Analytical Methods for Lawyers


v    Idea of the Course

    Brief survey of lots of areas useful to lawyers

    Many of which could be a full course--my L&E

    Enough so that you won't be lost when they come up, and

    Can learn enough to deal with them if it becomes necessary.

v    Mechanics

    Reading is important

    Discussion in class

    Homework to be discussed but not graded--way of testing yourself

       Prefer handout hardcopy or on web page? URL on handout

    Midterm? First time.

v   Topics

    Decision Analysis

    Game Theory

    Contracting: Application of Ideas




    Law and Economics.


    Multivariate Statistics: Untangling one out of many causes. Death penalty

v    First Topic: Decision Analysis

    Way of formally setting up a problem to make it easier to decide   


       Make a choice.

       Observe the outcome, depends partly on chance

       Make another choice.

       Continue till the end, get some cost or benefit

       Want to know how to make the choices to maximize benefit or minimize cost

    Simple Example: Settlement negotiations

       Accept settlement (known result) or go to trial

       If trial win with some probability and get some amount, or lose and have costs

       Compare settlement offer to average outcome at trial, including costs.

    Fancy example: Hazardous materials disposal firm

       You suspect employees may have cut some corners, violated disposal rules

       First choice: Investigate or don't.

       If you don't, probably nothing happened (didn't violate or don't get caught)

       If you do, some probability that you discover there is a problem. If so

       Conceal or report to EPA

       If you conceal, risk of discovery--greater than at previous stage (whistleblowers)

       If you report, certain discovery but lower penalty

    In each case, how do you figure out what to do? Two parts:

       If you knew all the probabilities and payoffs, how would you decide (Decision Analysis)

       What are the probabilities and payoffs, and how do you find them?

    Simple case again: Assuming numbers

       First pass

       Settlement offer is $70,000

       Trial cost is $20,000

       Sure to win

       Tree diagram

       Lop off inferior branch--easy answer

       Second pass: As above, but 60% chance of winning

       Square for decision, circle for chance node

       On average, trial gives you $40,000

       Is that the right measure?

       If so, inferior. Lop off that branch


       Risk aversion

       If you are making similar decisions many times, expected value.

       If once, depends on size of stakes.

    Where do the numbers come from?

       Alternatives: Think. Talk to client, colleagues,   Think through alternatives.

       Partly your professional expertise

       Forces you to think through carefully what the alternatives are.


       Might have data--outcome of similar cases in the past. Audit rate.

       Generate it--mock trial. Hire an expert.

       By intuition, experience. Interrogate. What bets would I accept?


       Include money--costs, profits, fines, Past cases, experts, .

       Reputational gains and losses

       For an individual, moral gains and losses? Other nonpecuniary?

    Sensitivity analysis

    (Land Purchase Problem?)

    Is ethics relevant?

       Criminal trial--does it matter if you think your client is guilty?

       EPA--does it matter that concealing may be illegal. Immoral?

       What if not looking for the problem isn't illegal, but

       Finding and concealing is?

v   Query re Becca

v    Mechanics

    Office Hours handout

    Everyone happy with doing stuff online?

v    Review: Points covered

    Basic approach

       Set up a problem as

       Boxes for choices

       Circles for chance outcomes

       Lines joining them

       Payoffs, + or -, and probabilities.

       Calculate the expected return from each choice, starting with the last ones

       Since the payoff from one choice

       May depend on the previous choice or chance.

       If one choice has a lower payoff than an alternative at the same point, lop that branch

       Work right to left until you are left with only one series of choices.


       Expected return only if risk neutral

       You have to work out the structure, with help from the client and others

       Estimate the probabilities, and

       Payoffs, not all of which are in  money.

    Sensitivity analysis to find out whether the answer changes if you change your estimates.

v    Handout problems

    Settle or go to trial

    Which contract to offer

       Easy answer for the team

       Note that we have implicitly solved the player's problem too.

       Upper contract, if he has back pain, playing costs him $2 million, gets him nothing, not playing neither costs nor gets, so don't play

       Lower contract, if he has back pain, playing costs him $2 million, gets him $10 million. Not playing gets and costs nothing. So he plays.

       Note also a third option, that we didn't mention--no contract.

       Better than the first

       Could change the numbers to make it better than the second

       Demonstrating that one has to figure out the structure of the problem.

v    Questions?

v    More book problems

    Land purchase problem


v    Game Theory Intro: Show puzzling nature by examples

    Bilateral monopoly

       Economic case--buyer/seller, union/employer

       Parent/child case

       Commitment strategies

       In economic case

       Aggressive personality.




v    Move to front of the room

v    Strategic Behavior: The Idea

    A lot of what we do involves optimizing against nature

       Should I take an umbrella?

       What crops should I plant?

       How do we treat this disease or injury?

       How do I fix this car?

    We sometimes imagine it as a game against a malevolent opponents

       Finagle's Law: If Something Can Go Wrong, It Will

       "The perversity of inanimate objects"

       Yet we know it isn't

    But consider a two person zero sum game, where what I win you lose.

       From my standpoint, your perversity is a fact not an illusion

       Because you are acting to maximize your winnings, hence minimize mine

    Consider a non-fixed sum game--such as bilateral  monopoly

       My apple is worth nothing to me (I'm allergic), one dollar to you (the only customer)

       If I sell it to you, the sum of our gains is   ?

       If bargaining breaks down and I don't sell it, the sum of our gains is   ?

       So we have both cooperation--to get a deal--and conflict over the terms.

       Giving us the paradox that

       If I will not accept less than $.90, you should pay that, but

       If you will not offer more than $.10, I should accept that.

       Bringing in the possibility of bluffs, commitment strategies, and the like.

    Consider a many player game

       We now add to all the above a new element


       Even if the game is fixed sum for all of us put together

       It can be positive sum for a group of players

       At the cost of those outside the group

v    Ways of representing a game

    Like a decision theory problem

       A sequence of choices, except that now some are made by player 1, some by player 2 (and perhaps 3, 4, )

       May still be some random elements as well

       Can rapidly become unmanageably complicated, but

       Useful for one purpose: Subgame Perfect Equilibrium

       Back to our basketball player--this time a two person game


       But Tantrum/No Tantrum game

       So Subgame Perfect works only if commitment strategies are not available






    As a strategy matrix

       Works for all two player games

       A strategy is a complete description of what the player will do under any circumstances

       Think of it as a computer program to play the game

       Given two strategies, plug them both in, players sit back and watch.

       There may still be random factors, but

       One can define the value of the game to each player as the average outcome for him.

    Dominant Solution: Prisoner's Dilemma as a matrix

       There is a dominant pair of strategies--confess/confess

       Meaning that whatever Player 1 does, Player 2 is better off confessing, and

       Whatever Player 2, does Player 1 is better off confessing

       Even though both would be better off if neither confessed













       How to get out of this?

       Enforceable contract

     I won't confess if you won't

     In that case, using nonlegal mechanisms to enforce

       Commitment strategy--you peach on me and when I get out

    Von Neumann Solution

       Von Neumann proved that for any 2 player zero sum game

       There was a pair of strategies, one for player A, one for B,

       And a payoff P for A (-P for B)

       Such that if A played his strategy, he would (on average) get at least P whatever B did.

       And if B played his, A would get at most P whatever he did

    Nash Equilibrium

       Called that because it was invented by Cournot, in accordance with Stigler's Law

       Which holds that scientific laws are never named after their real inventors

       Puzzle: Who invented Stigler's Law?

       Consider a many player game.

       Each player chooses a strategy

       Given the choices of the other players, my strategy is best for me

       And similarly for everyone else

       Nash Equilibrium

       Driving on the right side of the road is a Nash Equilibrium

       If everyone else drives on the right, I would be wise to do the same

       Similarly if everyone else drives on the left

       Multiple equilibria

       One problem: It assumes no coordinated changes

       A crowd of prisoners are escaping from Death Row

       Faced by a guard with one bullet in his gun

       Guard will shoot the first one to charge him

       Standing still until they are captured is a Nash Equilibrium

     If everyone else does it, I had better do it too.

     Are there any others?

       But if I and my buddy jointly charge him, we are both better off.

       Second problem: Definition of Strategy is ambiguous. If you are really curious, see the game theory chapter in my webbed Price Theory

v    Solution Concepts

    Subgame Perfect equilibrium--if it exists and no commitment is possible

    Strict dominance--"whatever he does " Prisoner's Dilemma

    Von Neumann solution to 2 player game

    Nash Equilibrium

    And there are more



v    A simple game theory problem as a lawyer might face it:


You represent the plaintiff, Robert Williams, in a personal injury case. Liability is fairly

clear, but there is a big dispute over damages. Your occupational expert puts the plaintiffs expected future losses at $1,000,000, and the defendants expert estimates the loss at only $500,000. (Pursuant to a pretrial order, each side filed preliminary expert reports last month and each party has taken the deposition of the opposing partys expert.) Your experience tells you that, in such a situation, the jury is likely to split the difference, awarding some figure near $750,000.


The deadline for submitting any further expert reports and final witness lists is rapidly

approaching. You contemplate hiring an additional expert, at a cost of $50,000. You suspect that your additional expert will confirm your initial experts conclusion. With two experts supporting your higher figure and only one supporting theirs, the jurys award will probably be much closer to $1,000,000 — say, it would be $900,000.


You suspect, however, that the defendants lawyer is thinking along the same lines. (That

is, they could find an additional expert, at a cost of about $50,000, who would confirm their initial experts figure. If they have two experts and you have only one, the award will be much closer to $500,000 — say, it would be $600,000.)


If both sides hire and present their additional experts, in all likelihood their testimony will

cancel out, leaving you with a likely jury award of about $750,000. What should you advise your client with regard to hiring an additional expert?


Any other ideas?


Set it up as a payoff matrix


If neither hires an additional expert, plaintiff receives $750,000 and defendant pays $750,000?


If plaintiff hires an additional expert, plaintiff receives $850,000 and defendant pays $900,000


If defendant hires an additional expert, plaintiff receives $600,000 and defendant pays $650,000?


If both hire additional experts, plaintiff receives $700,000 and defendant pays $800,000?





Doesn't hire




Doesn't Hire

750, -750

600, -650



850, -900

700, -800


What does Plaintiff do?


What does Defendant do?


What is the outcome?


Can it be improved?




v    Game Theory: Summary

    The idea: Strategic behavior.

       Looks like decision theory, but fundamentally different

       Because even with complete information, it is unclear

       What the solution is or even

       What a solution means

       With decision theory, there is one person seeking one objective, so we can figure out how he can best achieve it.

       With game theory, there are two or more people

       seeking different objectives

       Often in conflict with each other

       A solution could be

       A description of how each person decides the best way to play for himself or

       A description of the outcome

    Solution concepts

       Subgame perfect equilibrium

       assumes no way of committing

       No coalition formation

     In the real world, A might pay B not to take what would otherwise be his ideal choice--

     because that will change what C does in a way that benefits A.

     One criminal bribing another to keep his mouth shut, for instance

       But it does provide a simple way of extending the decision theory approach

     To give an unambiguous answer

     In at least some situations

     Consider our basketball player problem

       Dominant strategy--better against everything. Might not exist in two senses

       If I know you are doing X, I do Y—and if you know I am doing Y, you do X. Nash equilibrium. Driving on the right. The outcome may not be unique, but it is stable.

       If I know you are doing X, I do Y—and if you know I am doing Y, you don't do X. Unstable. Scissors/paper/stone.

       Nash equilibrium

       By freezing all the other players while you decide, we reduce it to decision theory for each player--given what the rest are doing

       We then look for a collection of choices that are consistent with each other

     Meaning that each person is doing the best he can for himself

     Given what everyone else is doing

       This assumes away all coalitions

     it doesn't allow for two ore more people simultaneously shifting their strategy in a way that benefits both

     Like my two escaping prisoners

       It also ignores the problem of how to get to that solution

     One could imagine a real world situation where

    A adjusts to B and C

    Which changes B's best strategy, so he adjusts

    Which changes C and A's best strategies


     A lot of economics is like this--find the equilibrium, ignore the dynamics that get you there

       Von Neumann solution aka minimax aka saddlepoint aka .?

       It tells each player how to figure out what to do, and

       Describes the outcome if each follows those instructions

       But it applies only to two person fixed sum games.

       Von Neumann solution to multi-player game (new)

       Outcome--how much each player ends up with

       Dominance: Outcome A dominates B if there is some group of players, all of whom do better under A (end up with more) and who, by working together, can get A for themselves

       A solution is a set of outcomes none of which dominates another, such that every outcome not in the solution is dominated by one in the solution

       Consider, to get some flavor of this,

       Three player majority vote

       A dollar is to be divided among Ann, Bill and Charles by majority vote.

     Ann and Bill propose (.5,.5,0)--they split the dollar, leaving Charles with nothing

     Charles proposes (.6,0,.4). Ann and Charles both prefer it, to it beats the first proposal, but

     Bill proposes (0, .5, .5), which beats that

     And so around we go.

       One Von Neumann solution is the set: (.5,.5,0), (0, .5, .5), (.5,0,.5) (check)

       There are others--lots of others.

       Other approaches to many player games have been suggested, but this is enough to show two different elements of the problem

       Coalition formation, and

       Indeterminacy, since one outcome can dominate other which dominates another which .

       Almost enough to make you appreciate Nash equilibrium, where nobody can talk to anybody so there is no coalition formation.

v    Applied Schelling Points

    In a bargaining situation, people may end up with a solution because it is perceived as unique, hence better than continued (costly) bargaining

       We can go on forever as to whether I am entitled to 61% of the loot or 62%

       Whether to split 50/50 or keep bargaining is a simpler decision.

    But what solution is unique is a function of how people think about the problem

       The bank robbery was done by your family (you and your son) and mine (me and my wife and daughter)

       Is the Schelling point 50/50 between the families, or 20% to each person?

       Obviously the latter (obvious to me--not to you).

    It was only a two person job--but I was the one who bribed a clerk to get inside information

       Should we split the loot 50/50 or

       The profit 50/50--after paying me back for the bribe?

    In bargaining with a union, when everyone gets tired, the obvious suggestion is to "split the difference."

       But what the difference is depends on each party's previous offers

       Which gives each an incentive to make offers unrealistically favorable to itself.

    What is the strategic implication?

       If you are in a situation where the outcome is likely to be agreement on a Schelling point

       How might you improve the outcome for your side?

v    Odds and Ends

    Prisoner's dilemma examples?

       Athletes taking steroids. Is it a PD?

       Countries engaging in an arms race

       Students studying in order to get better grades?

    Is repeated prisoner's dilemma a prisoner's dilemma?

       Suppose we are going to play the same game ten times in succession

       If you betray me in round 1, I can punish you by betraying in round 2

       It seems as though that provides a way of getting us to our jointly preferred outcome—neither confesses.


    Experimental games

       Computers work cheap

       So Axelrod set up a tournament

       Humans submit programs defining a strategy for many times repeated prisoner's dilemma

       Programs are randomly paired with each other to play (say) 100 times

       When it is over, which program wins?

       In the first experiment, the winner was "tit for tat"

       Cooperate in the first round

       If the other player betrays on any round, betray him the next round (punish), but cooperate thereafter if he does (forgive)

       In fancier versions, you have evolution

       Strategies that are more successful have more copies of themselves in the next round

       Which matters, since whether a strategy works depends in part on what everyone else is doing.

       Some more complicated strategies have succeeded in later versions of the tournament,

       but tit for tat does quite well

       His book is The Evolution of Cooperation

v    Threats, bluffs, commitment strategies:

    A nuisance suit.

       Plaintiff's cost is $100,000, as is defendant's cost

       1% chance that plaintiff wins and is awarded $5,000,000

       What happens?

       How might each side try to improve the outcome

    Airline hijacking, with hostages

       The hijackers want to be flown to Cuba (say)

       Clearly that costs less than any serious risk of having the plane wrecked and/or passengers killed

       Should the airline give in?

    When is a commitment strategy believable?

       Suppose a criminal tries to commit to never plea bargaining?

       On the theory that that makes convicting him more costly than convicting other criminals

       So he will be let go, or not arrested

v    Moral Hazard

    This is really economics, not game theory, but it's in the chapter

    I have a ten million dollar factory and am worried about fire

       If I can take ten thousand dollar precaution that reduces the risk by 1% this year, I will—(.01x$10,000,000=$100,000>$10,000)

       But if the precaution costs a million, I won't.

    insure my factory for $9,000,000

       It is still worth taking a precaution that reduces the chance of fire by %1

       But only if it costs less than ?

    Of course, the price of the insurance will take account of the fact that I can be expected to take fewer precautions:

       Before I was insured, the chance of the factory burning down was 5%

       So insurance should have cost me about $450,000/year, but

       Insurance company knows that if insured I will be less careful

       Raising the probability to (say) 10%, and the price to $900,000

    There is a net loss here—precautions worth taking that are not getting taken, because I pay for them but the gain goes mostly to the insurance company.

    Possible solutions?

       Require precautions (signs in car repair shops—no customers allowed in, mandated sprinkler systems)

       The insurance company gives you a lower rate if you take the precautions

       Only works for observable precautions

       Make insurance only cover fires not due to your failure to take precautions (again, if observable)



    Is moral hazard a bug or a feature?

       Big company, many factories, they insure

       Why? They shouldn't be risk averse

       Since they can spread the loss across their factories.

       Consider the employee running one factory without insurance

       He can spend nothing, have 3% chance of a fire

       Or  spend $100,000, have 1%--and make $100,000 less/year for the company

       Which is it in his interest to do?

v    Adverse Selection—also not really game theory

    The problem: The market for lemons


       Used car in good condition worth $10,000 to buyer, $8000 to seller

       Lemon worth $5,000, $4,000

       Half the cars are creampuffs, half lemons

       First try:

       Buyers figure average used car is worth $7,500 to them, $6,000 to seller, so offer something in between

       What happens?

       What is the final result?

    How might you avoid this problem—due to asymmetric information

       Make the information symmetric—inspect the car. Or

       Transfer the risk to the party with the information—seller insures the car

    What problems does the latter solution raise?

v    To think about:

    Genetic testing is making it increasingly possible to identify people at risk of various medical problems

    If you are probably going to get cancer, or have a heart attack, and the insurance company knows it, insurance will be very expensive, so

    Some people propose that it be illegal for insurance companies to require testing.

    What problems would that proposal raise?



v    Genetic Testing:

    A. No Testing

    B. Customers can test; insurance companies cannot condition rates on results

    Customers can test, insurance companies can condition rates

    What happens?

v    Contracts

    Why they matter

       A large part of what lawyers do is drawing up and negotiating contracts

       In many different areas of the law



       Sales contracts

       Contracts between firms

       Prenuptial agreements and Divorce settlements  

    Why make a contract?

       Why deal with other people at all?

       Because there are gains to trade

       The same property may be worth more to buyer than seller

       Different people have different abilities

       Specialization and division of labor

       Complementary abilities

       Risk sharing

     An insurance contract not only transfers risk

     It reduces it--via the law of large numbers

       Does a bet due to different opinions count as gains from trade?

       A spot sale isn't much of a contract--why anything else?

       Because performance often takes place over time

       And the dimensions of performance are more complicated than "seventeen bushels of wheat."

       Even a spot contract might include details of quality--not immediately observable--and recourse.

    Two Objectives in negotiating a contract

       Maximize the size of the pie

       Get as much of it as possible for your client

    The second was covered in the previous chapter

       If there is some surplus from the exchange

       Meaning that you can both be better off with a contract

       Than without one

       Then you are in a bilateral monopoly bargaining game

       You are both better off if you agree to a contract

       But the terms will determine how much of the gain each of you gets

       Where commitment strategies or control of information might help

       But at the risk of causing bargaining breakdown

     Each of us is committed to getting at least 60% of the gain, or

     I have persuaded you that what you are selling is only worth $10 to me, and it is worth $11 to you.

       And the pie goes into the trash

    This chapter is about the first--maximize the size of the pie

       Any time you see a way of increasing the size

       You can propose it, combined with a change in  other terms--such as price

       That makes both parties better off

       This point is central to the chapter—if you are not convinced, we should discuss it now.

v    Why incentives matter

    People often talk as if "more incentive" was unambiguously good

       Gordon Tullock's auto safety device

       There is such a thing as too much incentive

       What is the right incentive--for anything?

    Consider a fixed price contract to build a house

       Instead of spending $10,000 on roofing material that lasts 20 years

       The builder spends $5,000 on material that lasts 5 years

       After which the material must be replaced at a cost of $12,000

    What is the sense in which this is a bad thing?

       Compare to the case where the $5,000 material lasts 19 years.

       You want to set up the contract so he won't use the cheap material in the first case, but

       What about the second?

    How about the incentive not to breach a contract?

       Should contracts ever be breached?


       How do you get that outcome?

    Enforceability and observeability

       Consider the marriage contract

       Al-Tanukhi story

       Lots of dimensions of performance are unobservable by an outside party

       So a wife who wants a divorce   .

       You might want to think about the general problem of marriage contracts

     Traditional: Divorce hard, gender roles largely specified by custom

     Current: Divorce on demand, terms freely negotiable day by day, mostly not enforceable


     What are the problems in designing a marriage contract?

     We will return to that question

       Ideally, the contract specifies terms that are observable

       Not always a sharp distinction

       Sometimes performance can be imperfectly observed--how well is this house built?

       And one might specify how to observe it--name the expert body whose standards you are agreeing to.

       A second enforceability problem--what if a party breaches and can't pay the damages?


       In today's discussion, we implicitly assume that the only constraint on both parties is the contract itself

       In many cases that's not realistic. One or both parties is a repeat player, and wants not only to stay out of court but to keep customers and get more.

       We will return to that question later, since it is relevant to how to structure contracts.

v    Production Contracts—building a house.

    One party pays the cost, gets the house, the other builds it.

    Cost-plus or flat fee: Advantages and disadvantages

       Why is there a "plus" in cost plus?

       If one contractor will do the job for cost+$10,000, why won't another do it for cost+$9,000?

       Isn't the "plus" something for nothing? $9,000 is better than zero.

       Is it "plus" or "plus 10%?"


    Incentive to get inputs at the lowest possible cost

       Flat fee: any savings goes to the contractor

       So he wants to minimize cost--including both price and his time and trouble

       Which is what you want him to do

       Why do you care about his time and trouble?

       What would happen if you set up the contract to force him to buy the input at the lowest possible price (holding quality fixed--same brand of windows, say)? Imagine he had to pay you a five thousand dollar penalty if you could show that, somewhere, it was possible to buy an input for less than he paid?

       Cost plus: savings on price goes to you

       But any increase in time and trouble needed to get the lower price he pays

       So he won't try very hard to find a lower price

       Even if it would save you more than it costs him to do so

       Cost plus 10%?

       Friedman's rule for finding the men's room

       And why it sometimes doesn't work

       If you are using cost plus, how might you control the problem?

       What are the problems you will face?

    Incentive to get inputs of the right quality

       Do we always want the highest quality inputs?

       Do you only eat at gourmet restaurants?

       And buy the highest quality car you can afford?

       Flat fee contract: Incentive of the builder is

       To use the least expensive inputs, whatever their quality

       Because a dollar saved is a dollar earned--for him

       Cost plus contract, he doesn't care--extra quality comes out of your pocket

       Cost plus 10%?

       With a flat fee contract, how might you try to control the problem?

       What problems arise in doing so?


       Renegotiating the contract

       Your client forgot something important--try to prevent that in advance

       Something important changed.

       You are stuck in a bilateral monopoly with the builder

     The bargaining range is bounded on one side by the terms of the initial contract--if he fulfills it he is in the clear

     And on the other side by the most you are willing to pay for the change

     Which might be expensive

       You could include terms for changes in the contract

     Will that be easier with flat fee, cost plus, cost plus 10%?

     Think about it from the builder's standpoint.

       Risk bearing

       What if something changes that greatly increases the cost?

     Under flat fee, the builder swallows the loss

     Under cost plus, you do

       What if something changes that greatly lowers the value to you?

     You contract to have land cleared and a new factory built

     In 1929

     Risk allocation depends on the contractual terms for breach

     Or on negotiation--again, with a potential holdout problem

       Why does risk bearing affect the size of the pie?

     Because different parties have different abilities to bear risk

     Because poor contract terms or bargaining breakdown might lead to a smaller pie--the land gets cleared, the factory built, and it sits empty until 1942.



Electronic Equipment Service Contract


Global Consolidated Industries (GCI) has for years had an in-house electronic equipment maintenance department. It has been responsible for providing maintenance (such as periodic cleaning and lubrication of moving parts) and repair (fixing machines when they break down) on thousands of printers, photocopy machines, FAX machines, scanners, and so forth. The experience, in a word, has been a disaster. On most days, secretaries can be seen running from floor to floor and pushing in line to use other machines when theirs are inoperative. Even the CEO is often heard screaming about memos being late, meetings having to be rescheduled, and other headaches caused by out-of-order equipment.


GCI has decided that it is time to contract out for these services. As a member of GCIs general counsels office, you have been called in to participate in the contract negotiations with the outside service provider, Reliable Response Repair (RRR).


RRR has offered two contracts for your consideration. Under one contract, RRR receives a flat rate per machine each contract year. (For example, there is a $200 per year charge for a standard, mid-size photocopy machine.) Under this arrangement, RRR is obligated to provide all necessary maintenance and to repair broken-down machines promptly.


Under the second contact, RRR is paid $75 per hour (plus parts) for all maintenance and repair services. Under this arrangement as well, RRR is obligated to provide all necessary maintenance and to repair broken-down machines promptly.


Explain the pros and cons of each of the two contracts. Which seems best? Can you think of additional terms that would improve it?


v    What is RRR's incentive to do a good job of maintaining and fixing the machines under either contract?

v    To do it promptly?

v    What are GCI's incentives under each contract? Why might RRR care about that?
















v    Flat rate:

    RRR incentives

       Incentive to maintain if it is cheaper than fixing

       Incentive to do a good job of fixing, since if not they have to come back

       Promptness? Only to the extent you can enforce that term

       So you may want to define it more precisely

       Must show up within 2 hours, fix within 4, or

       Penalty based on how many hours machines are down each year, or

       Bonus for less than 6 hours down time per machine


       Very little risk to GCI—they know how much they will pay

       All of the risk is on RRR—what if a machine has problems and keeps giving trouble?

       But GCI is big enough so that such effects should average out

    GCI incentives:

       Why do you worry about those?

       GCI has little incentive to take good care of machines, train people well, control whatever inputs they provide that affect the chance of breakdown

       Little incentive to hold down RRR's cost by, say, not using machines heavily at two in the morning, or only asking for a technician to be sent when the problem is serious

       GCI has reduced incentive to buy good quality machines

       So the contract might specify machines presently on site, which RRR can inspect in advance

       Or specify what brands and models of new purchases are covered

v    Per hour:

    RRR incentives

       If per hour is more than their real cost, a serious problem

       Why maintain when you get paid to fix?

       Why fix well when you get paid to come back?

       If per hour is at their real cost, still have to monitor to make sure they are really working that many hours

       Promptness still a problem as above.

    GCI Incentives

       GCI now has an incentive to buy good machines

       To take good care of the machines

       Only to call a tech when really needed

       And RRR might charge more at 2 A.M. (modification of terms)

    Question: Does GCI have to use RRR under this contract?

       If not, they can use competition or the threat of it to control some of these problems, but

       A problem if RRR is hiring extra maintenance personnel specifically to deal with GCI repairs.

v    What if quality of repair affects machine lifetime?

    Either way, RRR has little incentive to do a good job in that dimension

    Perhaps GCI should lease the machines from RRR, with repairs and maintenance included in the terms.

v    Perhaps what we want is some of the cost on each party

    Per hour payment low enough to give RRR an incentive to maintain machines, fix  them right, but

    High enough to give GCI an incentive to do what it easily can to avoid breakdowns.

    The same principle as coinsurance.

       Neither party bears the full cost, so neither has as much incentive to prevent the problem as we would like, but

       Each bears enough of the cost to make it in its interest to take most of the precautions that ought to be taken.



Musician and Nightclub Booking Arrangement


Your client, Jerry the Jazz musician, is becoming increasingly well-known in the region. He has recently been offered a booking arrangement by the Nightowl nightclub, the ritziest jazz bar in the city, for Tuesday nights. They propose paying him $500 per appearance plus 10% of house profits. Because they want to have the opportunity to use other musicians for variety, taking advantage of out-of-town players who pass through, they are only willing to guarantee Jerry 26 Tuesday night appearances over the course of the year. They would give him one weeks notice with regard to each Tuesday, and he would be obligated to appear when called.


Jerry tells you that he finds this offer attractive because it would give him some stability in his income, something he has never had before. On the other hand, he does not like the idea that the arrangement would preclude his doing any other gigs on a Tuesday night (or out-of town gigs on Mondays or Wednesdays); given his increasing reputation, he occasionally gets great one-shot offers.


How do you advise Jerry regarding his contract negotiations with Nightowl?



v    Gains from trade

    Jerry and Nightowl both reduce uncertainty

    Appearing regularly at Nightowl probably benefits both

v    Problems that might be fixable:

    Jerry wants flexibility for out of town gigs

    How to reduce the cost of that to Nightowl?

       If he gives them a month advance notice, might be able to fill in

       They only plan to use him half the Tuesdays

       Still some cost--there might not be anybody good in town

       But perhaps less than the benefit to Jerry

       What if he can get off if he finds a substitute?

       How do we define an adequate substitute?

       Someone they have hired before?

       Someone from a pre-agreed list?

       What if he agrees to play a different day when he isn't there Tuesday?

       What if he can take off a fixed number of Tuesdays by one month advance notice?

       Hypothetical numbers

       Jerry wants the right to block out 5 Tuesdays, a month in advance

       Nightowl thinks it costs them $400/Tuesday

     Hassle of finding a replacement

     Risk of lower quality

     Disappointment of Tuesday customers who are fans of Jerry's.

       Jerry offers to accept $400 instead of 500 per appearance in exchange

       Saves Nightowl $100x26 Tuesdays=$2600, so they are better off

       Jerry can make $1000 more for out of town gigs, so gains $5000, loses $2600, so he is better off too

v    Other issues

    If Jerry has the option, he might choose big nights--New Year's Eve--since he is getting the same fee for every night from Nightowl, could get more elsewhere.

       How might we solve that?

       Pay him more for specified big nights?

       Or specified big nights he doesn't have the option of taking off?

       Or, when he notifies them, they bargain with him?

    Breach: Under the initial contract, what if he accepts a Tuesday gig and then Nightowl wants him that Tuesday?

       Liquidated Damages? What does the contract say?

       What if he is sick and can't play?

       Can Nightowl tell the difference? Depends how far away the gig is?

       Breach terms another way of getting flexibility

       Liquidated damages of $300 if be backs out with a month notice

       $500 a week's nnotice

       $2000 if he just doesn't show up

       How should we set the damages?

       How about calling in sick?

       Negotiation another way of getting flexibility

       Gets an invitation for an out of town gig

       Asks Nightowl if they need him that night

       If they do, starts bargaining

       Assymetric information? How is it in Nightowl's interest to act?

       Can Jerry tell?

v    Incentive issues

    For Jerry: What are his incentives

       To do a good job?

       To come when he says he will?

    What are Nightowl's incentives?

       To advertise Jerry

       To run a good club (why does he care?)

       To use him often?

       Should there be different terms for other nights?

       He isn't committed--but doesn't get paid as much?

       His time is probably worth much less than $500 if he doesn't have a gig

v    Verifiability:

    Jerry gets 10% of profits--how measured?

       You are an unscrupulous Nightowl owner--how do you hold down what you pay Jerry?

       Can he tell?

    Are there other ways of rewarding him related to how good a job he does?

       More easily observed? Revenue--but also a bit tricky

       More closely targetted on his contribution?

v    General issues here are:

    Enlarging the pie

    Via incentives

    Risk bearing?

    Verifiability of terms


State AG Litigation Contract


You are a lawyer in the consumer protection division of the state attorney generals office. Preliminary investigations as well as some undercover stories in the press reveal the possibility of a major billing scandal involving the health care industry. Following the growing number of states who have recently pursued such claims and the recent huge success in tobacco litigation, it is proposed to bring suit against a number of firms. The total damages claim is for hundreds of millions of dollars, possibly more than a billion.


 Your office, however, has only four attorneys, many of whom are quite busy on other matters. Therefore, it is agreed to hire an outside firm that specializes in large-scale litigation, probably one of those super-successful plaintiffs boutique firms. Many of them have already expressed interest and some have been interviewed.


Two further notes. First, although this novel litigation strategy has the potential to be extremely lucrative, it will also be expensive, requiring that millions of dollars worth of lawyers and experts time be invested up front. Second, the office is worried about the possible political fallout of making fee payments to outside lawyers that prove embarrassingly large.


Advise your department head on the compensation scheme that should be used in the contract with the outside firm. Focus on the form of the compensation scheme and any closely related matters. In preparing your advice, be sure that you do each of the following:


Describe different ways that the firm could be compensated.


Identify the major pros and cons of each approach.


Discuss how, if at all, any negatives of a given approach may be mitigated.



Compensation Scheme



Political, Other

Flat Fee








Contingent Fee









v    Flat Fee


       No financial incentive for lawyers to win

       Possible reputational incentive

       How well can a small AG's office monitor the lawyers?

       Can you control how hard they try by contract?


       None on payment for law firm

       But they bear all the risk of costs

       Who is more risk averse?


       No risk of stories on huge fee payment, but

       If the case fails, agency looks bad--money for nothing

v    Cost-Plus (hourly)


       To spend too much time if rate is higher than real cost of time to firm

       Too little if rate is lower, but

       Less of a problem than the previous case, where hourly rate is zero.

       Can you verify

       Hours actually worked

       Quality of work. Who do they assign, how hard does he try?

       Can you control by contract?


       All of the revenue risk is born by the state

       And most of the cost risk


       No risk of huge payments for now work, but

       Risk of huge payments for no return

v    Contingent Fee


       Firm wants to win.

       How large a fractional payout?

       Higher percentage, better incentives, but

       Less left for the state

       What about 100% and negative fixed fee?

       At anything less than 100%, incentive still imperfect. Assume 50%.

       If it costs the firm $1000 to increase expected return by $1500, they won't do it.

       So still want some oversight

       And hope reputation helps.

       No incentive for the firm to get relief other than a damage payment


       Is being shared between firm and state


       No risk of large payment for no result

       But very large amounts to lawyers if the suit is successful might be embarrassing

v    What is the maximand?

    Suppose the defendant is actually innocent

    The law firm still wants to win

    Does the state?

v    School Gymnasium: Applying what we have learned.

    Flat fee or Cost plus?

       The school probably doesn't know enough to monitor a cost-plus contract

       And is probably in a poor position to bear risk

       So flat fee is probably better, but

    Problems with flat fee

       Maintaining quality

       Have to specify a lot of details

       School doesn't have the expertise to do that, but

       Their architect might.

       Hire some sort of expert to write the specs

       Making changes

       Question your client carefully to keep later changes from being necessary

       Perhaps include in the contract that changes can be made on a cost plus basis

       Or plan on negotiating changes.

v    Arguments in litigation

    The book sketches the law and econ argument for enforcing the quality terms in a flat fee contract

       Because otherwise the builder has an incentive to degrade quality

       Even when doing so costs you more than it saves him.

    Do you think a judge would find that more or less convincing

    Than the "good faith" sort of argument?

v    Principle/Agent Contracts

    Lots of varieties, including

       Construction contracts we have been discussing

       Employment contracts

       Lawyer/client contracts--you are the agent.

       Is the President the voters' agent?


    Possible forms

       Pay by performance--did you sell a car? Win a case?

       Pay for inputs--how many billable hours?



       Employees frequently get a fixed salary, plus

       Bonus for specified accomplishments, by them or their unit or the firm, or

       Optional bonus--Google example.

       Your raise next year is to some extent a "by performance" for this year

    Incentives: How to make it in the interest of the agent to do what the principal wants

       What does the principal want?

       "To win her lawsuit?"

       At any cost?

       Performance based contracts give the agent an incentive

       To achieve the objective

       If the reward for doing so is greater than the cost of doing so

       Suppose the reward is 10% of the value of success

       Will the agent act as the principal would like?

       What about 200%?

       If all we are concerned about is the right incentive, the reward should be ?

       What are the problems with this solution?

     It might pay the agent too much.

     Consider a store whose profit depends on ten different employees.

     How would we solve that problem?

     The solution might impose too much risk on the agents.

       So there are costs to the rule that gives the right incentive.

       A further problem is measuring output

     Consider the President of a publicly traded company

     Perhaps profits are low this year because of high research costs which will bear fruit in five or ten years

     Or because of problems facing the industry for which he is not responsible.

     Consider a secretary or janitor or  . How do you measure output?

       One reason to decentralize firms is to make this problem a little easier to solve

     We can judge the output of the Buick division of GM better if it is run like a separate company

     Of one partner in a law firm if we can keep track of his accounts

    Input based contract

       For instance, paying an hourly wage

       Or billable hours

       Gives the agent an incentive on the measurable dimension of input

       But not on other dimensions--how hard he works, for instance.

    Fixed fee contract

       No automatic incentive to do anything

       Make the fixed fee for some measurable result (show up in court, etc.)

       Or have some way of defining what inputs the fixed fee is buying, and monitoring them.

       May rely heavily on reputation.

v    Risk bearing

    Performance based, risk born largely by the agent

    Input based, principal bears risk of outcome, risk of wanting more inputs.

    Fixed fee, principal bears risk of outcome, agent risk of costs.

v    Coffee house manager employment contract

    Performance based

       Do we have to base it on the profits of the whole firm?

       Or is there a better solution?

       What about compromises to reduce the risk the manager bears?

    Input based

       Performance depends on manager's inputs, but

       Much of it is qualitative, hard to measure, harder to prove to a court in case of dispute

       And the quantitative--hours put it in--requires someone monitoring the manager

       Which means someone working in his coffee house

       And so partly dependant on him for promotion etc.

    Fixed fee--flat salary

       Requires monitoring of inputs and performance

       If unsatisfactory, replace the manager

v    Joint undertakings


       Partnership--such as a law firm

       Joint project by two firms--Apple and IBM, say

       IBM develops a new chip (G5, 60 nm)

     Apple makes plans and promises based on it

     And Steve Jobs eats crow when he still doesn't have his 3 Ghz desktop.

       How might a contract deal with this (don't know if it did)

     IBM controls how hard they try

     And has more information on what they can do, risks (not enough information, as it turned out—everyone had more trouble with 60 nm than expected)

     So should IBM be liable for Apple's losses?

     But Apple is the one deciding what promises Steve makes, other decisions affecting amount of loss.



       Horizontal division—between partners, allocating income by business brought in, billable hours,

       Functional division—Apple and Motorola above.

    Risk sharing

       May modify "reward by output" within firm

       Partly output, partly input, partly fixed

    What is observable?

       Did IBM make best efforts to develop?

       Could Intel be used as benchmark?

       Did Apple act to minimize loss due to failure of IBM to deliver?

v    Sale or lease of property

    Quality dimension

       Of property as delivered

       And as returned


       Contractual restrictions on use, subletting,

       Security deposit

       Saves court costs if property damaged,

       Solves judgement proof problem, but

       How do you keep landlord from confiscating it if not damaged?

       Raises the general issue of structuring a contract wrt what happens if nobody goes to court. Will return to that Thursday

       Damage in delivery

       Make the party who has possession liable? Can best control

       Or the party who chooses third party to deliver


       What are you obliged to tell?

       Treaty of Paris, war of 1812, case.

       Poltergeist case

    Who bears the risk of the rented building burning down?


       Risk spreading? Probably landlord.

v    Loan

    Risk of bankruptcy,

       deliberate or otherwise.

       "deliberate" might include taking risks—heads I win, tails you lose.

       Control by

       Security interest in property—borrower can't sell it

       Controls on what borrower can do.

v    Resolving disputes

    Some can be avoided by anticipation, but .

       There isn't enough small print in the world to cover everything

       And events may occur that you hadn't thought of.

    Damages for breach

       Expectation damages lead to efficient breach, inefficient reliance

       Liquidated damages solve the problem—if damages can be estimated in advance.

v    Negotiating the contract

    Try to maximize the pie

       By offering to buy improvements that help your side at a cost to the other

       To sell improvements that help them at a cost to you

       To trade

    Try to maximize your share—typically in the price

       While remembering that if you ask for too much

       You risk bargaining breakthrough

       And getting nothing

v    China to Cyberspace: Contracts without court enforcement

    An issue for

       You—because part of an attorney's job is staying out of court

       Which you do in part by designing contracts

       Which it isn't in either party's interest to try to get out of

       Look at how many contracts amount to the consumer signing away as many of his potential claims as possible

     One explanation is that it is that way to benefit the seller at the buyer's expense

     That seems inconsistent with our analysis—any expense to the buyer will reduce what he is willing to pay for the product

     Why might this arrangement be in the interest of both? (stay tuned)

       Imperial China—because legal system was almost entirely penal

       You could complain you had been swindled, ask the district magistrate to act

       But you couldn't actually sue and control the case

       And the legal system said almost nothing about contract law

       Cyberspace, because

       Hard to use the legal system when dealings routinely cross jurisdictions

       The technology makes it possible to combine anonymity and reputation

     Public key encryption as a way of maintaining anonymity

     And digital signatures as a way of proving identity

    Either your realspace identity, or

    Your cyberspace identity

    I.e. that you are the online persona with a particular reputation.

    My legal eagle business plan

       For quite a lot of people, anonymity might be a plus

     Lets you opt out of the state legal system—which contracts often try to do.

     Protects you in places where security of property is low

    Do you want to be a programmer known to be making $50,000/year

    In China, or Burma, or Indonesia, or

    You might be worried about either private seizures—kidnapping your kids, say

    Or public ones.

     Might let you evade taxes or regulations at home.

    One way of enforcing contracts without the courts is reputation

       Reputational enforcement depends on your being a repeat player, so your reputation matters to you.

       It also depends on interested third parties knowing whether you cheated someone

       Since your "punishment" isn't designed to punish you

       But to keep other people from letting you cheat them

       If it is hard to know which party to a dispute is telling the truth

       Interested third parties will distrust both—either might be lying

       So it isn't in your interest, when cheated, to complain

       So reputational enforcement doesn't work

       Arbitration is a way of lowering the information cost to third parties

       If we went to a respected arbitrator, or one we agreed on advance

       And he ruled in my favor, and you didn't go along

       You are probably the bad guy

    Another way is structuring the contract so that it is never in either party's interest to breach

       I hire you to build a house on my property

       If I pay you at the beginning, it is in your interest to take the money and run, if you can get away with it.

       If I pay you at the end, it is in my interest to keep the house and not pay

       So I pay you in installments during the construction

       Arranged so there is no point at which either of us gets a large benefit from breach

       Sometimes doing this requires costly changes in the pattern of performance

     Lloyd Cohen's explanation of the consequences of no fault divorce

    In the traditional marriage, women performed early, men late

    Many men find younger women more attractive, so

    Incentive for a husband at forty, with the kids in school and his wife finally getting a chance to rest

    To dump her for a younger replacement

     How did women change their behavior to control the problem?

    Postpone childbearing in order to bring performance more nearly in sync

    Shift household production to the market and get a job

       Which both gets performance in sync, and

       Reduces the degree to which the wife is specialized to being the wife of that man

       And so at risk if he breaches.

       Since there are gains from completing the contract, in a world of certainty we ought to be able to structure payment and performance to achieve this, but

       In an uncertain world, where costs and benefits may change, it's hard

       We can always reduce my incentive to breach by my giving you a deposit at the beginning, which you hold and will keep if things break down

       But that increases my incentive to breach

       One solution is to use a hostage instead of a deposit

       I give you something—my son, my trade secret—that

     it costs me a lot to lose

     but benefits you only a little to keep

     so pushes down my benefit from breach a lot, yours up a little

       Another solution is to structure payments so that the incentive to breach is on the party who has reputational reasons not to

       You are going to do some work for me online—write a program, say

       If you are a repeat player with reputation, I pay in advance

       If I am, I pay for the program when it is delivered

       Arguably, these explains the feature of real contracts discussed above

     It is in the interest of both parties to avoid expensive litigation

     The seller is a repeat player with a reputation, the buyer is not

     So substitute reputational enforcement for court enforcement

     Which would you prefer

    To buy a product with a long warranty from Apple or Kitchen Aid—in a world where the warranty wasn't enforceable

    Or from a no-name seller, in a world where you could sue the seller for not carrying out the warranty?

v    Other ways of staying out of the court

    So far as possible, arrange the contract so that the result you want is the one that happens with no court intervention

    Caveat emptor is an example

v    General observations

    a bunch of simplifications

       cost rather than current value


       must be linked to some past transaction or event

       yield probable future benefits

       be obtained or controlled by the entity

       assets dont include good will, corporate culture,

       all probabilities are one or zero


    Compare to tort law

       All probabilities are one or zero

       Someone sues you for ten million dollars

       If probability of guilt is .4, you owe nothing

       If .6, you owe ten million

       Damages tend to be limited to

       pecuniary, medical costs, lost earnings

       less willing to include pain and suffering and the llike

    in both cases, we have to make decisions with a very crude process

       making legal outcomes depend on things in complicated ways is likely to raise litigation costs, legal uncertainty. Easier to prove a doctors bill than a pain.

       Accounting aims at sufficiently clear cut decision rules

       So that firms cant easily manipulate the outcome

       To make them look good

       Or reduce their taxes.

       At a considerable cost in accuracy

v    Understanding accounting

    First rule—ignore debit/credit or reverse their meaning

       Most of the time, a debit makes a firm richer

       A credit poorer

       One explanation: "Debit" is from Italian Debitare—what others owe you

       And what about credit?

    Second rule—()= -

    making sense of a balance sheet

       photograph of the firm at an instant—compare two dates

       show a list of assets, most liquid at the top, at two periods

       group into current assets, total

       and long term ("property, plant and equipment") and total

       total the two totals for total assets

       similar list of liability and owner's equity

       liability a negative asset

     probable sacrifice of economic benefit

       why do you put equity with liabilities?

       How much wealth does the firm itself (as opposed to stockholders and others) have?

       the fundamental equation

    making sense of an income statement

       designed to show the changes over a period of time

       money coming in: Sales revenue (or equivalent for other sorts of firms)


       cost of goods sold—raw material, labor, etc.

       operating expenses: Costs not attributable to particular output

       interest expense

       income tax expense

       at each stage, you have a net to that point

       and end up with net income

    making sense of a cash flow statement

       the one in the book

       money comes in as net income, but

       if part of the "income" is accrued but not received

     it goes into accounts receivable, not cash,

     so less cash

     reverse if some accounts from last year are paid, increasing cash

     so subtract from income the increase in accounts receivable

       accounts payable the same thing in the other direction

     we subtracted out expenses in calculating income, but

     if some expenses were accrued but not paid

     we still have the cash

       we subtracted out depreciation in calculating net income—but they didn't use up any cash. Add back in.

       also cash flows from

     borrowing (increases cash)

     paying dividends (uses up cash)


    making sense of T-accounts

       The T-account records a single transaction, not a balance or a total over time

       each transaction is entered twice

       if you buy something

       that decreases cash, increases asset (land, factory, raw materials)

       if you sell something, increases cash, decreases inventory

       what if you make money?

       Buy something for $100

       Sell it for $200

       How do you make the accounts balance?

    Joyce James Case


Joyce James graduated from college in June 2002.   As was traditional in the James family,  Joyces parents paid all of her expenses through college.  But, upon graduation, she was expected  to fend for herself financially.  On the date of her graduation, Joyce had neither financial resources  nor financial obligations.  Now that she is responsible for her own finances, one of her friends has  suggested that she might want to think about putting together a financial statement of some sort.  What sort of financial statement do you think would be useful for Joyce?  How would you propose  she  account for the following transactions?


1. At her graduation exercises, Joyce was awarded a prize of $5,000 her senior thesis on Day  Hiking in Ireland. The prize came in the form of five one thousand dollar bills.


2. She spent $2,000 of the prize money buying books she would need for graduate school,

which she was planning to attend in September.


3. She spent another $2,000 traveling through Europe over the summer and collecting memories  of a lifetime.


4. At the end of the summer, she took out a $4,000 loan to cover the costs of graduate school.


v    Why might she want to work out a financial statement?

    To keep track of her situation—decide if she is too much in debt, etc.

    For other people—to get a loan,

v    What kind of information is most useful to her?

    Probably a balance sheet, showing her assets and liabilities

    But to get there we will use T-accounts—more for our information than hers.

v    How do we record the prize?

    She gets $5000 in cash—where does that go?

    What's the balancing item?

    Is there a reduction in some other asset?

    An increase in a liability?

    If not, what's left.

v    She spends $2000 on books for grad School

    Where does the expenditure go?

    What's the balancing item?

v    She spends $2000 traveling in Europe and collecting memories?

    Where does the expenditure go?

    Are the memories an asset?

    If not, what balances the expenditure?

v    She takes out a $4000 loan to cover the costs of graduate School

    Where does the loan go?

    What balances it?

v    She spends $5000 on living expenses in graduate school

    Where does the expenditure go?

    What balances it?

v    Now put this all together for a balance sheet

    What are her assets?

    What are her liabilities?

    What is her equity?

v    Is this an accurate account of her actual situation?

    For what purpose?

    Are you thinking about loaning her money?

    Or marrying her?

v    The matching principle

    So far as possible, we want to put revenue and the associated costs in the same period

    So that we can see how what we are doing is affecting us

    So we try to recognize income when it is earned, not when we get it

       By showing it as an increase in accounts receivable

       If it isn't actually going to get paid until the next period

    And defer costs to when they will generate income

       Depreciation is an attempt to do that

       Your computer isn't a cost for this year but a cost spread over several years

       What happens if you buy identical inputs at different prices?

       What value to use to measure them when you sell them (or use them)?

       FIFO or LIFO?

v    The lawyer's perspective—why does all this matter to you?

    Contracts may specify things in terms of accounting entities

    The decision to make a loan may depend on accounting figures on the borrower

    Firms have legal obligations with regard to accounting, especially publicly traded firms, and you may have to tell them if they are fulfilling them.



Accounting for Lawyers: 

Upstage Theater Company Handout

The Upstage Theater Company (UTC) is a non-profit community theater group that puts on

several plays each year.  On December 31, 2001, the Company had the following balance sheet.





Costumes and Sets


Total Assets


Liabilities and Surplus

Bank Loan


Total Liabilities




In the course of 2002, the following events occurred.  The company would like your advice on how to account for these transactions.


1.         At the beginning of the year, an anonymous donor makes an unrestricted gift of  $1,000 to UTC.


2.         The company spends $1,000 on costumes and sets for the coming season.

3.         Over the course of the year, the company sells $3,000 of tickets for the years performances.

4.         Over the course of the year, the company spends $1,000 on the rental of auditoriums and other costs associated with putting on the years productions.


5.         Towards the end of the year, the company launches a new initiative to make advance sales of tickets for the next years season. $1,000 in advance sales are made.


v    $1000 gift

    where does it go?

    What balances it?

v    $1000 spent on costumes and sets

v    Sell $3000

    $3000 to cash

    could be balanced by equity, but

       we want to keep track of income and expenses

       so as to be able to write an income statement

       so put it there

       and plan to transfer to equity when we close the books, subtract expenses

       add net income to equity

v    Spent $1000 on rental etc.

    Subtract from cash

    Balance where?

v    Make $1000 in advance sales

    Add to cash

    Balance where?

    Is this income?

    Liability? Do we owe it to anyone?

    From the standpoint of an income statement, we owe it to next year's income

    Since we want to match up income with expenses

    So it goes to deferred income

v    Costumes don't last forever--how do we include depreciation in this?

    Suppose four year lifetime--25% depreciation each year

    Where does it go?

       Reduction of inventory, and

       Could be reduction of equity, but

       We are trying to keep track of expenses, so

       Goes to expenses

v    At the end of the year we close out the books

    Add up cash credits and debits, starting cash, gives final cash

       $2000 initial

       +$5000 debits

       -$2000 credits

    Add up costumes etc:


       =$3000 final.

    Add up income and expenses, transfer to equity (Surplus)

    End up with a balance sheet

       $5000 cash + $3000 costumes and setsw = $8000 assets

       $1000 deferred income +$4000 loan+$3000 equity=$8000

v    using the information

    a potential donor wants to know if his money is


       going down the drain ("throwing good money after bad)

    a potential lender wants to know if the company will be able to pay him back

    a government agency that wanted to subsidize the arts might want to know if these are good people to subsidize.

v    Summary of what we have done

    Asset adding to equity (donation)

    Asset converted to another use (cash to costumes)

    Cash balanced with income (ticket sales, will go to equity after netting costs when books are closed)

    Expenditure balanced with expenses (rental etc.--will go to )

    Asset balanced with a liability to the future (advance sales)

    Depreciation: Reduce an asset, balance with an expense, will go to

v    Back to the matching principle


       Revenue should be allocated to the period during which effort is expended in generating it

       An expense should be allocated to the period in which the benefit from it will contribute to income generation

       So if expense is in year 1, revenue in year 2

       Do you move expense forward or revenue back?

    If "effort expended" has an unambiguous date, move it to that year?

    Otherwise, answer depends on when you have the information?

       If we have an expense this year for income next year

       We probably don't yet know the amount of the income

       So move the expense forward--"prepaid expenses"

       Similarly for "Deferred Income"--we'll know more next year

    "accounts receivable" go the other way--moving income back

       because the amount is (hopefully) known

       as are the rest of the associated expenses and income

v    fixing the oil problem (Figure 4-6)

    what was left out of the story and the accounts?

    What happens when we put it back in?

    We are moving profits into equity--eventually

v    "Conservative bias"

    a misleading term if it means "err in the direction of underestimating income and equity"

       intangibles, after all, can go down as well as up

       as can the market value of assets

       and ignoring changes in overall prices actually overstates income--eventually

       Buy something for $1000

       All prices double

       Sell it for $2000

       Accounting profit: $1000

       Actual profit: zero

    more nearly a sceptical bias

    Err in the direction of ignoring things hard to measure

       Count intangibles if they have actually been bought at a price

       Use market value for financial assets where it is easily determined

v    Defining an entity

    How to reduce your taxes

       Have a small business

       Treat expenses for things used in your business and for consumption as business expenses

       IRS rules try to prevent this--home office, automobile, etc.

       But you are the one structuring and monitoring things

    What is happening is that you are (deliberately) blurring the lines between two entities

       Your business and


    How to run a law school at a profit (or loss)

       Some costs could be counted as costs of the Law School or of the whole university

       Maintainance of our lovely campus

       Some publicity costs

       Attribute them to the university, and the law school is making a profit

       To the law school, and it is making a loss

       Sometimes law schools or business schools have agreements with the university they are part of

       Defining how costs are divided

       And how much of the school's revenue the university is entitled to

       Which might be based on profit rather than revenue

       In which case the accounting matters

       Sometimes it might pay to move some activities into the law school to make those lines clearer

       Suppose the Law School thinks the university charges it too much for keeping track of student records

       Shift to the law school having its own people keep track of its students

       Have lunches in the faculty lounge instead of  Benson

       Do you prefer a profit or a loss?

       Depends who you are talking to

       If you owe a percentage of your profit to the University, prefer a loss

       If you are raising money, probably prefer a profit--but not too big a profit.


       Create an entity whose books your firm's accountants won't see

       Shift losses to it

       Sell something to the entity at much more than it is worth

       Or buy something for much less

       Or shift gains to it before Enron goes bankrupt--and make sure you control the entity

       One reason lawyers worry about making sure transactions are "arm's length."






Joe Landscaper and Gill Snowfall are both in the business of plowing driveways for a number of years.  Their only revenues are payments they receive for their plowing services.  Their only expenses are from the purchase of gasoline and the wear and tear on their trucks.


A. Joe plows driveways in December and is paid $500 in cash.


B. Gil also plows driveways in December and sends his clients bills for $ 600.


C. Joe gets $200 of gas in December and puts it on his credit card.


D.   Gill buys $250 of gas in December and pays cash.


Who had a better month?


E.  On January 1st, Gills old truck dies and he decides to purchase a new truck for



How would you account for this transaction?


v    Payments for Joe and Gil in December

    Joe gets $500 in cash, balanced by ?

    Gil gets $600 in ? balanced by ?

    When are we recognizing income?

v    Expenses for Joe and Gil in December

    Joe buys $200 of gas on his credit card

       $200 in expenses

       where does the matching $200 go?

    Gill buys $250 of gas, pays cash

       $250 in expenses

       and ?

    We want both expenditures to be in this period

v    Who had a better month?

    Compare their income statements

    Whose income minus expenses figure was larger?

    Whose cash has increased more?

    Which matters? When? To whom?

v    Gill buys a new truck

    Asset for asset swap

    At what point does the cost of the truck show up as an expense?

v    Does this fit the matching principle?

v    Stuff I'm leaving out

    The discussion of standards, boards, etc. matters

    But it isn't about analytical methods, although it is about accounting

    So you can probably make sense of it just as well without my help as with it.

v    How to use the information accounts provide?

    Who are you?

       Investor, interested in long term expectations of the firm

       Lender--wants to know if he will be paid back

       Supplier--wants to know if he will be paid. Lawyer, for instance.


    Will the firm be able to meet its short term obligations?

       Compare short term assets (Cash, accounts receivable, inventory)

       To short term liabilities (bills payable, short term loans, )

       Is "assets more than liabilities" enough?

       Depends how fast that is likely to change

       Lender has some control over that via contract

       Can require borrower to maintain some financial ratio

       Rule of thumb: current assets should be at leat 1.5 to 2 times current liabilities

       What if current assets almost all in inventory? In accounts receivable?

       How could a firm improve its short term situation?

       Take out a long term loan

       Increase its cash, or

       Reduce short term debts

       Does not increase long term solvency, but

     The fact that someone is willing to make a long term loan to them

     Is evidence that the lender thought they were solvent

     But   might want to check on the interest rate.

    Is the firm solvent--long term obligations?

       Look at ratio of liabilities to

       Assets, or


       Are these really different measures?

       Could a firm look good on one and bad on the other?


       Consider a firm with $10 million in assets, $9 million in liabilities

       What are the good things about that situation?

       What are the bad things?

       For whom?



       Why would much higher degree of leveraging be acceptable in some industries than in others?

     How predictable is the value of Apple's inventory of iPods vs

     Merrill Lynch's inventor of securities?

       Look at interest payments vs earnings available to pay them

       Interest coverage

     Calculate from Figure 4-3

     Operating Earnings/Inerest expense

       How close is the firm to being unable to pay interest on its debts?

    How well run is the firm?

       Accounts receivable/sales revenue--how long does it take the average customer to pay?

       Depends on the industry as well as management

       How long does it take MacDonald's average customer to pay?

       Turnover ratio: How fast does the firm turn over its inventory?

       "Just in time production" is a limiting case

       But a firm that is doing a bad job of estimating demand will have inventory build up, or

       Be short--high turnover ratio could be evidence of a mistake

       But also success--high demand for their goods.

       What is the average interest rate the firm pays on its loans?

       A high rate might be evidence of bad shopping for loans, or

       A high risk premium

       For all of these, one would want to compare to other firms in the same industry

    How profitable is the firm?

       Note that "profit" means a lot of different things

       Revenue minus cost

       The supermarket pays a dollar for that box of cereal

       Sells it for two dollars

       So their profit is 100%!

       If only we cut out the middle man

     Set up a consumer's coop

     Get government to distribute food instead of the supermarket

       But all of those alternatives require

     Salary to employees

     Rent, utilities, maintainance on the facilities

     Interest on the money used to buy the inventory

     Allowance for spoilage, unsold goods, theft,

       Operating Earnings/Revenue

       Operating Earnings: Revenue minus cost of goods sold and indirect expenses

       What is available to pay interest, taxes, dividends, and increase equity

       Return on assets

       Net income (after paying everything including interest and taxes)

       Divided by total assets

       If this company has a higher ROA than most, than either

     It is unusually well run (or lucky), or

     Someone else should get into the business too

     Duplicate its assets with an investment I, get higher than the usual return.

       Return on equity

       Same as ROA if no liabilities

       Think of equity as what the owners would get if they liquidated the firm--carefully.

       If return on equity is more than the market interest rate, they are better off keeping the firm going

    Two qualifications

       Some of these will be different in different industries

       All of these are subject to the problems with accounting as a measure

       Consider a firm

       whose chief asset is land bought long ago for a million dollars, now worth $100 million

       no large liabilities

       And currently making $1 million/year

       Making $1 million on assets of $1million is stellar performance

       So is $1 million on equity of $1 million

       Is the firm doing well? Should the owners keep going or sell out?

    Book value of a share

       Equity divided by number of shares

       A good measure--if equity really measures what the stockholders own.

       The usual problems

       Historical costs

       Neglect of intangibles

       And contingencies

    Earnings per share

       Net income (after everything)

       divided by number of shares

       If an accurate measure

       And if likely to continue into the long future

       A good basis for what the share is worth, but

       If it isn't worth that on the market, someone may know something you don't.

    Price/earnings ratio



v    Taking advantage of accounting flaws

    You are the CEO of a company, and want its balance sheet to look good

       Perhaps you are trying to get a loan

       Or issue some new stock

       Or justify your lavish retirement terms

       Or conceal the fact that you've been stealing from the company

    What perfectly legal steps might you take to increase equity

       As defined by accountants

       Other than increasing the real, long term value of the company.

    What if you want the balance sheet to look bad

       Because you want to drive down the stock price before your friend buys lots of it

       Or you are planning to take the company private, and want to pay the stockholders as little as possible

       How do you lower equity as measured by accountants, without actually hurting the company, at least very much?

    Why are the answers to these questions of interest to you as a lawyer?

       One reason is that you might want to advise a client as to legal ways of fooling people

       Is there another--perhaps more ethically attractive--reason?

v    Animal Rights league

    Shifting from cash to accrual

    How to account for pledges?

       Debit pledges Receivable, credit Revenue

       Next year, $285,000 in pledges actually paid

       Debit cash $285,000, debit revenues $15,000 (pledge write-off)

       Credit pledges receivable $285,000 + $15,000 (two items)

       Note that pledges paid are an asset for asset swap

       Pledges written off reduce revenue


       Figure that pledges are payment for future services

       Debit pledges receivable

       Credit deferred income

       Then next year

       Debit deferred income

       Credit revenues

       To decide, ask whether the revenue is from the telethon or advance payment for next year's work

       Third alternative—expected value

       On average, $100 in pledges is only $95 in expected contributions

       So debit pledges receivable this year at $285,00, credit revenue with same

       Next year, credit pledges receivable, debit cash

       More accurate, less of a hard number (probability), more of an economist's approach, less of an accountant's

    How to account for moving expenses and salary of new executive director

       Capitalized (an investment, to be depreciated) or expensed?

       Start by crediting cash $150,000, which is no longer in your account

       If you expense it, debit expenses by $150,000, easy

       If you capitalize it

       A new asset—prepaid moving expenses, debit $150,000

       Each year, credit that by that year's share, debit the same amount to expense (of having an executive director).

       Amortize 1/5 each year

       What if you capitalize it, and she quits after a year

       Remaining $120,000 is written off—investment that went bad

       Credit prepaid moving expenses (an asset, now reduced to zero)

       Debit expenses (which will get subtracted from revenue)

       Expensing easier, more common, but

       For a small company, large expense, amortizing it may be more realistic

       Since otherwise you lose lots of money the first year.

    Note that both of these raise the question of allocating income and expenses to the right period

    In both cases, the way you do it depends on a guess about the future

       Pledges might not be honored

       Jane might quit

v    Energy Cooperative

     Basically buying and selling fuel, with a subsidy

    How to account for cost of fuel bought: LIFO or FIFO

    Should they write off the value of half the computers, now obsolete

    Constraint: In default of a loan if

       Return on Assets falls below 5% or

       What is it now

       Net Income=$31,000. Assets $300,000.


       No problem?

       Liabilities to Surplus ratio above 200% ("Surplus"="Equity"

       What is it now?

       200%. Oops.

    LIFO will raise the

       (accounting) cost of fuel sold (priced at higher current price)

       So next net year's income will be less if we switch to LIFO

       Lowering the ROA--but unless the effect is very big, still no problem

       what about the value of inventory?

       Does not affect the left hand side of the accounts--total value of what you bought is what you paid for it

       Affects the right hand side--LIFO means inventory value falls faster as you sell oil

       Since you are "selling the more expensive (later) oil first"

       So assets will be lower at the end of next year if we use LIFO

       Which raises ROA, reducing any problem from lower income. But

       Lower assets mean lower surplus mean higher liabilities/surplus

       Oops We are in default

    Writing off computers

       Credit (Reduce) inventory, hence assets

       Reduce net income by $20,000

       Reduce surplus by $20,000

       If we did it for this year, net income from $31,000 to $11,000

       Assets from $300,000 to $280,000

       Pushing ROA below 5%, in default

    In either case, there are arguments for the change so

       Before making it

       See if you can negotiate a change in loan terms, or


v    Review The course so far.

v    Decision Analysis

    Way of formally setting up a problem to help you decide what to do

       Does not provide the information:

       Choices to be made and how they are related (the graph)


       Payoffs to the various outcome

       But it does point out to you what information you must obtain

       Set up a graph showing

       alternatives you choose

        alternatives chosen by chance, with their probabilities

       outcomes, with their payoffs--how much better or worse are you (or your client) if it comes out that way.

       Start at the right end--final outcomes

       At each point where you make a decision--the last one you will make--evaluate the expected value from each choice

       The final choice leads either to an outcome, with a value, or

       To a further choice made by chance, and you can evaluate its expected value: the sum of probability times payoff

       One of the alternative choices you can make gives the highest payoff--eliminate the others (cut off the graphs)

       Now that decision point has a value, just like the payoff of an outcome--the expected value from making the right choice there.

       Do this for all your final decision points

       Repeat the process at the next decision point left, repeat for all those.

       Continue until you know all decisions you will make

    How do you get the information to set up the problem?

       Not from decision theory

       From your expert knowledge of the situation

       Your client's expert knowledge

       Research you can do, such as looking at similar cases to see their outcome

       Consulting with other experts

    Sensitivity analysis

       Since the numbers are probably uncertain

       It's worth varying them a bit, and seeing if your decision changes

       If the decision is very sensitive to some payoff or probability, perhaps you should investigate further to make sure you have it right.

    Risk aversion

       So far I have assumed you are maximizing expected return--the sum of dollar payoff times probability over all alternatives of the decisions controlled by chance

       For gambles small relative to your assets, that is the right thing to do

       For large gambles, the fact that additional dollars are probably worth less to you the more you have comes into play

       You have to ask yourself which gamble you prefer, not merely which has the larger expected return.

v    Game Theory: Strategic behavior. My best moves depends on what he does, his best on what I do

    Bilateral monopoly bargaining

       Common interest in getting agreement

       Conflict over who gets how much

       Bluffs, threats, commitment strategies

    Many player game adds in the possibility of coalitions

    Can represent a game as

       A sequence of choices, like decision theory, but with two (or more) people plus chance making decisions

       Useful for solving a game by finding a subgame perfect equilibrium

       Very much like the decision theory approach

     start at the right, the last decision anyone makes

     figure out which choice at that point is in that chooser's interest, lop off all others

     do it for all the rightmost choices

     them move left and do it again

     I don't have to worry that if I do X he will do Y if I know that, once I do X, it will be in his interest to do Z instead.

       Note that this assumes away commitment strategies

       "If you do X I will do Y, which hurts you

       even though it hurts me too

       because knowing that, you won't do X, and that benefits me."

       In some games--one time, no reputation--commitment strategies are unlikely, so subgame perfect is a sensible approach

       In other games that is not the case.

    Represent as a strategy matrix (two player games usually)

       A strategy is a full description of what I will do given any sequence of choices by you and by chance

       Given my strategy and yours, there is some outcome, or expected outcome, that results

       So we can imagine a matrix showing all my strategies down the left, all yours across, outcomes for both of us in the cells

       And this approach, for a zero sum game, gets us to the Von Neumann solution

       A pair of strategies, each optimal against the other.

    One can look for a dominant solution to such a matrix

       As in prisoner's dilemma

       One choice is best for me, whatever you do

       Another best for you, whatever I do

       So we will choose those two

       Of course, there may be no such solution.

    One can look for a Nash equilibrium to a many player game

       My strategy is optimal for me, given what everyone else is doing

       The same is true for everyone else

       But we might be all better off if we all changed together

       For instance, from driving on the left to driving on the right.

       Or even if two of us changed together

       For instance, both rushing the guard instead of going back to our cells.

    Von Neumann solution to many player game

       Not in the book, not responsible for

       But I sketched the idea briefly.

    Schelling points

       In a bargaining situation, people may converge on

       An outcome perceived as unique--50/50 split, or what we did last time, .

       Because the alternative is to keep bargaining, and that is costly.

    Moral Hazard: Economics not game theory but in the chapter

       If part of the cost of my factory burning down is paid by the insurer

       I will only take precautions whose benefit is enough larger than their cost so that they pay for me as well as for us

       So some worthwhile precautions won't be taken

       Applies to any situation where someone else bears some of the cost of my action.

       One solution is for the insurance company to require certain precautions

       Another is to reduce the problem by not insuring too large a fraction of the value

       But sometimes, moral hazard is a feature not a bug, because the insurance company now has an incentive to keep the factory from burning down, and might be better at it than you are.

    Adverse selection: Also economics not game theory

       Market for lemons--problem with used cars

       Might solve by guaranteeing the used car--but that raises moral hazard problems.

       Bryan Caplan on a blog: Why doesn't this destroy the adultery market?

       Why do you want him to leave his wife and marry you if

       He's the sort of bum who is first unfaithful to his wife and then dumps her?

v    Contracting

    Basic idea: How to maximize the total gain from the contract. All the rest is bargaining over cutting the pie.

    Basic solution--give people the right incentives.

       Arrange it so that if something costs $10,000 and produces a combined benefit for the parties of more than that, it is done, if less than that, it isn't

       Where something might be

       What materials you use to build a house

       Searching for the best price

       Deciding to breach the contract


    construction contracts: Two and a half basic forms

       fixed price

       incentive to minimize cost

       but also to do it by skimping on quality

       cost +

       no incentive to minimize cost

       or skimp on quality

       cost +percentage of cost

       incentive to maximize cost

       and build only gold plated cadillacs

       choose according to

       which problems are hardest to control

       who you want to allocate risk to

       ways of trying to limit the damage done by the wrong incentives in each case

       remembering that what you can specify is limited by

       what you know enough to specify (quality, for instance)

       and what you can observe.

    Other sorts of contracts add another interesting option

       Pay by results

       For instance a contingency fee for a law firm.

       Or commissions for salesmen

    We discussed


       Joint undertaking

       Sale or lease of property


v    Accounting

    Understand four things about the mechanics

       A balance sheet

       Cash flow

       Income statement

       T accounts

    And how they are related

       T accounts show each transaction


       Once on the left side, once on the right

       Either because a gain balances a loss or

       Because a gain without a loss increases income and eventually equity

       Fundamental equation: Assets=liabilities+equity (assets-liabilities=equity)

       To keep that true when a transaction occurs, either

       Liabilities don't change (increase one, decrease one)

       Assets don't change (increase one, decrease one)

       Change in assets equals change in liabilities

       Change in assets or liabilities is reflected in change in equity

       Some combination of the above


       Allocating income and expenses to the right time period—not always when income received or expenses paid

       Various simplifications of what is really happening, to reduce the influence of judgement calls and thus reduce the ability of the accountant or firm to manipulate results

     Purchase price rather than market value

     Ignore intangibles unless they were purchased

     Treat uncertain outcomes as zero probability (p<.5) or certain (p>.5)




v    What is finance

    Analysis of decision problems involving the allocation of resources over time

    In a world of uncertainty

v    The nature of the firm


    Why is the capitalist beach made up of socialist grains of sand?

    The inside contracting system

       Firm A makes gun stocks

       Firm B makes the barrels

       Firm C makes the receivers

       Firm D assembles and sells the guns

       What happens to B, C, and D if A is shut down because its owner gets sick?

    More generally, think about an economy which was markets all the way down

       Some parts of ours come close

       The one person law firm--but he probably hires a secretary

       People who mow lawns

       Free lance writers

       Markets work well for selling a well defined good at a time--mowing a lawn

       For performance over time, we need contracts

       And we have seen some of the potential problems that contracts raise

       And the problems with trying to control them

       So one solution is a firm instead

       The contract is "you do what the boss tells you within the following limits"

       And if you don't like it you quit

       But that solution raises its own problems

       Instead of the costs of transacting in the market, you have

       The costs of monitoring your employees to make sure they are serving their employer's interest, not just their own

       Which gets harder and more expensive the more layers of control there are.


    Berle and Means (actually Adam Smith) problem

       If the firm needs a lot of capital it organizes as a joint stock company

       Each individual stockholder has little incentive to follow what the firm is doing or try to use his vote to affect it

       So management can do what it likes with the stockholders' money

       Are there mechanisms to control this problem?

       Base rewards on performance--bonuses, options

       Takeover bids and the threat thereof

       Hedge fund vs Mutual fund story

     Mutual fund managers get a fixed percentage of funds they manage

     Hedge funds, a percentage of the increase in fund value

     Both are potentially large stockholders with an incentive to monitor management

     Some evidence that hedge funds do it better

    Because their managers rewarded directly for success

    Because mutual funds are judged by relative performance, and hold many of the same stocks as their competitors

    Also, a controlling group of stockholders might be able to benefit themselves at the cost of other stockholders

       Firm A owns a large chunk of firm B, gets B to agree to contracts favorable to A.

       "Empty voting" story.

       Majority stockholders might take firm private on terms favorable to themselves

       Are there mechanisms for controlling this problem?

v    Relevance to legal issues

    The size of the firm

       If firms want to merge, are there benefits?

       Relevant to anti-trust law, where mergers are suspect

       Stockholders might be injured if managers are empire building

       So Coaseian arguments about what activities ought to be inside or outside the firm become relevant

       Also relevant to a CEO simply trying to do his job, serve the stockholders.

       If a firm wants to spin off parts of it, are there benefits?

       If the firm is worth more in pieces than as a whole

       Stockholders will benefit by the breakup

       Management might not

    Managerial discretion

       On the one hand, the reason the firm exists

       On the other, an opportunity for managers to benefit themselves at the cost of stockholders

       Parkinson story.

       Should "socially responsible" firms be suspect?

       Donation to art museums, opera,

       Helping out local schools?

       Treating employees better than the terms of the contract requires?

    Limits to majority stockholder control

v    Coase, Miller/Modigliani, and simplifying assumptions

    Coase analyzed externality problems in a world with zero transactions costs

       Not because he believed we are in such a world, but

       To show that in such a world the conventional analysis would be wrong

       Hence that the problems in some sense came from the transaction costs

       Which is relevant to understanding their implications

       If sufficiently interested, see several chapters of my Law's Order or my "The World According to Coase" on my web page.

    Miller and Modigliani analyzed the equity/debt question in a world of perfect information etc.

       Because showing that the ratio doesn't matter in that world

       Shows that the reasons it does matter have to do with imperfect information and the like.

v    Miller/Modigliani Theorem

    A firm can finance itself with debt or with equity

       Debt means the obligation to pay a fixed amount

       Equity gives a fixed share of the income stream

       Sort of

       Since the firm gets to decide whether to pay out dividends or retain earnings

       But the retained earnings go to the firm, which the equity holders own.

       Historically, equity pays a higher return than debt

       If saving for the long term

       You are almost always better off owning stock than bonds


       The return on equity is less certain

    Using debt is cheaper, so why not?

       The larger the fraction of the firm is debt, the more highly leveraged it is

       All variation in firm income goes to the equity holders

       So the uncertainty in the stock goes up, raising the risk premium

       And at some point, the amount of equity is low enough so that the lenders suspect their loan might be at risk--and charge a higher interest rate.

       One of the points we looked at in the previous chapter

v    Jenson and Meckling

    Incentive of firm managers as a special case of agency theory

    If you are my agent, I want you to act in my interest

       But you will act in your interest

       So I try to make it in your interest to act in my interest

    The problem results in three costs

       The cost to me of making you act in my interest--monitoring

       The cost to you of doing things that will make you act in my interest, so that I will hire you--for example posting a bond that forfeits if you don't

       The net cost of your not acting in my interest in spite of the first two

       Note that it's a net cost

       If we can predict that you will act in a way that benefits you by $2000

       And costs me $3000

       The net cost is only $1000

       And that is also the maximum cost to me--because knowing that,

     I will offer you at least $2000 less than if you were not going to do that

     And you will accept at least $2000 less.

       So the total cost due to the agency problem is the sum of the three

    In the case of a firm manager

       If he owns the whole firm, it's in his interest to maximize profit

       Taking account of not only pecuniary costs (money)

       But anything else that matters to him

       Such as being liked by his employees or respected by his neighbors

       Or not working too hard.

       The more of the ownership goes to other people, the less that is true

       Just as the factory owner who has insured against fire for 90% of the value will only take precautions whose benefit is much larger than their cost

       So the CEO who only owns half the firm will only work harder if it produces at least $2 of firm income for each $1 worth of effort

       Except that if other people own more than half, they might fire him if they see he isn't working hard, or in other ways is sacrificing their interest to his

       Which requires monitoring by the stockholders

       Which is hard if stock ownership is dispersed

    So there is a real advantage to the firm run by its 100% owner

       And in many cases that is what we see

       The problem arises mostly if the firm needs more capital than the owner's wealth

       Which could be borrowed--debt rather than equity

       But the highly leveraged firm is risky for the owner, and

       The lenders

    There is also a real advantage to a firm with concentrated stock ownership

       Because the large stockholder has an incentive to monitor management

       And if necessary try to get together with other large stockholders to replace it

       Hedge fund/mutual fund/stockholder situation

    All of which explains part of why firms are sometimes taken private



v    Review


       Firms exist because there are costs to organizing cooperation by exchange and contract on the market

       There are also costs associated with organizing cooperation by hierarchical authority

       A lot easier to buy paperclips and paper on the market than to produce them yourself

       Your top management doesn't have to know how the production is organized

       And competition will get you the lowest cost.

       But having a key employee outsourced could raise a lot of problems

       You can't do without him, so he could jack up his price, claim costs

       And you don't know and can't afford to turn him down.

v    Berle/Means/Smith

    With dispersed ownership, stockholders have little incentive to monitor the managers who are their agents for running "their" firm.

       So managers can serve their own objectives with the stockholders' money

       Which might mean being lazy or incompetent

       Or paying themselves lots of money

       Or buying status by contributing the firm's money to "worthy causes."

    Legal restrictions on such behavior are weak

       ("business judgement rule")

       perhaps have to be weak if the firm is to work as a hierarchical structure run by management

    Market restrictions exist via the threat of proxy fights, takeovers

       Ownership of shares doesn't have to be dispersed all the time

       Becomes concentrated if someone is buying stock to get control

       Or via large institutional stockholders--pension funds, mutual funds, hedge funds.

       What is a "junk bond" and why is it called that?

    But conflicts over stockholder control raise a new problem

       One group of stockholders, with an effective majority, might benefit themselves at the expense of other stockholders.

       Either by how the company is run, or

       By taking the company private, or merging it, on terms favorable to themselves

       The law tries to prevent this by requiring equal treatment.

v    Miller/Modigliani Theorem

    A company can finance itself with either debt or equity

    Debt, historically, receives a lower interest rate than equity

    But the higher the fraction of the financing is via debt, the riskier the equity

       Why not a 100% debt?

       Who then is the residual claimant?

       And what happens to the risk of default

    It turns out that, if you make some simplifying assumptions, the value of the firm is the same whatever the mix of debt and equity it chooses

    Which suggests looking at the failure of those assumptions in deciding what mix to use.

v    The firm as a problem in agency theory

    How do principals control agents?

       By monitoring their behavior--at some cost

       And punishing or firing them if they are not acting in the interest of the principal

       My recent tire purchase as an example

    How much control should there be?

       The amount that minimizes the sum of

       Cost to the principal, cost to the agent, net cost due to insufficient control

v    Time value of money

    How do you compare a payment today with a larger payment in the future

       Or a stream of payments over time with a single sum today

       For instance the income from owning a share of stock vs its present market value

    How compound interest works

       Suppose the interest rate is 10%=.1

       $1000 this year gives you $1000x(1+.1) next year gives you $1000x(1+.1) x(1+.1) in two years, and so on

       if we call the interest rate r, then

       $1000 this year gives you $1000x(1+r) next year gives you $1000x(1+r) x(1+r) in two years, and so on

       if the interest rate is small and the number of years is small, adding works pretty well

       1% compounded over 5 years is only a tiny bit more than 5%

       but 10% compounded over 10 years is quite a lot more than 100%

    Suppose you are comparing $1000 today with $1100 a year from now

       If you have $1000 today you can

       put it in the bank and get $1000(1+interest rate) in a year.

       So the $1000 today is worth at least $1000(1+r) in a year

       If you will have $1100 in a year you can borrow against it.

       If you borrow ($1100/(1+r)) today

       In a year the debt will be ($1100/(1+r))x(1+r)=$1100

       Which your $1100 exactly pays off

       So $1000 today is equivalent to $1000 (1+r) in a year, where r is the interest rate

    This assumes

       That the future payment is actually certain--future payments sometimes are not

       That you can borrow or lend at the same interest rate--which you might not be able to do

       If you can't, the argument shows the boundaries. $1000 is worth at least as much as $1000x(1+rl) in a year, where rl is what you can lend at

       At most as much as $1000x(1+rb) in a year, where rb is what you can borrow at

    Generalizing the argument, the present value of a stream of payments over time

       Meaning the fixed sum today equivalent to the stream

       Is the sum of the payments, each discounted back to the present

       Where a payment in one year is divided by (1+r), in two years by (1+r)x(1+r),

v    One example: You have just won the lottery--prize is 15 million dollars

    Actually, half a million a year for thirty years

    They offer you five million today as an alternative

    And the market interest rate is 10%. Should you accept?

    Harder versions

       How low does the interest rate have to be to make you reject their offer

       Your interest rate is 10%, the state can borrow at 5%. How much should they offer you?

    A useful trick

       What is the present value of $1/year forever

       If the interest rate is r?

       There is, or at least was, a security that works this way--a British Consol

v    Another example: With risk

    The court has awarded you a million dollar settlement, payable in five years.

    Of course, the firm might be out of business in five years

    What is the lowest offer you ought to accept, given that

       The prime rate is 5%

       You can borrow at 10%

       The firm can borrow at 15%

    First question: Why the difference?

    Second: Which rate should you use?

    First answer: the difference probably reflects risk of default

       The market thinks that, each year, there is about a 10% chance of default

       So a lender who lends $100 needs to be promised $115 next year in order to get, on average, $105. (slightly simplified because the two effects ought to compound, not add)

    Second answer:

       So you can use the market to estimate the risk you won't be paid, assuming that the same conditions that lead to defaulting on a debt lead to defaulting on a damage payment

       So you too should use 15% to discount the payment in order to decide whether to accept an offer

    Alternative approaches

       You could make your own risk estimate

       And might have to if the conditions that lead to one default are different than those that lead to another

       You might also want to use a higher rate if you are risk averse, since banks probably are not.

v    Choosing the interest rate to discount at

    Easy case

       Insignificant risk--the two alternatives are really both certain

       You can lend or borrow at the same interest rate

       Use that interest rate

    Hard case one--still risk free

       You must pay a significantly higher interest rate than you can get

        If you have enough capital so that you can pay for present expenditures by reducing the amount you are lending out, then your lending rate is the relevant one

       if you have to borrow, then the borrowing rate is the relevant one if in fact you will borrow

       if accepting later income instead of earlier income means not borrowing but spending less this year, more in the future, then the right rate is between the two numbers.


    Hard case two: Risk, but you are risk neutral

       Some risk that future payments won't be made

       Try to estimate that risk and discount accordingly

       Which can sometimes be made by seeing what interest rate the future payer has to pay to borrow money

    Hard case three: You are risk averse

       The payers borrowing rate is a lower bound to what you should use

       Try to estimate the risk and decide how risk averse you are

       Or your client is, if acting as an agent.

v    Why isn't the riskless interest rate zero?

v    How does the interest rate depend on risk?

    For a risk neutral lender

       Why a bank should be very nearly risk neutral

       Why a stockholder should be very nearly risk neutral

       Against what sort of risk should a stockholder not be risk neutral?

    Are there any special kinds of risk for which a bank or stockholder could be expected to be risk preferring?

v    Internal rate of return

    The same calculation we have been doing, from the other direction

    You are given the choice between a million dollars today and $100,000/year for eight years

       You calculate the interest rate at which the two alternatives are equivalent

       That is the rate of return they are offering you on your million

       So if it is more than the interest rate you can borrow or lend at, accept, if less, reject

    A firm is planning to build a million dollar factory

       Which will make the firm $100,000/year for eight years

       Then collapse into a pile of dust

       The internal rate of return is the interest rate at which it is just worth doing

       Or in other words, the rate of return the project gives the firm on its million

       Decide whether to build it according to what the firm's cost of capital is.


v    Predictable irrationality aka behavioral economics aka evolutionary psychology

    Economists generally assume individually rational behavior

       Meaning that individuals have objectives and tend to take the actions that best achieve them

       This makes sense to the degree that the rational actions are predictable

       The mistakes are not, so treat the as random error

    There is some evidence, however, for certain patterns of "irrational" behavior

       Endowment effect

       Not discounting the future the way economists think you should

       Would you rather have $100 today or $110 in a week? Many choose today

       Would you rather have $100 in a year or $110 in a year + a week?

       Few choose the $100

    Evolutionary psychology as an alternative to economics

       Similar pattern—act as if making the best choices for an objective

       But in evolutionary biology, we know the objective—reproductive success

       And evolution is slow, so we are adapted not to our present environment but to the environment we spent most of our species history in

       I.e. as hunter/gatherers.

    The endowment effect and territorial behavior

       Territorial animals have a territory they treat as theirs

       The farther into it a trespasser of their species comes, the more desperately they fight

       A fight to the death is usually a losing game even for the winner, so

       On average, the "owner" wins—the trespasser retreats

       A biological example of a commitment strategy in a bilateral monopoly game

       Think of the endowment effect as the equivalent for non-territorial property

       This is mine, so I will fight harder for it than it is worth

       Knowing that, you won't try to take it away from me

       We thus get private property without courts and police

       As long as inequalities of power are not too great

    Uncertainty and trading off future against present

       The environment we evolved in was risky and short of mechanisms for enforcing long term contracts

       So we are designed to heavily discount future benefits vs present benefits

       "A bird in the hand is worth two in the bush"

       but not to heavily discount a year plus a week over a year—both are future

       this also explains why we have to use tricks to get ourselves to sacrifice present pleasure for future benefits

       Christmas club for savings

       "I won't have ice cream for desert until I have lost five pounds"

       think of it as a rational economic you trying to control a much more short sighted evolved you

       and facing the usual agency problems in doing so

v    "If you're so smart, why aren't you rich?" The economist's answer

    Ways of making money on the stock market and why they don't work

       Suppose a stock has been going up recently.

       Buy it—it will probably keep going up?

       Sell it—it will go back down to its long term value?

       If either method worked—it wouldn't.

       There are a variety of more elaborate strategies which involve analyzing how a stock has done over time, or how the market has done, and using that information to decide whether to buy or sell

       People who do this are called "chartists."

       The idea is reflected in accounts of what the market did

       If it goes up and then down, that is called "profit taking"—with the implication that when it goes up it will go down.

       People talk about "support levels" and "barriers" and similar stuff.

    Suppose lots of investors are superstitious, so sell stock on Thursday the 12th, expecting something bad to happen on Friday the 13th

       So the stock (particular firm or the whole market, as you prefer) drops on or just before Friday the 13th

       What should you do if you know this and are not superstitious?

       What will the consequences be

       Generalize the argument to any predictable pattern.

       And you have the efficient market hypothesis, weak form

       The argument also works for lines in the supermarket or lanes in the freeway

v    The efficient market hypothesis

    Is the formal version of my Friday the 13th story

    You cannot make money by using past information about stock prices to predict future prices

       For instance, by buying a stock when it is below its long run average, selling when above

       Because lots of other people have that information

       The fact that it is below or above means other investors have some reason to think it is doing worse or better than in the past

       This is the weak form of the hypothesis—limited to price information

    You cannot make money by using other publicly available information either

       Such as the information sent out to stockholders

       Or the fact that demand for heating oil goes up in the winter

       Radio ads telling you to speculate in oil futures on that basis

       But oil futures already incorporate that information in their price

       Or the fact that this is an unusually cold winter—other people know that too.

       This is the semi-strong form of the hypothesis—all public information is incorporated in the stock price

    All information is incorporated in the stock price

       Cannot include information that nobody knows—a meteor is going to take out the main factory next week.

       What about information only one person knows?

       A handful of people?

       Does it depend on who the handful are and what the legal rules are?

v    Why the hypothesis cannot be (perfectly) true

    If even the weak form were perfectly true, and individuals knew it

       There would be no incentive to look for patterns in stock movements

       And if nobody is looking, the mechanism that eliminates the patterns doesn't work

    Consider the analogous problem with grocery store checkout lanes

       You have an armful of groceries, are at one end of the store—should you search all lanes to find the shortest?

       No—because they will all be about the same length, because

       If one is shorter than the next, people coming in between them will go to the shorter, evening them out.

       The efficient market hypothesis. But

    Two limits to it

       If it were perfectly true, nobody would bother to pay attention to line length,

       so it wouldn't work.

       Especially since length includes how much stuff each person has in his cart

       Which takes some trouble to look at and add up

       So, if people are perfectly rational, the differences in length have to be just enough to provide enough reward to those who do check to make enough people check to keep the differences down to that level.

       Who searches? Those for whom the cost of doing so is lowest

     Because they are good at mental arithmetic and

     Don't have an armful of groceries

     So you should go to the nearest lane.

       Not all information is public

       If you know that one checkout clerk is very fast and other people don't

     You go to her lane even if the line is a little longer

     And benefit from your inside knowledge

     Until enough people know to bring her lane up to the same length in time as the others

     At which point only insiders are in her lane

       What if you know one is very slow and other people don't

    These limits explain

       Hedge funds and the like

       Very large amounts of money

       Very smart people working for them

       In the business of finding very small deviations from efficiency and eliminating them

       At a profit.

       "Statistical arbitrate"

       Explaining Warren Buffet

       He claims to be proof that the efficient market hypothesis is false

       Because he has done enough better than the market so that, by chance, not one such investor ought to exist.

       But then, his ability to evaluate information might be extraordinarily good

       Which points out some of the ambiguity in the idea of publicly available information.

    At the individual level, the argument for throwing darts at the Wall Street Journal doesn't work if either

       You have information nobody else has

       The checkout clerk in lane 3 is very slow

       There is construction coming up in the left hand lane of the freeway

       The CEO of the firm is an old college acquaintance, and you know he is a clever and plausible crook

       You have an opinion you are willing to bet on and know many other people will bet the other way

       When the first Macintosh came out, I told a colleague I was getting one

       He asked why I didn't get a PC Jr.

       So I bought stock in Apple

       I have made four investments on that basis.

     Three made me money

     One lost it

    But at the time I thought it was more likely to lose money than make it

    But had a positive expected return.

       Which suggests two ways of making money in the stock market

       Knowing enough about the firm to tell if it is over or underpriced—accounting+ or

       Depending on your special information

     And not bothering to know everything else relevant to the firm

     Because the market will already have incorporated all that into the stock price.

       The third way to profit isn't by making money

       If my wife is an oil geologist, I should stay out of oil stocks

       Or even sell them short

v    Exercise, which I will put on the syllabus for you to think about

      What is economics?

      A way of understanding behavior

      Based on a simple assumption


      Meaning that people have purposes and tend to take those actions

      Not a statement about how people think

      But about the consequences

      True of cats and babies

      Not entirely true, but

      A lot human behavior fits that pattern, and

      We don't have a good theory for the rest, so

      Treat it as random error.

      In some contexts, truer than it ought to be

      Firms maximizing profits

      Large markets where random effects cancel out

      What does it apply to?

      All behavior in all times and places

      My size of nations

      Economic Analysis of Law:

      Armed Robbery

      Contracts under duress

      Mugger--argument for enforcing

      Parole system in warfare--argument against

      Pinochet--argument in both directions.

      Politics, marriage, war,   .

      Rational ignorance. Name of congressman?

      Armies running away. Njalsaga.

      Silent student problem

      Divorce rate?

      We find out by trying

      Conventional area of applications

      Explicit markets, prices, inflation, unemployment, etc.

      Ideas best worked out in those areas, so we will spend most of our time there, but

      With detours to apply the ideas elsewhere.

v    The coordination problem

    Why our society cannot exist and we must all be dead

       In order to achieve almost anything—produce food, build houses, make clothes

       We require the coordinated cooperation of millions of people

       The house requires, among many other things, wood

     Which requires people growing trees and cutting them down

     Which requires people making chain saws

     Which require people making iron and steel and gasoline

     Which require

       There are, broadly speaking, to solutions to the coordination problem

       Central direction—someone tells everyone what to do

     Which works on a small scale\

     But becomes hopelessly unworkable at the scale of a national economy

       Decentralized  coordination via prices, voluntary exchange, etc.

    How should we judge alternative solutions to the coordination problem

       As embodied in legal rules

       Government policies


    one way is by their net effect on everyone, which we can think of as the "size of the pie."

v    Perfect competition

    A simplified model of how the exchange market works

       Infinite number of participants, so each participant ignores the effect of how much he buys, sells, produces, consumes on the market price.

       Complete information

       So if you are willing to pay $2 for something

       It must be worth at least $2 to you—or you wouldn't have.

       All transactions are voluntary

       No theft, or

       Torts, or

       Involuntary interactions not covered by law or contract, such as my playing my car stereo so loudly that it bothers other drivers.

       In explaining perfect competition one often makes additional simplifying assumptions, then drops them later.

       You can find a much more extensive version in my Price Theory text, webbed on my site

       Or my _Hidden Order_, which I will put a copy of on reserve.

       In both I work through the simplified version, then put the complications back in.

    A pretty good approximation for some but not all market settings

       One big advantage over more complicated models is that we can solve it

       Prove theorems about the outcome, in particular.

       One can prove that it maximizes the size of the pie in a useful although not perfect sense

    Which means that one can look for ways of increasing the size

       By seeing where the assumptions break down

       And how those breakdowns reduce net benefit to people.

v    Demand and supply curves

    A demand curve shows quantity demanded as a function of price

       In casual conversation, I "want" X amount of something

       But in fact, how much I want depends how much it costs

       Because what I am really choosing is not "an ice cream cone" but

       + the pleasure from consuming an icecream cone

       -the value to me of the money I have to pay for it

       -the cost to me of the calories I get from it

       and whether that nets to plus or minus depends, among other things, on the price.

    As price changes, I move along my demand curve—choose to consume more if the price goes down, less if it goes up

       Adding up individual demand curves, we move along the market demand curve

       Which is the horizontal sum of individual demand curves

       Since the amount we buy is the sum of what I buy and you buy and

    A shift in the demand curve changes the relation between price and quantity

       Something happens which makes me willing to buy more (shift right) at any price

       Or less (shift left)

    Economists distinguish between

       a change in demand (demand curve changes)

       and a change in quantity demanded (quantity changes, whether because the curve moved or because the price changed with the curve staying the same)

       and that distinction avoids a lot of verbal confusion.

v    How much is it worth to me to be able to buy all the apples I want at $1/apple?

    Suppose I am willing to pay $3 to have one apple instead of zero.

       I am paying $1 to get something I value at $3,

       so gaining $2

       my "consumer surplus" on the first apple

    suppose I am willing to pay $2.50 to have two apples instead of one

       My surplus on the second applie is $1.50

       So my total surplus on the two aplles is $3.50

    But "willing pay $3 to have one apple instead of zero"

       Means that at a price of $3 I would buy one apple

       So my demand curve shows a quantity of 1 at a price of $3

    Following out the argument, my consumer surplus on buying all the apples I wish to buy at $1/apple is the area

       Under my demand curve and

       Above a price line at $1/apple

v    The same argument applies to a supply curve

    It shows how much a producer will produce and sell

    If I would produce a unit for any price above $1

    And can sell it for $3

    My producer surplus, aka "profit," is $2.

    Generalizing that argument, producer surplus is

       The area above the supply curve

       And below the price.

v    So total surplus from a particular market is the area between supply and demand curves

v    And the net effect on individual welfare of a change is the change in that area.

    But note that this assumes the ordinary market setting

    And we are about to see some problems with that assumption

v    Suppose we have price control on gasoline

    The market price would be $2/gallon, at which quantity supplied equals quantity demanded

    Instead the law fixes it at $1/gallon

    The book's version of what happens

    What is wrong with this story?

       At the price, consumers want to buy more than producers want to sell

       What decides who gets the gasoline?

    Simple answer: whoever gets to the gas station and before they run out.

    So lines start to form at gas stations

    How long does the line have to be for quantity demanded—at a price that includes the time waiting in line—to equal quantity supplied?

    What is the overall effect on surplus.

v    Government regulation over professions

    The arguments that are given in the book all assume a philosopher king government

       The government is trying its best to do good, but doesn't always succeed

       Is there a more plausible model?

    Facts on medical licensing history

       During the five years after Hitler came to power, about the same number of foreign physicians were admitted to practice as during the five years before

       During the Great Depression, the AMA informed medical schools that they were graduating too many students

       Every school cut back

       Medical licensing normally requires graduation from an approved School

       Where do you think the states got their list of approved schools?

    Licensing vs certifying

       If the problem is that consumers don't have the information, certifying is sufficient

       The argument for licensing is that, even with information, the consumers will make the wrong choice.

       Or that a large part of the cost from using a low quality professional is born by someone other than the person making the decision

       I have a building designed by an incompetent architect

     It falls down, injuring other people

     Whom I cannot compensate for their loss

     But—as in moral hazard in general, although I don't have the full incentive, I have a substantial incentive, since if the building falls down I lose a lot of money

     And my mortgage company has an incentive too

       I use an incompetent physician

     Don't get cured

     Spread my (contagious) disease

     But again

       The argument against is that licensing can be used to control consumers in someone else's interest, usually the profession

       Not only physicians and lawyers are licensed, but also

       Yacht salesmen and egg graders and barbers and

v    Monopoly


       A single firm that produces almost the total output for a market

       And so can control price--at the cost of selling less the higher the price.

       Of course, a firm in a competitive market can ask any price it wants too--but above the market price, its sales drop to zero.


       Only owner of a required input

       A choke point--the only pass through the mountains

       De Beers?

     Demand story--that DeBeers created the demand for diamonds for engagement rings. But

    "In fact, in 1938 some three quarters of all the cartel's diamonds were sold for engagement rings in the United States." (Before the publicity campaign started)

    unclear how much it is a story of an ad campaign that sold diamonds, how much of one that sold itself.

    Competing explanation by Margaret Brinig

     Do they control production?

    1957, Soviet production 20-30% of world

    Australia, Angola, Canada, Zaire (<3%),

    DeBeers mines "represented about half of total supply"

     A monopoly on marketing, not production

     Cartel? Natural monopoly? Unclear.

       Me. Or Apple. Or your corner grocery store.

     More generally, the sole producer of a particular variety of good

     Has some monopoly power wrt buyers who want that variety

     And that sort of monopoly is much more common, and probably more important, than the "giant firm controlling the X industry" type.

    Natural monopoly

       Economies of scale

       Sometimes increasing quantity reduces cost per unit, because fixed costs such as design or tooling can be spread over more units

       Sometimes it increases cost, because the larger firm has more layers between the president and the factory floor

       So average cost typically first falls with output, then eventually comes up again.

       If it keeps falling out to the full extent of the market, you have a natural monopoly

       Since it can make money selling at a price at which a smaller competitor would lose money

       It ends up with the whole market

       The common case of this is the specialized producer mentioned above

       Where the cause is not the large economies of scale, but

       The small size of the market

       A small town general store, me as a speaker, your favorite author

       But it could also exist on a large scale if there are very large economies of scale.

    Artificial monopoly: Predatory Pricing and The Standard Oil Myth

       "Big firm has deep pockets, sells below cost to drive out smaller firms"

       both firms are losing money, but the big firm has more money to lose, so lasts longer

       what is wrong with this story?

       McGee article in JLE

       He went through the many volume transcript of the Standard Oil antitrust hearing

       And found no examples of predatory pricing, actual or claimed

       The closest was a threat to Cornplanter oil to cut prices on them if they didn't stop expanding at Standard's expense

       The manager of Cornplanter, by his testimony, told the Standard Oil man that if they cut prices on him he would cut prices over a much larger area, costing them a lot more money.

       And that was the end of the matter.

       Hard to prove that predatory pricing is impossible

       Given the nature of game theory and commitment strategies

       But the big firm seems to have the weaker hand in the game

       Cheaper to try to buy out competitors—which Rockefeller did. But that has a long run problem

v    State enforced monopoly

    The original meaning of the term--monopoly privilege sold to raise money or given to favored subjects.

    Still a common form of monopoly

       It is illegal to compete with the Post Office in the delivery of first class mail

       It is illegal to sell liquor in states with a state liquor monopoly

       Until deregulation, the airlines were a cartel enforced by the CAB

       It was illegal to change fares in either direction without permission

       Or to start flying a new route without permission

       PSA story

       Professional licensing is a form of state monopoly

       As are patents and copyrights

v    What is wrong with monopoly?

    Consider a simple case

       Fixed cost of a million dollars a year to operate a factory

       Marginal cost of a dollar widget to produce widgets

       If you produce a million widgets/year, average cost = $2

       If you produce two million, $1.50

       And so on out to infinity

    What price maximizes the firm's profits?

       The lower the price, the more units they can sell

       Suppose they sold widgets for a dollar/widget--their marginal cost

       They lose a million dollars a year

       Raising the price and cutting quantity has to be a win

       When do you stop raising the price?

       consider marginal revenue--increase in revenue by selling one more unit

       If marginal revenue <marginal cost, you are losing money on the last unit sold

       So should cut back until you reach the quantity where MR=MC

       Any further cut costs you, since you are cutting a unit that brings in more than it costs.

       Selling one more unit/year gets you the price it sells for

       Costs you the reduction at the price at which all others units can be sold, since it takes a slightly lower price to increase sales

       So marginal revenue is less than the price

    If we consider the combined effect on seller and buyer, what price "should" the seller sell at?

       As long as price is above marginal cost

       There are consumers who value the good at more than it would cost to produce one more unit for them

       But are not getting it

       Producing that extra unit and giving it to the consumer would benefit the consumer by more than it cost the producer

       So the efficient rule is to sell at a price equal to marginal cost

    So a monopoly maximizes its profit at a higher price than the price that maximizes net benefit to customer plus firm.

       This is the standard economic argument for why a monopoly is inefficient

       And evidence of the risk of assuming technical terms have their common meaning

       Since the hearer will imagine the statement is about how badly run a monopoly firm is

       When it is actually about how a well run monopoly firm will act

    A second inefficiency: Rent seeking

       My railroad story

       The exchange control version

       The tariff version

       The price control version

       What's wrong with theft

       Gordon Tullock, "The Welfare Costs of Tariffs, Monopolies and Theft"

v    Oligopoly and cartel

    An oligopoly exists when economies of scale are large enough so there are only a few firms in the industry

    They might compete, trying to take account of the effect each has on prices

       We could model this as a Nash equilibrium

       Where each takes the behavior of the others as given

       And decides what price and quantity maximizes its profits

    Or they might coordinate, act as a cartel, all agreeing to hold down output in order to drive up prices

       In the U.S. at present, this is illegal

       Even if legal, each member of the cartel has an incentive to chisel—cut prices a bit under the table in order to lure customers from the others

       Unless the agreement is not only legal but enforceable

v    Monopolistic competition

    Lots of firms, differing in location or characteristics of the product

    Each one has a partial monopoly wrt customers "close" to it

    Competes for customers who are near two or more firms

    And if the outcome is above market profits, additional firms can enter the market

    Driving profits down.

v    What to do about natural monopoly? Three alternatives, all bad.

    Government monopoly--the post office

       What is its incentive to charge marginal cost?

       Or to hold costs down

       When some "costs" can be used to buy political support

       For instance from employee unions

       Or other sellers of inputs

    Regulated monopoly: Public utilities and the like

       If forced to charge marginal cost they go broke, so require a subsidy

       In practice the usual attempt to force average cost--still inefficient, but not as inefficient as what the monopolist would do

       But how do you know what average cost is?

       If you ask the accountants, the firm has no incentive to hold down cost

       Since whatever it is, that's what they are allowed to charge

       And why is it in the interest of the regulator to try to maximize social benefit anyway

       When he could be currying favor with the regulatee in exchange for a well paying job when he leaves government service

       Or buying votes for his political patrons at the cost of either the regulatee's stockholders or its customers