2. Questions on Tuesday Class?

3. Two Senses of Utility Philosopher’s Sense (Bentham) Economist’s sense
How happy it makes me feel
Only “happy” is too simple
How much I get what I value
What utilitarians want to maximize
Economist’s sense
What I prefer
As shown by what I choose

4. Why? The more I have of something, the less valuable one more is
Because I spend money first on what is most important, so each additional dollar is buying a good I value less
Neither of these is rigorously true
The fourth tire for my car is worth more than the third
There might be something very valuable, the cure for the disease that is killing me, that costs $50,000. So I would value $50,000 over $40,000 by more than $40,000 over $30,000

5. So if I had $40,000, I would be willing to bet $10,000 on a coin flip.

6. Which gets us to Von Neumann Utility
A gambler who will make the same bet many times accepts it if the expected value in money is positive–on average it is a winning gamble.
Von Neumann generalized the idea to: An individual faced with a gamble accepts it if the expected value in utility is positive
Risk Averse: Prefer a certain outcome to a gamble with the same expected value. Which means that declining marginal utility of income = risk aversion

7. DMU=Risk Aversion

8. “Risk Aversion”=DMU(I)=Risk Aversion in Income
One might be risk averse in income, risk preferring in length of life.

9. If You Find This Stuff Really Interesting
Chapter 13 of my Price Theory is Webbed

10. DMU and Income Redistribution
If marginal utility of income is lower the higher one’s income
A transfer from rich to poor raises total utility
Which, for a utilitarian, is an argument for income redistribution
But …

11. Two Problems With that Argument
The argument for DMU does not apply that the marginal utility of the rich man is lower than the poor man because they are different people and might have different utility functions
Redistribution is not costless

12. Different Assumptions, Different Conclusions
Everyone has the same utility function, different opportunities to earn money. —> DMU across people
Everyone has the same opportunities to earn money, different utility functions. —>Rich have a higher value for an additional dollar than poor
That is why they are rich

13. The Cost of Redistribution
Reduces the incentive to do productive things for both rich and poor, since earning an extra dollar only increases consumption by (say) $.80
Rent Seeking more generally. Increases the incentive to:
Lobby to increase or decrease redistribution
Spend resources figuring out how to reduce your taxes
Spend resources figuring out how to increase your subsidy
How important that is depends on elasticity at both ends. How sensitive is the transfer you make or get to your efforts.

14. Conclusion: For a Utilitarian
Increase the amount of redistribution until the utility loss from the cost of an additional dollar redistributed just balances the utility gain due to DMU(I)

15. Utilitarian Argument for Economically Efficient Law
Redistribute via tax and transfer to the optimal level as per the previous slide
An inefficient legal rule designed to help the poor has the same costs as direct redistribution, which just cancel the utility gain
Plus an additional cost because it is economically inefficient—gains less than losses

16. Risk, Insurance, and all That
Lots of legal rules allocate risk
Insurance allocates risk, and does it by voluntary transactions
If individuals are rational, and my choice mostly affects me …
Insurance should produce the right result
Which helps us figure out how the law should allocate risk

17. Why Not Insure 100% Against All Risks?
Cost of Insurance: Moral Hazard
(Also rent, wages, cost of preventing fraud, …)
To balance against benefit from DMU(I)

18. Moral Hazard Even higher at 150%
Another example of the net cost due to an externality
Once I am insured, my precautions partly benefit me, partly the insurance company
So I take a less than optimal level of insurance—do not spend a dollar unless it saves me substantially more than a dollar
The cost becomes very high if I am insured 100% against my factory burning down.
Even higher at 150%

19. Co-insurance Consider a jointly caused risk
I can take precautions, the insurance company can inspect and suggest or require precautions, it knows more about fire than I do
With zero insurance, it has no incentive
With 100% I have no incentive
With 50%, we both have a less than ideal incentive
But …

20. Co-insurance: The Second Order of Smalls
I will miss some precautions, but only the ones that are worth taking but not very worth taking—benefit less than twice cost
They will miss precautions, but only …
So each of us misses the less important precautions
Instead of one of us missing all, including the more important ones

21. Adverse Selection: The Market for Lemons
Half the used cars are cream puffs, half are lemons
The seller knows which is car is, the buyer does not
Buyers offer a price based on a 50/50 gamble, but …
At that price, all the lemons sell, some of the cream puffs don’t
So the odds of getting a lemon are really more than 50%
Buyers recognize that, so don’t offer a price based on 50/50
And at the lower price, fewer owners of creampuffs are willing to sell
In the limit, all lemons sell at a lemon price, no creampuffs sell

22. Can Knowing More Make Us Worse Off? Genetic Testing
Genetic Testing Makes Genetic Risk Uninsurable
You can’t make a bet after the dice have been rolled
The reason insurance is not a complete substitute for income redistribution
What about unemployment insurance?

23. The Obamacare Mandate and Adverse Selection
One solution: Force everyone to buy
The other: Don’t create adverse selection by forbidding insurance companies from pricing on the basis of expected cost to them.
Problem: The perceived unfairness of some people having large medical costs
Solutions?

24. Problems at the end of the Chapter
Tenant’s property burns down
Land bought by fraud and resold
Land sold with forged deed

25. Ex Post-Ex Ante: Questions on Chapter 7

26. Ex Post/Ex Ante: The Idea
In Ordinary Life
Should I go home by 880 or local streets?
Should I have bought that lottery ticket?
Should you have gone to law school?
In Employment
Do we pay salesmen by the hour?
Or by a commission on each sale?
In The Context of Law and incentives
Do we punish bad outcomes, or
Inputs that produce them?

27. Why Punish Attempts?
Why are you arresting me? The bullet hit the tree.
The man I was shooting at is fine
The tree is fine
To stack an ex ante punishment on an ex post punishment
Why?
Because we are not willing to impose an adequate ex post punishment

28. Digression: The Athenian Rule
Suing an innocent person imposes a risk on him
Because courts make mistakes
So he might be found liable even though he is not
If he is acquitted that risk does not eventuate, but …
That’s when we “know” he was innocent
So make the losing plaintiff owe damages to the defendant
Consider it as a solution to the “Patent Troll” problem

29. Advantages of Ex-Post Punishment
Exploits actors private information
I can monitor myself at no cost
And can see and know things the external regulator cannot
Rather like the advantage of an effluent fee over regulation
Which is also an ex-post punishment
Court can observe damage instead of guesstimating p and damage
Probably lower enforcement costs
easier to spot crashes than speeders
and a lot fewer of them

30. Disadvantages of Ex-Post Punishment
Wrong. Punishment prevents by deterrence
We want to prevent, not punish?
Ex-post requires large punishment with low probability
People are risk averse
And may be judgement proof
And non-monetary payments are inefficient
But there is an organ shortage … (We will return to this)

31. Why There Should Not Be Pure Ex-Ante Systems
A Small ex-post punishment does not have the problems of ex-post
Does have the advantages
So why not always supplement ex-ante with ex-post?
Are there any counter-examples?

32. Ex Post + Insurance Could Provide a Market Mechanism to Generate Ex-Ante Rules
To drive, I require adequate liability insurance
The insurance company can set any rules it wants as a condition
So makes the optimal tradeoff between risk aversion and moral hazard
How do we enforce the rules?
Convert traffic cops into private contractors enforcing the contract
Uber for (private) speeding fines?

33. Should We Punish Voodoo Killers?
More generally, should we punish impossible attempts?
In some sense, all failed attempts were impossible
So this brings us back to “should we punish attempts.”

34. The Moral Argument for Punishing Attempts
Punish on the basis of moral guilt
Being a bad shot is not a moral virtue
Which brings us to the problem of moral luck
Should you think worse of an ex-Nazi concentration camp guard than of someone who would have been one
If he happened to be born in that time and place?

35. To Think About Why is Marriage Different?
Why are patent law and copyright law so different?
Why are some torts strict liability, some negligence?
How, in principle, do you set the punishment for a crime?
Why do we have both criminal law and tort law?