Private Legal Systems
[The text below includes excepts from Regulation by Networks, 2003 BYU L. Rev. 1179 (2003)]

Opportunism.  An unfortunate but inevitable fact of life is that some people, some of the time, act opportunistically (that is, in a way that makes the opportunistic party better off but the community as a whole worse off).  For example, John promises Jane to sell, for $100, tickets to a concert taking place in another town.  Jane then books a hotel room and pays $40.  Before giving the tickets to Jane, Jack receives a better offer for his tickets, and sells the car to Jim for $150.  Jane is stuck without the tickets and with a hotel room that is now useless to her.  Unless Jim values the concert a great deal more than Jane, the group (John, Jane and Jim) is worse off due to John's default on his promise to Jane, because of the expenses Jane spent in reliance on John's promise.  In addition, Jane (and possibly others who hear of John's actions) will be very hesitant to make any more deals with John, and this is a loss as well, since those future potential deals could have benefited both sides.

The problem, of course, is that in a world without any governing legal system, there is very little to prevent opportunism.  Society does ingrain in most people a sense that opportunism is wrong, and therefore most people feel bad when they act opportunistically.  But when the potential gain from the opportunistic behavior is large, people either overcome this bad feeling or rationalize their behavior as non-opportunistic.

Individuals also take action to fight opportunism.  The most basic response by an individual is boycotting - if someone has cheated you before, you are likely to refuse to deal with him in the future.  In part, this has to do with concern that the same person will cheat you again.  But often, people refuse to deal with others who have deceived them in the past, even when they are not concerned about being cheated again.  This intuitive need to punish serves as a deterrent - the opportunistic party will know, before it acts opportunistically, that by doing so it is likely to forego all future transactions with the victim.  In some cases, this is a sufficient deterrent.  But when the potential gain from opportunism is very high, or when the victim is easy to avoid (e.g., there are many others to transact with) or is captive (e.g., the opportunist is a monopolist, and the victim won't be able to boycott him), this deterrent is very weak.

Government Regulation.  Government is a natural candidate for regulating conduct to mitigate opportunism.  Having a monopoly on violence and controlling specialized enforcement agencies that can enforce injunctions, fines and damages awards, the government can impose unique sanctions such as incarceration, and has better ability to impose fines than do most other potential regulators.  Unsurprisingly, therefore, law (and government enforcement of it) has a significant role in mitigating opportunism.  Contract law is intended to lend the power of government’s enforcement machinery to parties injured by breach of obligations.  Commercial law provides more specific rules for certain common types of commercial transactions, intended (among other reasons) to curb opportunistic frustration of the goals of those transactions.  Consumer protection law is, to a significant degree, aimed at correcting information asymmetries that make opportunistic behavior more likely.  Antitrust law similarly addresses opportunism that is caused by the possession or attempted acquisition of market power.  Industry-specific regulation often monitors for (and remedies) opportunism by or against the firms it regulates.

But while the government benefits from relatively powerful sanctions, its monitoring costs (and the cost of error) are significant.  Government often attempts to reduce monitoring costs either by creating a specialized regulator or, more commonly, by allowing private rights of action (which utilize the lower monitoring costs of private parties and, after verification by a court or agency, allow the use of government-sponsored sanctions).

Both techniques suffer from significant flaws.  Regulators are very expensive, subject to capture, and even under optimal conditions have greater monitoring costs than the parties to the transaction.  Private rights of action are subject to abuse, since regardless of their merit they impose costs (legal, reputational, temporal, etc.) on the defendant, and therefore may be used by a plaintiff manipulatively to extract a payoff from the defendant.  Furthermore, the governmental verification system, usually a trial before a court, is imperfect, as Judges often lack the information, expertise or time to properly verify suits.

Government also tends to do poorly when the harm caused to each victim is small.  Because the government's monitoring costs are high, investigation and enforcement actions are not feasible in cases where the harm caused is small.  Having policemen patrol every elementary school to prevent Billy the Bully from hitting Little Tommy, or having a trial on allegations that Martha did not return the pen that Ann lent her, is going to cost the taxpayer much more than it will benefit the harmed parties.  Government's poor ability to deal with small-stake opportunism has to do not only with cost but with incentives: government puts most of its effort into addressing issues that affect whether constituents will reelect them.  People rarely decide who to vote for depending on how good a job they did in deterring deceptive advertising or preventing credit-card fraud.

Government might do a poor job of mitigating opportunism even when the stakes are high.  Sometimes, government is too slow to create law in response to a new contingency.  In other cases, government enforcement of the law is lacking (e.g., where government does not have the resources, or where the behavior takes place within a population that is hostile to or suspicious of the government).

Private Legal Systems.  Where government cannot mitigate opportunism efficiently, private parties often create their own legal systems.  Like governmental legal systems (and unlike individual responses to opportunism), they are based on rules, which need to be created and enforced.  These are called Private Legal Systems (PLSs).

A significant body of legal literature (which is often referred to as ‘private ordering’) examines connectivity regulation by parties other than government: rules, norms and institutions that are self-imposed by private parties to govern their behavior and transactions.  In analyzing the institutions that mitigate opportunism, three elements are key: repeated-play, reputation, and network effects.

The repeated-play element addresses the perception of the parties to a transaction, that they are likely to transact again in the future.  Due to this perception, each party’s behavior in the current transaction may have consequences in future transactions.  For example, if John promises to buy Dan’s car, but then reneges on that promise, Dan may refuse to transact with John in the future, or may deal with John in the future under terms less favorable to John (both as punishment and because Dan now takes into account the greater likelihood of John defaulting again).  Knowing these are the likely consequences, John will be hesitant to renege on his promise in the first place (at least if he anticipates the loss of future transactions with Dan to be greater than the benefit from reneging on the current promise).

Reputation expands the scope of future consequences, by enabling other firms, who were not parties to a given transaction, to learn of the trustworthiness of the parties in that transaction and act on that knowledge.  Returning to the above example, John might realize that reneging on his promise to Dan will not only make Dan’s future reactions to him less favorable, but he might expect a similar reaction from anyone who learns of John’s default.  This reaction has nothing to do with sympathy for Dan – it is in the best interest of each person to be more averse to dealing with another person who is more likely to default on promises.  A credible account of past behavior (i.e., reputation) is usually perceived as a good proxy for assessing the likelihood of future default on obligations, and therefore interests third parties and affects their disposition towards the person who’s reputation they are aware of.

Network effects are 'demand-side economies of scale': The characteristic by which the benefit we derive from using a product of service rises the more others use it as well.  For example, the more people own a telephone, the more useful my own telephone is useful to me.

Network effects affect the kinds of opportunistic behavior that might occur, as well as the ability of networks (institutions characterized by network effects) to create efficient private legal systems to mitigate opportunism.  For this reason, many (possibly most) private legal systems are designed and maintained by networks.

 

To read more about network effects in general, click here.
To read more about the connection between private legal systems and network effects, click here.
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