Final
Exam
(You
may omit any complete question or questions for 20% credit)
I. Your
client was injured by a drunk driver; the other party's attorney has conceded
liability but disagrees with you about the amount of injury. You ask for a
million dollars, he offers $500,000. Each of you bases his claim on a report by
his hired medical expert.
Judging by
past cases, you believe that the jury will split the difference and award you
$750,000. You are considering hiring a second expert witness. The probability that
he will agree on $1,000,000 is .9, but there is a risk (.1 probability) that he
will agree with the defense on $500,000.
With two experts testifying to damages of a million and one to $500,000,
you expect the jury to award $850,000. If it's two to one the other way, you
expect $650,000. The cost of hiring the expert witness would be $50,000.
Diagram the
question of whether to hire a second witness as a decision theory problem.
Should you hire him? Does it depend on whether your client is risk averse?
Explain.
(5
points)
With a risk neutral client you hire, since expected return
is:
DonÕt hire: $750,000
Hire: $50,000 +.9(850,000) + .1 (650,000)=+780,000
A risk averse client will value the uncertain return from
hiring at less than its expected value. If the client is sufficiently risk
averse, he will prefer that you not hire.
[One student raised the possibility of hiring the second
witness and only having him testify if he agreed on $1,000,000. Not part of
what I intended, but a legitimate point.]
II. The
situation is as in problem I, with two changes. First, you have located a
reliable expert witnessone you are sure will agree with your figure on
damages. Second, you happen to know that the defense has located an expert
witness who is sure to agree with their figure, also for a price of $50,000.
With two witnesses on each side, the jury can be expected to award $750,000.
A. Analyze
the situation as a sequential game. First you decide whether to hire a second
witness, then the defense, observing your decision, decides whether to hire
theirs. Using the subgame perfect equilibrium approach, what should you do?
What is the outcome?
(5
points)
See diagram. Red boxes are choices by plaintiff, blue by
defense. Similarly for costs and final outcomes.
If Plaintiff hires, defense does better hiring ($750,000)
than not hiring ($850,000), so hires. Similarly if plaintiff does not hire. So
either way, defense will hire.
Plaintiff knows that, so hiring results in $50,000+$750,000
= $700,000, not hiring results in +$650,000, so plaintiff hires.
B. Consider the situation as a simultaneous game. You
decide to hire or not hire an expert witness, so do they. Draw the game matrix.
What will the parties do? Explain. (5
points)
Defendant 
Don't hire 
hire 
Plaintiff 


Don't hire 
(750,750) 
(650,700) 
Hire 
(800,850) 
(700,800) 
Hire dominates donÕt hire for both parties, so both hire.
C. What can
you say about the outcome in terms of the objectives of the two parties? Can
you think of any alternative approach that might lead to a more satisfactory
result for both? (5
points)
This is a prisonerÕs dilemmaboth parties are worse off than
if neither hired an expert. Perhaps they could agree in advance to limit
themselves to one expert each.
III. Briefly
explain the advantages and disadvantages of including a liquidated damages term
in a contract instead of waiting until breach occurs and then letting a court
judge damages. Are there any advantages to a penalty clause—liquidated
damages substantially above the actual cost imposed by a breach? (5
points)
Advantage: Reduces litigation cost, since the parties wonÕt
have to litigate over the amount of the damage. Replaces the partiesÕ estimate
in advance with the judgeÕs estimate after the fact, and while the judge will
have more information, the parties may be better informed. Also, liquidated
damages eliminate the incentive for an inefficiently high level of reliance by
the party that might be the victim of breech.
Disadvantage: The estimate is being made in advance, so might
over or underestimate the actual damage when breech occurs, giving a party too
much or too little incentive to avoid breech.
A penalty clause amounts to a property rule adopted by the
partiesone party can breech only with the permission of the other, or by
paying a penalty. That makes sense if the parties believe that they can better
resolve situations that might lead to breech via negotiation than via the
courts.
IV. Firms
sometimes make expenditures in one year in order to generate revenue in the
next year or collect revenue in one year for services they will produce in the
next year. How does an accountant handle such situations? Why? (5 points)
An accountant tries to group expenditures and the revenues
they produce together. That can be done by classifying the revenues as accounts
receivable before they are actually received, to get them into the same year as
the expenditures, or by treating expenditures as prepayments–an asset
that balances the expenditure–in the year they are paid. The motive is to
make it easier to evaluate the decisions that led to both expenditure and
revenue.
V. Briefly
explain why we would expect the efficient market hypothesis to be approximately
true and why it cannot be precisely true. (5
points)
If it is easy to see that a stock is underpriced, people will
buy it, driving its price up to its value, so the price of a stock will tend to
be equal to its actual valuethe expected value of the present value of all
income streams that come from owning it.
But if all stock prices are exactly correct there would be no
benefit to doing the research to identify underpriced (or overpriced) stocks,
so nobody would try, so the mechanism about wouldnÕt work.
VI. The
risk free rate of return, what an investor can get on an investment with a
known and certain payoff, is 4%. The rate of return on a random collection of
stocks is 6%. Why are they different?
Because the random collection of stocks has an uncertain
return and investors are risk aversesufficiently risk averse to be
indifferent between 4% for sure and 6% with whatever the uncertainty of a
random collection is.
Your
company's performance anticorrelates with the marketwhen most stocks go up,
yours goes down, and vice versa. What can you say about the return you will
have to offer investors in order to get them to invest in your firm? Explain. (5
points)
You will be able to get investments at less than 4%, because
an investor who adds your stock to a random bundle actually reduces his risk,
making it better than a risk free investment.
VII.
Briefly explain what economists mean by efficiency. (5
points)
Efficiency is a measure of the Òsize of the pie,Ó the degree
to which people get what they want. Outcome A is more efficient than outcome B
if the change from B to A provides net benefits, defined by how much each
person affected would pay to get the change (+) or prevent it ().
VIII.
Briefly explain Pigou's view of externalities and what to do about them and
Coase's critique of it. Use the back of the page. (10
points)
Pigou viewed an externality as a cost one party imposed on
another. His solution was to charge the cost to the former party, thus forcing
him to take account of it in deciding what actions to take.
Coase pointed out that the cost is typically the result of
choices by both parties. Imposing it on one leads to an inefficient outcome if
the other can solve the problem at lower costusing land under the flight path
for something not sensitive to noise instead of requiring planes to reduce the
noise they produce, for instance. He also pointed out that, as long as
transaction costs are low, the parties have an incentive to eliminate the
inefficiency by agreement. If I am imposing a $100 cost on you at a $50 benefit
to me, I should be willing to accept some payment between the two numbers to
agree to stop doing so.
IX. How do
economists define negligence? Briefly explain how a negligence rule can give
both tortfeasor and victim the correct incentive to take precautions. What
happens if some precautions cannot be observed by the court? (10
points)
Negligence is defined by economists as failure to take all
cost justified precautions. Under a negligence rule the potential tortfeasor
finds it in his interest to take all cost justified precautions, since if he
doesnÕt he will be liable for all costs and if liable for all costs it is in
his interest to take all cost justified precautions. Since he chooses not to be
negligent he wonÕt be liable, so the victim wonÕt be compensated, so it will be
in the victimÕs interest to take all cost justified precaution.
If some precautions cannot be observed by the court, the
potential tortfeasor will find it in his interest to take the efficient level
of the observable precautions, freeing him from liability, and then to base his
level of unobservable precautions only on costs to him.
X. What is
the argument in favor of a legal rule of caveat emptor (let the buyer beware)? Caveat venditor? In what sort of situation is each desirable? (5
points)
Caveat emptor gives the
buyer an incentive to take precautions to reduce risk and amount of
damagewear shoes when using a power mower, for instance. It also reduces
litigation costs, since the damage normally falls on the buyer when a product
fails, so no need for liltigation to shift the cost.
Caveat venditor gives
the seller an incentive to take precautions to reduce risk and amount of damage
from product failure. This is unnecessary if the buyer can easily discover the
risks, since then the seller already has the needed incentive. But it is useful
if buyers can be expected not to know the risk.
So Caveat emptor makes
sense where the important precautions to be taken are by the buyer or where the
buyer can easily judge risks of products he buys. Caveat venditor makes sense if neither is true and there are important
precautions to be taken by the seller.
XI. Briefly
explain the argument for setting expected punishment for a crime equal to
damage done. Might it be efficient to have expected punishment greater than
damage done for some sorts of offenses, less than damage done for others?
Explain. (5
points)
Expected
punishment equal to damage done forces the criminal to internalize the
externality, so he will only commit the crime if his benefit is more than the
victims loss, in which case the offense is efficient and we donÕt want to
prevent it. This is the right rule if we ignore the cost of catching,
convicting and punishing criminals.
If
catching and punishing criminals is costly, the efficient level of punishment
is sometimes higher, sometimes lower. It may be higher to deter some mildly
efficient offenses so as to save the cost of catching, convicting and punishing
the offenders. It may be lower to permit those offenses which produce a net
loss smaller than the additional cost of making expected punishment high enough
to deter them.
The
former situation is associated with a more elastic supply of offenses;
increasing punishment a little decreases the number of offenses a lot, and
spending more per offense on fewer offenses then ends up with lower total
expenditure. The latter situation is the other way around.
XII. A friend claims that boys
are relatively better at mathematical skills, girls at verbal skills. To test
his claim, you obtain a random sample of 900 scores from boys who took the SAT
last year. On average, their math
score is ten points higher than their verbal score, which appears to support
your friend's claim.
The test is
designed so that the difference between the math and verbal scores, averaged
over all test takers, is zero. You reason that if boys are not, on random,
relatively better at math, the mean difference for them should be zero too.
From your
sample, you estimate that for the population the standard deviation of the
difference of the scores is thirty. What is the standard deviation of the mean
of a sample of 900?
1
What is the
Z statistic for your result?
10
Do you
think it is significant at the .05 level? Yes .01 level? Yes
You may if
you wish use the attached table.
No need. Z=10 is huge.
Should you
use a single or double tailed test and why? (10
points)
Single tailed. His claim is that boys are better at math
skills, not that they are better at one or the other. So a result in the other
direction, negative Z, would be evidence against his claim, not evidence for
it.
XIII. Your
client, Megacorp Inc., employs more than 90,000 people of a bewildering variety
of ethnic origins. You have been sued by an enterprising law firm,
ClassActionsRUs, acting on behalf of J. Lilovich et. al., for discriminating
against Americans of Bosnian descent. Their evidence is a statistical study
showing that the wages of your Bosnian employees are lower than the average
wage of your employees by $430/year, a result which, their study shows, has
less than a .05 probability of occurring by chance. Since, they explain, the
odds that Megacorp is discriminating are better than twenty to one, they have
obviously satisfied the civil standard of proof.
List at
least three different and independent reasons why their argument is wrong. Pick
one of them and briefly describe how you would explain it to a jury. (10
points)
1. With lots of ethnicities, the odds that at least one of
them will, by chance, receive an average salary that low are high; the law firm
obviously checked all of them and only reported on the one for which the salary
was noticeably below average.
2. Since they didnÕt do a multiple regression, it is entirely
possible that the reason is differences in characteristics of the employees.
Perhaps, for instance, the Bosnians are on average more recent hires than other
employees, or less educated, or É
.
3. Aside from those problems, the odds coming out of the
study represent the probability that the average wage of an ethnicity would be
that far below the average by chance, assuming no discrimination, not the odds
of discrimination, given that the average wage came out that far below the
average.
Not being a lawyer, IÕll leave it to you to figure out how to
present one of these to the jury.
XIV. A
large statistical study of the results that high school students get on the SAT
exam finds:
A negative
correlation between age at which the test was taken and score.
A strong
positive correlation–.8–between number of books read per year and
score on the verbal part of the exam.
If you want
your child to get a good score on the exam and get into a good college, should
you require him to read a book a week and insist that he take the exam a year
early? Discuss. (5
points)
Probably not. Students who take the test early are likely to
do so because they are smarteither have skipped grades or concluded that they
can do well in an earlier grade than the test is usually taken. The causation
is probably running from intelligence to early test taking, not the other way
around.
Similarly, liking to read is both a cause and effect of high
verbal skills. We donÕt know whether making someone who doesnÕt like to read
read a book a year will raise his verbal skills or not.
XV. A
multiple regression on the results of the study described in the previous
question uses total SAT score (math + verbal) as the dependent variable, age,
IQ, parental income, parental education, average teacher salaries in the school
the student went to, average class size in the school the student went to,
number of books in the student's home, as independent variables. Despite the
correlations reported in the previous question, it turns out that none of those
variables is significant at the .05 level. Does this imply that none of them
significantly affects SAT outcomes? Explain. What further analysis of the data
might you use to see what is actually happening? (10
points)
The problem is that the independent variables are highly
correlated with each other, so no one of them much improves the fit given that
the others are already there. You should check correlations between variables,
remove one of any pair that are closely correlated (or two of any triple or É),
and redo the regression.