0. Econ 522 Economics of Law
Dan Quint
Spring 2017
Lecture 2

1. Logistics TA sections begin this Friday
“Fake homework” for Wednesday on website
First real homework also up, due next Thursday (Feb 2)
If you want to read ahead:
Richard Posner, “The Ethical and Political Basis of Efficiency Norm in Common Law Adjudication”
For a counterpoint to Posner: Peter Hammond, “Review: The Economics of Justice and the Criterion of Wealth Maximization”
Both have links on syllabus, and both are on
(Still on waitlist? Talk to me after class.)

2. Last week, we… defined law and economics
saw some brief history of the common law
and the civil law
and discussed ownership of dead whales
defined law and economics
“looking at the law like an economist”
really, focusing on the incentives created by the legal system
saw some brief history of the common law
based on pre-existing norms and practices
defers to previously-decided cases (precedents)
and the civil law
Napoleonic Code (based on “ancient sources and pure reason”)
one of my former students described the difference between the two legal systems as “spontaneous versus planned order”
civil law was created at one particular time
common law developed/evolved piecemeal, beginning with norms and practices, developing through legal precedents and through legislation
we also discussed ownership of dead whales
the point: in each case, common law judge deferred to local norms

3. Today: efficiency quick review of rational choice what is efficiency?
is efficiency a good goal for the law?
Probably the most important single economic concept we’ll use in this class is the notion of efficiency
The goal for today:
Define efficiency, understand what it is (and what it isn’t)
Think about whether efficiency is a good normative goal for a legal system
At various points in the semester, we will see aspects of the law that appear to be efficient
that is, elements of the existing law that appear to lead to efficient outcomes…
and may even appear to be designed to achieve efficiency
At the end of the semester, we’ll ask the question of whether we should expect the law to naturally be efficient, or at least evolve toward being more efficient over time
But for now, we’ll stick to the questions, what is efficiency, and do we want it?

4. Rationality, optimization, revealed preference

5. Most microeconomics is based on the premise of rational choice
People have preferences…
They understand their options, and how much they like each one
…and they optimize
They choose the option they like the best
This is what economists mean when we talk about rationality or rational behavior
Behavior that is consistent with someone having well-defined, consistent preferences
And this is what we’ll be assuming throughout the semester
We don’t insist that people have particular preferences
if I like some very rich, Belgian ale and you like Milwaukee’s Best Light…
then I might think you’re wrong as a beer drinker,
but I don’t think you’re wrong as an economist
People are allowed to have whatever preferences they have – they just have to consistently choose according to the same set of preferences
We will revisit this assumption at the very end of the semester 5 5

6. This leads to the idea of revealed preference
If I see you choosing something…
…I infer you like it more than your other alternatives
We assume people succeeded in doing what they like, rather than screwing up and doing the wrong thing
And this allows us to learn peoples’ preferences from their choices (to some degree)
If you walk past a Coke machine to buy Pepsi for the same price, I infer you prefer Pepsi to Coke
If you choose not to buy health insurance that cost $100 a month, I infer you prefer $100 to whatever benefits you would have gotten from the insurance policy 6 6

7. All this is useful if we want to judge what are “good” outcomes
If we assume that people have coherent preferences…
…and that we might be able to learn those preferences…
…then we can try to use those preferences to judge when one societal outcome is “better” than another
That is, rather than us having to invent our own measure of well-being to determine whether you’re better off under one set of laws than other, we can use your own preferences
We can ask whether you think you’re better off – that is, whether according to your preferences, you’re better off 7 7

8. One way to do this: Pareto criterion
a Pareto improvement is any change to the economy which leaves…
everyone at least as well off, and
someone strictly better off
example
you prefer $3,500 to your car
I prefer your car to $3,500
I buy it for $3,500 – Pareto improvement
an outcome is Pareto superior to another, or Pareto dominates it, if the second is a Pareto improvement over the first
I’m being very general here – a “change to the economy” could be a change in…
distribution of wealth
allocation of goods (who owns or consumes what)
production of goods (what gets produced)
supply of labor (who works how much)
any combination of these elements
example: you have a car – a 2002 Pontial Grand Am with 80,000 miles on it
and I have $3,500 in cash
and suppose you prefer $3,500 to the car, but I prefer the car to $3,500
Me buying the car – you get my money, I get the car – is a Pareto improvement
Both of us end up in a position we prefer
And nobody else cares
if something is a Pareto improvement, we say the new situation is Pareto superior to the old situation, or Pareto dominates it
the situation where I have the car and you have my $3,500 Pareto dominates you having the car
Vilfredo Pareto ( ) 8 8

9. Pareto superiority is not that useful a measure for evaluating a legal system
Pareto improvements are “win-win”
But 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
unfortunately, Pareto superiority is not that useful for evaluating a legal system
Pareto improvements are “win-win”
nobody is worse off than before
if a proposed policy change were a Pareto improvement, nobody would have any reason to oppose it
if put to a vote, it would pass unanimously
if something is a Pareto improvement, it’s pretty easy to make the case it’s a good thing
however, the world is a complex place - 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
if the car is ugly and I park it on the street, maybe my neighbors are a little bit worse off after I buy it from you
if I drive the car more than you would have, the sale leads to more air pollution
so we need another way to compare outcomes 9 9

10. Kaldor-Hicks and Efficiency10 10

11. We generally assume preferences are complete
Given any two options, I can figure out which one I like more (or else I truly don’t care)
Given two options – say, $4,000, or a 2002 Grand Am…
Maybe I prefer the money
Maybe I prefer the car
Maybe I’m exactly indifferent between the two
But one of these must be the case 11 11

12. We also assume more money is better…
If you don’t like it, you can always burn it…
…but we generally assume everyone prefers more money to less money
“Everybody needs money. That’s why they call it money.” Danny DeVito, in Heist 12 12

13. And finally, we assume preferences are continuous
If I prefer your car to $3,000…
…but I prefer $5,000 to your car…
…there’s some amount in between that makes me indifferent
We can say that’s my value for the car
If I’m exactly indifferent between $4,000 and your car…
…we can say I value your car at $4,000
This means for most things, we can equate how much you “like” something with how much money you would be willing to pay for it 13 13

14. Next, we define Kaldor-Hicks improvement
Informally: a K-H improvement is any change to the economy which increases the total value achieved by everyone in society…
…where the “value” someone gets from something is measured by their willingness to pay for it
we said Pareto improvements are win-win – everyone likes them
Kaldor-Hicks improvements may make some people better off and others worse off; but overall, “the gains outweigh the losses”

15. Next, we define Kaldor-Hicks improvement
Suppose there are three people in society, each has $100
If we find a policy change that leaves them with ($105, $105, $95), that’s a Kaldor-Hicks improvement
Going back to the car example
Your car is worth $3,000 to you and $4,000 to me
Government seizes your car and gives it to me
I’m better off, you’re worse off
But since I value the car more than you…
…this is a Kaldor-Hicks improvement
we said Pareto improvements are win-win – everyone likes them
Kaldor-Hicks improvements may make some people better off and others worse off; but overall, “the gains outweigh the losses”
(In fact, even if my neighbors are a little bit worse off after I take your car, as long as they’re worse off by less than $500, it’s still a Kaldor-Hicks improvement, since we could hypothetically come up with payments from me to them to turn me getting the car into a Pareto-improvement)

16. Another way to think about Kaldor-Hicks improvements
Unlike a Pareto improvement, a Kaldor-Hicks improvement can create some winners and some losers…
…as long as the winners gain more than the losers lose
If I get your car for free…
I end up better off by $4,000 (my value for the car)
You end up $3,000 worse off (your value for the car)
$4,000 > $3,000, so this is a K-H improvement
We can think of it as a net creation of value
We created $4,000 of value (me getting the car)
And destroyed $3,000 of value (you losing it) 16 16

17. Formal definition of a Kaldor-Hicks improvement
a change to the economy is a Kaldor-Hicks improvement if it could be turned into a Pareto improvement with monetary transfers
K-H improvements also called potential Pareto improvements
I get your car for free
If we combined this change with me giving you $3,500…
…then it would be a Pareto improvement
So even without the transfer, it’s a K-H improvement
One of the nice things about this
We said before, if I bought your car for $3,500, it’s a Pareto improvement
But then we realized, if that makes my neighbors even a tiny bit worse off, it would no longer be a Pareto improvement
And to turn it into a Pareto improvement, we’d need to figure out exactly who was worse off, and by exactly how much, and find a way to compensate them
Well, with Kaldor-Hicks improvements, we know that me getting your car (regardless of the price I pay) creates $1,000 worth of value
So if my neighbors are a tiny bit worse off, or people I fight for parking with on campus are a tiny bit off, that doesn’t matter – as long as we know they’re worse off by less than $1,000 total, we know this was still a Kaldor-Hicks improvement 17 17

18. Another example You and I are neighbors, you want to throw a party
The party would make me $100 worse off…
…and make you $50 better off…
…and make each of your 30 guests $5 better off
Is the party a Pareto improvement?
No – can’t be, because it makes me worse off
Is the party a Kaldor-Hicks improvement?
Yes – it increases total value: $50 + $150 – $100 = $100 > 0
(Or: you could throw the party, plus you give me $40 and each of your guests gives me $3 – that would be a Pareto improvement, so just having the party is a K-H improvement)
Another example 18 18

19. Efficiency
we will call a change to the economy efficient if it is a Kaldor-Hicks improvement
we’ll say law A is more efficient than law B if moving from B to A is a Kaldor-Hicks improvement
and we’ll say a situation is efficient if there are no available Kaldor-Hicks improvements
an efficient situation is when there’s no way to make some people better off, without making some others worse off by more
we’re already getting maximal value out of all available resources
this means we’re already getting maximal value out of the resources we have
every object is owned by whoever values it the most
anything worth more than the cost to produce it is being produced
people are employed as long as their disutility for working is less than the value they are creating
cars are safe enough that making them safer wouldn’t be worth the money it would cost
and so on
so there’s no way to improve the overall situation

20. Pareto vs Kaldor-Hicks improvements
Pareto improvement
Kaldor-Hicks improvement
“good for everyone”
makes some people strictly better off, doesn’t make anybody worse off
“good for society as a whole”
may make some people worse off, but increases total surplus/value
not that interesting, because they wouldn’t be controversial
we’ll often be looking for these

21. All semester, when we say “efficient”, this is what we’ll mean
Outcome A is more efficient than outcome B if it’s a Kaldor-Hicks improvement
If there’s more total surplus realized under outcome A
Or if outcome A, plus some monetary transfers, would Pareto-dominate outcome B
Outcome A is efficient if there’s no way to change it that creates a Kaldor-Hicks improvement
No way to increase total value being achieved

22. We said it’s efficient for you to have the party
Makes you $50 better off
Makes 30 guests $5 better off
Makes me $100 worse off
$50 + $150 – $100 = 100  party “creates $100 of value”
So it’s efficient for you to have the party
True whether you compensate me or not
Even if “my slice of the pie” is smaller, overall pie is bigger…
…which is all that efficiency measures
(or, having the party is a Kaldor-Hicks improvement)

23. What we’ve really done here
In a sense, what we’ve done here is created a way to add up different peoples’ utility functions…
…by equating utility with willingness to pay
We said the party made me $100 worse off
We equated my disutility from you making noise with the amount of money that would replace the inconvenience – if you threw the party and gave me $100, I’d be just as well off as before
Once we’ve done that, what’s efficient is whatever configuration of the economy “creates the most value”

24. One more example: is it efficient for me to drive to work instead of taking the bus?
Bus to campus from where I live is free
Driving is more convenient, but costs me $1 (gas)
Driving also imposes costs on other people: there’s more traffic, less parking, more pollution
Suppose when I drive to work, it makes 1,000 other people worse off by $0.01 each
By driving to work, I create $11 of total costs
It’s efficient for me to drive to work if the benefit I get is more than $11
If the benefit is less than $11, it’s inefficient for me to drive
example: is it efficient for me to drive to work?
benefits to me: faster, more convenient than bus
costs to me: gas, parking
costs to rest of society: more traffic, more pollution
add them all up, we figure out whether it’s efficient for me to drive

25. Some other, similar measures
our definition of efficiency: actions are taken when total benefits outweigh total costs
“goal” is to achieve all Kaldor-Hicks improvements
Ellickson: efficiency is “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’, while equity has to do with how it is sliced”
our definition of efficiency: all possible Kaldor-Hicks improvements have already been done
Ellickson, in the paper on whaling, defines efficiency as
“minimizing the objective sum of
transaction costs, and
(2) deadweight losses arising from failures to exploit potential gains from trade”
transaction costs we’ll talk about later
potential gains from trade are just possible Kaldor-Hicks improvements – so failures to exploit them is exactly inefficiency in our sense
Rather than efficiency, Posner (who we’ll discuss shortly) focuses on “wealth maximization” – maximizing the value of everything created and consumed in society
which is pretty much the same exact thing
Mitch Polinsky (“Introduction to Law and Economics”): “Efficiency corresponds to ‘the size of the pie,’ while equity has to do with how it is sliced”
again, just focusing on the total wealth or resources available to everyone in society, and doing anything possible to increase that total, without regard to how it’s divided up

26. What forces lead to inefficiency
We can get a deeper understanding of efficiency by thinking about what screws it up – that is, what forces and situations lead to inefficiency

27. To see whether something’s efficient…
Compare gains to everyone in society (total social benefit)…
…to costs to everyone (total social cost)
Example we already saw (me driving to work):
Total social cost = $1 (gas) + 1,000 X $0.01 = $11
Total social benefit = whatever benefit I gain by driving to work
So we just said: it’s efficient for me to drive to campus whenever the value I get from driving is more than $11
some days, it’s nice out, I don’t mind waiting for the bus; my benefit from driving might be $5, so it’s not efficient for me to drive
when it’s really cold, or snowing, maybe I really don’t want to walk to the bus stop and wait; my benefit from driving might be $15, so it is efficient for me to drive

28. How do we expect people to actually behave?
When people decide how to act…
…they consider the cost and benefit to themselves, not to everyone
private benefit and private cost
Driving only costs me $1
so I’ll drive whenever benefit to me is more than $1
On days when value I get from driving is more than $1 but less than $11, I’ll choose to drive to work even though that’s inefficient
The world would be a better place overall if I took the bus
But the world is a better place FOR ME if I drive, so that’s what I do

29. So externalities cause inefficiency
I’ll do something whenever private benefit > private cost
Efficiency depends on whether social benefit > social cost
If I was the only one affected by my choices, then social benefit = private benefit and social cost = private cost
when I’m deciding which movie to watch on Netflix, nobody else is affected by my choice, so my choice will be efficient
But when my choices affect other peoples’ payoffs…
social benefit ¹ private benefit, or social cost ¹ private cost
so actions I choose to take may not be efficient

30. A classic example of this: the Tragedy of the Commons
Hardin (1968), “The Tragedy of the Commons”
Picture a small fishing village on a lake
The more fish I catch, the fewer fish are left in the lake…
…and the harder it is for everyone else in the village to catch fish
So my fishing imposes a cost (externality) on everyone else
So everyone ends up fishing more than the efficient amount

31. Tragedy of the Commons – example
10 fishermen
Cost of fishing is 12 fish per hour
Notation
h = how many hours I fish
H = combined hours everyone in the village fishes
Fishermen catch 100 – H fish per hour
What is the efficient level of fishing? How much utility would that give to each fisherman?
4.4 hours per day per fisherman; fish/day
Left to their own devices, how much will each person choose to fish? How much utility will each person get?
Total fish caught
“Maximum Sustainable Yield”
H (100 – H)
Efficient Level of Fishing
2.5 5
7.5 10
Hours fishing, per day, per fisherman
We said efficiency is about maximizing total value
So one way to think about it: suppose you were king, and could tell everyone what to do, and all you cared about was maximizing the combined surplus of everyone in town. What would you tell everyone to do?
Rather than thinking about each individual fisherman, we can think about the sources of value and the sources of costs in the economy
There is fish, and there are the hours of disutility from fishing
If the total amount of fishing is H, we know how many fish will get caught – it’s H (100 – H)
And we know the cost of that fishing – it’s 12H
So the combined payoff to everyone in the village is H (100 – H) – 12 H = 88 H – H^2
So if we want the efficient level of fishing, we find the value of H that maximizes this, by taking the derivative and setting it equal to zero
That gives us 88 – 2H = 0, or H = 44
We maximize total combined payoffs by having people fish a combined total of 44 hours per day, or 4.4 hours per day per fisherman
How happy does that make people?
Well, with 44 hours of total fishing, we catch 56 fish per hour
So if we each fish 4.4 hours a day, we each catch fish, and pay costs of 4.4 * 12 = 52.8 fish, for surplus of fish per day
So that’s the efficient outcome – if we tell everyone what to do, and maximize their payoffs, everyone in town gets utility of almost 200 fish per day

32. Tragedy of the Commons – example
10 fishermen
Cost of fishing is 12 fish per hour
Notation
h = how many hours I fish
H = combined hours everyone in the village fishes
Fishermen catch 100 – H fish per hour
What is the efficient level of fishing? How much utility would that give to each fisherman?
4.4 hours per day per fisherman; fish/day
Left to their own devices, how much will each person choose to fish? How much utility will each person get?
8 hours per day per fisherman; 64 fish/day
Total fish caught
“Maximum Sustainable Yield”
H (100 – H)
“Equilibrium” Level of Fishing
Efficient Level of Fishing
2.5 5
7.5 10
Hours fishing, per day, per fisherman
Now let’s thinking about what everyone will choose to do if left to their own devices
I can’t control how much everyone else chooses to fish – I just take that as given
Let’s let H denote how much everyone in the village except for me is choosing to fish
So now my problem is to choose my own fishing level, h, to maximize
h (100 – H ) – 12 h, or h( 88 – H – h)
If we take the derivative, it’s 88 – H – 2h
If we set that equal to zero, 2h = 88 – H
Now if everyone else in the village is solving the same problem as me and reaching the same conclusion, we’re all fishing the same amount, so H = 9h
So 2h = 88 – 9h, or 11h = 88, or h = 8 – we all choose to fish 8 hours per day
How happy does this make us?
Well, if we’re all fishing 8 hours a day, we’re catching 100 – 80 = 20 fish per hour, so 160 fish per day
Our costs are 8 hours * 12 fish/hr = 96, so net, we’re left with 64 fish of wealth per day

33. What’s going on here?
Fishing imposes a negative externality on other fishermen
Each one ignores this externality when deciding how much to fish…
…so they all end up fishing more than the efficient amount
Same thing happens with other communal resources
Cattle grazing, whaling, overhunting, oyster beds
Aristotle: “That which is common to the greatest number has the least care bestowed upon it”
Elinor Ostrom, who shared the 2009 Nobel Prize in Economics, studies how different societies solve this problem
Positive externalities work the opposite way
Activities which create positive externalities are naturally done less than the efficient amount
(Ostrom is a political scientist)
(We’ll see an example of positive externalities in a week or two – public goods)
(Think about people painting murals on public walls, or playing music on the street for free, or writing free software – people do it, but they do it less than the efficient amount, because the person doing it pays the entire cost of the activity, but only receives part of the benefit.
This is the reverse of fishing – with fishing, each fisherman receives the full benefit of the fish he catches, but doesn’t pay the full cost. People writing free iPhone apps pay the entire cost of the activity, but only receive part of the benefit.)

34. So externalities can lead to inefficiency
Without some sort of regulation/intervention…
Activities which impose a negative externality will tend to happen more than the efficient amount…
…and activities which impose a positive externality will tend to happen less than the efficient amount
One recurring theme we’ll see in this class:
if we want the law to lead to efficient outcomes,
we can try to design the law to eliminate externalities!
“Internalization”
(We’re not saying this problem is insurmountable – just that it’s a problem.
That is, that these are situations where just allowing people to do whatever they want may not lead to efficiency.
Or, where thoughtful regulation might potentially be able to improve on the outcome the “free market” would produce.)
That is, look for ways to force people to pay for the negative externalities they impose on others (or reward them for the positive externalities)
We call this “internalization” – when we change someone’s payoff function to eliminate an externality, we say they internalize the effects of their decision, which leads to efficiency

35. Other forces which lead to inefficiency
So externalities are one force that leads to inefficiency. What are others?

36. Another thing that leads to inefficiency: barriers to trade
Cuban cigars
Suppose I’d pay $15 each for Cohibas
They cost $2 each to make, and another $3 each to transport from Havana to Madison
Clearly, it’s efficient for me to smoke Cohibas
But trade embargo on Cuba makes it illegal for me to buy them
Anything that prevents me from buying something I want can be a source of inefficiency
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…)
Suppose I really like Cuban cigars – I value them at $15 each, but they only cost $2 each to make and $3 to transport here
Clearly, the efficient thing is for me to get my cigars
But we have a trade embargo with Cuba that makes that illegal
So, being a law-abiding citizen, I don’t get to smoke Cohibas – which is inefficient
Anything that prevents me from trading with someone who has something I want, is a potential source of inefficiency
And one approach we’ll see to property law is to encourage people to trade among themselves, in order to get a more efficient allocation of property
(This may seem like an obvious point; but then, there are lots of things we’re not allowed to sell:
Kidneys, sex, cocaine, babies, votes, nuclear weapons, unlicensed legal advice…
Of course, there may also be legitimate reasons for some of these things to not be tradable…
But in every one of these cases, there’s at least the possibility that by banning the sale, we’re ruling out some efficiency-enhancing trades)

37. Another thing that leads to inefficiency: taxes
I value my free time at $40/hour
Working in a factory, I can build things worth $50/hour
Clearly, it’s efficient for me to work
Each hour I work creates $10 of new value
Doesn’t matter who gets it – it’s efficient for me to work
But suppose there’s a 25% income tax
Factory owner can’t pay me more than $50/hour
But $50/hour pre-tax is only $37.50 after-tax…
…and I’d rather stay home than earn $37.50 an hour
So I don’t get hired – which is inefficient
Taxes can be seen as a type of barrier to trade
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%, there’s no wage they could pay me that I’d accept
If they pay me more than $50/hour, they’d be taking a loss
If they pay me less than $53.33/hour, my after-tax income is too low to make it worthwhile for me

38. Another example of taxes leading to inefficiency
This is a new BMW that’s been cut in half
Taxes distort behavior away from efficiency
Taxes can often be thought of as a barrier to trade
But taxes also lead to inefficiency in other ways – because they distort behavior
(People may take inefficient actions to get around taxes.)
There’s an entire industry, estate planning, dedicated to helping rich people find legal ways to work around the tax system
Another dramatic example, from the Ukraine
Ukraine has very high import duty on new cars
But import tariffs are much lower on “spare parts”
To import a BMW into Ukraine, people cut it in half, bring it through customs as parts, weld it back together
This is perfectly rational – they save enough on taxes that it’s worth it
But the cost of doing this, plus decrease in value of car, is a deadweight loss from the tax – or, an inefficiency

39. Another thing that leads to inefficiency: monopoly
(or private information)
Another thing that leads to inefficiency: monopoly
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 CS
P = 100 – Q
P* = 70
Profit
DWL
Another force that leads to inefficiency: monopoly power
(Example)
Although we can interpret this another way:
The problem isn’t that there’s a monopoly, the problem is that there’s private information
When a customer walks into the store, the monopolist can’t tell whether this is a customer who would be willing to pay $90 for the good, or only $50
Since the customer has private information, the monopolist can only charge the same price to everyone, which leads to some people who value it above marginal cost not getting to buy it
We’ll see private information (soon) as one of the things that leads to inefficiency
MC = 40
Q* = 30

40. But, saying these things lead to inefficiency doesn’t automatically mean they’re bad
For example
we just said taxes lead to inefficiency…
…but without taxes, there’s be far too few public goods, which is also inefficient
we just said monopoly leads to inefficiency…
…but we’ll study patents, which are legal monopolies used to encourage innovation
But also, we’ve defined “efficient”, but we haven’t claimed that “efficient = good”
Which brings us to…

41. Is efficiency a good goal for the law?
or, “should the law aim to be efficient?”
Jump

42. Important distinction: positive versus normative economics
positive statements are statements of fact
can be descriptive: “2014 U.S. GDP was $17 trillion”
can be theoretical predictions: “if prices rise, demand will fall”
“economics of what is”
normative statements contain value judgments
for example, “less inequality is better”
or, “government should encourage innovation”
“economics of what ought to be”

43. Most of this class will be positive analysis
Predicting behavior, and outcomes, that follow from a law or legal system is positive economics
“Law X will lead to fewer 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 is the normative goal of the legal system
“Law X is better than law Y”
One candidate for that normative goal is efficiency
(If efficiency is the normative goal of the law, then we can say that one law is better than another law if it leads to more efficient outcomes; or that we should design the law to achieve efficiency)

44. Friedman gives a few arguments for studying efficiency
“The central question [in this book]… is a simple one: what set of rules and institutions maximize the size of the pie? What legal rules are economically efficient?
There are at least three reasons why that is the question we ask.
The first is that while economic efficiency… is not the only thing that matters to human beings, it is something that matters quite a lot to most human beings.
The second reason is that there is evidence that considerable parts of the legal system we live in can be explained as tools to generate efficient outcomes… It is a lot easier to make sense out of a tool if you know what it is designed to do.
A final reason is that figuring out what rules lead to… efficient outcomes is one of the things economists know how to do –
and when you have a hammer, everything looks like a nail.”
- Friedman, Law’s Order, p. 312

45. Indeed, focusing on efficiency will make things much easier for us in some ways
All we care about is “final outcomes” – who ended up with what – not why
We can ignore the direct effect of monetary transfers
Suppose the law says if I hit you with my car, I owe you $3,119
Me paying you that money has no impact on efficiency
So we can ignore the transfer itself, and think only about its effects on our incentives 45 45

46. Another argument why policy evaluation should at least start with efficiency…
Let’s first dispense with the straw man. I’ve never heard of an economist who believes that every efficient policy is good, and I’ve heard of very few who believe that every inefficient policy is bad.
It’s true that most economists do seem to believe that any good policy analysis should start by considering efficiency. That doesn’t mean it should end there.
I think economists are right to emphasize efficiency, and I think so for (at least) two reasons. First, emphasizing efficiency forces us to concentrate on the most important problems. Second, emphasizing efficiency forces us to be honest about our goals.
– Steven Landsburg
Landsburg’s first point is that any time a law or a policy is inefficient, there is, in principle, a different policy that could be better for everyone
And the bigger the inefficiency, the more society potentially has to gain by correcting it
He acknowledges that we don’t always want efficient rules, and we certainly wouldn’t want a rule that always says, “do what’s efficient” – this could have huge problems
(He uses the example of Bill Gates getting a lot of joy from blasting his music loudly, which keeps you awake at night
If Bill Gates is willing to pay $10,000 to blast his music, and it only costs you $1,000 to endure the noise, efficiency says he should play his music
BUT we don’t want a law that says, “Noise is OK as long as it’s efficient”
because then Gates might lie about how much enjoyment he gets from music,
and you might lie about how much the noise bothers you,
and you might even move closer to his house so you can find more things to complain about
The point is just, wherever there is inefficiency, there is the potential to improve outcomes;
and the size of the inefficiency gives us an idea of how big the stakes are) 46

47. “Emphasizing efficiency forces us to be honest about our goals”
Politician: Here’s my program to make the health care system work better by subsidizing health care for the poor.
Economist: Your program costs a billion dollars and delivers half a billion dollars worth of benefits. That’s inefficient.
Politician: So what?
Economist: Well, the “so what” is that maybe you could take that billion dollars and deliver a full billion dollars worth of benefits instead if you spent it a little differently. Why not just hand the cash out to poor people?
Politician: Because I don’t want to help all poor people. I only want to help sick poor people – and this is the only way I can think of to do that.
Economist: Ah. So your goal here is not to make the health care system work better at all. Instead it’s to transfer resources to sick poor people.
Politician: I guess so.
Economist: That’s fine. Now we can have a healthy debate about whether that’s what we want to do.
To explain the second point, Landsburg gives a hypothetical conversation between an economist and a politician, to show how efficiency analysis strikes down political smokescreens
Again, his point is not that all inefficient policies are bad…
…just that an inefficient policy only makes sense if it’s serving some other important purpose,
and starting with efficiency forces us to be clear about what that other purpose is 47

48. But… This answers the question, “Why should we study efficiency?”
Not the question, “Should the law be designed with the goal of achieving efficiency?”
We’ll tackle this latter question on Wednesday
Jump

49. Up next
Where we’re headed next: Richard Posner, “The Ethical and Political Basis of Efficiency Norm in Common Law Adjudication”
For a counterpoint to Posner: Peter Hammond, “Review: The Economics of Justice and the Criterion of Wealth Maximization”
After that, we’ll get to: Ronald Coase, “The Problem of Social Cost”
Wednesday, I’ll be showing an example of how “narrow taxes distort more than broad-based taxes” The example is online as a “fake homework”
See you Wednesday! 49 49