Economic Analysis of Law                                                                                 Spring 2009


(you may omit any complete question or questions for 20% credit)

I. Explain in your own words what it means to describe one outcome as more efficient than another.      (5 pts)

II. Externalities     (15 pts)

A. Why are external costs a problem? What about external benefits?

B. What is the Pigouvian approach to dealing with externalities? What are its advantages over direct regulation? How would Pigou deal with external benefits?

C. Explain, in your own words, Coase's critique of Pigou. Give an example of a situation where applying the Pigouvian approach makes the outcome less efficient than doing nothing. (Use the back of the page if necessary)

III. A factory pollutes a lake which is also used by twenty vacation resorts. It would cost the factory $1,000,000 a year to prevent the pollution. Each resort faces the following alternatives (remember that there are twenty resorts):

a: Operate as a resort on an unpolluted lake, making $100,000/year profit.
b: Operate as a resort on a polluted lake, making $40,000/year profit.
c: Operate as a hunting lodge, making $60,000/year profit, whether or not the lake is polluted

A. What is the efficient solution? Circle the correct answer.    (5 points)

The factory should (pollute/not pollute)

The resorts should be operated as (resorts/hunting lodges)

In answering parts B and C, describe first what happens if there is no bargaining between factory and resort owners, and then whether bargaining will change the outcome. Explain briefly.

B. The factory has the right to pollute if it wants to and is not liable.     (5 points)

C. Any resort can enjoin the pollution, so the factory can only pollute if it has permission from all the resorts.    (5 points)

IV. Pick one of the following pairs of alternatives. explain what they mean and the advantages of each, and give a real world example of each. Use the back of the page if necessary.    (10 points)

A. Ex post vs Ex ante enforcement

B. Rules vs Standards

C. Property rules vs liability rules

V. Pick one of the following and explain it:     (10 points)

1. Hawk/Dove equilibrium: What determines the percentage of hawks (bullies) in equilibrium? What does this have to do with the question of whether crimes of passion, such as killing someone in a blind rage, can be deterred?

2. Prisoner's Dilemma: Explain the argument for why the existence of plea bargaining might make criminals worse off. Would the argument still hold if transaction costs among defendants were zero? Explain.

VI. Briefly explain two of the following ideas, in each case giving one example of its relevance either to designing an insurance contract or to choosing a legal rule.
    (10 points)

1. Risk aversion

2. Moral Hazard

3. Adverse Selection