Midterm 2000: Answers
I. Economic Efficiency: (10 points)
Explain in your own words what it means to say that one outcome is
more efficient than another.
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
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
2. Individuals may not know
what is in their own interest—value heroin even though it is, in
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.
II. Externalities: (15 points)
Why does the existence of external costs lead to inefficient
outcomes? What about external benefits?
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
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.
B. Briefly describe the Pigouvian solution to the
problem and the
difficulties in implementing it.
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.
C. Briefly describe Coase’s critique of the Pigouvian solution.
the back of the page)
costs are jointly produced by “polluter” and
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
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?
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.
Noise and houses—unless the court
overestimates the damage by enough to
make it in the airline’s interest to engage in (inefficient)
reduction. Or unless litigation costs are large enough to produce the
same result ($80,000 damages and $40,000 in lawyer’s fees for
iii. Any landowner can enjoin airline noise.
No noise and houses.
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
i. Noise and houses—the landowners, even if they
can overcome the
public good problem, aren’t willing to offer the airline enough
for the noise reduction.
ii. Noise and houses. Airline and landowners may reduce litigation
costs by a permanent out of court settlement. Except that …
If courts overestimate the costs and/or litigation costs are high,
bargaining costs might force the no noise and houses outcome. This is
made less likely by the fact that the airline can settle with some
landowners and pay damages to the holdouts—as long as the total
than the cost of preventing the noise.
iii. Either noise and houses—if the landowners can overcome the
problem and accept compensation for permitting noise—or silence
houses if they can’t.
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?
Zero—the efficient outcome.
ii. Zero—except that there may be litigation costs of unknown
not more than $200,000 litigation cost to the airline, since otherwise
it will stop making noise).
iii. The airline pays $1,000,000 to buy noise reduction that produces a
benefit of only $800,000, for a net cost of $200,000.
IV: Answer one of the following two questions:
Explain the difference between a property rule and a liability rule,
and what determines which is appropriate to some particular legal issue.
a property rule, you can only use my property
with my permission;
if you try to use it without the law imposes costs on you designed to
be large enough to keep you from doing so. Under a liability rule, you
can use my property without my permission but are then liable to me for
the cost that your use imposes on me.
Property rules make sense if the transaction costs of moving goods to
their highest valued use via private transactions are low and the costs
and errors of doing it through litigation are high. Liability rules
make sense in the opposite case—where transaction costs of
transactions are high and courts can accurately and inexpensively
measure damages and allocate liability for them.
B. Explain the difference between ex ante and ex post enforcement, and
briefly describe the advantages of each.
ante tries to prevent an undesirable outcome, such
as a car crash,
by penalizing behavior that is believed to lead to that outcome—a
limit enforced by speeding tickets, for example. Ex post tries to
prevent the undesirable outcome by penalizing the outcome, thus giving
the party an incentive to prevent it.
The advantage of ex ante is that it can be applied with a higher
probability of a lower punishment, thus reducing problems of risk
aversion and the need to resort to inefficient punishments such as
imprisonment. The advantage of ex post is that it makes it in the
party’s interest to apply his private information about what he
doing and what he should be doing to prevent the outcome, while under
ex ante it is only the information available to the enforcement system
(how fast you are driving but not how much attention you are paying to
doing it) that is being used. Ex ante also permits the enforcement
system to impose its estimate of the relation between behavior and
consequences, while ex post is using the party’s estimate; under
circumstances the former may be superior, under some the latter.
V: Answer one of the following two questions: (10
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?
selection occurs when one party has
information relevant to the
value of what is being sold that the other party does not have and that
the first party cannot verifiably transmit. If I know my car is a
creampuff, I will price it accordingly, and will probably only be
willing to sell it at a creampuff price. But if the buyer does not and
cannot know, he will probably be unwilling to pay that price. So the
cars that sell are mostly lemons—selling at a lemon price. This
inefficient because a creampuff that is worth more to the potential
buyer than to its present owner still remains unsold.
One can minimize such costs by assigning the risk to the party who has
the information about that risk. For instance, the seller could
guarantee the car. [There are other acceptable answers, but this is
probably the most important one for our purposes.]
B. What is the economic argument for the “coming to the
defense? Against? What facts might be relevant to deciding whether the
defense should be allow in some class of cases?
argument for is that the second mover is often,
because he is the
second mover, the lower cost avoider of the problem; the developer can
choose to locate his development somewhere other than next to the pig
farm. It is much harder for the pig farmer to predict that the land
where he is going to locate his pig farm is next to where a developer
will want to build ten years later, and so avoid the problem by
The argument against is that in some cases the victim cannot avoid by
building elsewhere, because housing development is the most valuable
use of the land around the pig farm, hence the owners are being
injured, whether they build or don’t build—and in some of
the pig farmer could have predicted that the city was growing in that
direction and located somewhere else.