Questions From Last Week?

Questions For Review?

The Midterm Probably one question with numbers along the same general lines as the railroad/farmer examples Otherwise short explanations of ideas You are responsible for everything in the book so far

Review We have been learning the tools That we will use in the rest of the semester To make sense of different parts of the legal system

What is Economics? A way of understanding behavior Rationality : Individuals have objectives and tend to take the actions that best achieve them To give it content needs some knowledge of human objectives And it is not entirely true, but … Arguably rationality is the predictable element in behavior And much irrationality is random and averages out Alternative approach: Predictable irrationality Might work for oneself I can resist anything but temptation So avoid having bowls of potato chips in my viscinity Kahneman’s work a more general attempt at a theory of irrationality “Behavioral economics” But not for this class

Application of Economics to Law How will rational individuals act in response to legal rules? Provides a way of evaluating, hence designing, rules Possibly a way of understanding the rules that exist If they were designed or evolved to achieve some purpose Economic efficiency Putting content in “size of the pie” The degree to which everyone gets what he wants To add everyone up, we need some way of doing interpersonal comparisons By willingness to pay–dollars not utiles One reason a utilitarian might not see efficiency as the objective And not everyone is even a utilitarian The Posner Conjecture: Common law is as if designed to maximize efficiency Alternatively, if efficiency is what you want, what legal rules would get it?

Efficiency as Explanation or as Objective Both raise the same question How can legal rules be used to produce an efficient outcome? Private property and trade are the first approximation answer Law can be used to try to fix the problems with that solution Or law could be used to achieve an objective other than efficiency Such as more equal outcomes Or more just outcomes The approach is interesting in part because it unifies law Tort law: What rules maximize net benefit to everyone Contract law: What terms maximize net benefit to the parties Dollar benefit is what matters, since Dollars are what one party can offer the other to agree to terms Property law: What rules maximize net benefit Criminal law: What rules …

Market Failure Situations where individual rationality does not produce group rationality Polluting when the damage is more than the cost of preventing it Two prisoners confessing when both would be better off if neither did Voters being rationally ignorant of what they need to know to choose the better candidate All forms of market failure can probably be viewed as externality problems I take actions some of whose costs or benefits go to others And I ignore those costs or benefits in deciding what actions to take But some forms are easier to think of in other terms The public good problem Adverse selection: The market for lemons

Rent Seeking and Pecuniary Externalities Rent seeking is a particular externality problem I can bear a cost to transfer from you to me The transfer neither increases nor decreases efficiency, but The cost of doing it decreases efficiency Why theft is a bad thing A pecuniary externality is an externality that does not cause inefficient actions A’s action causes a transfer from B to C C’s benefit just balances B’s loss So A’s net benefit is the same as the net benefit for A+B+C So A has the right incentive If the transfer was from B to A, A would have the wrong incentive Getting us back to rent seeking

Solutions to Market Failure The regulatory solution and what is wrong with it It requires information some of which the regulator does not have And incentives to produce an efficient outcome, which the regulator does not have The Pigouvian solution and what is wrong with it (pre Coase) Controlling the externality requires information the firm does have, but … Knowing how much it should be controlled still requires information from whoever sets the tax And an incentive to try to set it at the efficient level The Coasian critique Nothing works, since costs are produced by both parties Everything works, since parties can transact to the efficient outcome The problem is transaction costs

Using the Ideas: Railroads and Wheat Fields Four different legal rules Four possible outcomes Spaghetti diagram: How to get each outcome from each rule Tells us how to choose a rule if we only knew enough Not only transaction costs and probability of optimal outcome being #X But also judicial technology And what range of cases the rule will apply to Pick that rule for which the net benefit is highest Summed over everyone affected And very situation to which the rule will ever be applied

Using the Ideas: Property Rules vs Liability Rules Property: If I want to use your property I need your permission If I use it without your permission, very bad things happen to me If it is worth more to me than to you, there should be an offer I can make and you will accept Liability: If I use your property without your permission I must compensate you for the resulting cost And if it is worth more than that to me, I will use it and compensate you Property works well if transaction costs are low Liability works well if the cost of using the court system to calculate and impose damages is low and the results accurate So use property when it works well and liability badly, liability in the opposite situation

The Economics of Insurance Relevant because legal rules often allocate risk Risk aversion=declining Marginal Utility of Income A reason to convert a low probability of a large loss into a certainty of a small loss Which can be done by risk pooling. But … It brings Moral hazard—the cost due to an externality voluntarily agreed to Because the benefit in reduced risk is worth it The cost can be reduced by a regulatory solution, insurance company rules Sharing the cost with the insurance company may be optimal. Because both you and they can affect the chance the factory will burn down And giving each of you a slightly inefficient incentive may be better than Giving one of you a very inefficient incentive Adverse selection—a problem leading to non-insurance Comes from asymmetric information—might fix in either direction Or eliminate individual choice—group policy. Government mandate Might create adverse selection by forcing the asymmetry As the Obamacare rules do, by keeping insurance companies from pricing based on cost Then fix the adverse selection by requiring everyone to buy Genetic testing raises similar issues You can’t make a bet after the dice are rolled and you have seen them But can if you have not seen them—buy insurance from a company that knows you have not been tested

Ex Post Enforcement vs Ex Ante Enforcement The general distinction: Ex ante uses information before something happens Ex post uses information after it happens In law enforcement Ex ante punishes the inputs to bad outcomes, such as traffic accidents Ex post punishes the bad outcome Advantages and disadvantages Ex post utilizes actor’s information, easy monitoring of himself Ex ante reduces costs due to risk aversion and inefficient punishments Ex ante substitutes the enforcer’s judgement for the actor’s judgement Which might be an advantage or disadvantage

Game Theory Idea of strategic behavior Approaches we look at Analyzing situations where each person’s actions depend on the other’s The problem is how to define a solution and then find it Approaches we look at 2 player fixed sum—defined and solved Multiplayer, Von Neumann definition, 3 person majority vote A solution is defined, but .. Not a very useful one Dominant strategy and Prisoner’s Dilemma: A solution, but an inefficient one Nash Equilibrium: Problems—the solution depends on how you define a strategy Subgame perfect equilibrium Assumes no commitment strategies Consider the tantrum game Which many of you may some day get to play

Value of Life Revealed Preference Puzzle You would not sell your heart, delivery now, for any price. Value infinite? But you will not bear unlimited costs to reduce the risk of death. Value finite Explanation: In the first case you are not multiplying by infinity But dividing by zero Because dollars are useless to a corpse. Usually Implications for tort damages for wrongful death Based on the value of life in the second sense Could actually pay ex ante for the risk If you could sell the claim for damages from a future tort Implications for tort damages for injuries short of death Making the victim whole may be very inefficient: The blind billionaire problem But you could compensate ex ante for the risk

Any Questions? The book and the powerpoints are available for studying Use the webbed midterms to check whether you are ready Then go back and go over whatever parts you got wrong