Differentiation through Legal Uncertainty

This paper challenges the conventional view of legal uncertainty as a purely distortionary force. We argue that for heterogeneous populations, simple legal standards can harness uncertainty to produce socially beneficial differentiation in incentives. We identify and formalize two mechanisms through which this occurs: a smoothing channel, where uncertainty breaks up the inefficient bunching of behavior that would otherwise be caused by a known standard, and a projection channel, where individuals rationally form differentiated beliefs about what the standard requires based on their own characteristics. We show that, while uncertainty worsens incentives for mid-cost types, it improves them for more extreme types and can raise aggregate welfare depending on the population mix. We apply our analysis to shed new light on a range of fundamental issues in legal design, including the optimal degree of legal complexity, the choice between rules and standards, and the choice between “sanctions” and “prices.”