Evolution of Legal Systems Emanuela Carbonara University of

Evolution of Legal Systems Emanuela Carbonara – University of Bologna ESNIE 23 May 2008

Outline n n How do legal systems evolve? The economics of legal harmonization The evolution of legal systems Ø Does evolution favor efficiency? What is the effect of rule competition on efficiency? 23 May 2008 ESNIE 2008 2

HOW DO LEGAL SYSTEMS EVOLVE? 23 May 2008 ESNIE 2008 3

Market for Rules: The “Supply Side” n States can 1. Enact new laws 2. Transplant rules from other legal systems 3. Harmonize/Unify 23 May 2008 ESNIE 2008 4

The Supply Side Follow - “mimic” legal rules from other jurisdictions Ø Import rules and adapt them to your existing rules and culture 2. Lead - “compete” with other legal systems Ø 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; Ø Transaction costs (legal barriers) for domestic firms are minimized • Examples: Delaware, “race-to-the-bottom v. 23 May 2008 5 ESNIE 2008 race-to-the-top” 1.

Market for Rules: The “Demand Side” Global market n Economic agents demand : Ø Ability to choose between domestic and foreign law Ø Clear “choice-of-law” and “choice-of-forum” rules n Globalization demands harmonization of legal systems Ø Increasing importance of transnational markets Ø Elimination of the “border effect” n The WTO is pushing countries for faster harmonization 23 May 2008 ESNIE 2008 Ø Harmonization benefits trade (Rodrik, 2004; 6 n

Legal Barriers n n Estimates that transaction costs for advanced economies amount to 40% in ad-valorem terms Ø Only 5% is due to typical trade barriers (Rodrik 2004) Turrini, van Ypersele (2006) Ø Study the “border effect” assuming it might be due to legal differences Ø Find striking result that even within a single country, trade between two regions is higher when subjected to the same court of appeal. 23 May 2008 ESNIE 2008 7

Bridging the Legal Gap I Legal transplantation Ø countries import statutes and principles belonging to other legal systems Ø Unilateral (non co-operative) effort by one country Ø Driven also by legal competition Ø 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. Ø Example 2: Ninety seven percent of the draft of book 2 of the new Armenian civil code, Obligations, the Russian civil code. 23 May 2008 was taken straight from 8 ESNIE 2008 1.

Bridging the Legal Gap II Legal harmonization and unification Ø Countries bargain on a set of objectives, then each one amends its legal system to reach the chosen objectives Ø Coordinated multilateral effort Ø Harmonization and unification differ for the degree to which the gap between legal systems is actually reduced Ø With unification countries agree to adopt a unified set of rules, replacing their national rules Ø 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”ESNIE by 2008 replacing national laws with 9 23 May 2008 n

The Costs of Legal Change n n Countries have to change their legal systems Ø costs of drafting a new law Ø 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 10

The Costs of Legal Change II n n 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) ØFree riding incentives (Garoupa Ogus 2006) 23 May 2008 ESNIE 2008 11

The Costs of Legal Change III n The “Transplant Effect” (Berkowitz, Pistor and Richard 2003) Ø 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. 23 May 2008 ESNIE 2008 12

THE ECONOMICS OF LEGAL HARMONIZATION 23 May 2008 ESNIE 2008 13

Issues & Questions n n Countries tend to resist to legal harmonization notwithstanding undeniable benefits There are the costs of legal unification Ø Adaptation 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 14

Legal Harmonization: The Model n n Carbonara and Parisi (2007) 2 countries, A and B, with different legal systems Ø A has legal system a Ø B has legal system b n n 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 15

Legal Distance D is the difference between a and b Ø D= - x. A- x. B n Define Ø = initial distance between a and b Ø xj = distance-reducing effort by country j (j =A, B) n A and B know the value of D at each moment in time n With legal transplantation, countries choose x. A and x. B simultaneously and non cooperatively given n With legal harmonization, countries choose x. A 23 May 2008 ESNIE 2008 and x to maximize joint surplus. They bargain 16 n

Distance Reducing Effort n n n x. A and x. B are strategic substitutes Ø The unilateral move of A towards B (or vice -versa) reduces the incentives of B to move towards A. The optimal x. A is decreasing in x. B Ø Free riding Distance is always positive in equilibrium Distance is larger when countries transplant 23 May 2008 ESNIE 2008 17

Countries Can Control Switching Costs n 2 – stage game: Ø Adjustment costs are endogenous Ø 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 Ø At stage 2, A and B choose x. A and x. B 23 May 2008 ESNIE 2008 18

Effect of Changing Switching Costs n n Direct effect on welfare Ø higher adjustment costs increase resources needed to reduce legal distance Ø reduce welfare Strategic effect Ø higher adjustment costs reduce x. A Ø by strategic substitutability x. B increases Ø more costs to reduce D are born by B Ø this enhances A’s welfare 23 May 2008 ESNIE 2008 19

The Strategic Effect n If strategic effect dominates Ø A invests to increase m. switching costs Ø precommitment strategy to reduce own ability to adapt to b in stage 2 Ø size of strategic effect depends on reactivity of equilibrium x. B (ultimately on B’s reaction function) • B’s adjustment costs • B’s costs of legal distance 23 May 2008 ESNIE 2008 20

Changing Adjustment Costs n n 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 Ø 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 21

Changing Costs and Cooperation n In general, it can happen that A invests to increase m. switching costs more when stage 2 is cooperative Ø B can be forced to increase x. B 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 22

Conclusions n n 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 23 May 2008 ESNIE 2008 23

THE EVOLUTION OF LEGAL SYSTEMS 23 May 2008 ESNIE 2008 24

Efficiency and the Evolution of Law Market-for-Rules Metaphors Ø Freedom of choice for applicable law leads to an expansion of the “size of the market” for legal rules. Ø Forum shopping and choice-of-law-rules enlarge the set of rules applicable to a transaction. n Efficiency Hypothesis -- Efficient rules should win the competition (Mattei, 1997, Ogus, 2002) Ø Demand-Side Explanations: They are chosen more often by private parties Ø Supply-Side Explanations: Legislators introduce most often chosen rules in their national legal systems 23 May 2008 25 ESNIE 2008 n

Evolution of Law and Path Dependency n Diffusion of legal norms is path and history dependent n There are substantial network effects Ø If many countries adopt a rule, the gains from adopting it increase, independently of its efficiency n There is a “tilting point” (critical mass) Ø Once the number of countries adopting a given rule is high enough, all countries may switch to that rule Ø Due to the “critical mass effect”, an inefficient norm might become universally widespread 26 23 May 2008 ESNIE 2008

Coexistence of Legal Norms n If such critical mass is not reached, norms can coexist in the steady state Ø This explains how legal families originated n Assume the evolution of law follows a replicator – like/payoff monotonic dynamics 23 May 2008 ESNIE 2008 27

A DIGRESSION: EVOLUTIONARY EQUILIBRIA 23 May 2008 ESNIE 2008 28

A New Idea of Rationality n n We abandon the idea that players are perfectly rational The strategy of an individual in its interactions is predetermined by its phenotype Ø E. 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 29

Biology Meets Economics n n n Individuals “inherit” one strategy to play Ø Cultural transmission Ø Socialisation Ø Background & education Ø Past 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 30

Evolutionary Equilibrium n n A strategy that cannot be upset by any successful invasion of another is part of an evolutionarily stable equilibrium (ESS). Monomorphic and Polymorphic Equilibria Ø Two or more strategies can be equally fit, coexisting in certain proportions Ø Then the population is said to be Polymorphic Ø Polymorphism is a concept close to the notion of mixed strategy. 23 May 2008 ESNIE 2008 31

ESS and Replicator Dynamics n n n 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 23 May 2008 ESNIE 2008 32

COMPETITION AND EFFICIENCY 23 May 2008 ESNIE 2008 33

A Model of Evolutionary Competition Carbonara and Parisi (2008): evolutionary model of contract law with international trade and endogenous legal barriers Ø Barriers depend on how widespread a rule in the world and on the actual use of the rule in transactions n States face switching and adaptation costs when changing their law n States and economic agents are independent actors n Rules compete 23 May 2008 34 ESNIE 2008 n

Results “Victory” in rule competition is only partially driven by strict efficiency. 2. Relevance of network effects Ø Percentage of countries adopting the same rule; Ø Rules shared by the majority of commercial partners. 3. Choice-of-law rules play an important role: Ø With more restrictive rules countries and firms tend to go in the same directions Ø With laxer rules the two processes can go in different directions 4. May 2008 More competition not desirable? 35 23 ESNIE necessarily 2008 1.

The Model n n There are two legal rules A and B Rule A is the “efficient” rule Ø 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 23 May 2008 ESNIE 2008 36

Choice-of-Law Criteria Choice-of-law clauses are validated according to a lois suppletive test Ø Parties are not allowed to select a governing law deviating from mandatory provisions of their legal system of origin Ø Rarely applied nowadays 2. Choice-of-law clauses are validated according to a substantial relationship test Ø 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 Ø Parties are free to choose the law governing their contract as long as non-derogable principles of their domestic legal system are not 37 23 May 2008 ESNIE 2008 undermined 1.

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. 23 May 2008 ESNIE 2008 38

Countries n n 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 follow Ø At time t, nt percent follow legal rule A Countries can transplant a new rule Ø They face switching costs 23 May 2008 ESNIE 2008 39

Firms n n 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) Ø At time t, xt percent use legal rule A (if legal) 23 May 2008 ESNIE 2008 40

Trade n n Firms are matched randomly in pairs A firm is matched Ø with a trading partner from A with probability n Ø 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 23 May 2008 ESNIE 2008 41

The Dynamics in the Very Restrictive Choice-of-Law Regime n 1 VA-VB>SCB A No Move Region VB-VA>SCA B x 0 23 May 2008 ESNIE 2008 42

The Dynamics in the Restrictive Choice-of-Law Regime a 2 b 1 a 1 b 2 1 x 23 May 2008 ESNIE 2008 43

The Dynamics in the Liberal Choice-of-Law Regime n a 2 (1, n° ) b 1 a 1 b 2 c 1 B nx. F(x) 23 May 2008 x ESNIE 2008 44

An Equilibrium with Rule Coexistence… n n n where only one rule is used in transactions (A) but all countries adopt the other rule Equilibrium evolutionarily stable iff and low 23 May 2008 ESNIE 2008 45

Which Choice-of-Law Regime? Ideally, optimal regime Ø Should minimize costs of reduced international trade Ø Should favor selection of efficient rules Ø Should maximize speed of convergence to the (efficient) steady state Ø Should minimize costs of the transition to the (efficient) steady state n Is it true that more permissive regimes have better chances of achieving all the above goals? n Are efficient rules more likely to “win the competition” under a permissive choice-of-law 23 May 2008 46 ESNIE 2008 regime? n

Case I: The Very Restrictive Regime Wins! n n n and are high Initial situation: a relatively high n but relatively few firms use A Then Ø RR leads to steady state A Ø R and F lead to steady state B • Intuition high : too many firms should bear in order to use A, they contract using B. 23 May 2008 ESNIE 2008 47

Case II: Liberal Regimes Can Win! n n n Again, and high Different initial conditions, low n and very high x Result Ø R and RR lead to B Ø F 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 . 23 May 2008 ESNIE 2008 48

Competition Fails n and are low Ø RR leads to steady state B Ø R leads to steady state A Ø F 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 23 May 2008 ESNIE 2008 49

Are Liberal Choice of Law Regimes Always Socially Efficient? n A very restrictive regime by efficient countries might speed up convergence to efficient rule n A very restrictive regime by inefficient countries is always harmful n No universal “superiority” of open choice of law regimes 23 May 2008 ESNIE 2008 50