how subsequent and subordinate rules will be made. The next level of trade is that which allows departure from the state of nature: establishment of market-organizing rules of non-coersg property rights and contract. These rules facilitate additional transactions among states. Finally, institutions can be established to constrain(positively or negatively )transaction choices in the future. 32 Of course, in contexts where there are no gains from trade, there should be no trade: no cooperation, no treaty and no integration. This is implicit in prIce theory-based neo-classic e: no economics. We identify below some of the sources of gains from exchange A. Externalities and Exchange Actions or inactions of states may have positive or negative"effects"on other states. Thus for example, the environmental law(or deficiencies therein)in one state may be associated with adverse or beneficial effects(negative or positive externalities)in other states, for example, because also"cause"adverse effects in other states by being too strict regarding the entry of foreign s n the first state's law permits pollution that flows to other states. Domestic eny into the national market, or too lax with respect to domestic industries, resulting in competitiveness effects(pecuniary externalities). Externalization through regulation that fails to protect foreign interests, pecuniary externalization through strict regulation that has protectionist effects or through lax regulation that may be viewed as a subsidy and subsidization itself may all be viewed as questions of prescriptive jurisdiction: which state -- or international body - will have power to gulate which actions? These external effects may cause other states to wish to alter some of these activities, through their own regulation, or through changes in the first state's regulation. There are two main ways to do so. The first is bilateral persuasion. The second is through institutionalization Bilateral persuasion may involve force, exchange or implicit reciprocities(either specific or diffuse): 33 it occurs in the"spot market. Institutionalization involves the transfer of power over time through a treaty or an international organization. Both are transactions However, externalization cannot be the lone touchstone for determining when local islation must fall to integrationist goals. 34 First, externalities are notoriously difficult to define 35 More importantly, the identification of external ities presupposes established proper rights. That is, economists take property rights as givens, and define externalities based on the 32 For an analysis of spillovers of public goods, and the consequent market for agreement constraining or facilitating spillovers, see Albert Breton, Public Goods and the Stability of Federalism, 23 KYKLOS 882(1970) 33 See robert o. Keohane, Reciprocity in International RelationS, 40 INT L ORG. 1(1986) 34 But see Jacques Leboeuf, The Economics of federalism and the Proper Scope of the federal ommerce Power, 31 SAN DIEGO L REv.555 (1994)(arguing that externalization is the appropriate touchstone) 35 Demsetz recognizes that"externality is an ambiguous concept "that includes external costs, external benefits, and non-pecuniary as well as pecuniary externalities. Harold Demsetz, Toward a Theory of Property Rights, 57 AM. ECoN. REV. PAPERS AND PROCEEDINGS 347, 348
how subsequent and subordinate rules will be made. The next level of trade is that which allows departure from the state of nature: establishment of market-organizing rules of non-coercion, property rights and contract. These rules facilitate additional transactions among states. Finally, institutions can be established to constrain (positively or negatively) transaction choices in the future.32 Of course, in contexts where there are no gains from trade, there should be no trade: no cooperation, no treaty and no integration. This is implicit in price theory-based neo-classical economics. We identify below some of the sources of gains from exchange. A. Externalities and Exchange. Actions or inactions of states may have positive or negative "effects" on other states. Thus, for example, the environmental law (or deficiencies therein) in one state may be associated with adverse or beneficial effects (negative or positive externalities) in other states, for example, because the first state's law permits pollution that flows to other states. Domestic environmental laws may also "cause" adverse effects in other states by being too strict regarding the entry of foreign goods into the national market, or too lax with respect to domestic industries, resulting in competitiveness effects (pecuniary externalities). Externalization through regulation that fails to protect foreign interests, pecuniary externalization through strict regulation that has protectionist effects or through lax regulation that may be viewed as a subsidy, and subsidization itself may all be viewed as questions of prescriptive jurisdiction: which state -- or international body -- will have power to regulate which actions? These external effects may cause other states to wish to alter some of these activities, through their own regulation, or through changes in the first state's regulation. There are two main ways to do so. The first is bilateral persuasion. The second is through institutionalization. Bilateral persuasion may involve force, exchange or implicit reciprocities (either specific or diffuse);33 it occurs in the "spot market." Institutionalization involves the transfer of power over time through a treaty or an international organization. Both are transactions. However, externalization cannot be the lone touchstone for determining when local legislation must fall to integrationist goals.34 First, externalities are notoriously difficult to define.35 More importantly, the identification of externalities presupposes established property rights. That is, economists take property rights as givens, and define externalities based on the 32 For an analysis of spillovers of public goods, and the consequent market for agreement constraining or facilitating spillovers, see Albert Breton, Public Goods and the Stability of Federalism, 23 KYKLOS 882 (1970). 33 See Robert O. Keohane, Reciprocity in International Relations, 40 INT' L ORG. 1 (1986). 34 But see Jacques Leboeuf, The Economics of Federalism and the Proper Scope of the Federal Commerce Power, 31 SAN DIEGO L. REV. 555 (1994) (arguing that externalization is the appropriate touchstone). 35 Demsetz recognizes that "[e]xternality is an ambiguous concept," that includes external costs, external benefits, and non-pecuniary as well as pecuniary externalities. Harold Demsetz, Toward a Theory of Property Rights, 57 AM. ECON. REV. PAPERS AND PROCEEDINGS 347, 348 (1967). 11
effects of one person s actions on the property rights of another, although the latter may not have ny legal recourse. 36 But in the regulatory contexts identified above, it is precisely the scope of each states power--its jurisdiction--that is at issue. This must be defined before we can operly speak of externalities. 37 We might expect that"property rights develop to internal external ities only when the gains of internalization become larger than the cost of internalization. "38 on Of course, the creation of such rights --and rules regarding the allocation of jurisdiction to scribe--raise a host of other issues. Power and wealth are, of course, central to this process Different distributions of power would likely produce different patterns of property rights, and these property rights then become the framework within which wealth is created and distributed, 39 and inescapably value-laden nature, of the decision to create property rights and to intermale sons, Economic analysis, primarily through the Coase Theorem, 40 exposes the distributive ramificatie externalities. 41 Moreover, to the extent that these property rights represent public goods, we might expect them to be underproduced by the market, acting alone. We return to these issues below B. Economies of Scale and Scope Related potential sources of gains from trade are economies of scale and economies of 36 To a realist lawyer, this is a strange formulation: if the harm can be done with impunity, the property rights bundle must not include the relevant stick. This leads us to a recognition that the entire concept of externality begs the question of legal rights. Therefore, arguments that we should design legal rights to internalize externalities are circular 37 See Joel P. Trachtman, Externalities and Extraterritoriality: The Law and Economics of Prescriptive Jurisdiction, in J AGDEEP BHANDARI& ALAN O SYKES, ECoNOMIC DIMENSIONS IN INTERNATIONAL LAW 642, 655-57(1997)(analogizing rules of prescriptive jurisdiction in international society to rules of property in domestic society) and enforcing property rights would decline, and the benefits would increase, as population density increases. Greater functional economic integration would presumably yield similar results in the international arena 39 KEOHANE, supra note 30, at 18 40 For a summary of the Coase Theorem and references to further literature, see robert d Cooter. The Coase Theorem. in THE NEW PALGRAVE: A DICTIONARY OF ECONOMICS 457.457-60 Tests, 25 J. L. EcoN 73(1982); Robert D. Cooter, The Cost of Coase, 11 J LEG. STUD/a1 (1987). See also Elizabeth Hoffman Matthew Spitzer, The Coase Theorem: Some experime (1982) 41 See BRUCE ACKERMAN, RECONSTRUCTING AMERICAN LAW 46-60(1984)
effects of one person's actions on the property rights of another, although the latter may not have any legal recourse.36 But in the regulatory contexts identified above, it is precisely the scope of each state's power -- its jurisdiction -- that is at issue. This must be defined before we can properly speak of externalities.37 We might expect that "property rights develop to internalize externalities only when the gains of internalization become larger than the cost of internalization."38 Of course, the creation of such rights -- and rules regarding the allocation of jurisdiction to prescribe -- raise a host of other issues. Power and wealth are, of course, central to this process. Different distributions of power would likely produce different patterns of property rights; and these property rights then become the framework within which wealth is created and distributed.39 Economic analysis, primarily through the Coase Theorem,40 exposes the distributive ramifications, and inescapably value-laden nature, of the decision to create property rights and to “internalize” externalities.41 Moreover, to the extent that these property rights represent public goods, we might expect them to be underproduced by the market, acting alone. We return to these issues below. B. Economies of Scale and Scope Related potential sources of gains from trade are economies of scale and economies of 36 To a realist lawyer, this is a strange formulation: if the harm can be done with impunity, the property rights bundle must not include the relevant stick. This leads us to a recognition that the entire concept of externality begs the question of legal rights. Therefore, arguments that we should design legal rights to internalize externalities are circular. 37 See Joel P. Trachtman, Externalities and Extraterritoriality: The Law and Economics of Prescriptive Jurisdiction, in JAGDEEP BHANDARI & ALAN O. SYKES, ECONOMIC DIMENSIONS IN INTERNATIONAL LAW 642, 655-57 (1997) (analogizing rules of prescriptive jurisdiction in international society to rules of property in domestic society). 38 Demsetz, supra note 36, at 350. It is also plausible to expect that the costs of establishing and enforcing property rights would decline, and the benefits would increase, as population density increases. Greater functional economic integration would presumably yield similar results in the international arena. 39 KEOHANE, supra note 30, at 18. 40 For a summary of the Coase Theorem and references to further literature, see Robert D. Cooter, The Coase Theorem, in THE NEW PALGRAVE: A DICTIONARY OF ECONOMICS 457, 457-60 (1987). See also Elizabeth Hoffman & Matthew Spitzer, The Coase Theorem: Some Experimental Tests, 25 J. L. & ECON. 73 (1982); Robert D. Cooter, The Cost of Coase, 11 J. LEG. STUD. 1 (1982). 41 See BRUCE ACKERMAN, RECONSTRUCTING AMERICAN LAW 46-60 (1984). 12
scope. 42 Given the increasingly global nature of society, and of problems such as environmental degradation and trade, it seems likely that there would be economies of scale, under some circumstances, in regulation of these matters. 43 Economies of scale have a number of components. First, states may enjoy economies of scale in contexts where they regulate transnational actors. For example, there may be efficiencies gained through coordinated rulemaking, surveillance and enforcement activities. In the absence of these transactions, states face heightened risks of evasion, detrimental regulatory competition (which can be driven by externalization) and unnecessary regulatory disharmony, all resulting in inefficiencies. 44 Second, there may be technological economies of scale, relating to equipment, cquisition of specialized skills or organization. Economies of scale may provide a motivation for integration, in order to capture these economies Economies of scope are reductions in cost resulting from centralized production of a group of products, especially where the products share a common component. 45 Once several areas of international regulation are established, economies of scope may be realized by regulating other areas. The Uruguay Round Agreements provide a good example of the utility both ex ante and ex post of expanding the subject matter of coverage. Ex ante, the expanded coverage of these Agreements allowed the grand bargain among those seeking liberalized trade in agriculture and the possibility for cross-retaliation among these areas in WTo dispute resolution oost,it added textiles and those seeking new rules in intellectual property rights and services Finally, economies of scale and scope may arise from increased frequency of transactions, or from longer duration of transactions. Given greater numbers of transactions in international lations, one would expect greater economies of scale. In addition, learning curve effects may, over time, give rise to economies of experience. 47 42 The dividing line between externalities, on the one hand, and uncaptured economies of scale. on the other hand is not clear 43 Of course, the fact that it is efficient to regulate activity from a global perspective does not mean that only one regulator should exist; rather it is a problem of contracting and establishing the most efficient institutional structure in response to technical or contextual factors. A similar caveat applies with respect to"economies of scope 44 See Joel P. Trachtman, International Regulatory Competition, Externalization and 45 See J Panzar &r Willig, Economies of Scope, 71 AM EcoN. REV. 268(1981) 46 Ex post tradeoffs can be compared to"relational contracting"where multiple relationships give rise to greater protection against opportunism. See KEOHANE, supra note 30, at 103-104 47 See Kenneth Arrow, Economic Welfare and the Allocation of Research for Invention, in THE RATE AND DIRECTION OF INVENTIVE ACTIVITY(R. Nelson, ed. 1981). All of these economies may be related to the phenomenon of"spillover"often considered in connection with neo-functional approaches to international integration. ERNST HAAS, BEYOND THE NATION STATE 48(1964)
scope.42 Given the increasingly global nature of society, and of problems such as environmental degradation and trade, it seems likely that there would be economies of scale, under some circumstances, in regulation of these matters.43 Economies of scale have a number of components. First, states may enjoy economies of scale in contexts where they regulate transnational actors. For example, there may be efficiencies gained through coordinated rulemaking, surveillance and enforcement activities. In the absence of these transactions, states face heightened risks of evasion, detrimental regulatory competition (which can be driven by externalization) and unnecessary regulatory disharmony, all resulting in inefficiencies.44 Second, there may be technological economies of scale, relating to equipment, acquisition of specialized skills or organization. Economies of scale may provide a motivation for integration, in order to capture these economies. Economies of scope are reductions in cost resulting from centralized production of a group of products, especially where the products share a common component.45 Once several areas of international regulation are established, economies of scope may be realized by regulating other areas. The Uruguay Round Agreements provide a good example of the utility both ex ante and ex post of expanding the subject matter of coverage. Ex ante, the expanded coverage of these Agreements allowed the grand bargain among those seeking liberalized trade in agriculture and textiles and those seeking new rules in intellectual property rights and services. Ex post, it added the possibility for cross-retaliation among these areas in WTO dispute resolution.46 Finally, economies of scale and scope may arise from increased frequency of transactions, or from longer duration of transactions. Given greater numbers of transactions in international relations, one would expect greater economies of scale. In addition, learning curve effects may, over time, give rise to economies of experience.47 42 The dividing line between externalities, on the one hand, and uncaptured economies of scale, on the other hand, is not clear. 43 Of course, the fact that it is efficient to regulate activity from a global perspective does not mean that only one regulator should exist; rather it is a problem of contracting and establishing the most efficient institutional structure in response to technical or contextual factors. A similar caveat applies with respect to "economies of scope." 44 See Joel P. Trachtman, International Regulatory Competition, Externalization and Jurisdiction, 34 HARV. INT' L L.J. 47 (1993). 45 See J. Panzar & R. Willig, Economies of Scope, 71 AM. ECON. REV. 268 (1981). 46 Ex post tradeoffs can be compared to "relational contracting" where multiple relationships give rise to greater protection against opportunism. See KEOHANE, supra note 30, at 103-104. 47 See Kenneth Arrow, Economic Welfare and the Allocation of Research for Invention, in THE RATE AND DIRECTION OF INVENTIVE ACTIVITY (R. Nelson, ed. 1981). All of these economies may be related to the phenomenon of "spillover" often considered in connection with neo-functional approaches to international integration. ERNST HAAS, BEYOND THE NATION STATE 48 (1964). 13
C. Types and Locations of Transactions in Power The new institutional economics assumes a dichotomy between transactions and institutions. But between the spot market transaction and the formal organization there exist many types of formal contracts and informal arrangements, and even the formal organization is a nexus of contracts. Thus, the supposed dichotomy is, in fact, a continuum: the boundary between the transaction and the institution is blurred he metric of this continuum is the relative scope of retained individual discretion: where the individual retains greater discretion, she is closer to the pole of the market; where the individual retains less discretion-and assigns more discretion rough contract or organization--she is closer to the pole of the firm. 49 This continuum is translated in international economic relations to the continuum running from intergovernmentalism to integration, where integration denotes a pooling of authority Indeed, Coase's dichotomy of firm and market may usefully be compared to Albert Hirschman,'s dichotomy of voice and exit. 50 The main difference between the market and the firm is in the duration of relations and in how decisions are made. In the (spot)market, decisions are binary: one either enters(buy)or exits(sell). The firm entails longer-term relationships, requiring that one exercise voice. Voice is heterogeneous, including various mechanisms that may amount to selective or partial exit, such as the ability to vote out a government D. Limits of the Structural Analogy It is not necessary to fully analogize the world of international relations to a private market to apply the tools of law and economics to the international realm. Indeed, we appreciate that the structural analogy described above has significant limitations when applied to international relations. 51 Some of the limitations of the analogy are also limitations of the scope of applicability 48 See Benjamin Klein, Contracting Costs and Residual Claims: The Separation of Ownership and Control, 26J. L. EcoN 367, 373(1983)( Coase mistakenly made a sharp distinction between intrafirm and interfirm transactions, claiming that while the latter represented market contracts the former represented planned direction. 49 In this context, discretion means residual discretion to be exercised in the future. This ormulation can be further refined. Through decentralization within the firm, the amount of individual discretion within the firm may be made to equal the amount of discretion an individual might retain outside the firm. Thus, the continuum has two parameters. The first parameter is the degree of integration into the firm (or other integration structure, including contract). The second arameter is the degree of centralization within the firm alberT O. HIRSCHMAN EXIT. VOICE AND LOYALTY: RESPONSES TO DECLINE IN FIRMS ORGANIZATIONS AND STATES (1970). See Joseph Weiler's use of this dichotomy to analyze European constitutionalization in Joseph Weiler, The Transformation of europe 100 YALE L J 2403(1991) 51 A number of the most obvious disanalogies--say, between the role that elimination through competition plays in the economic and international political spheres-are not discussed in text because they are less relevant to our analysis
C. Types and Locations of Transactions in Power The new institutional economics assumes a dichotomy between transactions and institutions. But between the spot market transaction and the formal organization there exist many types of formal contracts and informal arrangements, and even the formal organization is a nexus of contracts. Thus, the supposed dichotomy is, in fact, a continuum: the boundary between the transaction and the institution is blurred.48 The metric of this continuum is the relative scope of retained individual discretion: where the individual retains greater discretion, she is closer to the pole of the market; where the individual retains less discretion--and assigns more discretion through contract or organization--she is closer to the pole of the firm.49 This continuum is translated in international economic relations to the continuum running from intergovernmentalism to integration, where integration denotes a pooling of authority. Indeed, Coase's dichotomy of firm and market may usefully be compared to Albert Hirschman's dichotomy of voice and exit.50 The main difference between the market and the firm is in the duration of relations and in how decisions are made. In the (spot) market, decisions are binary: one either enters (buy) or exits (sell). The firm entails longer-term relationships, requiring that one exercise voice. Voice is heterogeneous, including various mechanisms that may amount to selective or partial exit, such as the ability to vote out a government. D. Limits of the Structural Analogy It is not necessary to fully analogize the world of international relations to a private market to apply the tools of law and economics to the international realm. Indeed, we appreciate that the structural analogy described above has significant limitations when applied to international relations.51 Some of the limitations of the analogy are also limitations of the scope of applicability 48 See Benjamin Klein, Contracting Costs and Residual Claims: The Separation of Ownership and Control, 26 J. L. & ECON. 367, 373 (1983) ("Coase mistakenly made a sharp distinction between intrafirm and interfirm transactions, claiming that while the latter represented market contracts the former represented planned direction.”). 49 In this context, discretion means residual discretion to be exercised in the future. This formulation can be further refined. Through decentralization within the firm, the amount of individual discretion within the firm may be made to equal the amount of discretion an individual might retain outside the firm. Thus, the continuum has two parameters. The first parameter is the degree of integration into the firm (or other integration structure, including contract). The second parameter is the degree of centralization within the firm. 50 ALBERT O. HIRSCHMAN, EXIT, VOICE AND LOYALTY: RESPONSES TO DECLINE IN FIRMS, ORGANIZATIONS AND STATES (1970). See Joseph Weiler's use of this dichotomy to analyze European constitutionalization in Joseph Weiler, The Transformation of Europe 100 YALE L.J. 2403 (1991). 51 A number of the most obvious disanalogies -- say, between the role that elimination through competition plays in the economic and international political spheres -- are not discussed in text because they are less relevant to our analysis. 14
of economic analysis. We believe that these limitations of economic analysis also exist, in less obvious form, in many of the areas in which law and economics has become dominant develop this idea--of a bi-directional critique --in section VI below The Problem of Nonmonetized Exchange The international market for power is different from the market for private goods along many dimensions, some of which are discussed above. While there may well be exchange in the market of international relations, this market is not normally a cash market. Rather, it is most often a barter market, with all the difficulties and transaction costs of barter. For example, agreements within the European Community to engage in mutual recognition of regulation are a kind of barter Similarly, all trade negotiations are essentially complex, usually multi-party, barter. Trade negotiators try to value the concessions they make and receive, but this is done in an extremely Inexact manner The fact that this market for state power is not extensively monetized does not block its economic analysis. Economists have increasingly turned their attention to the analysis of social phenomena where value is exchanged but not valued in money terms. 52 While price theory-based economic analysis is rendered more difficult in nonmonetized contexts, the type of institutional analysis described in this paper does not rely on monetization, and is very similar in its application to the private firm and to the international organization Finally, even preferences that are monetized, and money itself, may not be commensurable or fungible. 53 Again, however, this is much less an argument against the institutional analysis suggested here, but an argument about the limitations of price-theory based mathematical economics. The theoretical perspective of this paper would clearly be incomplete if it failed to take all preferences into account, including both those that are easily monetized, and those subject to greater problems of commensurability. 54 2. The Problem of State Rationality Another potential problem with this model is that it assumes that states are rational utility maximizers. 55 While the assumption of rationality of individuals is under sustained attack, an 52 For example, the public choice analysis of politics systematically applies economic analysis goods. ges of value in the political system, and outside the normal monetized market for private 53 See VIVIANA A ZEILIZER, THE SOCIAL MEANING OF MONEY (1994); Cass R Sunstein Behavorial Analysis of La, 64 U CHI. L. REV. 1175, 1192(1997)(arguing that money is not fungible); Herbert Hovenkamp, The Limits of Preference-Based Legal Policy, 89 Nw. U. L. REV 4(1994) 54 We return to the problem of incommensurability in Part VI, infra 55 While rationalist international relations theory does not attempt to explain these preferences liberal institutionalism recognizes the need to get inside the billiard ball, and understand how state preferences are formed and expressed
of economic analysis. We believe that these limitations of economic analysis also exist, in less obvious form, in many of the areas in which law and economics has become dominant, and develop this idea -- of a bi-directional critique -- in section VI below. 1. The Problem of Nonmonetized Exchange The international market for power is different from the market for private goods along many dimensions, some of which are discussed above. While there may well be exchange in the market of international relations, this market is not normally a cash market. Rather, it is most often a barter market, with all the difficulties and transaction costs of barter. For example, agreements within the European Community to engage in mutual recognition of regulation are a kind of barter. Similarly, all trade negotiations are essentially complex, usually multi-party, barter. Trade negotiators try to value the concessions they make and receive, but this is done in an extremely inexact manner. The fact that this market for state power is not extensively monetized does not block its economic analysis. Economists have increasingly turned their attention to the analysis of social phenomena where value is exchanged but not valued in money terms.52 While price theory-based economic analysis is rendered more difficult in nonmonetized contexts, the type of institutional analysis described in this paper does not rely on monetization, and is very similar in its application to the private firm and to the international organization. Finally, even preferences that are monetized, and money itself, may not be commensurable or fungible.53 Again, however, this is much less an argument against the institutional analysis suggested here, but an argument about the limitations of price-theory based mathematical economics. The theoretical perspective of this paper would clearly be incomplete if it failed to take all preferences into account, including both those that are easily monetized, and those subject to greater problems of commensurability.54 2. The Problem of State Rationality Another potential problem with this model is that it assumes that states are rational utility maximizers.55 While the assumption of rationality of individuals is under sustained attack, an 52 For example, the public choice analysis of politics systematically applies economic analysis to exchanges of value in the political system, and outside the normal monetized market for private goods. 53 See VIVIANA A. ZEILIZER, THE SOCIAL MEANING OF MONEY (1994); Cass R. Sunstein, Behavorial Analysis of Law, 64 U.CHI. L. REV. 1175, 1192 (1997) (arguing that money is not fungible); Herbert Hovenkamp, The Limits of Preference-Based Legal Policy, 89 NW. U. L. REV. 4 (1994). 54 We return to the problem of incommensurability in Part VI, infra. 55 While rationalist international relations theory does not attempt to explain these preferences, liberal institutionalism recognizes the need to get inside the “billiard ball,” and understand how state preferences are formed and expressed. 15