Legal uncertainty as a selective deterrent

By Matthias Lang

Legal uncertainty is prevalent. Consider uncertainty about the legality of a specific action: when taking the action, a firm does not know with certainty whether this action would be judged to be legal. For example, it is uncertain which evidence would be allowed and how it would be assessed. Previous literature has shown that legal uncertainty might deter the wrong actions – over-deterring socially beneficial actions, while under-deterring socially detrimental ones. 

In his recently published paper, BCCP fellow Matthias Lang studies welfare effects of legal uncertainty and shows that legal uncertainty can increase welfare – contradicting conventional wisdom. Governments can use legal uncertainty as a welfare-enhancing screening device with respect to firms' private information. Consequently, legal uncertainty can make a norm more selective and increase social welfare. 

This reasoning applies to many settings. A competition policy example are vertical restraints, like exclusive dealings, which are prohibited in the European Union under Article 101 (TFEU). Due to a Block Exemption Regulation, however, this rule does not apply if market shares of involved firms are below 30%. Although the European Commission gives guidelines how market shares are determined, it is extremely difficult to predict correctly market shares determined by competition authorities. Thus, a firm with market shares of 25% anticipates with some probability an estimate above 30% and to face a penalty. On the contrary, a firm with market shares of 35% anticipates with some probability an estimate below 30% and not to face a penalty. The paper shows that this legal uncertainty can be socially beneficial. Other examples for which the results are relevant are pollution thresholds in environmental law or transfer pricing in tax law. In privacy law, there are uncertain privacy thresholds for social networks and other internet businesses. Copyright and patent law similarly contain uncertain thresholds of originality for works to be eligible for protection. 

Suppose that the threshold of legality is uncertain and depends on the circumstances of the action. Courts cannot perfectly distinguish between these circumstances. An optimal threshold of legality balances – on average – the action’s external, social costs and private benefits. Hence, there are some legal actions that reduce welfare and some illegal actions that raise welfare, because welfare depends not only on circumstances, but also on other properties of the action. Legal uncertainty affects deterrence around the threshold in opposite directions: Probabilities of conviction increase for firms below the threshold, while probabilities of conviction decrease for firms above the threshold. Therefore legal uncertainty deters welfare-reducing actions and encourages welfare-increasing actions. Both effects are socially beneficial.

The case for legal uncertainty made here is just one argument in a large debate. On the one hand, legal uncertainty may reduce the accountability of enforcement authorities. On the other hand, precise legal norms often imply huge social costs, for example, in lengthy court cases about conceptual futilities. Legal uncertainty allows to save these costs in addition to the screening effects scrutinized here.

Read the full paper in its published version (January 2017, European Economic Review, 91, p. 274-289) or as working paper (September 2016).