Econ 522 Economics of Law Dan Quint Fall 2009 Lecture 2

1  Chao’s office hours: Mondays, 11-1  My office hours: Wednesdays, 1:30-3:30  If you’re not registered (and want to be), see me after lecture Logistics

2  defined law and economics  saw some brief history of the common law  and the civil law  and discussed ownership of dead whales Last week, we…

3  what is efficiency?  is efficiency a good goal for the law? Today: efficiency

4 What is “efficiency”?

5  a Pareto improvement is any change to the economy which leaves…  everyone at least as well off, and  someone strictly better off  example of a Pareto improvement  your car is worth $3,000 to you, $4,000 to me  I buy it for $3,500  an outcome is Pareto superior to another, or Pareto dominates it, if the second is a Pareto improvement over the first First concept: Pareto improvement What is efficiency? Vilfredo Pareto ( )

6  most new laws create some winners and some losers  so the Pareto criterion usually can’t tell us whether one policy is “better” than another  even the car example might not be a true Pareto- improvement  so we need another way to compare outcomes Pareto superiority is not that useful a measure for evaluating a legal system What is efficiency?

7  a Kaldor-Hicks improvement is any change to the economy which could be turned into a Pareto improvement with monetary transfers  car example again  your car is worth $3,000 to you and $4,000 to me  government takes your car and gives it to me  Kaldor-Hicks improvement  a Kaldor-Hicks improvement may make some people better off and others worse off, but “the gains outweigh the losses”  also known as potential Pareto improvements Next concept: Kaldor-Hicks improvement What is efficiency?

8 To check whether something is a Kaldor-Hicks improvement…  we could look for the transfers that would make it a Pareto-improvement  or, we can just count up the gains of the winners and the losses of the losers, and see which is bigger  the car example (again)  Kaldor-Hicks improvements may make some people better off and others worse off, but “the gains outweigh the losses” What is efficiency?

9  a situation is Kaldor-Hicks efficient, or just efficient, if there are no available Kaldor-Hicks improvements  (Pareto efficiency: no way to make some people in the economy better off without making some others worse off)  Efficiency: no way to make some people in the economy better off, without making some others worse off by more  we’re already getting maximal value out of all available resources Efficiency What is efficiency?

10  our definition of efficiency: all possible Kaldor-Hicks improvements have already been done  Ellickson: “minimizing the objective sum of (1) transaction costs, and (2) deadweight losses arising from failures to exploit potential gains from trade”  Posner: “wealth maximization”  Polinsky: “Efficiency corresponds to ‘the size of the pie’” Some other, similar measures What is efficiency?

11 We can also consider the efficiency of a single action, in isolation  an action is efficient if its total social benefits are greater than its total social costs  same as saying, a change is efficient if it is a Kaldor-Hicks improvement  example: is it efficient for me to drive to work? What is efficiency?

12 What forces lead to inefficiency?

13  Externalities  Barriers to trade  Monopoly power  Taxes We can better understand efficiency by considering what forces lead to inefficiency What forces lead to inefficiency?

14  Efficiency weighs social benefits and social costs  But individual decision-makers consider only their private benefits and private costs  Externalities are whenever people not involved in making a decision are affected by it  Example: is it efficient for me to drive to work? 1. Externalities lead to inefficiency What forces lead to inefficiency?

15  In general,  actions that impose a negative externality will tend to be done more than the efficient level  actions that impose a positive externality will tend to be done less than the efficient level  In contract and tort law, we will try to design the law to make people internalize their externalities 1. Externalities lead to inefficiency (cont’d) What forces lead to inefficiency?

16  If some guy in Canada owns something worth $100 to him, and worth $150 to me, then it’s a Kaldor-Hicks improvement for him to sell it to me  One approach to property law: make it as easy as possible for people to trade among themselves  (This may seem like an obvious point; but then, there are lots of things we’re not allowed to sell…) 2. Barriers to trade lead to inefficiency What forces lead to inefficiency?

17 CS Profit  Example  Demand for some good given by P = 100 – Q  Monopolist can produce good for $40/unit  Monopoly price is 70, demand is 30  Deadweight loss is inefficiency  Customers willing to pay more than marginal cost but unable to trade 3. Monopoly power leads to inefficiency P * = 70 P = 100 – Q Q * = 30 MC = 40 DWL What forces lead to inefficiency?

18  I value my free time at $40/hour  Working in a factory, I can build things worth $50/hour  Clearly, it’s efficient for someone with a factory to hire me  But if income tax is 25%, then it won’t happen 4. Taxes lead to inefficiency What forces lead to inefficiency?

19  For example  we just said taxes lead to inefficiency  but without taxes, there’s no way to fund public goods, and not having public goods is also inefficient  But also, we’ve defined “efficient”, but we haven’t claimed that efficient = good  Which brings us to… Of course, that doesn’t mean these things are always bad… What forces lead to inefficiency?

20 Is “efficiency” a good goal for the law?

21  positive statements are statements of fact  “economics of what is”  can be descriptive: “in 2007, U.S. GDP was $13.8 trillion”  can be theoretical predictions: “if prices rise, demand will fall”  normative statements contain value judgments  “economics of what ought to be”  for example, “less inequality is better”  or, “government should encourage innovation” Important distinction: positive versus normative economics Is efficiency a good goal for the law?

22  Predicting behavior, and outcomes, that follow from a law or legal system is positive analysis  “Law X will lead to more car accidents than law Y”  “Law X will lead to more efficient outcomes than law Y”  But in the background, we’d like some sense of what the goal of the legal system would be  “Law X is better than law Y”  Posner, and many others, argue that efficiency should be that goal Most of this class will be positive Is efficiency a good goal for the law?

23  Richard Posner (1980), The Ethical and Political Basis of Efficiency Norm in Common Law Adjudication  Starts with the observation: if you buy a lottery ticket and don’t win anything, you can’t complain  Imagine before we all started driving, everyone in the world got together and negotiated a liability rule for traffic accidents  If one rule is more efficient than another, we’d all vote for that rule ex-ante – ex-ante consent Richard Posner gives us one argument why the law should aim to be efficient Is efficiency a good goal for the law?

24  Even ex-ante, bad drivers might prefer a less efficient system if it meant drivers weren’t responsible  Posner deals with heterogeneity with a different example  And of course, this consent is all hypothetical  Posner’s basic argument: if we choose the most efficient legal system, everyone is “compensated ex-ante” for the choice, and should willingly accept the outcome they get Things are a little more complicated… Is efficiency a good goal for the law?

25  The “lottery ticket” analogy requires risk neutrality  50% chance at $1,000,000 is just as good as 50% chance at $900,000 and 50% chance at $100,000  If $100,000 is “worth more to you” when you’re broke than when you already have $900,000, this argument doesn’t work  Counterpoint to Posner: Hammond (1982)  Efficiency is really a special case of utilitarianism, and subject to the same limitations  “Value” = “willingness to pay”  $1 worth the same to everyone Posner’s argument does have its limitations… Is efficiency a good goal for the law?

26  efficiency is not equity  efficiency is not fairness  efficiency is not maximizing happiness “Suppose that pituitary extract is in very short supply… and is therefore very expensive. A poor family has a child who will be a dwarf if he doesn’t get some of the extract, but the family cannot afford the price [or borrow the money]. A rich family has a child who will grow to normal height, but the extract will add a few inches more, and his parents decide to buy it for him. In the sense of value used in this book, the pituitary extract is more valuable to the rich family… because value is measured by willingness to pay, but the extract would confer greater happiness in the hands of the poor family.” - Posner, Economic Analysis of Law This highlights some of the things efficiency is not Is efficiency a good goal for the law?

27  Cooter and Ulen (textbook ch. 1)  Efficiency should not necessarily be the goal of society  But efficiency should be the goal of the legal system  If redistribution is desirable, it’s better to make the legal system efficient, and address distribution through taxes  Cooter and Ulen offer four reasons why the tax system is a better way to redistribute wealth than the legal system A more pragmatic defense of efficiency as a goal for the law Is efficiency a good goal for the law?

28 1.Taxes can target “rich” and “poor” more precisely than the legal system can 2.Distributional effects of legal changes are harder to predict 3.Lawyers are more expensive than accountants 4.More narrowly-targeted taxes cause greater distortion than broad-based taxes Four reasons the tax system is a better way to redistribute wealth than the legal system Is efficiency a good goal for the law?

29 (Example of why narrowly-targeted taxes cause greater distortion) Is efficiency a good goal for the law?

30  We’ve seen two arguments in favor  Posner: it’s what we all would have agreed on ex-ante  C&U: if you want to redistribute, it’s better to do it through taxes  But there are definitely some problems with efficiency  Distribution matters; not everything is monetizable; people might care about procedural fairness  My take  In this class, we’ll mostly focus on the positive questions  But in the background, I think of efficiency as a “pretty good”, but definitely imperfect, measure of “goodness” So, summing up… is efficiency a good goal for the law? Is efficiency a good goal for the law?

31  Next class, we’ll see some numerical examples of some of what we did today, introduce some basic game theory, and begin property law  See me if you’re not yet registered That’s it for today