Federalism, Efficiency and Competition

Abstract

This Article provides empirical and theoretical support for the proposition that permitting actors to contract for the law that applies to their transaction would improve state rules and regulations by reducing interest group incentives to promote inefficient laws. In general, competition between lawmaking bodies limits the extent to which they can impose costs on those who have little influence on the lawmaking process because they reside outside of the jurisdiction. Enforcing bargains over applicable law is particularly effective in promoting jurisdictional competition because it significantly lowers exit costs and thereby increases jurisdictional competition as compared with a rule that forces individuals and firms physically to relocate to a particular jurisdiction in order to be subject to its laws. Although jurisdictions seek to block easy exit from their laws by imposing legal constraints on the enforceability of choice-of-law contracts, we show that a multi-stage process of jurisdictional competition tends to erode these constraints. Given our analysis, theory and data indicating that law is inefficient may be incomplete because they examine only jurisdictions' initial attempts to externalize costs rather than the ultimate outcome of jurisdictional competition. We support our conclusion by analyzing the competition effects on contractual choice of law in three areas -- corporate law, unincorporated firms, and franchise regulation. In addition to its general implications for jurisdictional competition, our analysis has specific implications for the appropriate mode of analyzing the efficiency of state law and of a federal system.

JEL Classification: K2, K4