Assignment for Next Class (Double Class) Agenda for 15th Class Admin Slides Double class on Friday 1-3PM, Rm 101 Prisoners’ Dilemma and Collective Action Problems Cleaner Skies Introduction to Information Assignment for Next Class (Double Class) ## 61-64 Questions to think about P. 253ff Qs 4 (WG4) and 5 (WG1) P. 273 Qs 1 (WG2) and 3 (WG3) King v Burwell (Obama Care case), #129 (pp. 616-29) pp. 628-29 Qs 1 (WG1), 2 (WG2), 4 (WG3), 5 (WG4), 7 (WG1), 11 (WG2)

Mid-Semester Feedback People liked Discussion and debate Readings, materials, and varied topics Interesting and helpful to other classes and law in general People wanted Shorter writing assignments Ending Monday class on time so have break before Contracts No Consensus More / less lecture/discussion More / less econ

Last Class -- Sarnoff Application by of Coase Theorem in real case How negotiations between parties can unlock value Negotiate around covenant not to compete, when new business is very profitable Person bound by covenant can offer to pay to be relieved of covenant Lawyer as transactions costs engineer But also problems that could impede value-enhancing negotiation Lack of access to capital Disagreement about how profitable new business would be

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 When numbers are large, transactions costs are high, so legal rules matters

Cleaner Skies

Information Efficiency of competition assumes perfect information Imperfect information is a transactions cost Efficient allocation of resources may be impaired by imperfect information Imperfect information (like externalities) is ubiquitous When law school and student choose each other Law school doesn’t know how smart or hardworking students are Students don’t know how good school is Law school tries to gather info – admissions process Students try to gather info – US News, campus visits, blogs But information gathering is expensive and imperfect When promisor breaches May not know how much harm will cause promisee May not know whether judge will find breach or not Judge or jury may not know whether breach intentional or accidental Judge or jury may not know whether promisee could have mitigated damages Discovery and trial try to get answers to these questions, but expensive and not completely accurate

The Market & Information Market corrects or mitigates some informational problems Product markets Consumer Reports, Angie’s List, Amazon consumer reviews, EBay ratings, etc. Insurance Medical exam before life insurance Loan markets Credit ratings, loan applications Schools (see previous slide)

Information & the Law Much of law is concerned with information Litigation is principally about production of information Much consumer regulation is forced disclosure of information Nutritional labeling Securities Law Prospectus before initial offering Quarterly reporting of profits MPG for cars APR for loans and savings instruments Contract law Limitation of damages to those which are “forseeable” forces promisee with high damages to disclose (Hadley v Baxendale) Product liability law makes price of product reflect producer’s estimate of expected liability Expected liability likely (otherwise) unknown to consumer Title recordation in Property law

Moral Hazard Insurance context Contracts generally Insured has suboptimal incentive to take precautions If insured against fire, may not install sprinklers or be as careful with fireplace If have health insurance, may not be as careful to eat right or exercise If have health insurance, may request treatments that unlikely to be effective Tort law is form of insurance Product liability may make consumers less careful Duty to rescue may make parents (and others) less careful Government programs are a form of insurance Welfare may dull incentive to work Income tax may dull incentives to work Contracts generally After contract entered into, party may have incentive to act in way that is detrimental to other party Employee may not work hard Lawyer paid by hour may spend too much time on project Renter may not take good care of apartment

Responses to Moral Hazard Gather information Moral hazard is result of fact that insurer does not know how insured is behaving If insurer knew, then could condition insurance on insured behaving properly Insurer’s “monitor” insured Fire insurer may inspect home for smoke detectors, brush clearance, roof materials, etc Government monitors welfare recipients, requires job search, etc. Deny insurance if precautions not taken Comparative/contributory negligence in tort Insurance exclusion for arson Fire employees if shirk Build incentive into contract Insurance seldom covers full cost of hazard So insured has some incentive to take precaution Employer can make pay proportional to output Government regulation seldom helpful Government doesn’t usually have superior information But sometimes can help By using information gathering of criminal law By threatening larger penalties (e.g. imprisonment) E.g. imprisonment for securities fraud

Moral Hazard, Coase Theorem, & Externalities Cost of obtaining relevant information is transactions cost If info could be obtained costlessly, moral hazard wouldn’t exist Since info is expensive, inefficiency may result Moral Hazard is kind of externality Insured imposes costs on insurer Employee imposes costs (or less benefit) on employer Sometimes not considered an externality, because Insured and insurer are in contractual relationship Employer and employee in contractual relationship

Principal-Agent Problem Many situations where one person (agent) works for another (principal) Lawyer works for client Employee works for employer Promisee works for promisor Problem How get agent to act in interest of principal Problem is often moral hazard Agent can take actions which adversely affect prinicipal (not work sufficiently hard (shirking), damage equipment, etc.)

Responses to Principal-Agent Problem Monitoring Terminate contract if agent shirks Performance-based contract Pay agent in accordance with some measure of performance Contingent fee for lawyer Plaintiff’s lawyer gets 1/3rd of damages, if prevails Piece work Pay CEO in stock or option Bonuses for good performance evaluations Input-based contacts Hourly fee or wage Cost-plus construction contracts Fixed fee contracts Salary Best contract depends on circumstances Incentive contract -- if performance easy to measure Fixed fee – if repeated interactions or agent is very concerned about reputation Input based – if cost unpredictable, agent is risk averse, and efficiency can be monitored

Adverse Selection I Markets may fail where one side lacks information and thus sets prices based on average Thus inducing those who are above average to leave the market (b/c price not attractive to them) Classic example: Insurance If insurer has imperfect information Insurance priced at average risk But person who knows low risk may then decide not to insurer But that raises average risk of those still buying insurance Thus raising prices Causing more people to drop out of insurance market Examples Health insurance Product liability/warranty, if voluntary Those who are careful may opt not to purchase warranty Thus raising average risk and cost…

Adverse Selection Example I Suppose 2 people want life insurance A is smoker, 10% probability that will die next year $10,000 expected cost to insurer for $100,000 policy A is willing to pay $11,000 for insurance B is non-smoking marathon-runner 1% probability that will die next year $1,000 expected cost to insurer for $100,000 policy B is willing to pay $2000 for insurance If insurer can’t get credible information on smoking and exercise habits Price for insurance, if both A and B are both buying insurance must be at least, $5500 (average of $10,000 and $1,000) But then insurance is not worthwhile to B

Adverse Selection II Lemons problem Used car purchaser has imperfect information Willing to pay price that reflects average used car quality But person who has above average quality used car doesn’t want to sell at average price, so doesn’t sell But that lowers average quality and thus price, leading more used car owners not to sell Other examples Loans for new businesses

Responses to Adverse Selection Ex ante information gathering So can price product in accordance with individual characteristics, rather than market average Life insurance – blood pressure and cholestoral screenings, different rates for smokers, etc. Health insurance – exclusion of preexisting conditions Inspection and certification of used cars Warranties Reputation Mandatory insurance So no one can drop out of market Health insurance “mandates” / universal coverage