1. Assignment for Next Class (Double Class)
Agenda for 15th Class
Admin
Slides
Double class on Friday 1-3PM, Rm 101
Prisoners’ Dilemma and Collective Action Problems
Cleaner Skies
Introduction to Information
Assignment for Next Class (Double Class)
## 61-64
Questions to think about
P. 253ff Qs 4 (WG4) and 5 (WG1)
P. 273 Qs 1 (WG2) and 3 (WG3)
King v Burwell (Obama Care case), #129 (pp )
pp Qs 1 (WG1), 2 (WG2), 4 (WG3), 5 (WG4), 7 (WG1), 11 (WG2)

2. Mid-Semester Feedback
People liked
Discussion and debate
Readings, materials, and varied topics
Interesting and helpful to other classes and law in general
People wanted
Shorter writing assignments
Ending Monday class on time so have break before Contracts
No Consensus
More / less lecture/discussion
More / less econ

3. Last Class -- Sarnoff Application by of Coase Theorem in real case
How negotiations between parties can unlock value
Negotiate around covenant not to compete, when new business is very profitable
Person bound by covenant can offer to pay to be relieved of covenant
Lawyer as transactions costs engineer
But also problems that could impede value-enhancing negotiation
Lack of access to capital
Disagreement about how profitable new business would be

4. Prisoners’ Dilemma Dominant Strategy. Nash Equilibrium
Suspect 2
Confess
Keep quiet
Suspect 1
-5, -5
-1, -7
Keep Quiet
-7, -1
-2. -2
Dominant Strategy. Nash Equilibrium
Each suspect imposes negative externalities on the other
Parties cannot communicate, so transactions costs high, so parties do not reach efficient result

5. Pollution Externalities Game
Firm 2
Pollute
Install
Firm 1
-4000, -4000
-2000, -5000
-5000, -2000
Almost identical to Prisoners’ dilemma
If numbers small, might expect agreement to install pollution control
When numbers large, negotiation very difficult
Collective action problem
Everyone better off if everyone installs pollution control equipment
But each person better off if free rides
Better to not install pollution control equipment, if everyone else does

6. Collective Action Problems
Collective Action Problems are ubiquitous
Becoming informed voter, voting
Funding public goods, e.g. fire departments, bridges, national defense
Global warming
Fishing
Every collective action problem is also an externalities problem
Sometimes groups can resolve
Political lobbying by interest groups
Democracy
Voluntary organizations
Clubs
Often government is only or best solution
When numbers are large, transactions costs are high, so legal rules matters

7. Cleaner Skies

8. Information Efficiency of competition assumes perfect information
Imperfect information is a transactions cost
Efficient allocation of resources may be impaired by imperfect information
Imperfect information (like externalities) is ubiquitous
When law school and student choose each other
Law school doesn’t know how smart or hardworking students are
Students don’t know how good school is
Law school tries to gather info – admissions process
Students try to gather info – US News, campus visits, blogs
But information gathering is expensive and imperfect
When promisor breaches
May not know how much harm will cause promisee
May not know whether judge will find breach or not
Judge or jury may not know whether breach intentional or accidental
Judge or jury may not know whether promisee could have mitigated damages
Discovery and trial try to get answers to these questions, but expensive and not completely accurate

9. The Market & Information
Market corrects or mitigates some informational problems
Product markets
Consumer Reports, Angie’s List, Amazon consumer reviews, EBay ratings, etc.
Insurance
Medical exam before life insurance
Loan markets
Credit ratings, loan applications
Schools (see previous slide)

10. Information & the Law Much of law is concerned with information
Litigation is principally about production of information
Much consumer regulation is forced disclosure of information
Nutritional labeling
Securities Law
Prospectus before initial offering
Quarterly reporting of profits
MPG for cars
APR for loans and savings instruments
Contract law
Limitation of damages to those which are “forseeable” forces promisee with high damages to disclose (Hadley v Baxendale)
Product liability law makes price of product reflect producer’s estimate of expected liability
Expected liability likely (otherwise) unknown to consumer
Title recordation in Property law

11. Moral Hazard Insurance context Contracts generally
Insured has suboptimal incentive to take precautions
If insured against fire, may not install sprinklers or be as careful with fireplace
If have health insurance, may not be as careful to eat right or exercise
If have health insurance, may request treatments that unlikely to be effective
Tort law is form of insurance
Product liability may make consumers less careful
Duty to rescue may make parents (and others) less careful
Government programs are a form of insurance
Welfare may dull incentive to work
Income tax may dull incentives to work
Contracts generally
After contract entered into, party may have incentive to act in way that is detrimental to other party
Employee may not work hard
Lawyer paid by hour may spend too much time on project
Renter may not take good care of apartment

12. Responses to Moral Hazard
Gather information
Moral hazard is result of fact that insurer does not know how insured is behaving
If insurer knew, then could condition insurance on insured behaving properly
Insurer’s “monitor” insured
Fire insurer may inspect home for smoke detectors, brush clearance, roof materials, etc
Government monitors welfare recipients, requires job search, etc.
Deny insurance if precautions not taken
Comparative/contributory negligence in tort
Insurance exclusion for arson
Fire employees if shirk
Build incentive into contract
Insurance seldom covers full cost of hazard
So insured has some incentive to take precaution
Employer can make pay proportional to output
Government regulation seldom helpful
Government doesn’t usually have superior information
But sometimes can help
By using information gathering of criminal law
By threatening larger penalties (e.g. imprisonment)
E.g. imprisonment for securities fraud

13. Moral Hazard, Coase Theorem, & Externalities
Cost of obtaining relevant information is transactions cost
If info could be obtained costlessly, moral hazard wouldn’t exist
Since info is expensive, inefficiency may result
Moral Hazard is kind of externality
Insured imposes costs on insurer
Employee imposes costs (or less benefit) on employer
Sometimes not considered an externality, because
Insured and insurer are in contractual relationship
Employer and employee in contractual relationship

14. Principal-Agent Problem
Many situations where one person (agent) works for another (principal)
Lawyer works for client
Employee works for employer
Promisee works for promisor
Problem
How get agent to act in interest of principal
Problem is often moral hazard
Agent can take actions which adversely affect prinicipal (not work sufficiently hard (shirking), damage equipment, etc.)

15. Responses to Principal-Agent Problem
Monitoring
Terminate contract if agent shirks
Performance-based contract
Pay agent in accordance with some measure of performance
Contingent fee for lawyer
Plaintiff’s lawyer gets 1/3rd of damages, if prevails
Piece work
Pay CEO in stock or option
Bonuses for good performance evaluations
Input-based contacts
Hourly fee or wage
Cost-plus construction contracts
Fixed fee contracts
Salary
Best contract depends on circumstances
Incentive contract -- if performance easy to measure
Fixed fee – if repeated interactions or agent is very concerned about reputation
Input based – if cost unpredictable, agent is risk averse, and efficiency can be monitored

16. Adverse Selection I
Markets may fail where one side lacks information and thus sets prices based on average
Thus inducing those who are above average to leave the market (b/c price not attractive to them)
Classic example: Insurance
If insurer has imperfect information
Insurance priced at average risk
But person who knows low risk may then decide not to insurer
But that raises average risk of those still buying insurance
Thus raising prices
Causing more people to drop out of insurance market
Examples
Health insurance
Product liability/warranty, if voluntary
Those who are careful may opt not to purchase warranty
Thus raising average risk and cost…

17. Adverse Selection Example I
Suppose 2 people want life insurance
A is smoker, 10% probability that will die next year
$10,000 expected cost to insurer for $100,000 policy
A is willing to pay $11,000 for insurance
B is non-smoking marathon-runner
1% probability that will die next year
$1,000 expected cost to insurer for $100,000 policy
B is willing to pay $2000 for insurance
If insurer can’t get credible information on smoking and exercise habits
Price for insurance, if both A and B are both buying insurance must be at least, $5500 (average of $10,000 and $1,000)
But then insurance is not worthwhile to B

18. Adverse Selection II Lemons problem
Used car purchaser has imperfect information
Willing to pay price that reflects average used car quality
But person who has above average quality used car doesn’t want to sell at average price, so doesn’t sell
But that lowers average quality and thus price, leading more used car owners not to sell
Other examples
Loans for new businesses

19. Responses to Adverse Selection
Ex ante information gathering
So can price product in accordance with individual characteristics, rather than market average
Life insurance – blood pressure and cholestoral screenings, different rates for smokers, etc.
Health insurance – exclusion of preexisting conditions
Inspection and certification of used cars
Warranties
Reputation
Mandatory insurance
So no one can drop out of market
Health insurance “mandates” / universal coverage