Midterm
(you may omit any complete question or questions for 20% credit)
I. Economic Efficiency: (10 points)
A. Explain in your own words what it means to say that one outcome is
more efficient than another.
Measure the benefit to someone of getting outcome A instead of outcome
B by the largest amount he would pay to do so; measure costs similarly.
A is more efficient than B if the summed benefits are larger than the
summed costs.
Answer
B. Briefly discuss reasons why the more efficient outcome might
be, in
some plausible sense, the less good outcome.
1. There may be values (justice, ancient redwoods, the will of God)
that are not reducible to “individuals getting the outcomes they
want.”
2. Individuals may not know what is in their own interest—value
heroin
even though it is, in some sense, bad for them.
3. The willingness to pay criterion measures benefits in dollars. But a
dollar may represent much less happiness to some people than to others.
So a change that benefited a rich man by ten dollars and harmed a poor
man by nine dollars would be an improvement in efficiency but almost
certainly a lowering in total happiness.
Answer
II. Externalities: (15 points)
A. Why does the existence of external costs lead to inefficient
outcomes? What about external benefits?
Individuals make decisions based on total costs and benefits to
themselves. If my decision also imposes costs on someone else, I may do
it because net benefits are positive to me even though net benefits are
negative taking into account the external cost. I have then produced an
inefficient outcome.
Similarly, if there is a positive externality, I may not take the
action (because costs to me are larger than benefits) even though
taking it would produce net benefits (including the external benefit),
which again results in an inefficient outcome.
Answer
B. Briefly describe the Pigouvian solution to the problem and the
difficulties in implementing it.
Charge someone who produces an external cost an amount equal to the
cost, thus making net cost for him equal net cost to everyone. This
requires the agency imposing the Pigouvian tax both to be able to know
what the external cost is and to have an incentive to accurately
measure it and impose it.
Answer
C. Briefly describe Coase’s critique of the Pigouvian solution.
(Use
the back of the page)
1. External costs are jointly produced by “polluter” and
“victim.” If
the victim can solve the problem at a lower cost (change the process by
which he bleaches mats so that they are no longer turned black by the
chemical emitted by a nearby factory, to take one of the cases Coase
discusses), you will get the efficient outcome without Pigouvian taxes
and an inefficient outcome with them. And the optimal solution may
involve actions by both parties.
2. Without Pigouvian taxes but with well defined property rights, if
transaction costs are low, the parties will bargain by themselves to
the efficient outcome.
3. So the problem is really the transaction costs that sometimes
prevent such bargains, and the best solution is an initial definition
of rights that minimizes the summed cost of transactions to produce the
efficient outcomes and inefficiency due to the failure to produce the
efficient outcomes.
Answer
III. Designing Legal Rules: (20 points)
An airport has only one airline flying out of it; the land under the
flight path belongs to ten landowners. The airline can either do
nothing to reduce noise from planes landing and taking off, or spend a
million dollars a year to completely eliminate the noise; for
simplicity we assume that those are its only alternatives. The
landowners can use their land either for housing or as farmland.
Each landowner’s property is worth $200,000/year as farmland,
$400,000/year as housing without airplane noise, $320,000/year as
housing with airplane noise.
A. What is the efficient outcome?
Answer
B. For each of the following legal rules, what is the outcome if there
is no bargaining between the parties:
i. The airline is not liable for noise.
ii. The airline is liable for noise.
iii. Any landowner can enjoin airline noise.
Answer
C. For each of the rules, what is the outcome if there is bargaining?
Briefly explain. In some cases you may want to discuss alternative
possible outcomes.
Answer
D. Suppose transactions costs are very high, giving the same outcomes
as in B above. How large is the inefficiency from each rule, relative
to the efficient outcome?
Answer
IV: Answer one of the following two questions:
(10 points)
A. Explain the difference between a property rule and a liability rule,
and what determines which is appropriate to some particular legal issue.
Answer
or
B. Explain the difference between ex ante and ex post enforcement, and
briefly describe the advantages of each.
Answer
V: Answer one of the following two questions: (10
points)
A.. What is adverse selection? Why does it lead to inefficient outcomes
(give an example). How might one minimize costs due to adverse
selection in designing a contract or a legal rule?
Answer
or
B. What is the economic argument for the “coming to the
nuisance”
defense? Against? What facts might be relevant to deciding whether the
defense should be allow in some class of cases?
Answer