Law and Development 2023

2023 May 11
4. Theories of law and development (1): Economic theory of law and development
Readings:"Chapter 3: Institutional theories of development" and "Chapter 10: Property rights, contracts anddevelopment" in Michael J. Trebilcock and Mariana Mora Prado, Advanced introduction to law
and development, 2nd edition, Edward Elgar, 2021.12
The E-Book is available on the Nagoya University Library website(https://ebookcentral.proquest.com/lib/nagoyauniv/detail.action?docID=6837135)
Goal:
To understand the relationship between development paradigm and the legal reform strategy.
To understand how legal institution affects the market economy.
To understand relationship among market, transaction costs and law.
1. Development paradigm and the legal reform
From the economic perspective, the development paradigm (predominant development strategy
in a particular period in post-WWII history) can be categorized into "capital fundamentalism" and“market fundamentalism."(1) Capital fundamentalism: Capital input and the State's role in economic development
based on rational planning
According to capital fundamentalism, the insufficiency of capital is assumed to be the cause ofunderdevelopment. Therefore, a developing country needs additional capital input from outside
sources. If sufficient capital is available and the developing country's government can create arational economic development plan with the support of the international community,
development should be achievable. As a result, capital fundamentalism presupposes thegovernment's ability to create a rational policy and implement it accordingly. In this context,
capital fundamentalism assumes the government's active intervention in the economy.

12

E-book is available on the Nagoya university library website
24Law and Development 2023

A common theory regarding the capital
Economic growth
Population growth

gap centers on the disparity between
economic
growth.

growthWhenandpopulation

population

growthsurpasses economic growth, the GDP
Capital gap

per capita decreases, and the population
becomes poorer. Consequently, there
must be a significant enough influx of
external capital (the Big Push theory) tofill this gap. While this theory outlines
the required amount of capital input, it

does not specify how the capital should be allocated.
Given the belief in rationality in the development of policymaking, several leading law schools
in the United States and the United Kingdom sent law professors to developing nations, primarilyin Latin America and Africa, to advance legal reforms aimed at modernizing society and politics.
This initiative is known as the "law and development movement (LDM)." We will delve further
into the LDM in subsequent sections13.
Nonetheless, in numerous developing nations, government-led development plans have failed toachieve their intended goals. As a result, economists began to view the government not as acatalyst for development but rather as a source of economic failure.
(2) Market Fundamentalism
In response to growing disillusionment with government-led development, market
fundamentalism emerged as the new development paradigm in the late 1970s. Several Latin
American countries transitioned from state-led economies to market economies during this period,
including Chile in 1973, Uruguay in 1974, and Argentina in 1976. Additionally, in the 1980s,
more countries, such as Vietnam, China, the former Soviet Union, and Eastern Europe, adopted
market economies.
Todaro and Smith14, in their widely cited textbook on development economics, explain the shift
towards free market policies as follows:13

For the experience of the law and development movement in 1960s, see:
Trubek "Toward a Social Theory of Law: An Essay on the Study of Law and Development" Yale
Law Journal Vol.82, p.1, 1972.
14
Todaro and Smith, Economic Development, 12th edition, Pearson, 2015, pp.556-557
25

Law and Development 2023

"As a result of the disenchantment with planning and the perceived failure of government
intervention, many economists, some finance ministers in developing countries, and theheads of the major international development organizations advocated increased use of themarket mechanism as a key instrument for promoting greater efficiency and more rapid
economic growth. U.S. President Ronald Reagan made a famous reference to the “magic of
the marketplace” in a 1981 speech at Cancun, Mexico. If the decade of the 1970s could be
described as a period of increased public-sector activity in the pursuit of more equitabledevelopment, the 1980s and 1990s witnessed the reemergence of free-market economics."
Market fundamentalism posits that an independent market mechanism can lead to the mostefficient allocation of resources, and any external intervention in this mechanism may negatively
impact productivity. Consequently, market fundamentalism advocates for legal policies of
deregulation and privatization. For the market mechanism, see section 2 "Market mechanism" ofthis lecture material.
(3) "Good governance" and the "rule of law."
During the 1990s, institutionalist economics, also known as New Institutionalist Economics (NIE),
emerged as a development paradigm15. Institutional economics emphasized the government's rolein creating institutions that could enhance market efficiency by establishing ownership andreducing transaction costs, or what is commonly referred to as "good governance" for the market.
Moreover, good governance and the rule of law align with human development and have
expanded its scope to encompass more inclusive development, such as participation and equity.

15"Beginning in the early 1990s, an institutional perspective on development has become
increasingly prominent in development thinking, captured in the mantra 'institutions matter,' or'governance matters.' This perspective views the quality of a country’s domestic institutions as amajor determinant of its development prospects." (Trebilcock and Prado, p.34)
26

Law and Development 2023

The World Bank (2017). World development
report 2017: Governance and the law.
Washignton, The World Bank. p.96

2. Market mechanism
https://www.japan-guide.com/g18/3931_top.jpg

In economics, the term "market"
does not refer to a physical location
where many sellers gather (such as a
shopping center or bazaar). Rather, amarket in economics refers to theprocess by which purchasers (called
the "demand side") and sellers (called
the "supply side") of a useful item

(called "goods") agree on the value of the goods and exchange them at a mutually satisfactory
price (the agreed value is called the "price" of the goods).
To simplify the concept, let us consider the scenario where there is only one type of good being
sold in a limited location, such as a small town where you want to buy an ice cream.
- Purchasers know well the taste (quality) and price of all ice cream shops in the town.
- Sellers know that other shops are selling similar ice cream. A seller can decide the ice creamprice and knows the ice cream price of other shops.
- There is no reason for a seller to sell ice cream at a lower price than others, and if a seller sells
ice cream at a higher price, purchasers will buy it at another shop.

27

Law and Development 2023

- As a result, the ice cream price of the town will be the price that purchasers are willing to buy,and sellers are willing to sell it for.
- Furthermore, if purchasers feel the ice cream price of the town is too high, they will not buy ice
cream (they may buy hot tapioca milk tea instead of ice cream).
- If more purchasers want to buy ice cream (for instance, due to hot weather), more ice cream will
be sold even if the price is high.
In this case, the market is the process by which you, as the buyer, and the seller of the ice creamagree on a price that is satisfactory for both parties based on their perceived value of the ice cream.
The process described above can be represented using a Supply-Demand Curve (S-D Curve):
Supply (S)Demand (D)Price (P)Price is determined by the quantity of demand and thequantity of supply (or the quantities of demand and supply
are determined by the price) at an equilibrium point E(price P* and quantity Q*). The figure below shows that

Equilibrium (E)P*

the intersection E (Equilibrium) moves toward the upperright (from E to E') when the demand curve shifts
rightward (from D to D'). This means that as a result of
increasing demand, the quantity of supply increases

Q*
Demand (D)Prince (P)Quantity (Q)New demand (D')
Demandincrease(moves toward the positive side of the x-axis, Q'>Q*), andthe price of goods in the market rises (moves toward thepositive side of the y-axis, P'>P*). For example, more

P'
P*

Supply (S)New Equilibrium (E')

people will buy ice cream due to hot weather (increased
demand for ice cream), and ice cream shops do not have toEdiscount the ice cream price (the ice cream price rises).
From another perspective, we can interpret the same figure
Q*

Q'

Quantity (Q)as the demand curve shifts upward. In this case, the figure
explains that because people are willing to pay a higher

price, supply increases. For example, when the ice cream in the town is recognized as a high-end
brand, people will buy it regardless of the price.
This process indicates that each person allocates their limited resources most efficiently (tomaximize their satisfaction with goods).

28

Law and Development 2023

Government intervention in the market (e.g., tax and subsidy)
Guess what would happen if the government intervenes in the ice cream market in the town by
imposing a tax to increase its revenue. The effect of the tax on the market can be described asfollows:
The government imposes a tax on the selling price

Demand (D)S'

Price (P)of good X (ice cream).

Supply (S)Price paid by purchaser (P’)

amount of the tax, the supply curve shifts upward(S to S'). As a result, a new price and quantity are

Equilibrium after tax (E')

P*

Because sellers must increase the price of X by thedetermined after the tax (P', Q').

E

If we compare the price before and after the tax, theProfit of seller (P’’)
Tax

Q'

Q*

Quantity (Q)burden of the tax is the same for both sellers andpurchasers (PP'=PP'').
Originally, there is a demand for the goods (Q*).

However, because purchasers have to pay a higher price due to the tax, the quantity of supply
decreases to Q' (thus, the tax has a negative effect on the ice cream economy in the town, Q' <Q*). Sellers might want to supply ice cream at the price of P''. However, if they do so, ice cream
cannot be sold, and there would be a surplus of stock. If we consider another market of goods Y(such as hot tapioca milk tea) that uses the same material (milk) as X, the milk for X will betransferred and over-supplied to other goods (Y), and the price of Y will decrease (sellers of Y
will suffer a loss).
As explained above, according to the market mechanism, interventions from outside the market
distort the price-quantity balance and have a negative effect on productivity. There are various
types of interventions to consider (please draw D-S curves yourself):
Subsidy: the price of supply side decrease (S curve moves downwards) and the good will
be overly supplied due to artificially padded up demand.
Restricting participation (limited permission given for doing the business): Quantity
from supply side will be set lower level than unrestricted participation to market, therefore
the price will continue increasing.
Price limit (controlling upper most of the price): Demands continue increasing, while thegoods is insufficiently supplied.
In summary, a free-market economy does not generally welcome state intervention. The market
requires government legal regulations only to maintain social safety (such as policing and29https://www.tokyo-np.co.jp/
article/120752

Law and Development 2023

minimum welfare) and to correct market failures (such as monopolies, inadequate supply of
public goods, etc.).
3. Institutionalist Theory: Transaction cost and economic performance"Institution"
In this section, we will examine Institutionalist economics, which is a predominant
theory in current development strategies. According to Douglas North, who won the Nobel Prizein Economics in 1993, Institutional economics aims to explain the reasons for the differences in
economic performance among countries. While market economic theory suggests that economies
should converge, in reality, they diverge. North believes that differences in institutions are thecause of this phenomenon. As Trebilcock and Prado quote, North defines institutions as "the rulesof the game of a society, or, more formally, the humanly devised constraints that structure humaninteractions. They are composed of formal rules (statute law, common law, regulation), informal
constraints (conventions, norms of behavior, and self-imposed codes of conduct), and theenforcement characteristics of both" (Trebilcock and Prado, p.35).
The metaphor of "the rule of the game" implies that each market actor plays in the market tomaximize their own benefit within the rules. Therefore, the output of economic activity under aparticular institution might be less than the output under another institution16. According to NIE,
the economic performance of a country may be worse than that of others because of bad
institutions.
"Transaction cost"
NIE complements the economic theory of the market mechanism rather than rejecting it. As
explained earlier, market fundamentalism assumes that market mechanisms can allocate resources
most effectively and increase productivity. However, this assumption is based on the concept ofa "perfect competition market (perfect market)" in which:- Everyone can produce goods without restrictions.
- Everyone can participate in the market as either a seller or buyer.
- Everyone has access to the same full information on the demand, supply, price, and qualityof goods.
- Resources can be instantly moved to produce other goods.

16

For example, soccer players behave in order to maximize goal points within the rule that prohibit
using hands. As a result, amount of goal points in a soccer game might be fewer than goal points ofhandball game that allows using hand.
30

Law and Development 2023

In reality, a perfect market that allows for the optimal allocation of resources does not exist.
Therefore, it is important to consider how the price and quantity of goods are determined in animperfect market.
North asserts that an imperfect market requires transaction costs, which in turn determine theeconomic outcome of the market. Furthermore, North argues that institutions largely determine
transaction costs. As institutions establish the rules of the game, market participants repeatedly
act to maximize their benefit within the institution. This creates increasing returns and selfenhancing institutions, leading to a path-dependent and persistent development process in acountry. Therefore, differences in institutions between countries can explain the development gap
among them.
Transaction costs are made up of measurement costs and enforcement costs. Examples ofmeasurement costs include the costs of obtaining information on goods and counterparties.
Enforcement costs include the costs of protecting rights, settling disputes, and ensuring that otherparties implement contracts accordingly (monitoring costs). These transaction costs are added tothe price of goods as hidden costs, resulting in a difference between the nominal price (which
includes hidden transaction costs) and the actual value of the goods.
The figures below illustrate how transaction costs affect the price of transacted goods.

31Law and Development 2023

Hidden cost for transaction

Nominal price of selling car

Estimated cost for
future dispute risk
Additional rate ofinterest.
Cost to investigate
X’s reliability.

Actual price of 100
units of car

I want to sell 100 units of car to Company
X for 10 years loan.
If X complains the quality of cars andreject to pay, I must have lengthy
negotiation with X and visit X’s place
repeatedly.
I may ask the help of a powerful persons
to take money from X by myself. In thiscase, I must pay rewords for them.
Even worse, I may not able to havepayment after all those effort. I should
add this estimated cost of loss to theprice.

By using a D-S curve, we can express the transaction costs as follows:32Law and Development 2023

D (demand)

S (supply)

P (price)"S" represents supply based on
the nominal price that includes
hidden transaction costs. In theS' (supply)

market, price and quantity are
determined by this nominal price.

P*P'

E (equilibrium)

However, the actual benefit of theE'seller is lower than the nominal

Transaction costprice (i.e., nominal price minustransaction cost).
Actual priceIf we can significantly reduce the
Q* Q'

Q (quantity)transaction costs, the supply
curve moves downward (S'). In

this situation, the nominal price of the goods decreases, and the quantity increases (positive effecton the economy). Furthermore, the actual gain of the supply side also increases. Thus, reducing
transaction costs benefits both the demand and supply sides equally.
Now, we understood that transaction costs affect the economic performance of a market, andreducing transaction costs has a positive effect on the economy. Next, we should consider how to
reduce transaction costs. Some examples are shown below:
I want to sell 100 units of car toCompany X for 10 years loan.
But, I’m not sure Company X will
pay the fee accordingly.

I can access to X’s mandatory
disclosed financial reporteasily.

Actual price of 100
units of car

I can get information on X’s
asset and payment capacitywith ignorable cost.

33

Law and Development 2023

I want to sell 100 units of car toCompany X for 10 years loan.
X offers a plot of land as collateral
for the loan.

But, I am worried if a third
party already have a mortgage
on the same land.

Actual price of 100
units of car

By checking the land register
book, I can confirm I am thesole mortgagee.
Even in case of X’s default, X’s
payment for me is safe. The
fee to see the register book isvery cheap.

I want to sell 100 units of car toCompany X for 10 years loan.
X offers a plot of land as collateral
for the loan.

Hidden cost for transaction

Nominal price of selling car

If X complains the quality ofcars and reject to pay, I mustbring the case to the court

Actual price of 100
units of car

The court is professional andneutral. I expect the court settle
the case within reasonable time. I
should hire a good lawyer.
If the court admits my claim, I canenforce the judgement inaccordance with the procedure atthe prescribed cost.

As explained above, information disclosure, clearly defined property rights (including
information about ownership) and, not least, functioning dispute settlement system may reducetransaction cost (including measurement costs and enforcement costs). In this context, legal
institutions play significant role in reducing transaction costs.
However, legal regulations are not enough. Those legal regulations must be observed andenforced. For that purpose, simple and transparent procedures, impartiality in public
administration, and, but not least, credible commitments from the government are essential.
Therefore, recently, "good governance" and the "rule of law" projects have become mainstream
in economic development strategy17.

17"The World Bank estimates to have supported 330 'rule of law' projects dealing with legal andjudicial reform in over 100 countries."
Alvaro Santos, "The World Bank's uses of the 'rule of law' promise in economic development," inThe new law and economic development: A critical appraisal, ed. David M. Trubek and AlvaroSantos (Cambridge University Press, 2006), 253.
34

Law and Development 2023

So far, I explained the role of legal institution in making the market mechanism effective.
Regarding the relationship between law and development since the 1990s, the following two
points cannot be overlooked:
The first point is the political dimension of good governance and the rule of law, which are morethan just tools for the development of the market economy. International cooperation for legal
reform was triggered by regime changes in socialist countries in the late 1980s, and thus inevitably
involved the promotion of democracy and human rights.
The second point relates to the outcome of legal reform projects in non-Western countries. These
projects have mainly focused on safeguarding property rights and contracts for economic
development. However, it has become apparent that merely replicating Western laws cannot
ensure their successful implementation. Therefore, the significance of legal reforms that consider
preexisting local institutions is being acknowledged.
These matters concern the definition of development, which encompasses more than justeconomic growth. We will explore them in the following session, taking into account access tojustice and the local context.
Next session:
Law and Development other than economic development: Local context and the Access to JusticeReading:"Chapter 4: The Rule of Law and Development" in Trebilcock and Prado, pp.48-66.
Further readings:
T.A. Benjaminsen et al., "Formalisation of land rights: Some empirical evidence from Mali, Niger
and South Africa" Land Use Policy 26 (2008) 28–35
https://www.sciencedirect.com/science/article/pii/S0264837708000781 *Accessible only fromuniversity network
van Rooij, B. and van de Meene, I., Access to Justice and Legal Empowerment. Making the Poor
Central in Legal Development Co-operation, 2008, Leiden University Press
https://library.oapen.org/handle/20.500.12657/32868

35

Law and Development 2023

Appedix: Plan B to reduce transaction cost = relying traditional personal relation
I want to sell 100 units of car toCompany X for 10 years loan.
X offers a plot of land as collateral
for the loan.

If X complains the quality ofcars and reject to pay, I mustbring the case to the court
I sell cars to the Company Y
owned by my family member. I
have had transactions with Y
repeatedly. Y won’t violate thecontract.
But, Y’s company is smaller thanX’s company and is capable to buy
only 10 units of car.

Actual price of 10
units of car–

Measurement cost•

Develop formal, credible and widely accessible information system(clearly defined property rights, system, cadaster and land
registration, public accounting etc.)
OR•

Having transaction only with familiar persons (family members, small
community members, long-time business partners)•–

The endless repeated game can avoid "prisoners' dilemma"

Enforcement cost•

Creating formal reliable a third-party dispute settlement or enforcement
institution.
OR•

Relying self-enforcement mechanism (risk of losing reputation, risk of
exclusion from small community)•

Avoiding long term contract and limiting to instant exchange by cash.
Plan A

Plan B

Formality

FormalInformalParty's relation

Impersonal

Personal

Transaction size

Large

Small

Dispute settlement

Third-party decision

Self-enforcement

Institution forming cost

High*

Low

Economies of scale

Yes**

No

36

Law and Development 2023

*As for judicial system, the cost for hiring experts and staffs, constructing court building etc.
**If a country hires one judge at a salary of $100,000 a year, and that judge rules one case ayear, the cost of dispute resolution would be $100,000 a case. If the judge rules 50 cases a year,
cost per a case would be reduced to 200$.

37