Review of Last Week

Problem: External costs not included in the calculation Pigou ’ s solution: Impose the cost on the actor Coase ’ s Critique Nothing works — Pigou might make the higher cost avoider liable. Everything works — given transactions It all depends on transaction costs Instead of focusing on the technical nature of the cost Focus on why people can ’ t bargain to take account of it

Applying Coase to the legal system –Court decides who is the lowest cost avoider Tells him what to do (regulatory solution) Makes him liable (Pigouvian solution) Requires that the court at least knows the damage. or … –Court makes general rules designed to assign liability to the party who will usually be the lower cost avoider Coming to the nuisance as an example –Is it the right answer — second mover is the lower cost avoider? –Perhaps not if later use is predictable. Last clear chance as a similar rule

General Procedure for Constructing Legal Rules If we start with this rule, how do we Get to whichever result is efficient And what makes getting there costly or prevents us from doing so

Suppose we really knew the litigation/transaction technology –Consider a particular case — 1 railroad, 100 farmers –Efficient outcome is … and inefficiency of others is … –From each starting point, what is the summed cost –Of transactions to get to the efficient outcome –Plus inefficiency due to failing to get there Suppose we really knew all the ex ante probabilities –The probability that there will be 93 farmers, and … –The efficient outcome will be a spark arrester, and … –The inefficiency of fires instead is … and … –The inefficiency of clover instead is … –Repeat for all possibilities. Now sum cost over all situations weighted by probability for each rule Choose the rule for which it is minimal.

So we have an answer for the general problem –The full solution requires more knowledge than we have, but with what we know –It should at least give us qualitative results Situations with large numbers on one side strengthen the case for one rule against another Cases where one side can almost always solve the problem at lower cost than the other strengthen … Cases where damages are easy (hard) to measure strengthen the case for one side (the other side). Etc.

Coase Article Coase Article: Classic article that laymen can read. –The problem associated with an externality is jointly caused--the result of actions by both parties. –Farmer and cattleman, outcome does not depend on who is liable But bargaining, attempted extortion, etc., is possible His farmer cultivating land not worth cultivating in order to be paid to stop. Loosely analogous to my railroad leaving off the spark arrester More precisely, to a railroad with the right via liability running a train not worth running in order to be paid by the farmers to stop doing so. Two points that should be obvious to those with an econ background –Opportunity costs are costs –Marginal costs determine action. So Coase ’ s result holds when everything has been bargained through »i.e. in a zero transaction cost world.

A firm is one solution to the transaction costs of the market Consider a shopping mall. –The owner provides free parking, and makes his money back in store rentals. –He figures out what mix of stores, restaurants, etc. will make people want to come, and so maximize the total return –He keeps the public areas clean –In fact, he provides a centralized alternative to nuisance law, government, etc. –And he also must choose among regulatory (must put restaurants in the food court) Pigouvian (measures traffic brought in through random polls, gives rent reduction to the stores that people come to visit) Coaseian (Simply gives out long term leases, lets tenants bargain among themselves to get stores with synergy adjacent, etc.) Whether it makes more sense to solve problems by putting both actors into one firm depends on the tradeoff between administrative costs of the firm and the alternative market costs.

Government regulation is another solution Which has its own costs and errors, and so may give worse results than the other solutions Or better.

And a final solution is to do nothing Some problems cost more to cure than the cure is worth. –That is how we deal with lots of externalities –Positive ones like beautiful buildings, and –Negative ones like people wearing ugly clothes.

Where transaction costs are high Court decisions matter, and cases suggest at least some general recognition of reciprocal problem and cost/benefit issues. –In the limit of infinite transaction costs, we are back in a Pigouvian world –With the Coaseian critique about double sided causation still valid –Property rule if it is clear what the right answer is –Liability rule if it is unclear what the right answer is, but damages can be measured.

Additional points in the article Common law of nuisance v statute. –Statute may extend or reduce the coverage of the law of nuisance. –What we observe is frequently government authorised, not the result of lack of regulation –And perhaps should be. What is owned is a right, not a thing. For instance, the right to produce pollution

If factors of production are thought of as rights, it becomes easier to understand that the right to do something which has a harmful effect (such as the creation of smoke, noise, smells, etc.) is also a factor of production. Just as we may use a piece of land in such a way as to prevent someone else from crossing it, or parking his car, or building his house upon it, so we may use it in such a way as to deny him a view or quiet or unpolluted air. The cost of exercising a right (of using a factor of production) is always the loss which is suffered elsewhere in consequence of the exercise of that right-the inability to cross land, to park a car, to build a house, to enjoy a view, to have peace and quiet, or to breathe clean air.

Economists who study problems of the firm habitually use an opportunity cost approach and compare the receipts obtained from a given combination of factors with alternative business arrangements. It would seem desirable to use a similar approach when dealing with questions of economic policy and to compare the total product yielded by alternative social arrangements.

Other possible legal rules Majority or supermajority for group –To solve some farmers problems Farmers can enjoin but must pay, or … Farmers must bribe RR to put on smoke arrester –Unitization of oil fields I pump oil from the well on my property Oil flows in from under your property So it is in the interest of each of us to pump too much Unitize the field, treat it as joint property of all of us –Creates other problems — corporate law. The corporation is the joint property of the stockholders Someone has to run it How do you prevent the executives from stealing the stockholders blind?

Chapter 6: Economics of risk Why is this here? A lot of legal rules are about allocating risk, such as … product liability rules breach rules under contract Negligence v strict liability Economics of insurance provides a context for analyzing such questions Considerations include –Risk aversion –Moral Hazard –Adverse Selection

Risk Aversion What it is –Given the choice between a certain outcome ($100) –And a gamble with the same expected value(.5 chance of $200) –You are risk averse if you always prefer the former Risk Aversion=Declining Marginal Utility of Money –If each additional dollar adds less to your happiness –Then the second $100 is worth less than the first, so –$200 is worth less than twice as much as $100 –So.5 chance of $200 is worth less than 1.0 chance of $100 “ Risk Aversion ” is a misleading term, because –You might have declining marginal utility for money, but.. –Increasing marginal utility for number of children or years of life This is very much like the standard argument for transferring income from rich to poor –If you could insure, before being born, against being born poor –You would, since you would be trading less valuable dollars (when born rich) for more valuable (when born poor) If you are risk averse, you will want to insure against your house burning down –You are trading low value dollars (if it doesn ’ t burn dow) –For high value dollars (if it does, making you poorer) Lottery-insurance paradox –If you are risk averse, you should buy insurance but not lottery tickets –If you are risk preferring, you should buy lottery tickets but not insurance –Yet some people buy both.

Moral Hazard Take 1: Moral Hazard as a bug –If your factory is insured against fires Why pay the extra cost of a sprinkler system? The money you save by preventing a fire is the insurance companies, not yours So you will take an inefficiently low level of precautions –Health insurance You have an incentive to go to the doctor too often, Not take care of yourself enough. –Externality problems--but ones voluntarily chosen You get insured because the inefficiency due to the resulting externality Is less than the gain due to reduced risk Take 2: Is Moral Hazard a bug or a feature –Perhaps the insurance company is better qualified than you are to keep your factory from burning down-- and requires a sprinkler system –Service contracts insure against small losses, which seems to make no sense But Sears is more expert in getting your appliance fixed than you are And the service contract makes it in their interest to have it done right and cheaply –Combine life insurance with health insurance, to give the health provider an incentive to keep you alive? We are back to Coaseian double causation. –We want you to have an incentive to take precautions, not break appliances, etc. –But we want someone else to also have an incentive to deal with the same problems Putting the incentive where it does the most good

Adverse Selection Market for lemons –Seller of a car knows if it is a lemon –Buyer does not, so offers the same price for both –The owner of a lemon is more likely to accept that price –So accepting is evidence the car is a lemon, so –Buyers offer a price lower than the average value of cars –And now even fewer of the good cars sell What is the problem? –Not “ it sells at the wrong price ” (distribution) but “ it doesn ’ t sell ” (allocation, efficiency) –Solution? Seller provides a guarantee. –Which brings back moral hazard. Why should I take good care of the car? If something goes wrong, the seller will have to pay for it.

Consider the Case of Genetic Testing Assume we have a good test for how bad a risk you are-- how likely to die or have expensive medical problems. –Insurance companies would like to know –So would you –In part to decide whether to buy insurance –Think of it as “bad heart (genes)” vs “good heart” We could let insurance companies –Insist on a test before insuring you –Or offer lower rates if you have been tested and are low risk. We could forbid them from doing so –But let individuals get tested –What are the consequences? We could ban the test for everyone Which alternative is best? Why? Might we be better off if the test was never invented?

Insurance companies can require testing You cannot insure against being born with a bad heart –Just as you cannot now insure against being born poor –Because the outcome is known before you buy the insurance You could refuse to be tested and try to buy insurance –But the insurance company will conclude that you probably got tested, discovered you were a bad risk –And that ’ s why you don ’ t want them to test you –And they will price your insurance accordingly Can insure against residual (non-genetic) risk –At a low price if you have a good heart –At a high price if you have a bad heart

Insurance Companies may not –Require the test, or … –Charge more to those who refuse What happens? Insurance company charges assuming you have an “ average ” heart? You can still get tested, not tell them the result – If you have a bad heart Insurance is a good deal So you buy it –If you have a good heart, bad deal, don ’ t buy it –So mostly the people who buy insurance have bad hearts The insurance companies discover this –If you buy insurance you probably have a bad heart –So they should charge accordingly –Making insurance an even worse deal if you have a good heart –Adverse selection at work You cannot insure against having a bad heart And can only insure against non-genetic risk if you have a bad heart

Nobody can use it (or it doesn ’ t exist) How you can insure –Against being born with a bad heart –And against non-genetic heart risk. But … You cannot take precautions based on knowing you have a bad heart So the existence of the genetic testing might make us worse off –By eliminating an opportunity to insure against a risk –Which might or might not outweigh the benefit to us of the additional knowledge.

If you have been tested, you can either –Let them know the result (or retest you) –Or let them assume you have a bad heart and charge accordingly If you have not been tested you can prove it –So they offer you insurance at the “average” price –Since you have an average chance of a bad heart If you want to insure against a bad heart, you –Buy insurance before you are tested –Then get tested if you want the information Now you can insure against both genetic and residual risk Clearly the best alternative--but may not be possible What if insurance company –Knows if you have been tested –Can condition price accordingly

Legal Rules to Think About I rent a house –It burns down –Should I or the owner bear the cost? I buy land from John –Paying with lead bars plated with gold –I sell the land to Bill –The fraud is discovered--but I’ve vanished –Who owns the land? I forge a deed to John’s land –Use the forged deed to sell the land to Bill –The fraud is discovered, I have vanished –Who owns the land? What are the common law rules? Why?