Public Choice: The Theory of the Firm and the Theory of Market Exchange

Public choice, sometimes referred to as the economic theory of legislation, applies game theory and microeconomic analysis to the production of law by legislatures, regulatory agencies and courts. In general, microeconomic analysis, as it applies to legal problems, contains two theoretical components-the theory of market exchange and the theory of the firm. The theory of the firm posits that the transaction and information costs associated with contracting across markets will force production and exchange out of the marketplace and into organizations called firms, which are organizations specifically designed to reduce these costs. One of the major problems with market arrangements arises from the difficulty of assuring contractual performance within a market setting. Increasingly economic theory has come to recognize that problems of postcontractual opportunistic behavior, particularly the danger of expropriation of firm-specific capital investments, explain why certain transactions take place within firms instead of across markets. Thus, in many cases, the principal advantage of organizing as a firm is that such organizations mitigate the costs associated with ensuring that contracting parties keep their promises