Midterm

(You may leave any complete question or questions blank for 20% credit)

I. A. Briefly explain what it means to say that a change in a legal rule--or anything else--increases economic efficiency.

It means that the summed gain to those who gain by the change is larger than the summed loss to those who lose, where both gains and losses are defined by what each person would be willing to pay to get or prevent the change.

B. What roles does economic efficiency play in the economic analysis of law?

(10 points)

It provides one possible explanation for law—Posner’s conjecture that the common law is best viewed as a set of rules “as if designed” to maximize economic efficiency. It also provides one possible objective for someone designing legal rules—to maximize efficiency.

(Alternative good answer) It unifies the study of law, since the same analysis turns out to apply to figuring out what legal rules are efficient in different parts of the legal system—tort, crime, contract, property, … .

II. A. Briefly explain and distinguish real externalities (such as pollution), pecuniary externalities, and rent seeking.

Real externality: My action imposes a cost or benefit on at least one other person.

Pecuniary externality: My action imposes a cost on (at least) one other person and an equal benefit on (at least) one other, such that the net cost is zero.

Rent seeking: My action transfers from another person to me, giving me an incentive to take the action as long as the cost to me is less than the amount I get.

B. Pick one of the above and briefly explain why it does or does not lead to inefficient outcomes. (10 points)

(You only have to do one—I’m doing all three)

Real Externality: I will take an action as long as the net benefit to me is positive, even if the net benefit including external cost is negative, so will sometimes take actions that, on net, make us worse off (negative externality). I will not take an action whose net benefit to me is positive, even if the net benefit including external benefit is positive, so will sometimes fail to take actions that would, on net, make us better off.

Pecuniary externality. My net benefit is our net benefit, since the external effects cancel, so it does not lead to an inefficient outcome.

Rent seeking: I will bear costs, if necessary, in order to make the transfer. The transfer cancels, the cost I bear does not, so there is a net cost to the action I take.

III. According to Coase, a Pigouvian tax will sometimes make the situation more efficient, sometimes less. Explain. (5 points)

If the Pigouvian tax transfers the externality resulting from both parties’ actions to the lower cost avoider, it makes it in his interest to avoid if doing so costs him less than the external cost, which is an improvement. If it transfers it to the higher cost avoider, it eliminates the lower costs avoider’s incentive to avoid and results in the higher cost avoider avoiding instead.

IV. A railroad runs through farming country; there is one railroad company and a hundred farmers. The railroad's locomotives throw sparks which sometimes start fires, doing $100,000 worth of damage each year. The railroad company could prevent the fires by installing spark arresters on its locomotives at a cost of $50,000/year. The farmers could prevent the fires by switching from wheat to clover, costing them $70,000/year in lost income. (15 points)

A. What is the efficient outcome? (you may answer by circling the correct alternative in each pair—or giving it if you are taking the exam on a computer)

Sparks or spark arrester? Wheat or clover? Resulting in fires or no fires?

B. No transactions are possible between farmers and railroad. What happens if:

The railroad is free to throw sparks.

Sparks or spark arrester? Wheat or clover? Resulting in fires or no fires?

The railroad must pay the farmers damages for the fires caused by its sparks.

Sparks or spark arrester? Wheat or clover? Resulting in fires or no fires?

The railroad must pay a fine to the government for the damage due to the fires caused by its sparks.

Sparks or spark arrester? Wheat or clover? Resulting in fires or no fires?

[Unless you don’t count strategic behavior by the railroad as a transaction, in which case it might continue to throw sparks in order to get the farmers to switch to clover.]

In each case, is the result efficient?

First is not second and third are, with the possible exception noted in the parenthesis above.

C. Answer the same questions, assuming that transactions are possible and costless.

1. Sparks or spark arrester? Wheat or clover? Resulting in fires or no fires?

2. Sparks or spark arrester? Wheat or clover? Resulting in fires or no fires?

3. Sparks or spark arrester? Wheat or clover? Resulting in fires or no fires?

D. Transactions are possible but not costless. What transactional problems, if any, might prevent the parties from getting to the efficient outcome in each case?

In case 1, the farmers face a public good problem in paying the railroad to install the spark arrester.

In case 2, one possible problem is the cost of farmers suing the railroad and the risk that the court might misestimate the damages.

In case 3, there is the possibility of strategic behavor by the railroad as described above, leading to clover instead of a spark arrester.

V. Answer one of the following two questions: (10 points)

A. We might try to prevent highway accidents with an ex ante rule, such as a speed limit, or with an ex post rule, such as making the driver responsible for the accident liable for the resulting costs. What are the advantages of each approach?

The advantage of ex ante is that you are applying small punishments, rather than a very large punishment with low probability. The latter has a higher punishment cost, both because people are risk averse and because the punishment may be too large to be paid with a fine, requiring an inefficient punishment such as imprisonment or execution.

The advantage of ex post is that it makes it in the actor’s interest to use his private information, both about what he is doing and about what he should be doing, in deciding how to act, since he is going to pay the cost if the accident happens.

Further points: Ex ante is likely to require enforcement costs—traffic cops. Ex ante might be better if some of the actor’s private information is wrong—he thinks he is a better driver than he is. Measuring actual damage when an accident happens should be easier than estimating the expected cost imposed by driving fast.

My neighbor sues me because noise from my factory makes it hard for him to sleep. The court agrees that my factory is a nuisance and must decide whether to award damages or grant injunctive relief. Discuss the advantages of each. What circumstances might be relevant to deciding which is preferable?

The injunction means that the measure of cost to me is what I am willing to accept in exchange for agreeing to put up with the noise. With liability, the court has to estimate that. On the other hand, the injunction sets up a bilateral monopoly which might lead to large bargaining costs, or even bargaining breakdown—My neighbor is trying to squeeze more out of me than the right to make noise is worth to me, so the factory shuts down, or changes its operations to eliminate the noise, even though that costs much more than the cost to him of being kept awake.

This suggests that the injunction is more desirable the harder it is to measure the damages from the outside, and less desirable the larger the bargaining range—the difference between the cost to me of preventing the noise and the value to you of my doing so.