2. Questions From Last Week?

3. Questions For Review?

4. 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

5. 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

6. 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

7. 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?

8. 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 …

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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