1. Econ 522 Economics of Law
Dan Quint
Spring 2013
Lecture 2

2. Logistics TA sections begin this Friday
“Fake homework” for Wednesday on website
If you want to read ahead, look at Coase, “The Problem of Social Cost,” but we probably won’t get to it till next week

3. 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

4. Today: efficiency 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?

5. What is “efficiency”?

6. First concept: Pareto improvement
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
To build up to efficiency, we need a few other concepts
We begin by defining a Pareto improvement
a Pareto improvement is any change to the economy which leaves…
everyone at least as well off, and
someone strictly better off
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 worth $3,000 to you and $4,000 to me
I buy it from you for $3,500  Pareto-improvement
I’m better off (I prefer the car to $3,500)
you’re better off (you prefer $3,500 to the car)
everyone else is indifferent
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 ( )

7. 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

8. Next concept: Kaldor-Hicks improvement
a Kaldor-Hicks improvement is any change to the economy which could be turned into a Pareto improvement with monetary transfers
also called potential Pareto improvement
car example again
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
combined with me giving you $3,500, it’s a Pareto improvement
so me getting your car is a Kaldor-Hicks improvement
a Kaldor-Hicks improvement may create winners and losers, but gains outweigh the losses
I’m $4,000 better off, you’re $3,000 worse off, $4,000 > $3,000
a Kaldor-Hicks improvement is any change to the economy which could be turned into a Pareto improvement by moving money around
these are also known as potential Pareto improvements
example from before
your car is worth $3,000 to you and $4,000 to me
I buy it for $3,500  Pareto-improvement
the government seizes your car and gives it to me  Kaldor-Hicks improvement
I’m better off and you’re worse off
But the change could be turned into a Pareto improvement by transferring $3,500 from me to you
So it’s 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)

9. 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 – it makes you and your guests better off, makes me worse off
Is the party a Kaldor-Hicks improvement?
Yes – because the party, combined with the appropriate money transfers, would be a Pareto improvement
(Example: you throw the party, you give me $40, each of your guests gives me $3 – that’s a Pareto improvement)
Another example

10. To check if something is a Kaldor-Hicks improvement, we can…
look for transfers that turn it into a Pareto-improvement…
…or, just count up the gains of the winners and the losses of the losers, and see which is bigger
a change in the economy is a Kaldor-Hicks improvement if the winners’ gains outweigh the losers’ losses
if you have the party…
I’m $100 worse off
You’re $50 better off
30 guests are each $5 better off
– $100 + $ X $5 = $100 > 0
Gains outweigh losses, so party is a Kaldor-Hicks improvement
(“the party created $100 in value”)
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, in dollar terms, and see which is bigger
if the government gave me your car…
you are $3,000 worse off
but I’m $4,000 better off
if nobody else is affected, since $4,000 > $3,000, this is a Kaldor-Hicks improvement
if I have 10 neighbors, and they’re each $50 worse off because I park it on the street…
then my gain of $4,000 still outweighs your loss of $3,000 plus their loss of $500
so it’s still a Kaldor-Hicks improvement
Kaldor-Hicks improvements make some people better off and some worse off, but the gains outweigh the losses
so at least in theory, the winners could “pay off” the losers and make everyone better off than before

11. 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

12. 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”

13. Example: is it 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 or not you compensate me
Even if “my slice of the pie” is smaller, overall pie is bigger…
…which is all that efficiency is concerned with

14. Another 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

15. 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’”
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

16. 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

17. To see whether something’s efficient…
Compare gains to everyone in society (total social benefit)…
…to costs to everyone (total social costs)
Example we already saw (me driving to work):
Total social cost = $1 (gas) + 1,000 X $0.01 = $11
Total social benefit = whatever 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

18. 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 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

19. 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

20. 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 an externality on everyone else
So everyone ends up fishing more than the efficient amount

21. Tragedy of the Commons – example
20 fishermen
Cost of fishing is 8 fish per hour
Notation
h = how many hours I fish
H = combined hours everyone fishes
H = hours everyone but me fishes
Fishermen catch 260 – H fish per hour
What is the efficient level of fishing? How much utility does that give to each fisherman?
6.3 hours per day per fisherman; fish/day
Left to their own devices, how much will each person fish? How much utility will each person get?
12 hours per day per fisherman; 144 fish/day
Total fish caught
“Maximum Sustainable Yield”
H (260 – H)
Efficient Level of Fishing
“Equilibrium” Level of Fishing 3 6 9 12
Hours fishing, per day, per fisherman
One way to think about efficiency: 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?
Each fisherman’s payoff will be h (260 – H) – 8h, so if we add them all up, everyone’s combined payoff will be H(260 – H) – 8H
H ( 260 – H ) is the total number of fish caught, 8H is the total amount of time/effort/disutility spent fishing
To maximize this, we can take the derivative and set it equal to zero
Derivative is 260 – 2H – 8 = 252 – 2H, so maximized at H = 126
We maximize total combined payoffs by having people fish a combined total of 126 hours per day, or 126/20 = 6.3 hours per day per fisherman
That means they catch 260 – 126 = 134 fish per hour, so each fisherman catches 6.3 * 134 = fish per day, get 8 * 6.3 = 50.4 disutility from fishing, for payoff of fish/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 794 fish per day
But how much will people fish if they’re left to choose for themselves?
My payoff is h (260 – H) – 8h, or h (260 – H – h) – 8h
Derivative = 260 – H – 2h – 8 = 0
Since H = H + h, we can write this as 252 – H – h = 0, or h = 252 – H
So everyone will fish the same amount, so H = 20h, and 21h = 252, so h = 12
So everyone in town fishes 12 hours a day
So H = 240, and we all catch 260 – H = 260 – 240 = 20 fish/hour
So we each fish for 12 hours, and catch 240 fish; and we each get disutility of 12 X 8 = 96 fish from fishing; so we each get utility of 144 fish
So the situation is very inefficient
Due to the externality, everyone’s getting a payoff of 144 fish
But if everyone worked less, everyone would get a much higher payoff

22. 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.)

23. So externalities can lead to inefficiency
Without some sort of regulation/intervention…
Activities which impose a negative externality will be done more than the efficient amount…
…and activities which impose a positive externality will be done less than the efficient amount
One idea we’ll see several times in this class:
if we want the law to lead to efficient outcomes,
we can try to design the law to eliminate externalities!
“Internalization”
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

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

25. 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 Cuba 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)

26. 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 if income tax is 25%, then it won’t happen
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

27. Another example of taxes leading to inefficiency
This is a new BMW that’s been cut in half
Taxes distort behavior away from efficiency
Pictures are 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

28. 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

29. 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 get companies to innovate
But also, we’ve defined “efficient”, but we haven’t claimed that “efficient = good”
Which brings us to…

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

31. Important distinction: positive versus normative economics
positive statements are statements of fact
can be descriptive: “in 2007, U.S. GDP was $13.8 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”

32. 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 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 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)

33. 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
There’s definitely some truth to this last bit – focusing on efficiency will make our analysis much simpler in a lot of ways

34. But…
This answers the question, “Why is it interesting to study efficiency?”
Not the question, “Should the law be designed with the goal of achieving efficiency?”
To answer this latter question…

35. Posner gives us one argument why the law should aim to be efficient
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 one argument why the law should aim to be efficient
Posner is an appeals court judge, and teaches at the U of Chicago law school
Paper on the syllabus: The Ethical and Political Basis of Efficiency Norm in Common Law Adjudication
(he also has a book, “Economic Analysis of Law”)
Begins with the observation: if you buy a lottery ticket and don’t win anything, you can’t complain
By making the bet, you accepted the possible consequences in advance
Even if you don’t win, you’ve already decided you’re content to live with that outcome
You were “compensated ahead of time” for the possibility that you wouldn’t win, by the possibility that you would
Now, imagine before we all started driving, everyone in the world got together and negotiated a liability rule for traffic accidents
People don’t yet know whether they’ll be victims or injurers
Assume everyone is the same age, equally good drivers, etc.
If one liability system is more efficient than another, we’d all vote for that one ex-ante
If I’m driving and hit a bicyclist, I’ll be upset that I live in a world where drivers are liable for accidents they cause
But if that system is more efficient, I would have supported it before I knew which side I’d be on
Posner calls this ex-ante consent

36. Ex-ante consent – simple example
Suppose there are two candidate rules for accident liability
One favors pedestrians, one favors drivers
The one favoring car drivers is more efficient
Posner’s point: before we know who we’ll be, everyone would unanimously agree to the second rule
Expected payoff, drivers
Expected payoff, pedestrians
Expected payoff if you don’t know which one you’ll be
Strict liability rule
-100
-50
Once you’ve already been hit by a car, you don’t care which system is more efficient – you prefer the one that gives you a higher payoff
So you’d rather live in a world with a strict liability rule
But Posner’s point: before the accident happened, if we didn’t yet know which role we’d play (injurer or victim), we’d both prefer a negligence rule
That is, if one rule is more efficient than another, then we’d all agree to it ex-ante
He refers to this as ex-ante consent
So, we both agree society should be governed by a negligence rule
Once you’re hit by a car, you don’t regret your choice
Because you were compensated for it ex-ante – you were compensated for your lower payoff when you’re a victim, by the promise of a much higher payoff if you’re an injurer
This is the lottery ticket analogy: if you buy a lottery ticket and lose, well, that’s life.
He also points out that if you’re that concerned with your payoff if you’re a victim, you can buy accident insurance – and if a negligence system is more efficient, you’ll still be better off ex-ante than under strict liability
So Posner’s idea: we were all compensated ex-ante for the choice of the more efficient system.
And therefore, it’s as if we all consented to it
Negligence rule
-20
-60
-40

37. Things are a little more complicated…
People without cars would prefer a less efficient system if it meant drivers were responsible
Posner deals with heterogeneity with a different example
Landlord-friendly versus tenant-friendly laws
Might think tenants would prefer pro-tenant laws
But rents are determined competitively
If laws become more tenant-friendly, rents might go up to compensate
And if tenant-friendly law is less efficient, it could make both sides worse off!
The argument gets a bit more complicated when people aren’t all homogeneous
If everyone has the same likelihood of being the driver or the victim, maybe this argument is convincing
But some people don’t drive cars, but still get hit by cars
Posner deals with heterogeneity with a different example
There’s one law which is more favorable to tenants, and a different law that’s more favorable to landlords and more efficient
You might think tenants would prefer the first law, landlords the second
But rents are set in a competitive market
If we switch to the tenant-friendly law, rents would probably go up to compensate
And if the tenant-friendly law is less efficient, it might make both sides worse off – so even tenants would have agreed ex-ante to the other one

38. Example: new law requiring landlords to pay for their tenants’ heat
Suppose tenants get $1000 value from apartment, minus rent
Landlords pay $100 for heat, $600 in other costs
Without this law, tenants would pay for their own heat
They’d heat apartment less, get $980 value and pay $60 for heat
Might think tenants would prefer inefficient tenant-friendly law…
But rents are set competitively, would go up to compensate…
So both landlords and tenants do better under the old law!
Tenants’ payoffs
Landlords’ payoffs
Tenants
Landlords
Landlord pays for heat
1000 – rent
rent – 600 – 100
1000 – 850 = 150
850 – 600 – 100 = 150
Tenant pays for heat
980 – 60 – rent
rent – 600
980 – 60 – 760 = 160
760 – 600 = 160

39. Ex-ante consent, ex-ante compensation
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
Of course, all this consent is hypothetical…
…and it does have certain limitations
Posner’s basic idea is that, even if we end up being losers under this system, we were “compensated ex-ante” by the possibility of being bigger winners
If you buy a lottery ticket and you lose, you were compensated ahead of time for that loss – by the possibility that you would win
As members of society, all of us were compensated ex-ante for choosing the efficient rules, since these were the lottery tickets with the highest expected value
Of course, this consent is all hypothetical
No one actually called a giant meeting of everyone (living, dead, not yet born) to vote on a liability rule
But if they had, they’d agree to the more efficient rule
Think of it as deciding between two lottery tickets and choosing the one with the higher expected value
So, Posner argues, if we choose the most efficient legal system, everyone is “compensated ex-ante” for the choice, and should willingly accept the outcome they get

40. Limitations to Posner’s argument
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
The “lottery ticket” analogy requires risk neutrality
Implicitly, it assumes that a 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: review of Posner’s book by Peter Hammond (1982)
Efficiency is a special case of utilitarianism
Utilitarianism: to decide what society should do, take everyone’s individual utility function, add them up, maximize the sum
Problem: classical utility theory doesn’t allow comparisons across different individuals (utility has no natural “scale”)
Efficiency gets around this problem by assuming someone’s value for something equals their willingness to pay for it
That is, it assumes $1 is worth the same to everyone

41. This highlights some of the things efficiency is not
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
recall that efficiency equates utility (or how much society wants you to have something) with your willingness to pay for it
efficiency is not equity
efficiency is only about how much wealth exists, not how it is divided up
laws favoring businesses over consumers, or rich over poor, may be efficient, but still may not be socially desirable
(again, if $1 is more valuable to someone poor than someone rich, efficiency can’t account for this)
efficiency is not fairness
for one thing, efficiency considers only outcomes, not process
who has how much matters, but not whether they got it by working hard, or by being lucky, or by having light-colored skin…
a law might be efficient but violate our intuitive notions of right and wrong
example from before: might be efficient for government to seize your car and give it to me, but this might strike you as wrong or unfair
another example: this class is full, several people on waiting list
efficiency: whoever is willing to pay most for a spot in the class, values it most, should get it
how about I auction off the last few seats in the class, and keep the money?
leads to efficient allocation – the “right” people end up in the class
but probably not a rule we want to encourage
Poletown Neighborhood Council v. City of Detroit (early 1980s)
efficiency is not maximizing happiness
by equating value with willingness to pay, efficiency ignores the possibility an incremental dollar might mean more to someone poor
and it ignores the possibility of “really really really wanting something” but not being able to afford it
example: suppose I need a heart transplant, but could only pay $500,000 for a heart, and some rich guy thinks it would be cool to have a human heart in a box, and is willing to pay $1,000,000
a creepy example from Posner, Economic Analysis of Law:
(part of the problem here is the distinction between willingness to pay for something you don’t have, and willingness to accept an offer to sell something you already have. efficiency doesn’t really distinguish between these two ways of valuing something; when they’re not equal, it’s hard to make sense of things.)

42. A more pragmatic defense of efficiency as a goal for the law
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
Cooter and Ulen (textbook ch. 1)
Efficiency should not necessarily be the goal of society
Redistribution/supporting the poor may be an important social goal
(We may recognize that $1 is “worth more” to someone with very little than it is to someone with a lot, and we may want society to redistribute wealth in that direction)
But even so, efficiency should still be the goal of the legal system
Even if some redistribution is desirable, it’s better to make the legal system efficient, and address distribution through the tax system
Cooter and Ulen offer four reasons why the tax system is a better way to redistribute wealth than the legal system

43. Four reasons the tax system is a better way to redistribute wealth than the legal system
1. Taxes can target “rich” and “poor” more precisely than the legal system can
Distributional effects of legal changes are harder to predict
Lawyers are more expensive than accountants
More narrowly-targeted taxes cause greater distortion than broad-based taxes
1.Taxes can target “rich” and “poor” more precisely than legal system can
If we tried to redistribute wealth through the legal system, we’d have to target broad classes of people
For example, we could pass laws that favor consumers over corporations, or patients over doctors
But some consumers are rich, and some shareholders in corporations aren’t that rich
Taxes are based on income or assets – tied directly to wealth
2.Distributional effects of legal changes are harder to predict
Example we saw before: suppose we try to redistribute wealth by passing laws which are more favorable to tenants
But rental prices might go up to compensate, leaving tenants worse off than before
3.Lawyers are more expensive than accountants
(or really, transaction costs are higher when we try to redistribute via legal system instead of taxes)
4.More narrowly-targeted taxes cause greater distortion
Laws designed to redistribute wealth would be more narrowly targeted: liability laws that are unfavorable to drivers with expensive cars, or to plastic surgeons
These would function like narrowly-targeted taxes – a tax on Lamborghinis, or a tax on being a plastic surgeon
Income taxes tax wealth directly (very broad)
The ponit: narrow taxes cause greater distortion  greater deadweight loss
If you tax bagels, people buy donuts instead
This distortion leads to a greater loss of utility than if you taxed everything, and people just consumed a tiny bit less of everything
We’ll see an example of how this works on Wednesday

44. So, summing up… is efficiency a good goal for the law?
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”

45. For Wednesday…
One argument from C&U for why law should focus on efficiency, redistribution should be done through taxes:
“narrow taxes cause more distortion than broad taxes”
Wednesday, we’ll work through an example of this
“Optional homework problem”
If you want to read ahead, look at Ronald Coase, “The Problem of Social Cost” (although we probably won’t get to Coase till next week)
See you Wednesday!