In (simple) law and economics models, legal rules are analyzed as elements of the opportunity structure. The parties – or if the relevant decision is taken by the lawyer who seeks a client, the lawyers – maximize profit given legal constraints. If a new law changes these constraints, creating new opportunities to make money, they take advantage of it. If parties are initially uncertain about profitability, they replace knowledge with (subjective) expectations. Therefore, according to the rational choice prediction, the diffusion path of the legal innovation should look as in the left panel of the graph:
However, as the right panel demonstrates, reality has been very different in the case of class actions in Israel. Based on a dataset compiled by Keren Weinshall-Margel, the graph highlights the cumulative distribution of all class actions brought from March 2006, when this new remedy was introduced, until August 2012. It is striking to note that the cumulative distribution is almost perfectly exponential. Patently, legal innovation is akin to product innovation. It needs time to diffuse.
In our paper, we analyse this phenomemon. What informs the decision of law firms to enter the market, by launching their first-class action? What drives their decision to stay in the market, by bringing further actions? The parallel between legal innovation and product innovation invites alternative explanations. On the one hand, market sociology suggests that new lines of business are contagious: the underlying process is assumed to be imitation. On the other hand, the economics of innovation would model law firms as rational actors aiming to maximize profit, but facing uncertainty about the profitability of a new technology. Once a firm has entered a new market (here, by launching its first class-action), it can assess the profit derived from this investment in time and resources. Even before entering the market, it could capitalize on the experiences of its competitors; and if no information is available, the simple observation that other firms bring class actions can be read as a signal about the expectations their competitors have for the profitability of this new line of business.
Available data does not allow us to fully discriminate between these competing sociological and economic explanations. However, we show that market entry (the first class-action brought by a law firm) can be explained by the presence of other law firms in the market, even before meaningful information about profitability is made available. The presence of other law firms in the market remains relevant once profitability can be assessed. We also highlight that early adopters are large law firms.
Our findings suggest that legal reform is more complicated than suggested by simple law and economics models. If the legislator cares about addressing a normative concern by introducing a new rule, it should also take into consideration the conditions needed for the new rule to be picked up by relevant actors. If possible, the legislator may want to orchestrate this diffusion process, rather than waiting for firms or individuals to seize the new opportunity on their own initiative.
Christoph Engel is director at the Max Planck Institute for Research on Collective Goods in Bonn, and Professor of Law at the universities of Bonn and Rotterdam.
Alon Klement is Professor of Law at Tel-Aviv University.
Keren Weinshall-Margel is Katia & Hans Guth-Dreyfus Lecturer in Conflict Resolution and Law at Hebrew University Jerusalem.