that produces social norms. The main reason why accounting practices cannot simply be accepted as legal rules has been seen by such practices evolving from a process with spillover effects to parties who are not involved in their emergence.“” Accounting practices in the business community do not reflect a compromise between insiders and outsiders.

Summary: Loss of Importance of the Structural Approach

in German Civil Law

The shift from rule finding to rule making in adjudication in fields where codified law explicitly refers to social norms marks the development of legal rules outside of legislation. The examples selected and discussed in this paper are representative of the diminishing relevance of the structural approach in civil law. They could easily be augmented. The conclusion is not, however, that social norms evolving from spontaneous order do not exist or are altogether ignored by the courts. On the contrary, in any business or community, social norms, practices, conventions, and standards about proper behavior, due level of care, and so forth will develop over time. As a matter of fact, they usually are part of the argument before the court and considered by the court. However, these norms are submitted tojudicial control. Social norms are also typically not only the result of spontaneous process but are reciprocally influenced by legal norms and standards. Judicial rule making thus dominates the field, where legislation refers to social norms. Judicial rule making is necessarily part of judicial policy making, but of course not necessarily part ofjudicial efficiency orientation. Judicial rule making may fairly be described as an inextricable mixture of very different criteria and factors, including a philosophy of justice, but at least a consequentialist-or teleological-

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approach can be identified as typical for judicial arguing in rule-making decisions. Furthermore, it has been shown that the arguments in many trading civil law cases of the German Federal High Court are closely related to efficiency arguments.

Efficiency of Spontaneous Order? If the transformation of social norms into legal norms is of little importance in German civil law and if its importance was declining over the last 100 years, the question remains as to how reliable would a structural approach be if adopted on a much larger scale. The adoption of the structural approach could include the following steps: 1. 2. 3. 4. 5.

Define the problem of cooperation. Find a social norm that tries to solve the problem. Investigate whether the social norm has developed under conditions that are favorable to efficient cooperative behavior, especially in an infinite relationship. Decide whether negative effects of cooperation among cooperative players on third parties can be neglected. Transform the social norm into a legal rule and thereby extend its domain into regions in which the preconditions of self-enforcing cooperation are not fulfilled.

The optimism towards the evolution of efficient social norms has been underpinned by some game-theoretic results, which show that some of the malicious problems (such as that shown by the prisoner’s dilemma) disappear if the number of games approaches infinity or if the probability that the game is repeated is constant and high in every period. In one-shot games the Nash equilibrium, that is, the optimal strategy for each player given that the strategy of all other players is given and in equilibrium, is noncooperative. In a finitely repeated game with a fixed number of games, cooperation also does not evolve because it pays to inform on competitors during the last period. This causes “tattling” during the period before the last and so forth, such that cooperation becomes collusion. But if the probability of repetition is high or even 1 in any period (supergame),” spontaneous cooperation may emerge and one can find a simple perfect equilibrium in which players cooperate. Thefirst question regards the domain of infinite supergames. Is it simple to distinguish real-life situations that take the form of supergames from those that do not before transforming a social norm into a legal norm? A practicing Catholic, who believes in heaven, may conceptualize marriage as a supergame; others do not. How are social norms between partners in Catholic countries to be interpreted? It is doubtful whether the concept of emerging efficient social norms can be supported by game theory. The folk theorem shows that game theory, as such, can only explain the possibility of cooperation, not its necessity in infinite games.’ It indicates that any payoff combination above the minimax equilibrium in a one-shot game is the average payoff in some perfect equilibrium of the infinitely repeated game. This result means that a forecast on the kind of- the equilibrium solution in a supergame is impossible. This result is not confined to prisoner’s dilemma games but holds for all supergames. Although eternal cooperation is a perfect equilibrium outcome in the infinite game under at least one strategy, so is practically anything else: “What the folk theorem tells us is that claiming that particular behavior arises in a perfect equilibrium is meaningless in an infinitely repeated game.“5” The folk theorem is an admission of incompleteness.

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There are many examples in which cooperation is inefficient. One is the “tender trap,“57 which leads people to chose a wrong convention although they have no difficulty seeing that a different convention would lead to substantial gains for all players. This can be demonstrated by the following tender trap game: Cl Rl R2

C2 5,5 O/O

O/O 212

Here Rl, R2 denote the action combination of the row players; C 1, C2 the respective action combination of the column players; and the numbers in the matrix are payoffs of the row/column players. The efficient pair of strategies is (Rl, C I), which may not, however, be attained in a spontaneous order. Assume the choice between two computer languages. The players can use language I, which under the strategy combination RI/Cl leads to a mutual gain of 5 for each player. If they both choose language II the mutual gains are 2. If they choose different incompatible languages there are no gains. It can be shown that R2/Cl, as well as R2/C2, can emerge as evolutionary stable languages, depending on the distribution of the first users of the languages. If more than 2/7 of them use language I in the beginning, cooperation develops versus the use of language I. In that case, the expected payoff for each player is higher than 5 x (2/7) by c.h oosing language I and lower than 2 x (517) by choosing language II. Otherwise cooperation develops versus the less efficient language II. In that case players are caught in a low level equilibrium trap. Cooperation evolves and creates an improvement over a social state, in which a noncooperative set of strategies is used. Pareto efficiency, however, is not attained. In general this kind of inefficient cooperation can emerge if the compatibility of systems leads to a gain. These network externalities cause a decline of user costs for each user by every additional user.jH They make it profitable to follow the leaders rather than to choose the best quality. These self-enforcing effects can lead to social norms, which are self-enforcing but neither efficient nor wanted. The self-enforcing effects of these norms may lead to the emergence of norms that people do not voluntarily accept (excess acceleration) or they may prevent a norm system from developing that people would be willing to accept (excess inertia).“’ It has been argued that in nature as well as in human society there may exist a tendency for “robust” solutions of the cooperation problem, such that evolution selects those strategy combinations that lead to a payoff much above the minimax payoff in a one-shot game. It is assumed that in the long run only those actors who use robust strategies will survive. The predictive power of this optimistic evolutionary theory, however, is still to be determined.“” Evolutionary norms are the norms of survivors whose activities are either useful for others or who are strong enough not to be thrown out of the game. It is difficult to see how any concept of social justice or protection of the weak can evolve as a result of supergames. If players can fight to the death without risk, what prevents them from doing so? Just as the shark will automatically attack any wounded shark, so the game players will use their advantage.“’ Problem of Spillover Efects

It is doubtful whether social norms can be regarded as efficient solutions to cooperation problems between players. It is even more doubtful if one relates efficiency to

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all members of the society, including the nonplayers. Cooperation can always emerge at the expense of others. The social norm that prevents competitors from “predatory pricing” can be directed against newcomers in a market for experience goods.“’ Comparative advertisement is regarded as a bad habit in Germany and forbidden,“” unlike other countries, though it provides consumers with important information at low costs. Efficiency in game theory is relative to the group of players. The welfare concept of efficiency, however, is related to all members of the society. If a cooperative social norm evolves, an analysis has to be made of its consequences to third parties before transforming it into a legal norm. This transformation, however, involves some kind of cost-benefit analysis or public policy. The advantage of the norm for the cooperating group has to be balanced with its adverse effects on others. This would be an exercise that leads to a calculation very similar to Posner’s auction rule, which, from a subjectivist and evolutionary point of view, must be rejected. Cartels are a negative example of the acceptance of spontaneous order by the German judiciary. Before World War I Germany became the “classical country of cartels.” In 1905 385 cartels existed in Germany, comprising 12,000 companies. This kind of cooperation was tolerated and positively sanctioned by the German legal order. Cartels were not only tolerated, but in some cases-even before 1933-were enforced by regulatory law.@ In Germany, cartels were seen as the “children of misery” (Kinder der Not), and the tolerance of monopolism was seen as a necessary means to overcome economic crisis.“” This attitude developed for many reasons that cannot be reviewed here, but one of them was that economic theory and the role of competition (as commonly known and understood in the United States and Britain at that time) played a minor role in the thinking of policy makers and economic scientists in Germany. In the so-called cartel discussion it could be argued that cartels were necessary from a social point of view to avoid overproduction. In 1897 the Reichsgericht ruled, in a famous decision, that cartels were not against the law. The court argued that a collapse of prices as a result of unrestricted competition was not only against the interest of the individual firm, but also detrimental to the community. The court referred to the argument that cartels are instruments to avoid social catastrophes that may result from overproduction. The court also held the view that legislation could not prohibit cartels, even if their existence was certified. This decision of the Reichsgericht opened the legal door for a broad expansion of cartels. It was much criticized in later times, but it must be seen that in the debate at the end of the 19th century cartels were evaluated differently by different scholars. Although the problem and the implications of cartels were discussed vehemently, many contemporary scholars argued that cartels were necessary to contain economic catastrophes and to solve problems of cooperation.“” To have accepted the spontaneous order of cartels and monopoly capitalism is today criticized as a fundamental error of German civil law that failed to assess properly the adverse effects of this kind of cooperation. Signaling Problems and Spontaneou

Order

Signaling problems arise if the level of performance of an actor cannot be observed. The result is adverse selection and the lemon probletn, as analyzed by Akerlof.“? Social institutions, such as reputation, brand names, and good will, can help to over-

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come these problems. ” Whether these social institutions are always the best mechanism to cure signaling problems is at least doubtful, as examples from sociobiology suggest. In a deer herd genetic quality cannot be directly observed by the hinds who take the size of the antlers as a proxy for physical and genetic fitness. ‘The result is the spontaneous development of ever-growing antlers, which in the end grow to a size that impedes their capacity to move.“” The peacock, with its burdensome tail, is another example. It pays a peahen to chose the peacock with the largest tail because the offspring will also have a large tail, thus attracting the next generation’s peahens.70 The status system, as represented by cast or nobility, is another way of signaling.” History shows that in the very long run such systems are not stable, but if sophisticated enough, and if people are highly uninformed, such systems can survive for hundreds of years. In the Prussian kingdom it was not possible for a long time to open up the career of an army officer to the common man. During battles, deserting from the army (though heavily punished) was widespread. Among the nobility, whose members had no place to go in the whole of Europe after deserting, there was no incentive to desert. As high performance during the battle was especially important for officers, even the enlightened monarchs of the late 18th century did not dare promote ordinary people into the ranks of officers. The vendetta system does not seem to be an efficient social norm.” Lawyers and economists should be warned not to simply assume that social norms are in the interest of those who follow them. Conflicting

Social Norms

Another problem arises if social norms differ across regions and social groups. ‘l‘his becomes more likely the more differentiated a society is and the more diverse cultural, ethnic, and religious features develop. In Ahrensburg, a small city outside of Hamburg, it is possible for a pedestrian to stop a car in the shopping area by just putting one foot on the street, whereas this is not possible in Hamburg and would be unthinkable in Leipzig. A judge who would try to define the due level of care of car drivers vis-a-vis pedestrians in shopping areas on the basis of social customs could be easily trapped by a multiplicity of norms and would have to choose the one that he thinks is reasonable under a public policy perspective. The same problems arise if interactions take place between different social groups or religious communities. Even if one transformed social customs into rules on the basis of region or social group, metarules would have to be found in the case of interactions between groups. These metarules could again follow different principles from others. Conclusions The development of German Civil Law proves that the transformation of social norms and conventions into legal rules is no longer symptomatic for the process of adjudication. On the contrary, the tendency has been to move away from a structural approach towards a public policy approach. It has been shown in this paper that even in the former domains of the structural approach the role of the court is not restricted to finding social norms, that is, to verifying social norms empirically and adopting them as legally binding. That current role includes the shaping of the legal rule, considering and weighing its presumable consequences. This fundamental

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change also relates to those fields where social norms evolved to solve problems of cooperation. It has also been shown that in these areas the transformation of social norms and customs is not replaced by a narrow approach that tries to solve social problems by merely deducting rules from precedents and texts. Instead, the courts ask f-or the implicit targets of alternative rules and evaluate them under a public policy perspective that can be interpreted as a perspective of economic efficiency. The structural approach to adjudication has been proposed by those economists who are in general skeptical about welfare economics and the possibility of costbenefit analysis. They favor rules of a spontaneous order that develop under conditions favorable to cooperation. The diminishing role of spontaneous order in civil law is not in itself a conclusive argument against the logic of the structural approach; it can, however, not be ignored because the decline of the structural approach refers to almost all fields ofjurisdiction, where positive law explicitly refers to social norms. This indicates that preexisting social norms are not suited to solve actual legal problems. The reasons may be found either in the low speed of development of social norms through cooperative games or in structural deficiencies of the games in which social norms have developed. According to game theory, even in inhnite games cooperation does not necessarily occur. If cooperation results, efficiency does not necessarily evolve as a result of equilibrium strategies. If equilibrium strategies occur among players, the benefits of cooperation may result from the exploitation of nonplayers. Social norms that develop under such conditions cannot be accepted and transformed into legal rules because they clearly lack legitimacy. Apart from this, a multiplicity of solutions to cooperative problems may emerge in a spontaneous order in subgroups of the society. In a case like this, the structural approach leaves the problem of getting to legal rules unsolved, either because different and contradicting social norms are accepted for different subgroups, thus leading to inconsistencies of the legal order and the need to find metarules in cases of communication between subgroups, or because if one certain norm is chosen, individual preferences will again be violated. If the structural approach does not provide guidelines for the courts to establish efficient legal rules, the consequence could either be to concentrate on the public policy approach or to give up the efficiency concept as a rationale for adjudication. This would lead to absurd consequences because in many cases a public policy perspective is obvious, for example, in road traffic or product safety regulation. On the other hand, the subjectivist critique of cost-beneht analysis must be taken seriously because it points to some fundamental limits of any policy-oriented constructivist rule making. This critique should serve as a warning against a new wave of planning euphoria that neglects the problems of interpersonal comparisons. It should not, however, deter any welfare economic-based public policy approach, especially in adjudication. Adjudication is a process of rule making by piecemeal engineering, not of shaping the total structure of society by one grand design. The risks of false development exist, but they can be contained. Gordon Tullock is not known to be an enthusiastic supporter of welfare economics, but we agree with his following statement: “Suppose that we do have some group of decision makers who are interested in benehtting society and have some motive which would lead them to implement this interest. Presumably over time, through trial and error, improved theoretical knowledge, and so forth, they would be able to gradually improve the law,“73

300 Notes Paper presented at the 8th European Association of Law and Economics annual conference, August 29-31, 1991, Copenhagen, Denmark. 1. POSNER, R. A. (1987) ~ro~~omics nnul)l\is oflnur, 3rd ed. Boston: Little Brown. 2. MISHAN, E. (1988) Cost Den+ analyszs, 4th ed. New York: Prager, p. 83. 3. MASH, C. A., and PEARCE, D. W. (1981) Thr .rocd appraisal of projects. New York: John Wiley and Sons, p. 3 I, 4. We use this word with reluctance and would have preferred rhe term ~O.\P~IIP~.Z.\NI. O/+ctn~i.\m is a word of contention against those who favor a welfare economics, public policy-oriented approach to law. It places them near totalitarian views of the Hegelian kind, which pretend that social development and society as a whole are objective in the sense that they are independent from the individual utility rankings and that society has a preference of its own that is not tied to the preferences of the individuals. However, ob)ectivism in the sense that it is used here does not deny that the common good is a t-esult of individual utility I-ankings. It remains, however, that there exist methods of cost-benefit analysis that allow a policy maker to assess the welfare consequences of a public project or a legal norm. 5. HAYEK, F. A. (198 I) Rrdd, Gwtz,grbung und Frrzhrit: Dir lllution de,_ .~uicrlm Gwchtigkrit. In Hayek’s view, rules serve unknown goals. L.andsberg am Lech: Verlag Moderne Industrie. 6. HEINER, R. (1990) “Rule governed behavior in evolution and human society.” In Cc~n\trttctiotrul politicr~l eco~lorny, 19-46; I)F AI.LSSI, I.., and S,rAAF, R. J. (IYXII) Subjective value in contr-act Iaw. ]ournal ofIn.&tutiorml ud Throwticcrl Economrcs. 56 l-577; K~zzo, M., ( 1979) “Uncertainty, subIjcctivity, and the economic analysis of’ law.” In %mc,, urlcrriuiuty, and ditryudd~l-ium, edited hy M. J. I&Lo, 80, Lexington: Lexington Books. C~OT~R, K. I). ( 1991 ) T/&P.sltuctrcr~~~ upp~xrt/tfo ad~udicatin~g socid ~wm.~,John M. Olin \%‘orking Paper, Berkeley, CA: UC Bcl-keley; EI.I.I(:I
WIT, U. (I 987) Itldi~~iduclli.ctischr C~runrllagm &r r7du/or-isrhun iikonomik. ‘I‘iibingen: .J. B. C. Mohr; EGER, ‘1‘., and W~ISE, P. (1990) N ormen als gesellschaftliche Ordner. Jnhrht~cA fii~- Okonomir ud Gr.w/l.tchuJ/, Frankfurt Campus, pp. 65-l I 1 ; EGER.‘r. Die cvolutorischen Urspriinge des Rcchts. r)iskzrs,szo?l\.\~hrzftr?/ da E;crchbewic/u. Wirtschaftswissenschaften der Gesamthochschule Kassel, No. 40. See Schmidtchen, \uprrr II. 6, p. 340 and Heincr, suprcc II. 6. ACKERMAN, B. (1991) Law, economics, and the problem of lega culture. Dukr f,uw,Jou~-d 929 (1986); D. Schmidtchen, 1991, suprn n. 6. M. R~zzo, .\qm n. 6, p. 85. M. KIZZO, ~ul,ru n. 6, p. 85. L. DE Ar.essr and R. I.. STAAF, .$ZL~T(I n. 6, p. 569. I.. DE ALESS] and R. J. STAAF, supra n. 6, p. 570. D. SCHMIDTCHEN,1991, .cuprrrII. 6, ~1.338. RASMOSEN, E. (1991) Gurnr~ a& inJormution, An introductior~ to game thwq. Oxford: Blackwell, p. 91.

1 1. See especially

1‘2. 13. 14. 15. 16. 17. 18. 19.

30 I

47. 48. 49. 50. 51. 52. .L X3. 54. 55. 56. 57.

58. 59. 60. 61. 62. 6:s. 64. 65. 66. 67. 68.

69. 70. 71.

72.