Agenda for 12th Class Efficiency Externalities Assignment for Next Class ##56-58 Question to think about / Writing assignment for Group 1 Q 1 on p. 237

Review I Cost-Benefit analysis needs to take into account costs and benefits that are not usually expressed in monetary terms Life, health, pollution, dead plankton Methods Surveys Observation of market effects

Review Derek & Amartya Cost-Benefit analysis and utilitarianism Usually cost-benefit analysis leads to greater happiness But not always That is point of Derek-Amartya example If Amartya pays Derek $2.50 for book, then happiness increases Derek gets $2.50 which values more than book and can buy medicine Amartya gets book which he values more than $2.50 Also passes cost-benefit analysis Net benefit of $0.50 to Derek: Gets $2.50, loses book worth $2 to him Net benefit of $0.50 to Amart.: Gets book worth $3 to him, pays $2.50 Social net benefit of $1 If tyrant takes book from Derek and gives it to Amartya No payment, just forced transfer Happiness does NOT increase Derek loses book that loves and does not get medicine Amartya gets book that doesn’t care much about But still passes cost-benefit analysis Net loss of $2 to Derek (value of book to him) Net benefit of $3 to Amartya (value of book to him) Problem is that money does not bring same amount of happiness to D & A

Redistribution of Income Utilitarian can justify because of declining marginal utility of money Taking $1 (or $1000) from rich person and giving it to poor person is likely to increase happiness in society Although must take into account cost of taking money Cost of running tax system Disincentive for rich person to earn and save Rights based arguments for redistribution (Rawls) Equality is basic principle of justice, and economic inequality can only be justified to the extent that it is necessary to encourage people to work and generate income in the first place. People don’t deserve their income, because income largely attributable to genes and childhood environment, which people get from parents Techniques for redistribution Progressive Taxes Social programs: Social security, welfare (TANF), Medicaid, Medicare, Food Stamps Lawsuits: Very inefficient way of redistribution Very few actually benefit Lawyers get half (and they are not usually poor) Costs often passed back to consumers in higher prices May distort incentives to take precautions, perform/breach contracts

Questions 2) People around the world (and even in the United States) die every day because they cannot afford relatively inexpensive medical treatments that would keep them alive. Is it immoral for people to take vacations or buy iPods and nice clothes when the money could be contributed to charities (such as Doctors Without Borders) that would use the money to save lives? 3) Are you convinced by the utilitarian or rights–based arguments for the redistribution of income? If not, do you think redistribution of income is unjust? Do you think there are better arguments for the redistribution of income?

Efficiency I Efficiency Pareto. Situation is Pareto superior if it makes at least one person better off and no one worse off Situation is Pareto optimal or efficient, if there is no situation which is Pareto superior to it Problems Very few legal changes make no one worse off Ignores distribution Situation in which I have all the wealth is efficient

Efficiency II Kaldor-Hicks Efficiency Wealth-maximization Situation is Kaldor-Hicks superior if winners can compensate losers and still be better off Situation is Kaldor Hicks optimal or efficient, if there is no situation which is Kaldor-Hicks superior to it Roughly equivalent to cost-benefit analysis, where costs & benefits judged by willingness to pay Problems. Willingness to pay is not always ethically attractive criterion Wealth-maximization Posner calls use of Kaldor-Hicks efficiency to choose among legal rules “wealth maximization” Confusing, because “wealth” usually refers to things like stock, bonds, jewels, and real estate But selling stock to go on vacation can be “wealth maximizing,” if person values vacation more than stock

C D A B B’s well-being A’s well-being

Competitive Markets and Efficiency In general Competitive markets are Pareto efficient Kaldor-Hicks efficient Maximize sum of producer and consumer surplus Where surplus is measured For producers as difference between cost and price For consumers as difference between subjective benefit and price Any deviation from competitive price Harms someone (so not Pareto superior) Blocks mutually beneficial transaction Artificially low price blocks transaction between higher cost seller and high value buyer Analysis assumes No externalities Perfect information No transactions costs Benefits measured by willingness to pay

Externalities Externalities are ubiquitous Negative externalities Pollution All torts: trespass, negligence, product liability, medical malpractice, etc. Traffic Playing loud music Being mean to friends or strangers Positive Externalities Volunteer work Rescuing friend or stranger Running an organization well Voting (governmental or corporate) Being green

Policy Responses to Negative Externalities “Internalize” externalities Make it in the self-interest of the person imposing externality to do the right thing Impose liability equal to harm Most of tort law Impose corrective taxes equal to harm Carbon tax Congestion tax Cigarette taxes? Cap & trade is, in effect, tax b/c emitters will have to pay for permits (or forgo revenue which could have received for selling them) Impose Criminal Penalties Most crimes impose externalities Murder, robbery, theft Query re “victimless crimes,” such as drugs and prostitution Regulate Set maximum automobile emissions Require “best available technology” for electric power plants Set capital requirements for banks

Questions on Externalities 4. Review the statutes at issue in the cases we have read so far—the sentence enhancement statute in Smith, Title VII in Weber, and The Sherman Antitrust Act in National Society. Do they address externalities? Were there externalities in Union Pacific v Jones? If so, what rule would cause the railroad to internalize those externalities? From an economic point of view, what would the best legal rule be regarding the duty to rescue?

Externalities & Coase Theorem When externalities affect small number of people who can negotiate ex ante or who deal with each other repeatedly, probably don’t need law to correct or encourage Nice or mean things done to family or friends Contracts usually deal explicitly with externalities E.g. promisee pays for positive externality granted by promisor Parties indemnify each other for harm But law sometimes imposes mandatory terms E.g. Product liability, medical malpractice liability Covenants running with land, homeowners associations Deal with externalities among neighbors But when externalities affect large numbers of people, need law Pollution, congestion, torts among strangers, etc.

Prisoners’ Dilemma Dominant Strategy. Nash Equilibrium Suspect 2 Confess Keep quiet Suspect 1 -5, -5 -1, -7 Keep Quiet -7, -1 -2. -2 Dominant Strategy. Nash Equilibrium Each suspect imposes negative externalities on the other Parties cannot communicate, so transactions costs high, so parties do not reach efficient result

Pollution Externalities Game Firm 2 Pollute Install Firm 1 -4000, -4000 -2000, -5000 -5000, -2000 -3000. -3000 Almost identical to Prisoners’ dilemma If numbers small, might expect agreement to install pollution control When numbers large, negotiation very difficult Collective action problem Everyone better off if everyone installs pollution control equipment But each person better off if free rides Better to not install pollution control equipment, if everyone else does

Collective Action Problems Collective Action Problems are ubiquitous Becoming informed voter, voting Funding public goods, e.g. fire departments, bridges, national defense Global warming Fishing Every collective action problem is also an externalities problem Sometimes groups can resolve Political lobbying by interest groups Democracy Voluntary organizations Clubs Often government is only or best solution