Table of Contents
I. Mechanics of Course
II. Sketch of course
III. What is economics
IV. What is the Economic Analysis of Law
V. What is economic analysis of law good
for? Why should people study it?
VI. What is the relation between economics
broadly defined and economics more conventionally defined?
VII. What is economic efficiency?
Second Week: Externalities
I. Externalities: The conventional
II. Externalities in the law
III. Coasian critique of externality
theory: An argument in three acts.
IV. Some further implications:
V. Damages vs fines:
VI. Fines vs Damage Payments in summary:
VII. Other Coasian stories:
VIII. Coase vs Pigou--a summary:
IX. Property rules vs liability rules:
X. Another take: Its all a matter of
Third Week: Insurance
I. Insurance: why it is interesting:
II. Why insure?
III. The economics of risk aversion:
IV. Von Neumann and Morgenstern
formalized this argument as Von Neumann utility
V. One problem with insurance: Moral
VI. The other problem with insurance:
VII. Application to product liability.
Who is liable for damage done by exploding Coke bottles?
VIII. Why doesn't the law make these
calculations for ordinary insurance, deciding for you whether you are
insured or not?
IX. Why not apply the same analysis to
Fourth Week: Ex Ante/Ex Post,
Strategic Behavior, etc.
I. Review: Marginal vs average.
II. Ex Ante, ex Post:
III. "Impossible attempts": Should there
be a penalty for attempting to kill someone by a method that cannot
IV. Strategic behavior:
V: What is property?
VI: Determining property rules really
involves a set of questions:
VII. Property rules--including
Intellectual Property (I.P.), primitive societies, et multae caetera:
VIII. Intellectual Property Law: What
the law is.
IX. The Economics
Fifth Week: Contract Law
I. Contract Law:
II. But contracts can be enforced in
other ways than by law--and are.
IV. Consumer fraud, liability, etc. [I
will be covering this material Monday 11/4]
VI. Information and Incentives: Laidlaw
v Organ [I will be covering this material Monday 11/4]
VII. Contracts, a summary.
I. Divorce: Lloyd Cohen article.
II. Why has marriage become a less
stable contract over the past century?
III. The economics of wedding
rings-argument from an article by Margaret Brinig (not in the
IV. Adoption market:
V. It is often claimed that, when I
have a child, I impose net costs on others, so that leaving people
free to decide how many children they have will result in
VI. Regulation of Sex. Why do we do it?
Adultery laws, fornication laws, ...
I. Tort Law:
III. Causation complications
V. Complications in tort damage analysis
VI. Liability alternatives
VII. Summary of implications
VIII. Amount of damage payment awarded
IX. My Explanation 1: Punitive damages
are for very deterrable torts
X. My explanation 2: Punitive damages
are for strategic torts
XI. Why pay tort damages to the victim?
XII. Three steps to an efficient world
XIII. Damages for loss of earning
capacity, death, injury
I. The nature of the criminal law:
II. Economist's view of what should be a
crime and why.
III. If this is how we set our
punishments, then the reason we do not make them higher is that we
are afraid of deterring efficient crimes. Can that be right? Is the
reason we do not increase the punishment for murder that we are
worried that we would then have too few murders? [This set of issues
is discussed in more detail in my "Payne v Tennessee" and "Punitive
IV. The cost of crime control.
V. If punishment were costless, the
optimum level would be expected punishment equal to damage done,
deterring all and only inefficient offenses. How do we calculate the
optimal punishment taking account of the cost of imposing it?
VI. Why count the criminal's costs at
VII. Rich vs Poor--should they pay the
same fines? In some cases yes, but in others no, because:
VIII. Marginal deterrence: My article
(with William Sjostrom) is accessible from the web page.
IX. The Paradox of Efficient Punishment:
X. Some more points involving crime:
XI. Criminal law summary:
I. The Issue of Monopoly
II. The Efficiency and Inefficiency of
Discriminatory Pricing: A XMas Tale
III. Solving the efficiency problem of
natural monopoly by regulation:
IV. What about legal rules to discourage
V. As these examples show, imprecise
verbal arguments about monopoly behavior, or economic behavior in
general, often produces the wrong answer. There is something to be
said for precision--and for formal mathematical models.
VI. The English vs the American Rule
History as Data
I. Looking at how other societies did
II. Iceland. History. Harald's
unification of Iceland. [This is given in much greater detail in my
Production and Enforcement of Law: A Historical Case" which you have,
and which is also on the web]
III. 18th century England. [This is
given in much greater detail in my
on 18th century England]
IV. Twentieth Century California. [This
is discussed in more detail in my
review "Less Law
Than Meets the Eye," and in much more detail in Ellickson's book]
VI. Efficiency and the common law:
From The Top: A Summary of the
I. What is economics?
II. What is economic analysis of law?
III. Allocational vs distributional
issues: At the heart of many political arguments, including the
preception of economic analysis of law as conservative.
IV. Economic efficiency
V: What is Law?
VI. Essential economic concepts
VIII. Contract Law
IX. Family law
X. Tort law
XI. Criminal Law
XIII. The English vs the American rule
XIV. Some interesting historical cases
XV. Summary of Summary
Class Outline: Economic Analysis of Law
This outline contains what I said, what I think I said, and what I
ought to have said, so discrepencies between what it contains and
what you remember are not necessarily due to your poor memory.
- I. Mechanics of
- A. Written material will consist of:
- 1. A short book by Polinsky
- 2. Lots of articles which will be handed out in class;
note that in some cases only part of the article is
- 3. An outline of the lecture, which will be handed out
each week for the preceding week, deus volenti. You're
- 4. An optional supplementary text by Posner. This is a
big book, covering a huge range of material, by one of the
leading scholars in the field.
- B. I have a web page for the course at
http://www.best.com/~ddfr/Econ154.html. My EMail address is
- C. There will be a midterm at about
- D. The final will cover everything, and be
mostly or entirely essay.
- E. last year's lecture notes and exams,
from when I taught this course at Santa Clara University, are
or will be available on the web page and in the library.
- II. Sketch of
- A. This week--introduction
- B. Part I: Economic Analysis of Law,
organized by ideas.
- C. Part II: Organized by legal
- III. What is
economics? [For a longer discussion,
1 of Price
- A. An approach to understanding behavior,
based on the assumption that Individuals have objectives and tend to choose the
correct way of achieving them.
- B. Some Examples:
- 1. Why have locks on doors?
- a. A sufficiently determined burglar can get into
anything short of a bank vault, with a sledgehammer and
crowbar or through the window.
- b. A lock makes it harder, thus more work and a
greater chance of being caught, thus a less profitable
- c. So we put locks on our doors because we believe
that burglars are rational.
- 2. A policeman has evidence that will convict a
criminal; what does he do with it?
- a. Convictions costs the criminal $50,000, benefits
the policeman's career by $10,000
- b. Dragnet answer: arrest the criminal.
- c. Economics answer: Sell the evidence to the
criminal for some price between $10,000 and $50,000
- d. To keep this from happening, some of the policemen
have to be watching the other policemen instead of the
- e. The solution proposed by Becker and Stigler was a
bounty system, where the policeman receives as salary the
fine paid by the convicted criminal. If he takes a bribe,
he is merely cutting out the middleman.
- f. Which is how our civil system works--we call the
"bribe" an out of court settlement.
- 3. Civil forfeiture
- a. Under Federal law and the law of many states,
property used in certain crimes can be seized by the
government, without proving that the owner was guilty of
- b. In at least some states, the value of the seized
property goes to the police department that seized it.
- c. Which gives police departments an incentive to
look for rich people they can find (or create) evidence
against, rather than criminals in general.
- d. A similar problem exists with punitive damages.
- 4. If we impose the maximum possible penalty for armed
robbery, the additional penalty for murder if you are
already committing armed robbery is zero, so we have made it
in the interest of armed robbers to kill their victims.
- IV. What is the
Economic Analysis of Law?
- A. First Project: The consequences of legal
- 1. If we impose the maximum possible penalty for armed
- a. The implication is not necessarily that we
shouldn't do it--it will deter some armed robberies
- b. But increase the number of armed robberies with
- c. And we should take that into account in deciding
whether to execute armed robbers.
- 2. Plea bargaining:
- a. It seems as though it should weaken punishments,
since a defendant will only accept a plea bargain if he
thinks it is a better deal than the risk of being tried
- b. But it may strengthen them. Prosecutors have
limited resources; if 90% of defendants plea bargain,
resources can be concentrated on the remaining 10%,
making conviction more likely--and making defendants
willing to accept harsher bargains.
- 3. Requiring CD players in cars. Seems to benefit
consumers--until we take account of the effect on the price
of cars. The same argument applies to requiring hot water in
apartments, safe jobs, ... . Fixing one term of a contract
in favor of one party is not in general a transfer, since
prices, or other terms in the contract, shift to compensate.
- 4. Requiring seat belts. Accidents are the result of
rational decisions--how fast to drive etc. Making cars safer
makes risky driving cheaper, which increases the amount of
it. Sam Peltzman actually observed this result by
statistical analysis of accident rates before and after a
sharp increase in required safety equipment.
- B. Second Project: Predicting legal
- 1. The Posner Conjecture: Common Law tends to be
- 2. One basis for this conjecture might be a plausible
mechanism by which efficient law would be generated. In my
opinion, Posner has never provided one.
- 3. An alternative basis might be evidence that the
observed rules of the common law tend to be the same rules
that economic theory tells us are efficient. Posner offers a
lot of such evidence. One problem is that the conclusions of
economic theory are not always clear cut, so a clever
economist who knows what the rule is might be able to
construct arguments for why it is efficient--and might be
able to do so for whichever alternative the law chose.
- 4. An alternative approach to predicting legal
rules--legislated ones--is public choice theory, which tries
to apply economics to the political marketplace. We will
probably not be covering that in this course.
- 5. This project is also a positive one--explaining what
the law is, not what it should be.
- C. Third Project: Evaluating Legal
Rules--Efficiency as a norm.
- 1. Controversial, but ...
- 2. Economic efficiency is a value, and maybe the one law
can best achieve
- 3. Allocation vs distribution
- V. What is economic
analysis of law good for? Why should people study it?
- A. One attraction of the economic analysis
of law, from the standpoint of legal scholars (or potential
legal scholars) is that it ties together diverse areas of law,
providing a common theoretical structure.
- B. It is also useful for understanding
economics, because you learn about ideas by trying to
- 1. "Property" sounds like a simple idea--and isn't.
- a. Does ownership of land include the air above--to
what height? The earth underneath? Oil in the earth
- b. What can you do to protect your ownership?
Physically keep people out (build a high wall)? Shoot
trespassers? Sue trespassers--but only for damage
- 2. "Cause an externality" seems like a simple
concept--and isn't. When I play loud music while my roommate
wants to sleep, there is a resulting cost--but it would be
eliminated either by my turning off my music or by my
roommate deciding to get up and party.
- 3. Coase revolutionised our understanding of
externalities, market failure, etc., in part by looking at
how the common law of nuisance treated such problems.
- 4. "Cause" is also a difficult concept more generally.
Consider the case of two hunters simultaneously shooting a
third--one in the head, one in the heart. Who caused the
third hunter's death? Neither--and both.
- C. The law is also useful to economists as
a vast pool of interesting puzzles.
- D. And as data.
- 1. How people do things is a fact--evidence.
- 2. When you prove they would be better off doing things
differently, you have probably demonstrated a flaw in your
theory--since people generally know what actions are in
- VI. I have been
offering a broad definition of economics, one that goes far beyond
prices, unemployment, and the like. What is the relation between
economics defined in that way and economics more narrowly
defined--what you find in the typical micro text?
- A. The latter has been worked out in more
- B. and it helps us understand economics in
the broader sense.
- 1. To understand marriage, use ideas developed in
explaining long term contracts between firms. Talking about
a marriage market is not merely a metaphor--it is a real
market, even if the prices are not explicit or in money.
- 2. To understand your three year old's apparently
irrational behavior ("I want icecream and will throw a
tantrum if I don't get it, even though you will then send me
up to my room without any icecream") think about the logic
of commitment strategies in ordinary economics. If he
persuades you that he has committed himself strongly enough,
next time you may give him the icecream to avoid the
- C. The broad approach helps us intuit the
narrow. We do a lot of rational choosing in our daily lives,
and can apply the intuitions developed there to understanding
the behavior of firms, workers, etc.
- VII. What is economic
efficiency? (Posner calls it "Wealth
Maximization") [For a longer
discussion, see Chapter
15 of Price
- A. The problem--evaluating different
systems of rules, their outcomes, etc.
- 1. By whose values?
- 2. How aggregated?
- B. The economic solution.
- 1. Revealed preference: Heroin or Insulin, the fact that
someone is willing to pay lots of money to get it is
evidence that it is valuable to him. How valuable? It is
worth to him the maximum amount he would be willing, if
necessary, to pay for it.
- 2. Aggregate effects across people by using willingness
to pay as a common unit. We are using value (utility
measured by dollar willingness to pay) rather than utility
(units of pleasure, or happiness, or something similar). A
dollar might represent more utility to one person (poor--or
materialistic) than to another (rich--or ascetic) but it
represents, by definition, the same value.
- 3. Note that value measured in dollars is not the same
thing as pieces of green paper. If I am willing to pay $400
for a new printer and buy it for $300, I end up with $300
less money--but I am $100 better off than before the deal.
- C. Defense of the economic solution.
- 1. If we wish to describe behavior, it is revealed
preference, not "value as known in the mind of God," that is
the relevant tool.
- 2. If we wish to predict outcomes, willingness to pay is
more relevant than utility. Whether lobbying, litigating, or
simply buying goods on the marketplace, one man's dollar
will have about the same effect as another's, independent of
how much happiness a dollar represents to each.
- 3. What about using efficiency as a normative
criterion--to decide how society should be organized?
- a. Both elements are then problems, but ...
- b. It is not clear one can do better. God is not
available to run the society. Other people are available
to make choices for us, but even if they (sometimes) know
what is good for me better than I do, they are less
certain to seek my good than I am. They may take the
opportunity to seek their own good at my expense.
- c. Many economic choices involve gains and losses to
large and diverse groups, in which case differences in
utility/dollar may average out.
- d. Even if efficiency is a good proxy for utility,
however, is utility all that matters? If there are
utility monsters (people who feel much more intently than
the rest of us do) should we devote all of our resources
to their pleasure? If you can save the lives of three
people about to be lynched by framing one innocent person
for the crime, should you do it?
- e. Utility is probably not all that matters, but it
is one big thing that matters, and if we know how to
maximize it and don't know how to maximize the rest of
what matters (or cannot agree about what it does), then
rules that maximize utility (or efficiency as a proxy for
utility) may be the best we can do.
- D. Efficient vs Inefficient outcome:
"Efficient" is a sort of outer bound benchmark, the best result
we could hope to achieve by any economic system.
- 1. I define a "bureaucrat god" as someone who knows
everything anyone in the society knows, and has unlimited
ability to calculate how to coordinate people's actions and
to make them do what he tells them to.
- 2. An outcome is efficient if a bureaucrat god could not
improve it ("improve" in the sense we have been
discussing--make a change that produces total benefits
larger than total costs).
- 3. If an outcome is efficient, no change in the
economic/legal system can improve it, since we have no tools
available that the bureaucrat god does not also have.
- 4. If an outcome is inefficient, we might be able to
improve it. But we also might not, since we have no
bureaucrat gods available to run our economy.
- E. Other definitions of efficiency. [I
didn't get to this part in class]
- 1. Pareto:
- a. An improvement is a change that benefits someone,
hurts nobody. This definition avoids interpersonal
comparison, but ...
- b. In practice, few changes in legal rules and the
like are pareto improvements.
- 2. Hicks/Kaldor:
- a. An improvement is a change that would be a pareto
improvement if combined with suitable transfers among
- b. This almost always gives the same conclusion as
Marshall's definition (what I started out explaining).
- c. Because if there are net benefits, then the
gainers gain enough to compensate the losers, and if the
gainers gain enough to compensate the losers, then there
are net benefits.
- d. Actually, there is an exception to this apparently
obvious conclusion, explained in my article "Does
Altruism Produce Efficient Outcomes? Marshall vs Kaldor"
on my academic web page.
- 3. Both the Kaldor and Pareto approach make it look as
though you are not trading off gains to one person against
losses to another, when in fact you are. That is why I
prefer Marshall's approach.
- E. What matters is that you understand
these ideas, not that you agree with them.
- 1. Accept rationality as a working hypothesis for this
- 2. Take Posner conjecture as a conjecture, look at
evidence for and against.
- 3. Feel however you like on the third project.
- VIII. Law
- A. Where it comes from:
- 1. Constitution
- 2. Legislature
- 3. Courts
- a. On their own--Anglo-American common law.
- b. Interpreting the constitution to constrain the
- c. Interpreting legislation.
- 4. The hierarchy of courts, appeals.
- a. District to Circuit to Supreme
- b. Each level can refuse to hear appeal
- c. Appeal on the law, not the facts, which the
appeals court accepts as determined by the lower court.
- 5. Why courts matter--the inherent ambiguity of English.
You cannot write laws clearly enough to leave no hard cases,
so the courts (at least) fill in the details.
- B. Consistency/inconsistency.
- 1. In many areas, state laws differ.
- 2. Federal laws are the same everywhere in the U.S., but
different circuits may differ in their interpretation of
them until the Supreme Court hears the issue and settles the
- 3. In the case of patents on software, a specialized
lower court with expertise in the field gradually pulled the
Supreme Court into interpreting the law the way the lower
court thought it should be interpreted.
- 4. In interpreting new issues on the basis of old court
decisions, courts frequently argue by analogy.
- 5. Which raises the interesting question--is it analogy,
or function, or interest, or ... that determines the
development of the law.
- C. How are cases decided.
- 1. Adversary system
- a. That means that each party is in charge of finding
and presenting the evidence for his side of the case.
- b. As opposed to an "inquisitorial" system where the
judge is in charge of finding out what the facts are.
- c. Real systems, American or European, have elements
of both, but American is more adversarial, European more
- 2. Jury is available for both criminal and civil (U.S.
- 3. Judge decides law, jury facts--supposedly.
- a. But consider the incentive for a juror who
disapproves of the law to "interpret" the facts so as to
get what he considers the just verdict, or ...
- b. For a judge who has a strong opinion on the facts
to "interpret" the law so as to push the jury towards the
- D. We have multiple legal systems
- 1. Federal, state
- 2. Criminal/Civil
- a. The difference being whether the state or the
victim controls what happens
- b. And collects damages, if any (damage/fine;
- c. Different standard of proof.
- d. Civil law includes property, contracts, and torts.
- 3. Administrative law.
- 4. Property law:
- a. What rights do you have when you own something?
- b. What can you sell? Land, but not your kidney.
- c. How else can you lose the rights? Under the
doctrine of adverse possession, if someone else acts
openly as if he owns the land, or some right such as the
right to cross over it, and you do nothing to object, he
- 5. Contract
- a. What suffices to form a contract
- b. What terms will be enforced
- c. What terms will be read in--resolving ambiguity
- d. How will breach be treated?
- 6. Tort law: What determines liability
- a. strict, negligence, comparative negligence
- b. Causality--what does it mean for someone to cause
- E. Some interesting issues include
- 1. Why do civil and criminal law
- a. Exist in their current form. Each is a particular
bundle of legal rules
- b. Apply to the particular things they apply to
- 2. Adversarial vs Inquisitorial systems for trying cases
- 3. Who pays the cost of litigation
- a. English (loser pays) vs American (each party pays
his own litigation expenses) rule for civil cases.
- b. Should we reimburse criminal defendants who are
acquitted for their defense expenditures?
- c. What about defendants who are convicted and later
- 4. Enforcement strategies
- a. How to punish criminals
- b. How hard to try to catch them
My Web pages are now also available at:
Railroads, Candy Makers, and All That
[Also see the discussion in Chapter
18 of Price
- I. Externalities: The conventional Analysis
- A. The simple argument for
- 1. If people who take actions receive the benefits and
pay the costs of those actions
- 2. Then they will take those actions and only those
actions for which net benefits>net costs
- 3. Which is the efficient rule
- 4. And this condition is met in the ideal competitive
market (for explanation, see a Price Theory text--preferably
- B. The problem:
- 1. If I can take an action some of whose costs are born
by other people
- 2. For example, produce both steel and pollution, sell
the steel, pay wages and the cost of input, but not pay the
cost of the pollution
- 3. Then I will produce steel even if total costs,
including pollution, are > total benefits for at least
some of my output--i.e. produce more than the efficient
- 4. And I will produce steel in the way that minimizes my
total cost, not all total cost--for example, will not do
costly things to reduce pollution, even if they are, on net,
- C. Simple solution--direct
- 1. The EPA or equivalent decides who can pollute how
much where, what methods of pollution reduction have to be
- 2. The problem is that do do that right they would have
to know both the damage done by pollution and the cost of
all the alternatives--which they probably don't
- 3. And it is not in the interest of firms to tell them,
since a firm that can persuade the EPA that there is no way
of reducing its pollution at any reasonable cost gets to
keep on polluting.
- D. Fancier solution--effluent tax.
- 1. Charge each firm for the damage done by its
- 2. It can decide whether to pollute and pay, control
pollution, or stop producing.
- 3. And it is in its interest to choose the most
- E. There is still an informational problem,
since the taxing authority has to estimate the damage done by
polluting in order to set the tax--but at least it does not
have to estimate the cost of not polluting. It can trust the
firms to solve that problem in their (and our) interest.
- F. Both solutions face a further
problem--how to make it in the interest of the regulator/taxing
authority to make the rules that produce an efficient
- 1. It might be more politically attractive to sell out
to the polluters in exchange for campaign contributions.
- 2. Or impose very stringent rules in order to be bribed
not to enforce them.
- 3. We will be mostly ignoring this class of problems at
- II. Externalities
in the law
- A. Direct regulation of
- B. Laws as effluent fees: Speeding
- 1. If we wanted to eliminate all speeding, we would hang
speeders--or confiscate their cars.
- 2. If we believe that speeding imposes some, but not
infinite, cost on others, we try to impose a penalty
sufficient to deter speeding--except when speeding is worth
enough so that the driver is willing to pay the price.
- C. Damage payments as effluent fees: Tort
- 1. One way of inducing drivers to take precautions is to
make them liable for the cost of the damage they do to
others if they don't.
- 2. By allowing their victims to sue them for damages.
- D. Criminal punishments as effluent
- 1. Crimes impose costs on their victims.
- 2. By making the criminal pay a punishment equal (on
average) to those costs, we deter crimes, except
- 3. When the benefit to the
criminal is greater than the cost to the victim, so the
criminal is willing to pay the price. Example: Hunter lost
and starving in the woods who breaks into a cabin, steals
food, phones for help.
- 4. In other words, we deter inefficient and only
- 5. An alternative approach, if we think the court can
tell when offenses are efficient, is to special case
them--to punish only the inefficient crimes. The lost hunter
is excused from punishment under the "doctrine of
- 6. Note that criminal punishments are typically costly.
When I pay a damage payment, someone receives it. When I am
executed, nobody gets the life I lose. When I am imprisoned,
nobody gets my liberty and the taxpayers have to pay for the
- 7. We should modify our rules to take account of this.
There may be some offenses that are inefficient--we would
like to deter them if we could do so costlessly--but cost
more to deter than it is worth.
- E. Some of these examples involve a payment
to the "victim" and others involve payment to the state. We
will see shortly that this difference is sometimes
- III. Coasian
critique of externality theory: An argument in three
- A. Nothing works: Two sided
- 1. A doctor builds a new consulting room onto his house,
adjacent to where a neighboring candy maker is operating
machinery. The machinery was no problem previously, but is
vibration now prevents the use of the consulting room. The
- 2. As this example shows, "external costs" are typically
due to joint actions.
- a. Polluting and breathing
- b. Using the same lake for a summer resort and a
place where a factory dumps chemicals
- c. Operating a recording studio next to a fraternity
house that has parties
- 3. Making either one party liable to the other
eliminates the other party's incentive to solve the problem.
- 4. A railroad throws sparks that start fires in the
adjacent grain fields. One solution is for the railroad to
put on a spark arrester that will prevent the sparks. An
alternative is for the farmers to plant some non-inflammable
crop (hereafter "clover") along the rail line.
- B. Everything works: The Coase
- 1.The doctor wins his his case, but the efficient
outcome is to move the consulting room, not the factory. So
the candy maker pays the Doctor to move the consulting room
and let him continue to operate his factory.
- 2. As long as there are net gains from changing the
outcome, there is some way of allocating the gains that
makes everyone better off, so the change should occur. More
- 3. The Coase Theorem: If transaction costs are zero, any
initial allocation of property rights will lead to an
- 4. Here "transaction costs are zero" means "if there
exists a transaction that benefits all parties, it will
- C. It all
depends--on transaction costs.
- 1. 1 Railroad and 1 farmer--fine. Whatever the legal
rule is, they bargain to the efficient outcome.
- 2. Railroad, 100 farmers, railroad has the right to
- a. And should... no problem. sparks
- b. And shouldn't--public good problem. Still sparks,
even if the spark arrester is less costly
- c. A public good problem occurs when a good, if
produced, will be available to all the members of a
pre-existing group. In this case, if someone pays the
railroad to install the spark arrester, all of the
farmers will benefit--whether or not they helped pay. So
each farmer may try to be a free rider--get the benefit
without paying for it.
- 3. Farmers have the right to enjoin.
- a. And should...no problem. No sparks, and that is
the efficient outcome.
- b. And shouldn't...holdout problem. Suppose that the
cost of a spark arrester is $200,000, the cost of
switching to clover is $100,000 ($1000/per farmer). RR
offers each farmer $1100 to switch. One farmer notices
that if everyone else agrees, his agreement will let the
RR save a lot of money--but if he blocks the settlement
(i.e. insists on enjoining the RR from throwing sparks)
they will have to pay for a $200,000 spark arrester. So
he tries to hold out for much more than $1100. So do
others. No agreement. No sparks. No clover.
- 4. Farmers have the right to sue--for $3000 damages
- a. If no sparks is the efficient solution, you get it
immediately--the RR installs the spark arrester instead
of paying damages.
- b. If sparks +clover is the right solution, get it
after bargaining. A farmer can try to hold out--but the
RR can settle with the other farmers, and pay the holdout
$3000 for the fires in his fields. The holdout loses out
on whatever premium the RR was paying above the cost of
switching to clover.
- c. If sparks without clover is the efficient
solution, that happens immediately too. The RR is only
willing to pay the farmers up to $3000 each to switch to
clover--but switching costs them more than that (that is
why clover is not the efficient solution in this case).
- d. So the damage rule appears to be the best
solution--if damages are easily and cheaply measurable by
the court. We have so far ignored both the cost of
litigation and the risk of court error.
- IV. Some further
- A. We should include other
- 1.the fourth option--RR has the right, but a liability
rule. That means that any farmer can enjoin sparks--but is
then liable to the railroad for the cost of putting on the
- 2. Which gives a public good problem if no sparks is the
right solution. No individual farmer wants to enjoin,
because he will then pay for the spark arrester while
everyone else gets the benefit of no sparks.
- 3. And we could consider still more possible legal
rules, including one where the RR can force the farmers to
switch to clover--but owes them damages for doing so, and
rules where the damage payments go to the state instead of
the other party.
- B. How we would figure out the optimal
property rules, if we knew just barely enough: The spaghetti
- 1. We start with three possible legal rules, four
possible outcomes (one, spark arrester + clover, is
uninteresting here, although one could imagine situations
where we wanted both parties to take precautions).
- 2. We are going to apply our legal rules to a lot of
different situations in the future, and the courts will not
know enough to revise the legal rule for each situation. In
other words, we can't say "in any situation where the
efficient outcome is sparks, give the railroad the right to
throw sparks, in any situation ... ." We need a single legal
rule to cover many future cases.
- 3. We have some estimate of how likely different
situations (sparks efficient, clover efficient, etc.) are to
arise in the future.
- 4. So we consider, for each initial rule, how hard it is
to get from that rule to each of the possibly efficient
outcomes. We then choose the least costly rule, allowing for
how likely it is that each outcome will be the most
efficient (and how much is at stake, and how costly getting
to that outcome from that initial rule will be).
- 5. Note that the costs coming from problems that block
the move from initial rule to final outcome are of two
- a. The cost of organizing a transaction--bargaining
out a solution to the public good problem.
- b. The cost of failing to organize such a
transaction, and thus ending up with an inefficient
- V. Damages vs
- A. The strategic case: suppose the RR owes
a fine to the government for each fire; further suppose that
the spark arrester is the efficient solution, but clover is
better than fires.
- 1. The RR keeps throwing sparks, pays fines for a while,
knowing that ...
- 2. The farmers, who are suffering from the fires and not
collecting the fines, will eventually switch to clover
- 3. Note that this depends on a particular asymmetry--one
RR, many farmers.
- a. With one of each, the RR has no bargaining
advantage. The farmer might refuse to switch to clover in
order to get the RR to put on the spark arrester.
- b. With many of each, no strategic behavior. Consider
the case of auto accidents. It doesn't make sense for me
to drive recklessly in the belief that everyone else will
be very careful to compensate--because I am only one
one-millionth of their driving environment.
- B. The
non-strategic case with bargaining:
- 1. There is a factory polluting a small lake; preventing
the pollution will cost the factory $1,000,000/year.
- 2. The pollution does $700,000/year worth of damage to
the resort at the other end of the lake--ruins the fishing,
people don't want to swim in water that smells bad, etc.
- 3. Efficient outcome--keep polluting, since prevention
costs more than it is worth.
- 4. The government imposes a Pigouvian tax--every year,
the factory must pay $700,000 in fines to the EPA for its
pollution. The factory keeps polluting. The resort keeps
- 5. The resort owner offers the factory $400,000/year to
stop the pollution--which is a good deal for the resort,
since stopping the pollution is worth $700,000 to it.
- 6. The factory accepts. It saves $700,000 in fines and
gets an additional $400,000 from the resort, so it is worth
paying the $1,000,000 cost.
- 7. The result is inefficient.
- 8. Coase + Pigou is too much incentive. "Incentive" is
not automatically a good thing; what we want is the right
incentive, neither too much nor too little.
- 9. Note that the problem will not arise if the $700,000
is a damage payment to the resort instead of a fine--now the
resort doesn't care whether or not the factory pollutes (and
pays for it).
- C. The non-strategic case without
- 1. The probability of accidents depends on precautions
by both parties.
- 2. We want each to take any precaution whose payoff in
decreased accidents is greater than its cost.
- 3. To give them an incentive to do so, we must make each
party liable for all of the costs--double liability in
- 4. At which point they have an incentive not to report
- VI. Fines vs
Damage Payments in summary:
- A. Strategic argument for damage
payment--where parties are identifiable and one side has a big
- B. "Coase+Pigou is too much" argument for
- C. Joint cause argument for fine--adding up
to double liability.
- D. Liability has the advantage (and
disadvantage) of private enforcement.
- 1. An incentive to report the accident
- 2. But also an incentive to sue when you have not been
injured--in order to collect.
- VII. Other Coasian
- A. Suppose rights with regard to polluting
the lake are well defined but for some reason the factory and
the resort find it hard to bargain to the efficient solution.
Perhaps there are many resorts. Perhaps it is hard for the
resort to tell how much pollution the factory is putting
- B. One solution is for the factory to buy
the resort, or vice versa. Once they belong to the same firm,
there is no longer an externality--the cost of pollution and
the cost of pollution control are being paid by the same
- D. Generalizing the argument provides an
explanation of why we have firms--which was the subject of
Coase's other famous article:
- 1. If you have taken an intermediate micro course, you
know that trade on the market provides the perfect system
for decentralized coordination. So why have firms? Why not
do everything by contract?
- 2. Suppose we do it that way (the "Inside Contracting
System," which was widely used in the 19th century). Each
stage of production is being done by a separate firm or
individual, with contractual agreements among them. "I will
deliver ten assembled rifle actions per day for you to put
into the stocks you are making, and I will get $7 per action
from what he eventually sells them for."
- 3. Something goes wrong. One party fails to fulfill his
contract, imposing costs on everyone else up and down the
line, which he may not have the resources to reimburse.
- 4. More generally, the market solution to coordination
is limited by transaction cost problems of various sorts,
while the hierarchical solution (the ordinary firm) is
limited by the problem of controlling people by command (the
worker's objective is to maximize his welfare, not the
firm's profits--only if the worker owns the firm, as he does
in a system where every worker is his own firm contracting
with other such firms, are the two objectives the same), the
informational problems of centralized authority, etc.
- 5. Think of the firm as a balance between the problem of
transaction costs and the problem of hierarchical control.
The bigger the former problems are the larger firms will be,
the bigger the latter problem, the smaller firms will be.
- VIII. Coase vs
- A. In some contexts, such as traffic
accidents and much pollution, we have large numbers on both
sides, so no Coasian negotiation is practical.
- 1. So property rights will end up where they start,
- 2. So we want the "right" Pigouvian solution--which
requires an opinion on who can best adjust.
- 3. And might mean fining both parties to make both
adjust--the auto accident case.
- B. In some contexts, it is obvious who is
the lowest cost avoider--so the Pigouvian solution is correct.
But watch out for the Coase+Pigou problem if transaction costs
- C. In contexts where transaction costs are
low and it is not obvious who is the lowest cost avoider, the
Coasian solution is best--define rights clearly and let the
parties bargain to the efficient solution.
- D. The Coasian approach gives the same
double incentive on the margin as does the double liability
solution I described for auto accidents. My incentive to take a
precaution that saves both me and you costs is the sum of my
savings plus what you will, if necessary, pay me to take
it--and similarly for your taking precautions. So on the
margin, each of us takes account of all costs and so takes all
precautions that are worth taking.
- IX. Property
rules vs liability rules:
- A. The difference:
- 1. Property rule: If I want to use your property I have
to get your permission, and if I use it without your
permission I receive a punishment which may be much larger
than the damage I actually did. In effect, the rule pushes
people into coordinating by mutual agreement, rather than by
unilateral action followed by litigation.
- 2. Liability rule: I can use your property without your
permission and then pay (in the form of a damage judgement
when you sue me) for the damage done.
- B. A liability rule requires the court to
measure the value of what has been taken, damaged, etc., so the
harder it is for courts to measure value, the greater the
advantage of a property rule.
- C. Under a property rule, the only way
someone other than the owner of the property gets to use it is
via a transaction with the owner, to get his permission. So
liability is more attractive the harder it is for parties to
- D. Consider ordinary private property. A
property rule is clearly superior to a liability rule. If I
want your property, labor, etc. I buy it. The alternative would
be a system where I get groceries by going into the store,
taking them, and having the owner sue me for their
- E. Consider pollution, or risk of airplane
crashes--liability is clearly a superior rule. I can't
contract, before taking off, with all of the people through
whose roofs my airplane might conceivably crash if enough
things go wrong.
- X. Another take:
Its all a matter of information
- A. Consider the RR/Farmer situation with a
fully informed court.
- 1. If you scrape my car and instead of having it
repainted I wait a year until it has rusted through then sue
you for the value of the car, I will lose; the victim of a
tort is obliged to take reasonable care to minimize the
- 2. So if the court knows that clover is cheaper than
fires, farmers who have fires due to sparks will only be
able to sue for what it would have cost them to switch to
clover--that being the reasonable way of minimizing the
- 3. The reason this usually does not work in practice is
that the court can observe the fires and the damage done,
but is unlikely to have enough information to figure out the
cost of all the alternative precautions the farmer could
- B. More generally, if a court knew
everything relevant to figuring out how people ought to ask
(i.e. what action--spark arrester, clover, checking your car
brakes, driving at exactly 43 miles an hour, operating a candy
factory only for seven hours a day, having a party at the frat
house this Saturday but not next Saturday because next saturday
is the best time for the recording studio next door to tape a
new album, ...) it could solve all legal problems by telling
everyone to do the right thing and hanging those who didn't.
Everyone will obey, nobody will be hanged, so we get the
perfect outcome with no litigation and no punishment.
- C. This is analogous to the central
planning solution to running a society--or the direct
regulation solution to pollution problems. Figure out what
everyone should do and make them all do it.
- D. But since in practice the various
parties to the dispute have private information that the court
does not have, we try to use an incentive system
instead--Pigouvian taxes, Coasian bargaining, or whatever--to
make it in their interest to use their private information to
choose the correct action.
- E. Why don't we solve the whole problem
this way--set up legal rules under which the court does not
have to know anything, because it is in the interest of all
parties to use their information to produce the right
- F. Because we don't know how to do it for
the hard cases.
- G. For ordinary markets that is just what
we do. All measures of value are determined by market
transactions reflecting the values of the participants. But
when we have to deal with externalities, public goods,
transaction costs, etc. it becomes hard, and perhaps
impossible, to set up institutions that work this way.
- I. Insurance: why it is interesting:
- A. Because one recurring legal issue is who
will bear the costs if something goes wrong-i.e. who is
insuring whom. For example:
- 1. Contracts. Something changes, so either I don't want
to produce what I agreed to or you don't want to buy it. Who
bears the costs resulting from such problems?
- 2. Auto accidents: Who pays for them?
- 3. Product defects and the associated costs. When a coke
bottle explodes, injuring someone, is Coca Cola liable for
the resulting medical costs?
- 4. Wider political issues of welfare, unemployment
insurance, health insurance, etc.
- B. All of these involve the same set of
issues, as we will see.
- C. Starting with straightforward private
insurance, which provides the simplest introduction to the
- II. Why insure?
- A. In expected value terms, insurance is a
losing deal for the customers-on average, they pay out more in
premiums than they collect in claims. If that were not true,
insurance companies would go broke, since they not only have to
pay claims but also other expenses (salaries, rent,
- B. But a dollar is not a dollar is not a
dollar. Insurance may be a bad deal if you are calculating in
dollars paid out and collected on average, but a good deal in
terms of what those dollars buy.
- C. Consider two futures:
- 1. 50/50 chance of $10,000/year or $90,000/year
- 2. or a certainty of $50,000/year
- 3. Which do you choose?
- 4. Why?
- D. Consider the goods you would buy in each
case. The goods you would give up if your income dropped from
$50,000 to $10,000 are probably a lot more important to you
than the goods you would buy if it rose from $50,000 to
- III. The economics of risk aversion:
- A. On average, an additional dollar is
worth less to you, in terms of the importance to you of what
you use it for, the more dollars you have. This is the same
reason we were not entirely happy with the solution to
interpersonal comparisons that we used in defining
efficiency-compare value measured in dollars-but this time in
an intrapersonal context.
- B. Where revealed preference solves the
problem of how to measure the difference
- C. And people buy insurance
- 1. because a dollar in the future where their house
burns down is worth more to them
- 2. than a dollar in the alternative future where it
- D. This argument implies that you will
insure against large risks but not against small risks, since
the difference in value to you between the goods you would buy
with an extra dollar if your income was $49,990 and the goods
you would buy with an extra dollar if your income was $50,010
- IV. Von Neumann and Morgenstern formalized this argument as
Von Neumann utility-which is defined in
such a way that individuals, in choosing among alternative
gambles, maximize expected utility rather than expected
- A. The varying value of a dollar shows up
as declining marginal utility of income.
- B. Also known as "risk aversion."
- C. Which does not mean "fear of
uncertainty" but simply "declining marginal utility of
- D. Someone could perfectly well be risk
averse in money (he prefers a certainty of income X to a
lottery whose expected value is X-where X was $50,000 in our
earlier example) yet risk preferring in years of life (he
prefers a 50/50 gamble of zero or 20 years to a certainty of 10
years). He has declining marginal utility of income, increasing
marginal utility of years of life.
- E. the figure below shows that declining
marginal utility of income (the slope of the utility function
becomes flatter as income gets higher) implies risk aversion
(the utility of the average payoff from a gamble is higher than
the average of the utility of the possible outcomes). In the
example shown, the gamble is a 50/50 chance of $10,000 or
$90,000. The utility of the average outcome ($50,000) is
greater than the average of the utilities of the outcomes .
- V. One problem with insurance: Moral Hazard.
- A. I insure my factory for 100% of its
value, then stop taking (costly) precautions to make sure it
won't burn down. If it does burn, that is the insurance
company's problem, not mine.
- B. Solution-only insure for 80%.
- 1. The result is still inefficient.
- 2. If I can reduce the expected loss from fires by $100
at a cost of $10, I will-since I am saving myself $20.
- 3. But if it costs $30 I won't-and should.
- C. Or have the insurance company mandate
- D. We have been here before:
- 1. Moral hazard is another name for an
- 2. It results in the usual inefficiency
- 3. Mandated precautions are the regulatory solution-but
by someone with a private interest in mandating the right
precautions, which might not be true for the EPA.
- E. Presumably risk aversion gains are worth
inefficiency cost, or the customer wouldn't buy the insurance
policy, but ...
- 1. Not if others bear some of the moral hazard's cost.
- a. Consider auto accidents. If I am carrying
liability insurance, the risk of having to pay for the
damage done by my risky driving will not deter me, so I
will drive more carelessly-harming others.
- b. That does not matter if the legal rule is such
that I end up paying the full cost of my dangerous
driving, but ...
- c. Maybe we should ban auto insurance if we don't
have adequate internalization via damages, fines, etc.
- d. And, in the case of criminal punishments, we do.
It is illegal to insure against them.
- 2. And not if insurance is not the result of a voluntary
- a. Either mandatory-as in assigned risk pools. Auto
insurance companies are required to insure the very bad
risks at a high price, but not high enough to make the
insurance companies willing to do it voluntarily.
- b. Or implicit in the legal system, as in legal rules
that you may not contract out of (non-waivable contract
rules) or cannot (tort rules for auto accidents).
- F. In some cases, "moral hazard" is a
feature, not a bug, either because
- 1. We want people to engage in risky behavior that
produces positive externalities. Give cops life and medical
insurance. Or ...
- 2. Because we are transferring the risk to someone more
competent to deal with it:
- a. Insurance company vs employee of large firm.
- i. Company has more expertise
- ii. and better incentives, due to inadequate
bonding of the employee.
- iii. The employee in charge of keeping the
building from burning down skimps on precautions.
Ninety-nine times out of a hundred nothing happens,
and he gets a raise for keeping costs down. One time
out of a hundred the company loses a ten million
dollar factory-and fires the employee. A better gamble
for the employee than for the firm.
- b. I read an article arguing that the failure of this
mechanism was the reason that nuclear reactors have poor
- i. In other risky fields, safety engineering
research is produced by the insurance companies that
insure chemical factories etc. and want to know how to
make sure they don't end up paying out a lot of money
due to major accidents.
- ii. Nuclear reactors are largely insured by the
- iii. Their concern is not convincing
experts-safety engineers working for insurance
companies-that they are safe, but convincing
amateurs-mayors and city councils and citizens of
towns where a reactor is to be located-that the
reactor is safe.
- iv. Which is done by having big switches, big
dials, the sort of engineering that is well suited for
science fiction movies but makes it hard for the guy
on duty to actually keep track of what is happening.
- c. Sharecropping-in the case where the landlord is
also providing inputs of capital, expertise, etc.
- d. Note that this is the double incentive problem
again-ideally we would like each of the two (landlord and
sharecropper) to receive 100% of any increase or decrease
- e. We could do it via a third party risk bearer-but
landlord and sharecropper would then conspire to produce
an inefficiently high output.
- 3. A different way of putting this is that we have been
implicitly assuming that the person who bears the cost if
the legal system does nothing (lets costs lie where they
fall) is also the person best able to control the cost, so
transferring it to someone else increases the inefficiency.
Sometimes it might be the other way around.
- a. Suppose the only way of preventing the problem of
exploding Coke bottles is better quality control by the
- b. If so, transferring the cost to the manufacturer
solves a moral hazard problem instead of creating one.
- VI. The other
problem with insurance: Adverse Selection.
- A. The market for lemons.
- 1. There are two kinds of used cars-cream puffs and
lemons. The potential seller knows which he has; the
potential buyer does not.
- 2. Both would rather own a creampuff, so the price a
buyer will pay for a creampuff (if he knows that is what he
is getting) is higher than for a lemon, as is the price an
owner will require before he is willing to sell.
- 3. Since buyers don't know which they are getting, they
offer a price representing a weighted average of the value
of the two.
- 4. Suppose a cream puff is worth $4000, a lemon is worth
$2000, half of the potential sellers have cream puffs.
- 5. Buyer offers up to $3000, but ...
- 6. That is a good price for a lemon, so all owners sell,
- 7. A bad price for a creampuff, so few owner sell
- 8. So buyers, anticipating that problem, change their
weights and offer only $2500, and ...
- 9. Even fewer cream puffs sell.
- 10. We could end up with only lemons selling-at lemon
- 11. This is inefficient-because cream puffs are worth
more to potential buyers than to potential sellers, yet are
remaining with the latter.
- B. Possible solutions:
- 1. If everybody knows, no problem.
- a. Require repair records?
- b. Permitting repair records will do, if they can be
authenticated. It is in the interest of someone selling a
creampuff to produce the records that prove it is a
- c. The analogous approach to the AIDS problem is a
reliable ID card, certifying that the bearer was HIV
negative as of a recent test. People who are negative
have an incentive to get tested and show the card-people
who are positive can't.
- 2. If nobody knows, no problem. Not an option here, but
might be in other cases.
- 3. So the problem is asymmetrical information.
- 4. Another solution is for the seller to guarantee the
- a. Which brings us back to insurance
- b. And double causation. Now that breakdowns are
insured against, the owner has less incentive to take
precautions against them.
- c. Ami Glazer's solution to the lemons problem: Find
a car you like; ask the dealer if, for an additional sum,
he will guarantee it. Repeat until someone says yes. Then
buy the car-without the guarantee. The fact that he was
willing to guarantee the car is evidence that he doesn't
expect it to break down-unless he has correctly guessed
- C. Selling life insurance.
- 1. If someone comes into your office and demands to buy
a large life insurance policy right now, you don't
sell it to him
- a. because you suspect he knows something about his
odds of collecting that you don't.
- b. Someone has just taken out a contract on him
- c. Or he tested HIV positive
- d. Or his girlfriend jilted him, and he is planning
to fall off a cliff this afternoon.
- 2. More generally, the customer has some private
information relevant to how likely he is to collect.
- 3. His decision to buy signals you that the private
information is in the direction of making him a bad risk, so
you adjust the price accordingly.
- 4. Note that we apply exactly the same logic when we say
"If you're so sure, what will you bet?" Putting your money
where your mouth is is a form of signalling.
- 5. And betting that you are going to die early (i.e.
buying life insurance) signals that that is what you
- D. Or health insurance
- 1. You know whether your hobby is reading science
fiction or kickboxing or jumping out of airplanes
- 2. Which is relevant to how good a risk you are
- 3. And your buying signals that you are a poor risk.
- E. Or anything else with asymmetric
- F. Again, the problem disappears if
everyone knows or if nobody knows
- 1. Suppose we can identify people prone to various
medical problems by genetic testing (as, increasingly, we
- a. If nobody knows, there is no adverse selection
problem-both buyer and seller of insurance treat the
buyer as a random individual.
- b. If everybody knows, there is no adverse selection
problem-and people with unhealthy genes pay more for
- c. In the latter case, having unhealthy genes is an
uninsurable risk-because you know how the gamble turned
out before you buy the insurance.
- 2. This is analogous to the economic argument for
welfare. Risk aversion is normally dealt with by market
transactions-buying insurance. But you can't insure against
being born poor, because by the time you are there to buy
the insurance, you already know how the gamble turned out.
- 3. Suppose we forbid insurance companies from
discriminating by gender in the price of life insurance-they
must sell at the same price to men and women, even though
women on average live longer.
- a. Men and women can still use their information
about life expectancy to decide whether to buy.
- b. So we get adverse selection. Men buy too much life
insurance, since they are getting it at less than its
real cost (given their greater chance of collecting
early) and women buy too little.
- c. In this case, we have the effect of asymmetric
information because one side of the transaction is
forbidden from using information that both sides have.
- G. Note also that this is an efficiency
problem, not (only) a fairness problem.
- 1. If you have a cream puff that is worth $3000 to you
and $4000 to me, but it does not get sold because of adverse
selection (I only offer $2000 because I believe that it is
probably a lemon) we are on net $1000 worse off.
- 2. If I get insured at too high a price (because the
insurance company thinks I am a bad risk) that is only a
transfer, but ...
- 3. If I don't get insured because the price the
insurance company charges (knowing that people who buy
insurance are likely to be bad risks) is more than the price
I will pay (knowing that I am a good risk) that is a net
- VII. Application to product liability. Who is liable for damage done by exploding Coke
- A. Consider two alternative legal
- 1. Caveat Emptor (latin for "let the buyer
beware"): You take your good as it is, defects and all. If
the coke bottle explodes, the injured consumer pays his own
- 2. Caveat Venditor ("let the seller beware"): If
something goes wrong with the product, the seller is liable
for the damage.
- 3. I am treating the distinction as sharper than it
really is. If your wife shoots you with your gun, something
has gone wrong, but the fact that a gun shoots the person it
is pointed at does not generally count as a product defect
even if it happens to have been pointed at the wrong person.
So implicitly we are talking only about some subset of
"things going wrong" that are plausibly associated with
something wrong with the product.
- 4. But that can still be a large and hazy category.
- B. The Coke company can self-insure, the
- 1. If Coca-cola is selling ten billion bottles a year,
of which one in a million will blow up, they can count on
almost exactly 10,000 exploding coke bottles per year. It is
still a cost, but not much of a risk, since the size of the
cost can be predicted with accuracy.
- 2. So transferring the cost to Coca-cola reduces the
risk aversion part of the cost. Before the change, the
customer faced a very uncertain cost. After the change,
neither party faces a very uncertain cost.
- 3. This only works if the events in question are
independent. One bottle blowing up does not affect the
probability that another one will.
- 4. On the other hand, Coke cannot self-insure against
the risk that legal rules will shift against them. If courts
decide to award much larger damages to consumers injured by
exploding Coke bottles, that will apply to all of the
bottles. Coke (in the U.S.) cannot "average out" futures in
which the courts become more pro-plaintiff against ones in
which it becomes less, the way it can average bottles that
do and bottles that don't explode. It might be able to do
some averaging across jurisdictions-but a very large
fraction of its potential liability is in the U.S.
- C. Moral hazard argument:
- 1. If the relevant margin for control is care in
manufacturing, then liability (caveat venditor)
reduces the moral hazard problem.
- 2. If the relevant margin is careful use by the buyer,
then caveat venditor increases the problem.
- D. Adverse selection argument:
- 1. What do we assume about consumer information?
- 2. If consumers cannot observe quality or judge it by
firm (or product) reputation, then we have a lemons problem
with caveat emptor-everybody produces a below optimal
quality, because a higher quality, being unobservable,
cannot command a higher price.
- 3. A different way of saying this is to consider a
situation where the seller knows how safe the coke bottle
is, the buyer does not.
- a. If he sells me a coke bottle, I don't know what I
am buying (since I don't know the risk of explosion and
do care), so don't know whether it is worth the price.
- b. I buy too much if it is riskier than I think
(since I am underestimating the true price-or, if you
prefer, overestimating the true value), too little if it
is safer than I think.
- c. If he sells me a coke bottle with a guarantee, he
knows what he is selling, since he knows the chance that
he will have to pay off on the guarantee.
- d. And I know the value to me of what I am buying. I
don't know the chance of an explosion-but I don't care,
since he has insured me against that risk.
- 4. If consumers are well informed about average quality
by firm, then caveat emptor is fine from both an
adverse selection and a moral hazard standpoint. No moral
hazard, because Coke has an incentive to provide good
quality control so that consumers will want to buy their
- 5. Adverse selection can also apply on the customer's
side. Under caveat venditor, I don't want to sell a
car to someone who will use it for drag racing, then sue me
when there is an accident.
- E. So far it looks as though we can simply
balance risk aversion, moral hazard, and adverse selection to
choose the optimal rule.
- 1. Either the optimal broad rule- "producers are always
liable," "producers are never liable"
- 2. Or have the court look at the product and decide
which rule is preferable for that product.
- 3. The conclusion seems to be that if consumers are well
informed about average product quality by firm, or can judge
individual products, the optimal rule is caveat
- 4. Ditto if the main risks comes from decisions by
consumers (shaking a warm coke bottle up and down while
making a point in an argument-you can't idiot-proof
everything because idiots are so damn ingenious).
- 5. Caveat venditor is the optimal rule if the
consumer is poorly informed both about the individual
product and about the average quality of products produced
by each firm, and the important decisions relative to
accidents are decisions by the firm.
- 6. And the advantage tilts towards caveat
venditor if the loss is large and the producer is much
better able to self insure than the consumer. Note that not
all imaginable cases involve a small buyer and a big
seller-consider GM as a buyer of labor.
- 6. But ...
- F. Litigation cost and insurance:
- 1. So far, we have not been talking about insurance in
the literal sense-we have a Coke company, a customer, but no
- 2. Why not? Instead of asking whether people want
protection against risk, why not ask whether tort liability
is the cheapest way to produce it? What about ordinary
- 3. It has two big advantages, one disadvantage.
- a. An insurance company wants a reputation for paying
out readily; a firm may well want the opposite
reputation. A reputation for being tough might make
consumers less willing to buy the product-but in order to
justify caveat venditor, we must assume that
consumers are poorly informed. A reputation for being
tough makes injured consumers (and their attorneys) less
willing to sue-and tort attorneys may be well informed
about the litigation reputation of the firms they
- b. Risk aversion doesn't depend on whose fault it
was, so product liability is lousy insurance. What if you
get hurt and it wasn't due to a faulty product? You are
better off buying insurance that covers injuries from a
wide range of causes.
- c. Disadvantage-product liability may put the
incentive somewhere useful (on the firm that could take
greater precautions not to make defective products),
insurance doesn't (except to the extent that your health
insurer mails you medical tips, etc.)
- 4. One advantage of letting the loss lie where it falls
is that nobody has to sue anybody, so you don't have any
- VIII. We have been
running through arguments about how to decide whether or not the
law should force Coke to "insure" its customers against exploding
Coke bottles. Why doesn't the law make these calculations for
ordinary insurance, deciding for you whether you are insured or
- A. Because under ordinary circumstances,
you have the right incentive to make the right decision for
yourself. You get risk protection, pay moral hazard plus
administrative costs in the price of the insurance.
- B. Where that is not true, there is an
argument for government involvement:
- 1. Mandatory auto insurance-to make sure that if you
cause an accident, you can pay for it.
- 2. National health insurance-if we believe that the rest
of us won't let you die in the street, so if you are
uninsured and sick we end up paying.
- 3. Or if we think that the adverse selection problem,
which gives an inefficient outcome on the private market, is
- 4. This is a public approach analogous to a group
policy, which is a private way of controlling adverse
- IX. Why not apply the same analysis to tort
- A. Instead of asking "when should the firm
- B. Ask "when will the firm choose not to be
liable although it should be, or vice versa?"
- C. In other words, the alternative to both
caveat emptor and caveat
venditor is freedom of
- D. Under freedom of contract, the court
sets a default rule, which applies if the parties do not
specify some other rule of liability. But the parties are free
to contract around the default rule, thus setting their own
- 1. If the default is caveat emptor, the seller
can offer a guarantee, thus shifting the rule (for whatever
sorts of defects the guarantee covers) to caveat
- 2. If the default is caveat venditor (malpractice
liability), the buyer can agree to sign a waiver of
liability committing him not to sue, thus converting the
rule to caveat emptor.
- 3. Under current U.S. law, guarantees are normally
enforceable but waivers often are not. You can agree not to
sue your physician for malpractice, perhaps in exchange for
a lower price of service-but if something goes wrong you can
change your mind and sue anyway.
- E. This is an issue that will appear again
- 1. One reason for legal rules is to fill in gaps that
parties cannot, or do not bother, to fill in themselves.
- 2. A different reason is to compel rules different from
the ones that parties would choose.
- 3. Different sets of arguments apply to the two cases:
- a. "What is the rule that maximizes their joint
benefit?" Make that the default-because if you don't, you
are merely putting them to the trouble of contracting
around the default rule.
- b. "Why is it not in their interest to take the
optimal rule?" That tells you what direction you want the
mandatory rule to alter their behavior in.
- 4.When you are writing waivable rules, "fixing"
inefficiencies due to externalities etc. isn't really an
option, because if you try the parties will contract around
- Week 4: Ex
Ante/Ex Post, Strategic Behavior, Etc.
- I. Review: Marginal vs
- A. The diamond water paradox--marginal
value vs average value.
- 1. Marginal Value: Value of having one more gallon given
what you have
- 2. MV times quantity is not total value
- 3. In other words, the value to you have having water is
a lot more than 1000 times the value of one more gallon used
to water the lawn.
- B. What is the cost of cooking dinner for
- 1. Very low, if it means nine people instead of eight.
- 2. Pretty high (in labor) if it means one person instead
- C. Two hunters in
the woods. If either or both shoot the third, he is
- 1. So the marginal cost imposed by B shooting C (given
that A was already doing so) is zero.
- 2. As is the marginal cost of A shooting C (given that B
was doing so)
- 3. But the cost of A and B shooting C is one life.
- 4. The marginals don't add up to the total.
- D. Two drivers--takes two to tangle.
- 1. There are only two drivers in the world.
- 2. If A drives and B doesn't, or B does and A doesn't,
or neither does, zero collision cost.
- 3. If both drive, $100 expected accident cost.
- 4. So the marginal cost of one more driver (two instead
of one) is $100--whichever driver it is.
- A. Consider two different approaches to
preventing auto accidents:
- 1. Ex Ante--laws against speeding, required brake
inspections, laws against DUI, etc.
- 2. Ex Post--tort liability, criminal penalties
for drunk drivers in accidents, etc.
- B. Consider the question of attempted
- 1. If we are punishing ex post, according to
damage actually done, attempted murder is not a crime since
nobody was killed. The bullet went into a nearby tree--which
is doing fine.
- 2. If we are punishing ex ante, according to the
effects we predict behavior will have on average, then
attempted murder is a crime--shooting at people results, on
average, in killing some of them.
- 3. For a further puzzle, consider the (moral?) question
of why we punish murder more severely than attempted murder.
If punishment reflects desert--what the crime tells us about
the wickedness of the perpetrator--shouldn't the punishment
be the same? Being a bad shot is not a moral virtue.
- 4. What about the case of impossible attempts--trying to
kill someone by sticking pins in a voodoo doll? Should that
be a crime?
- C. What are the advantages of
ex post ?
- 1. Ex post has some of the advantage of effluent
fees over regulation. The court must measure damage done,
but doesn't have to know the relationship between
precautions and accidents--the driver provides that.
- 2. Nor does the court have to be able to monitor
behavior in order to punish its consequences, and thus deter
- 3. The driver
has a lot of private information about costly activities
that are hard to monitor. Driving when sleepy, angry, paying
attention to the conversation instead of the road, ...
- 4. On the other hand, both methods use the driver's
private information about how costly the precaution is (in
that respect, both are analogous to effluent fees), since
with speed limits, a driver can still violate them-and pay
the ticket-if he thinks doing so is important.
- 5. Ex post has the further advantage that
measuring the costs easier after they have happened.
- D. Advantages of ex ante ?
- 1. Popular wrong answer: "ex post doesn't prevent
accidents." Sure it does--by deterring them.
- 2. Risk
aversion--do you want to lose your house, all your property,
and be indentured for five years if you make a mistake
- 3. Other punishment costs--can't collect ten million
- 4. What can we do that is equivalent in deterrent effect
to one chance in a million of a ten million dollar fine?
- 5. Maybe one chance in a million of execution, or life
imprisonment, or ...
- 6. None of which pay us anything.
- 7. So ex post forces us to use punishments which
are large, and as a result inefficient.
- E. Implication:
- 1. People are risk averse only for large losses. So
small ex post punishments are unambiguously superior
to ex ante.
- 2 So an entirely ex ante system, with no ex
post costs, cannot be the right answer
- 3. We want ex post at least equal to the largest
fine you can pay without serious risk aversion costs.
- 4. Plus possibly some ex ante if that isn't large
- F. Freedom of contract solution?
- 1. Require insurance for appropriate amount.
- 2. Permit insurance company to impose ex ante
rules as a condition of insuring you.
- III. "Impossible attempts": Should
there be a penalty for attempting to kill someone by a method that
- A. Argument against--we don't mind if
people stick pins in voodoo dolls, so why impose costs on us
and the attempted murderers to prevent it?
- B. Argument for: The legal rule isn't about
voodoo, it is about methods that don't work. There must be some
uncertainty about what methods work, or nobody would use the
ones that don't.
- C. Consider a rational murderer choosing
between voodoo and poison:
- 1. Rational believer in voodoo?
- 2. Why not--we all believe in, and under some
circumstances trust our lives to, things we don't really
understand, and trust because people we trust tell us they
- 3. If he knows it doesn't work, he won't use it.
- 4. If he is certain it works, our legal rule (punishment
for impossible attempts) has no effect, since he is certain
it does not apply to him--and the rule is costly, so why do
- 5. But if he thinks either method might be the one that
works, penalizing him either way helps to deter him. When he
decides whether to try to commit murder, he must take into
account the risk that he will choose an impossible method
and not only will fail, but might be caught and punished.
- D. Of course, another way of providing the
same additional deterrence might be by raising the punishment
for success. But what if raising the penalty on methods that do
work is not an option--we can't hang him twice. We can hang him
once if he succeeds, and lock him up if he fails--even by an
- E. My article on Payne v Tennessee
discusses the ex post
, ex ante
issue in a somewhat different
- 1. Should murderers be punished more severely (for
example, execution instead of life imprisonment) for killing
particularly valuable victims--for example, a mother with
- 2. If the answer is "yes," that is a form of ex
post punishment--punishment by the damage actually done.
- 3. The alternative is to punish according to what the
court thinks the murderer knew when he committed the
murder--a sort of ex ante punishment.
- 4. In other words, punishing you particularly severely
if the court thinks you knew the victim was likely to be a
particularly valuable one, but independent of whether the
victim actually was particularly valuable (you get the death
penalty for killing someone, because the court believes that
you didn't notice the empty bottle of sleeping pills next to
- 5. The article (not the part assigned) also discusses
some questions about the relation between punishment and
moral desert which are outside the subject matter of this
course but which some of you may find interesting.
- IV. Strategic behavior: The
problem (see my Price Theory
- A. Bilateral monopoly.
- 1. Economic example: I have the only apple, worth $1 to
me. You are the only customer, and value it at $2. If we can
agree on a price, there is a net gain of $1 to be divided
between us, with the division implied by the price.
- 2. My six-year-old threatens to throw a tantrum if she
doesn't get her way. Doing so imposes net costs, so there is
a gain to finding some mutually acceptable outcome. Don't
assume you can simply be firm and always win. You may have
thought out the logic of bilateral monopoly bargaining
better than she has, but she has a hundred million years of
evolution on her side--during which offspring who succeeded
in getting a larger share of parental resources were more
likely to survive to reproduce.
- 2. Doomsday machine.
- a. The idea. Lots of very dirty bombs buried under
the Rockies. If the Russians attack, the bombs go off and
the fallout kills everyone on earth. So the Russians
won't attack, and we don't need to pay for nuclear arms.
- b. The reality: Our (and their) nuclear systems were
doomsday machines, with human triggers. They worked, and
therefore were not used--fortunately.
- 3. Bully: If you train
yourself to punch out anyone who gets in your way, and
people know it, they will stay out of your way, and you
don't have to fulfill the commitment--until you run into
someone else following the same strategy, and one of you
ends up dead. A doomsday machine on the individual level.
- 4. In general, the outcome of such games depends largely
on issues of commitment and reputation, which are hard to
include in our analysis.
- B. Prisoner's Dilemma
- 1. Simple: Both prisoners are better off if both keep
their mouths shut, but given what one does, the other is
always better off confessing. So they both confess.
- 2. Iterated. If we play the game multiple times, you
might think that a prisoner would keep his mouth shut one
time, for fear his partner would betray him next time in
- 3. Why it doesn't work:
- a. On the last play, no further threats of
retaliation remain, so we are back with the original
game--and both players betray.
- b. But since I know you are going to betray me on the
last play, there is no cost to me to betraying you on the
play before last.
- c. Repeat. The whole series of plays unravels, and we
both betray every time.
- d. It seems intuitively wrong, but logically right.
- 4. Why it does work:
- a. In the real world, we are playing such games an
indefinite number of times
- b. And want a reputation for being people who don't
betray their partners, so that people will be willing to
work with us, and ...
- c. Not betray us, since they want a reputation for
not betraying honest partners.
- d. All of which is hard to model.
- 5. Plea bargaining and armies running away are examples
of multiplayer prisoner's dilemmas.
- a. The defendants would all be better off if none of
them copped a plea, since the prosecutor would have to
divide his limited resources among many cases, and would
get few convictions.
- b. But, given what everyone else is doing, it is in
my interest to accept a plea bargain if it is a little
better than my expected result at trial.
- c. Almost everyone accepts, leaving the prosecutor
enough resources to make the expected result at trial
pretty bad for the defendant.
- C. Economics avoids including strategic
behavior in its analysis wherever possible.
- D. But can't always:
- 1. RR example: throw sparks, despite fines, to get the
farmers to switch to clover.
- 2. Punitive damages example: Beat people up, despite
fines, to get them to do what you say next time (there are
complications which will get discussed later).
- 3. Why do some cases get tried instead of settling out
of court, and thus holding down litigation costs?
- a. one reason is because the two sides disagree about
the likely outcome.
- b. But another is because each side is trying to get
a settlement on its side of the bargaining range--and the
result is no settlement.
- 3. Nuisance suits: Sue in order to settle.
- 4. Strategic imposition of costs: Threaten that if they
don't settle, you will make the trial costly for them--by
requiring the company president to spend three days
answering your questions.
- E. "Solutions." These are discussed at much
greater length in Chapter
11 of Price Theory . The basic
problem is to come up with a clear definition of what a
"solution" to a game is.
- 1. Von Neumann solution to two person, fixed sum
game. A pair of strategies and a value V for the game, such
that if player A follows his strategy he will get at least V
whatever B does (and maybe more), if player B follows his
strategy he will lose at most V whatever A does (and maybe
- 2. Von Neumann solution & the Core are
solution concepts for multi-person games: Each is a solution
concept where one solution can include many
outcomes--perhaps an infinite number. There may be multiple
Von Neumann solutions. There is at most one core--but may
not be any.
- 3. Nash equilibrium: Given what everyone else is
doing, I am doing the right thing--and the same is true for
every other player.
- a. Unstable against cooperation
- b. What the equilibrium is depends on how you define
- c. In the case of oligopoly, does "I adjust, keeping
what everyone else is doing the same" mean "when I change
my output, everyone else keeps his output the same and
sells it for what he can get" or "when I change my price,
everyone else keeps his price the same and sells what he
can at that price?"
- d. The two different definitions of
strategy--quantity and price--give very different
predictions for the workings of an oligopoly.
- 4. Subgame perfect equilibrium. Assume away
commitment. If at any point in the decision tree, someone at
that point would never find it in his interest to make a
particular choice, eliminate that choice from the tree. This
is how we proved that repeated prisoner's dilemma gave the
same result as a single play of prisoner's dilemma.
- 5. None of these solutions is very satisfactory, with
the possible exception of the first--which only applies to a
situation where there really is no strategic behavior.
- V: What is
- A. we take the institution for granted--for
- B. But it is a specific kind of rule and
concept, as you can see by applying it in less familiar
contexts. My obligations to you are good only against me, but
your ownership of property is good against the world--everybody
is legally obliged to respect it.
- C. You ask a friend to borrow his bicycle.
- 1. he can have it back when he wants
- 2. If you give it to someone else, the owner can still
- D. You ask a friend for information on a
- 1. He has no right to have it back--to have you stop
using the dentist unless you pay him for the information. Or
even to demand that you give him the dentist's name if he
- 2. He has no right against third parties.
- E. A gives you a business idea; you sign a
non-disclosure agreement, etc. You tell it to B who tells it to
C, who uses it. A can sue you, but he has no claim against C to
"have his idea back," assuming C did not induce the
- F. There is a very partial exception to
this in trade secret law, discussed below.
- G. And a partial exception to the idea that
you can always reclaim your property in the legal rule of
"adverse possession," which implies that if someone else treats
your land, or some right with regard to your land (such as the
right to walk across it) as his for long enough (about seven
years, varying by state) and you do nothing to indicate that it
is yours, it becomes his.
- H. So a recording system becomes important
for maintaining property rights, especially for valuable items
such as land.
- I. And how fancy the property rights
are--to what degree you are free to unbundle them and sell only
part of the bundle--may depend on how easy it is for innocent
third parties to figure out what they are getting. If you
unbundle the tires from a car, the purchaser can learn it by
inspection. But what if you unbundle mineral rights from the
land? The right to decide what color your front door is from a
- J. So for most forms of property other than
land, the bundle of rights is fixed.
- 1. You can sell me your car, along with an agreement
that I will not drive it on Sunday or sell it to anyone who
- 2. But if I resell without requiring the buyer to sign
such a contract, you have no claim against the new owner--he
got the full bundle of rights to the car
- 3. only a claim against me for violating the contract.
- VI: Determining property rules really involves a set of
- A. How rights should be bundled (Coase
article, next week)
- B. How should you be allowed to defend your
property rights (property vs liability)
- C. What should be property?
- D. We are concentrating on the last at the
- VII. Property rules--including Intellectual Property (I.P.), primitive
societies, et multae
- A. Property vs commons.
- 1. Argument for property is obvious. Why plant if you
can't harvest? Tragedy of the commons.
- 2. Argument for commons? Cost of enforcing and/or
transacting over property.
- 3. English language
as a commons. We could give ownership of every new word to
its inventor, and there would be some advantages to doing
so--but less than the costs.
- 4. From primitives to cyberspace.
- a. When does it pay to define and enforce property
rights in land? Not if you are hunting large animals
across it--the rights you want are in the animals. Yes if
you are planting on it.
- b. Giving away information on the internet vs
charging for it. Porn does the latter, almost everything
else does the former.
- c. A lot EMail is transmitted on an "I'll forward
your packets, you'll forward mine" basis.
- d. All you can eat restaurant as a commons. An
Internet Service Provider with a fixed monthly charge is
a commons too--no charge for additional use. These are
voluntary commons in the middle of private property, so
it can't be just a case of "it didn't occur to them to
treat it as property."
Boundaries. Floating islands story:
- Stack island, which belonged to someone,
floated down the Mississippi (erosion at the upstream end,
deposition at the downstream end), into a strip of the river
where all islands belonged to the owner of the land on the west
bank of the river. Who did it belong to?
- 1. Property rights would be hard to work with in a world
where that was the norm instead of the exception--where the
boundaries that defined land ownership kept moving in
unexpected and inconsistent ways. Arguably, in intellectual
property it is the norm.
- 2. In patent law--what is the boundary of an idea?
- a. This shows up as the question of what does or does
not infringe a patent.
- b. And in how much you can claim--Morse's 6th claim
was for all ways of using the electromagnetic force to
transmit signs or images to a distance. That includes the
fax machine, the internet, the telephone, .... . The
court denied it.
- 3. In copyright? Not much of a problem defining
boundaries if we if only prevent literal copying, since it
is easy to see if that has occurred. But as you get farther
from that ...
- a. Advertisements using the framework of a popular
cartoon series may infringe its copyright.
- b. The movie Dr. Strangelove seems to have
been based on the novel Red Alert, although with
- 4. Wild animals are generally not private property,
because the cost of keeping track of which animal belongs to
whom is too difficult.
- 5. Underground petroleum moves around as you pump some
of it out.
- a.If I pump long enough, and you don't have not
drilled your own oil well and started pumping, I may end
up pu mp out all of your oil as well as mine.
- b. So each of us has an incentive to drill too early
andpump too fast, in order to (at some cost) get the oil
before the other does.
- c. The usual solution is "unitization," a legal rule
under which some fraction, often 2/3, of the owners of
land above a common oil pool can vote to have the oil
treated as a common resource, belonging to all the land
Defending. Dogs and
property rights. The bionic burglar alarm.
- 1. Changes in technology change what rights can be
- 2. Consider a primitive people trying to decide whether
land should be private property or a commons. The cost of
private property includes the cost of guarding it--there is
no point in my planting wheat if my neighbor is going to
come by at night and harvest it for himself. That cost was
substantially lowered by the domestication of dogs, since
dogs, being territorial can learn to identify their master's
property and bark at trespassers. Perhaps that was what
tilted the balance in favor of private property. If so, we
may owe most of human civilization to the dogs.
- 3.The widespread availability
of copiers means that copyright can no longer be enforced
against people who make small numbers of copies for their
own use. Similar arguments apply to enforcing copyright in
- 4. One approach to dealing with enforcement issues in
I.P. is to enforce your rights not against those violating
them but against those making the violation possible, under
the doctrine of contributory infringement. In one case, a
firm had a process patent on a way of using a chemical in
growing rice. Other firms sold the (unpatented) chemical,
along with instructions on how to use it--the purchasers
then violated the patent by using the chemical in the patent
way. The patent holder sued the firms selling the chemical
for contributory infringement and won, there being no other
substantial uses for the chemical.
- 5. Sony v Betamax is a famous case that went the other
way--making a VCR is not contributory infringement. The
argument was that, while a VCR can be used to tape a movie
off TV, infringing the copyright owner's rights, it can also
be used for time shifting programs, so there are substantial
non-infringing uses, so the manufacturer of the VCR is not
responsible for the infringing uses.
- D. Transaction costs
- 1. Chasing large
animals across private property. It would be costly to
bargain with each property owner when you reach his boundary
for the right to cross his property--and while you were
bargaining the animal would be getting away.
- 2. Propertising English. Suppose each word belonged to
its inventor. Writing a sentence would require a lot of
licensing negotiation. One argument against patents for
software is that they present a similar problem. A
programmer must do a patent search on every programming
trick he uses to make sure someone has not patented it.
- 3. All you can eat restaurants. Cost of monitoring is
higher than the efficiency loss--for spaghettti, lettuce,
but not steak. The more expensive something is, the greater
the net cost due to consuming an inefficiently large amount
- E. Creation of Property
rights: Rent seeking problems.
- 1. Homesteading. If I get ownership of 160 acres of
government land by being the first person to farm it for X
years, there is an incentive to start farming
prematurely--losing money on the farming in exchange for
obtaining ownership of valuable land. If I wait until the
land is worth farming, someone else will already be there.
- 2. Patent races. If I make my invention a day before you
do, I get all the rights to it, you get none. So there is an
incentive for an inefficient competition to be first.
- 3. This should not be a problem for copyright. Nor is it
a problem that someone who builds a house or an automobile
then owns it. What is the difference?
- 4. Crucial difference--homesteading or a patent race
takes something from the commons. It eliminates a valuable
opportunity (to homestead that piece of land or make that
invention) that others previously had. The other examples do
- 5. In other words, such an act confers a negative
externality on others.
- 6. But this may be a good thing if there is a positive
externality to be balanced.
- a. Perhaps the homesteading law was a good idea,
because settlement that was "premature" in terms of the
profit of farming to the farmer was not premature in
terms of total costs and benefits. The first settlers
might provide a "defense externality" by each making it
easier for the others to defend themselves against
Indians (or Canadians in the Pacific Northwest or
Mexicans in the southwest).
- b. Similarly, the inventor generates not only
knowledge that he owns (how to practice his patent) but
also knowledge (how to make other inventions outside of
the patent, by using unpatented parts of his idea) of
value to others. This is an argument for giving him a
benefit in exchange (at other people's expense), but it
is not an argument for making the benefit depend so
heavily on when he makes the invention, since we get very
little extra from his making it a week earlier--which may
be what gives him the patent.
- c. How soon we want something invented depends in
part on how rapidly the cost of inventing it is falling
with time. If it costs the same amount to invent it this
year as next year, we might as well invent it this year;
if it will cost a tenth as much to invent it a year
later, we might be better off waiting. One advantage of
trade secret protection over patent protection is that it
gives qualitatively correct incentives in this regard.
The faster the cost of inventing something is falling the
shorter the period for which you can expect to maintain
it as a trade secret, hence the lower the incentive to
invent it early.
- F. Supply elasticity.
- 1. What is the cost of leaving a positive externality
external? That depends on how much the reduced incentive
- 2. I get only part of the benefit from not dressing
horribly or not having a deliberately ugly house. But since
it costs me very little (perhaps less than nothing) to do
those things, even part of the benefit is enough--so few
people have deliberately ugly clothing or houses.
- a. In such situations, a problem arises only when
tastes differ--so that your "deliberately beautiful" (or
at least "desirable in some way") is my "deliberately
ugly" (punk haircuts, for example).
- b. Or when one party is malevolent and wants to hurt
- c. Or when one party is engaging in
extortion--imposing costs on others in order to be paid
to stop doing so. Most people are strongly committed to a
strategy of not giving in and paying off in such
- 3. Would there be "almost enough" intellectual property
even without protection?
- a. Reputation and other tie-ins provide some
incentive. People wrote books, poems, etc. long before
the invention of copyright (Homer, Dante, ...). The first
firm to come up with a product has a first mover
advantage--consumers identify the product with that firm.
The first firm may be able to establish standards, and
consumers are uncertain whether other firms are
successfully imitating them.
- b. c. 1900 the U.S. did not recognize British
copyrights, yet British authors got sizable royalties
from their American sales. With large fixed costs and
time delays due to typesetting, the first publisher (who
got the manuscript from the author) had a sizable
advantage over pirates (who had to wait for the first
publisher to print his edition before they could start
pirating it). Lotus has no patent on the idea of a
spreadsheet (which would have gone to Visicalc anyway),
yet has a large first mover advantage.
- 4. A related issue is the supply curve of the copier. A
good which is very expensive to copy (paintings, at least
until recently, live lectures--although Hal Holbrook's Mark
Twain performances may be a counter-example) may not need
intellectual property protection.
- 5. A related issue raised by Kitch is whether it is
important to coordinate the production of intellectual
property in some area, in order to make sure six people are
not working on one part of the problem and none on another.
Ownership of the area via a patent is one way of doing this.
The owner can hire everyone else, or subcontract, and
coordinate their efforts.
- VIII. Intellectual Property Law: What the law
- A. Copyright Law
- 1. Applies to expression, not idea.
- 2. Applies mostly against literal copying
- a. A bit vague at the edges--Superman (or at least
his copyright owner) won an infringement suit against
another superhero that was too similar to him.
- b. Is Superman an expression of the idea of a
superhero, or is a particular Superman comic book an
expression of the idea of Superman? On the former
reading, Superman is copyrightable, on the latter he is
- c. A movie derived from a book would violate the
book's copyright even if there was very little verbatim
- d. In computer law, the issue of non-literal copying
has become an important one.
- 3. Copyright protection has very weak requirements of
originality. The information in a phone book is not
copyrightable, on the grounds that producing it was a
mechanical process requiring essentially no human creativity
- 4. Copyright provides very long protection.
- B. Patent Law
- 1. Applies to the idea, not just the expression.
- a. Inventor must describe the best implementation he
- b. But better implementations are still covered by
his patent, and
- c. Constructive reduction to practice is now an
option, which means that he does not have to actually
produce a working model--just a description from which a
patent examiner believes that one skilled in the art
could produce a working model.
- 2. Novel and non-obvious.
- a. The inventor hasn't been doing it for more than a
- b. Nobody else has been doing it in public for more
than a year
- c. One skilled in the art could not readily figure
out how to do it.
- 3. Useful.
- a. In the 19th c. this was interpreted as "not
positively undesirable," on the theory that giving a
patent on a useless invention did no harm. A famous case
stated that an invention to assist debauchery or private
assassination would probably not be found patentable.
- b. One infringer actually won by using this standard
to challenge the validity of the patent he infringed. He
argued that the invention was positively undesirable, so
the patent was invalid, so he should be allowed to
practice the undesirable invention. It was a process to
mottle tobacco, thus making it look like tobacco that
came from places whose product was of high quality--a
legal fraud on the consumer.
- c. More recent courts have given more substance to
the requirement of utility, holding, for example, that a
process to synthesize a chemical with no known uses is
not useful, thus not patentable.
- 4. Bounds of the invention are set by the claim.
- a. If the claim is too broad, you don't get your
patent, either because someone else has already done
something that fits your broad claim or because the court
thinks you are claiming more than you invented. Morse's
sixth claim (disallowed) was for all ways of using
electromagnetism to transmit letters and figures to a
distance--and thus covered the fax, EMail, TV, ... . That
was his idea, the telegraph he had invented was simply
one implementation of that idea. The court didn't buy it.
- b. If the claims are too narrow, the patent is not
- 5. First to invent gets the patent in the U.S., first to
- 6. Patents provide relatively short protection.
- C. Trade Secret law:
- 1. Almost entirely deals with the consequences of acts
that would be banned anyway, such as:
- a. An employee violating his obligation of loyalty to
his employer by selling a competitor secret information.
- b. Breaking into a lab at night and photographing the
- c. etc.
- 2. Trade secret law allows the victim to sue for sums
based on the value of the secret.
- 3. And gives some rights against an innocent third party
who has received the secret.
- D. Trademark/trade dress law: In effect,
this body of law propertizes a limited part of the language. If
a particular restaurant design has come to mean your chain in
the minds of consumers, you may be able to prevent another
restaurant from copying the design. Similarly for a
trademark--a word that has become closely associated with your
- IX. The Economics
- A. Why have protection?
- 1. Traditional answer: Incentive to produce writings and
- a. But is it the right incentive?
- b. The more people will pay to license your patent or
buy your books, the greater the value you have produced,
and the greater the reward you get, hence the incentive.
- c. The longer it will be before someone else would
have produced the same intellectual property
independently, the greater the value you have produced.
And Copyright accordingly gives longer protection than
- d. But patent is still a "one size fits all"
system--it is not likely that all patented inventions
would hae been independently reinvented in exactly 17
- 2. To discourage secrecy
- a. A patent make secrecy unnecessary, since if
someone copies your idea you can sue him.
- b. Giving up secrecy is the price of getting a
patent, since you must reveal the best method of
practicing the invention that you know in sufficient
detail to allow others to use it.
- 3. Kitch homesteading alternative--the objective is to
- a. Once a range of ideas has been converted into
private property by a patent, the owner can develop it,
coordinating future research
- b. just as a prospector who has filed a claim can
develop the mine without worrying about other people
digging holes next to his and taking "his" ore out.
- B. Why not use contract instead of
- 1. The originator of a work or invention could transfer
it to others on condition that they agree not to make copies
or use the idea, and only to transfer it to other people who
accept the same agreement.
- a. Instead of suing someone for violating your patent
or copyright you sue him for violating his contract with
- b. But when you find copies being sold, how do you
know which of the people who bought it from you andsigned
the contract is the source of the original that is being
- 2. Copyright: The problem is how to enforce it against
innocent 3rd parties.
- a. It could be done by a legal system in which the
buyer has only bought part of the bundle of rights
corresponding to the work. He does not have the right to
make copies, so cannot sell it to others. In effect,
copyright law creates such a system, with respect to
removing that one item from the bundle.
- b. This is the way our legal system handles
restrictions on real property, such as easements and
restrictive covenants that "run with the land."
- c. But extending it to other forms of property,
without the elaborate registration systems we have for
land, could be a problem, and is something our legal
system is generally reluctant to do.
- 3. Patent.
- a. Using contract instead of patent is done to a
considerable extent to protect trade secrets. The rule on
innocent 3rd parties who get a trade secret through
someone else's violation of his obligation, without
knowing they are doing so, is that they can practice the
secret only if not doing so would impose serious costs on
them (i.e. if they have already built the factory using
the secret process).
- b. But there is a serious problem with this approach
in situations where use and sale of the patented good, or
the good produced by the patented method, reveal the
invention. It is hard to enforce a contract binding every
buyer to hide the good he bought from everyone who will
not agree to respect the inventor's sole right in the
ideas it embodies.
- 3. The issue of contract as a substitute for
intellectual property may become an issue again in the
context of computer networks, where new technology may make
the enforcement of intellectual property law very difficult.
- 4. One solution for copyright would be to somehow tag
every copy of the computer program you sell, so that if a
pirate copy appears you can prove which buyer is
responsible--and sue him for violating his agreement not to
allow others to copy the program.
- C. Why do we have different patent and
copyright rules, and why are they applied to the things they
are applied to?
- 1. The Constitution refers to "writings and discoveries"
but does not specify the rules for each.
- 2. Commons problem:
- a. Small for copyright--if I didn't write and
copyright the book, it is very unlikely that someone else
would have written it.
- b. Big for ideas--quite often, several people are
trying to make the same invention.
- c. So we have much tighter rules and shorter
protection for patents than for copyrights.
- 3. Costs of fighting over fuzzy boundaries are an
argument against protection.
- a. Literal copying is easy to spot and prove.
- b. Copying of ideas is much harder.
- c. So we have easier and longer protection for
- D. Copyright Protection for
- 1. A program is not a writing, since it is intended to
control a machine, not be read by a person (more like a
cam--some courts got that right).
- 2. But it has the characteristics that make copyright
suitable to writings.
- 3. As long as protection is limited to literal copying.
- 4. A lot of problems appear when you push it to cover
- E. Patent protection for software.
- 1. The Supreme Court opposed it under the "mental steps
doctrine," (you could not patent something that was simply a
series of mental steps, such as the rule for doing long
division) but ...
- 2. Gradually backed down, under pressure from the CAFC,
which was an inferior court but knew more about the subject
and had stronger opinions on it.
- 3. Many believe creating a problem
- 4. Not because software is not an invention, but because
its characteristics may make protection cost more than it is
- a. A new field, so courts don't understand it very
well and give patents for things already in the art.
- b. Very fast changing.
- c. Arguably the cost of writing programs is low
compared to the cost of making machines, the sort of
thing patent law was designed for, so the incentive of
patent may be unnecessary. Lots of programs were written
and lots of progress made before the Supreme Court
started recognizing software patents.
- F. Why doesn't patent law pre-empt trade
- 1. Sears vs Steiffen says it sometimes does--a
state cannot give the equivalent of patent protection to
things that do not qualify for a federal patent.
- 2. But in general it does not. Kewanee v Bicron
says that states are allowed to have trade secret law, even
though it deals with some of the same things as federal
patent law, and does so in a different way.
- 3. Trade secret helps fill in some of the gaps left by
patent law, since ...
- a. Patent is one-size-fits-all; either you get it or you
- b. You can use trade secret law to protect secrets that
are not sufficiently important or non-obvious or whatever to
qualify for patent protection but are still worth something.
- c. You can use trade secret to protect secrets too
important for patent--ones that you believe you can keep
secret much longer than 17 years (the formula for Coca-Cola,
- d. You can use trade secret to protect ideas that you
think are non-obvious but the patent examiner thinks are
obvious. If he is right, someone else will invent the idea,
making your secret worthless. If you are right, you get some
of the protection you deserve.
- e. And trade secret law has the right incentive pattern
with regard to timing--it is not worth spending a fortune to
invent something this year that will be easy to invent next
year, since your trade secret will only last a year.
- I. Contract
- A. We need enforceable contracts to permit
transactions over time.
- 1. Why not do everything as a spot transaction--here is
the money, there is the apple?
- 2. Building a house.
- a. If I pay and then you build, you can cheat me by
stopping work as soon as my check clears.
- b. If you build and then I pay, I can cheat you by
deciding to "renegotiate" when the house is finished.
Nobody but me is willing to bid for a house sitting on my
land, so you accept a price below what we agreed to
rather than losing everything.
- c. Even if you build on your own land, then sell me
house and land, you can cheat me if I cannot fully
measure quality. So you might want to insure your
work--especially if you don't have a reputation.
- 3. The loss from not being able to enforce contracts is
not cheating but inefficiency due to the possiblity of
cheating. Because we anticipate these problems, the house
never gets built--even though it it is worth building.
- B. One issue is how to allocate unexpected
losses. We have been here before:
- 1. By who can best insure.
- 2. By who can best control.
- a. I can take precautions to make sure my factory
doesn't burn down, my workers don't go on strike.
- b. And my decisions (I might be buyer or seller--or
some other role) may affect how much is at risk. Do I
take actions that will cause me serious problems if the
contract somehow falls through--or do I take precautions
"just in case."
- c. Reliance expenditures are costs born in reliance
on the other party performing his part of the
contract--costs that will be wasted if the contract falls
through. An example would be modifying my factory to
produce the goods I am making him at lower cost--where
the modification is useless if he decides he doesn't want
- 3. By who best knows the risk, so can include it in the
- 4. The allocation of such losses might be included in
the contract ("if the producer is unable to fulfill his
obligation due to forces beyond his control, ...") or it
might be done by a court after the fact.
- C. In many contexts, contracting parties
face a competitive market before they contract but are locked
into bilateral monopoly once they have signed the contract and
born costs associated with fulfilling it. This raises the
possibility of large bargaining costs, as parties use the
threat of breach to "renegotiate" after the fact.
- 1. Imaginary example: UCLA hires me for $50,000/year. I
move there from Virginia.
- a. I am losing money on the first two years, because
of moving costs etc. So are they--because of my having to
learn the ropes.
- b. After two years, they tell me they are cutting my
wage to $45,000. I wouldn't have come at that price--but
it is too late to get back my moving costs.
- c. I tell them that I will quit if they don't raise
my salary to $55,000. They wouldn't have hired me at
that, but there is no way they can get back the money
they lost on me while I was learning the ropes.
- d. We are now stuck in bilateral monpoly bargaining.
We need a long term contract, signed before I come, to
solve such problems.
- 2. So the courts should enforce contracts against
- 3. With some mechanism to deal with breach due to
changed circumstances. What?
- D. There is never enough fine print to
specify the terms in full, so where the contract does not say
what to do, the court fills in what it thinks the parties would
have agreed to.
- 1. Parties will try to construct contracts that are
efficient for the mini-society consisting of the parties to
the contract, since increases in the size of the pie make it
possible for everyone to have more.
- 2. If I see a way of changing the terms of the contract
we are negotiating that benefits you by $2000 and hurts me
by $1000, I point it out to you and propose that we
incorporate the change and shift the contract price by $1500
in my favor, thus making both of us better off than if I had
kept my mouth shut.
- 3. So if the court wants to fill in the terms the
parties would have written, it should figure out what terms
were in the interest of the parites.
- 4. One reason to do this is to maximize economic
efficiency--but this only applies if the terms don't have
significant effects on other people, since the parties will
only take effects on themselves into account. We don't want
to make assassination contracts "more efficient" in the
sense of making them better serve the interest of the
- 5. Another reason is that if the courts don't try to do
what the parties would have done, the parties have an
incentive to write more detailed contracts, so as to get
their preferences rather than the court's preferences. That
is costly. By filling in the blanks as the parties would
have when unlikely eventualities occur, the court reduces
the cost of drafting contracts.
- E. One way of dealing with changed
circumstances is for parties to break or renegotiate the
contract. We then need legal rules specifying what happens if
one party fails to fulfill his contractual obligations
(breaches the contract).
- F. These questions arise both in the
context of negotiating a contract (the parties want to find the
efficient terms) and filling in the blanks (parties would have
chosen the efficient terms, so the court adds them).
- G. It also arises where a court is trying
to modify the terms agreed to by the parties
- 1. Of course, if the court disagrees with the parties
about what the efficient terms are, the court may be wrong.
- 2. And one consequence of courts modifying contract
terms in ways the parties don't like will be the parties
writing more detailed contracts in order to stay out of
- II. But contracts can be enforced in other ways than by
- A. Within our society:
- 1. Reputation. Why our exterminator kept coming back
(after trying, repeatedly and unsuccessfully, to eliminate
- 2. Norms: Robert Ellickson's study of Shasta County
revealed a society where, for some issues, people ignored
the relevant laws and settled their conflicts on the basis
of informally enforced norms of neighborly behavior--one of
which was not suing each other.
- 3. Why do countries pay off on their debts?
- B. Limitations to such enforcement methods:
- 1. A "one time killing" --someone might make enough by
one violation of an agreement to make up for the
reputational costs (countries do occasionally default).
- 2. Some firms are not dependent on reputation, so can't
use it to guarantee contracts. But such firms don't need
long term contracts, since if they did reputation would be
important, so the inability to enforce such contracts
against them does not matter very much.
- 3. Individuals may not have a reputation outside of
their local area, so reputational enforcement may work in
Ellickson's context of neighbors, but not for forcing me to
pay back a loan from a bank in the next state.
- C. The substitute for force is information, since
reputational penalties only work if it is fairly easy for those
dealing with you to find out whether you are a good guy or a
bad guy on the basis of your past behavior. This requires ...
- 1. Either a society of neighbors, where people can judge
reliability for themselves, or ...
- 2. Specialist courts, producing the information and
relying on their own reputation to certify it.
- D. What is the Mafia--or, more generally, "organized
crime?" Perhaps it is mainly such a court system, authorising
the use of force against people in the criminal market who have
broken their contracts.
- III. Damages
- A: Two extremes
- 1. No damages. Either party can walk away from the
contract at any time. This is the rule we follow for most
small contracts--a dinner engagement, ordering a computer
that they don't have in stock yet, etc.
- a. To prevent opportunistic breach requires precise
timing of performance by each party, making it
unprofitable for either party to breach at any time.
- b. For example, as you build the house I pay you,
week by week, in such a way that there is no point at
which either of us is better off backing out of the
contract than fulfilling it.
- c. But one of us might still use the threat of breach
strategically--if breaching hurts me a little and you a
lot, and I think you will agree to change the terms of
the contract in my favor if I threaten to breach.
- d. And timing performance does not solve the problem
when something changes that alters the gains to one or
- e. But it does help if everything goes as planned, so
you want to do it so far as practical, thus eliminating
at least one source of breach.
- 2. No unilateral breach permitted--either party can
enforce specific performance (i.e. you must do what you
agreed to, under threat of very large punishments).
- a. This does not mean that the contract will actually
get performed--just that the party who wants to breach
must first get the other party to agree.
- b. Which he won't give unless he is at least fully
compensated, but ...
- c. If a change makes performance very costly, there
is now a huge bargaining range--since if I have to
perform doing so will cost me a fortune, even if it only
benefits you a little.
- d. And you might end up with bargaining breaking
down, and performance
- e. The two parties are stuck in an expensive
bilateral monopoly game.
- B. What are the margins on which we want to
give people the right incentive to avoid breach?
- 1. To sign or not to sign--since one way of keeping a
contract from being breached is not to sign it.
- 2. To breach or not to breach
- 3. How much to spend in reliance: Expenditures by both
parties whose value depends on whether breach occurs. For
example, my tooling up to make the custom widgets that you
have agreed to buy from me--which is a waste of money if you
decide you do not want them.
- C. Possible rules: Court set.
- 1. Reliance: Make the victim as well off as if the
contract had not been signed.
- 2. Expectation: Make the victim as well off as if the
contract had been fulfilled.
- D. Two ways of preventing breach
- 1. Expectation damages gives the right incentive to
breach or not to breach, since it transfers the cost imposed
by breach (how much worse off the victim is, compared to
performance) to the breaching party.
- 2. Reliance gives the right incentive to sign (when
breach might occur), since it means that the victim is as
well off with breach as if he had not signed.
- a. If both parties know the odds of breach this does
not matter, but...
- b. It matters if the potential breaching party knows
- c. Just as in the insurance, adverse selection case.
- 3. Both expectation and reliance measures induce
- a. The potential victim of breach knows he will get
his reliance expenditures back in case of breach
- b. So he decides how much to rely as if the
probability of breach were zero.
- c. But his reliance expenditures are a waste if the
contract gets breached--he gets reimbursed for them, but
at the cost of the breaching party.
- d. So the efficient level of reliance would be one
that allowed for the probability that breach would make
the reliance expenditures worthless.
- e. Which you get with a fixed damage payment in case
of breach, independent of amount of reliance (liquidated
- E. What about having the damages set by the
- 1. Liquidated damages--the parties specify damages for
breach in advance.
- a. Solves the reliance problem.
- b. But it only solves one of the other two problems
if the parties can figure out in advance what the correct
expectation (or reliance) damages would be.
- 2. Generally liquidated damages agreements are
enforceable, unless interpreted by the court as a
- 3. Penalty clause, meaning that the damages are larger
than the damage done.
- 4. Why not enforce that too? The parties had some reason
to make the agreement.
- 5. A penalty clause serves the same function here as a
property rule--instead of "pricing" unilateral breaches it
tries to eliminate them, forcing the party that wants to
breach to negotiate to get the permission of the other
- IV. Consumer fraud, liability, etc.
- A. Distinguish the argument for default
- 1. Who can more cheaply control
- 2. And has better information
- a. A photographer spends $10,000 and six months
photographing African wildlife, then sends his film to a
mass market developer--which loses it.
- b. Should the developer be liable?
- c. No. The developer does not know, and the
photographer does, that losing these films costs $20,000,
instead of the $20 or so cost of losing an ordinary roll
- d. The cheapest way of solving the problem is not for
the developer to take extraordinary precautions with
every roll, to protect the one roll in ten million that
is worth such precautions, but
- e. For the photographer to send the films to a custom
developer, and warn the developer how important they are,
so that that developer can then take special care with
- 3. And can more easily bear the risk
- B. From the argument for non-waivable
- 1. If the consumer knows he is ignorant, he can insist
on a guarantee, etc.
- 2. If consumers do not know that they need a guarantee,
how do we get the laws imposing a non-waivable--given that
the consumers are also the voters?
- C. Does having the court decide
(non-waivable or default) case by case make more sense than a
- 1. Better tailored to the facts, but ...
- 2. Less predictable.
- 3. Did you buy the lawnmower under a rule of caveat
emptor or caveat venditor? Only the Supreme Court
- V. Duress
- A. Real duress: A mugger points a gun at
you and demands your money or your life. You write him a check
for $500 and he lets you go. Should you be able to stop payment
on the check? In other words, should contracts made under
duress be binding?
- 1. Argument for: If you can stop the check, you can't
give him the money (assuming you don't have much on you) so
he shoots you.
- a. Worse still, you write the check and then he
shoots you--to keep you from stopping payment.
- b. Anticipating such, you don't write the check,
since writing it actually gives him more of an incentive
to shoot you, in a world where you can stop payment.
- 2. Argument against: In a world where such checks can be
stopped, there is less incentive to be a mugger, so you are
less likely to have people point a gun at you and demand
your money or your life.
- 3. Here, as in many other cases, you have to consider
the effect of the rule not only on what happens once you are
in a situation, but on the effect that the knowledge of that
has on your getting into the situation. In this case the
analysis has three levels:
- a. After you have written the check, gotten home, and
had a drink, calling up the bank to stop payment clearly
benefits you, but ...
- b. Because the criminal anticipates that you will do
so, in a world where you can stop payment on such checks,
he doesn't accept your check and shoots you instead (or
accepts and then shoots you), so being able to stop
payment makes you worse off, but ...
- c. Because the criminal anticipates that you won't be
able to pay very much for your life (in a world where you
can stop payment on such checks), he doesn't threaten you
in the first place, so being able to stop payment might
make you better off.
- 4. And in fact, contracts made under duress are not
enforceable. This makes sense, since the combined act "he
puts you under duress, you sign the contract" does not in
general produce a desirable outcome (economic improvement),
in the same sense that the combined act "he offers you a
contract, you sign it" in general does.
- B. Form contracts ("contracts of
- 1. Consider the sort of contract that a consumer faces
when he rents a car or an apartment, buys a computer
program, ... .
- a. It is drawn up by the other party in a standard
form, applied to many transactions, and ...
- b. Although he may have a choice as to some optional
terms, the consumer's basic choice is to sign or not to
- c. Does this count as a sort of "duress," since one
party cannot bargain about the terms?
- d. And does that imply that the arguments for freedom
of contract do not apply to such contracts?
- 2. Innocent explanation: Form contracts reduce drafting
costs, eliminate the problem of the firm having to control
the employee who negotiates the individual contracts.
- 3. The argument for freedom of contract still applies,
since the firm, in drafting the contract, will take account
of benefits and losses to its customers. Anything that makes
the terms of the deal more attractive to the customer will
also increase the amount he is willing to pay.
- 4. The freedom of contract argument even applies to a
monopoly. The more unfavorable the contract is to the
consumer, the lower the price the monopolist will be able to
charge and still sell his goods. Although a monopolist has
no competitor, his customers still have the alternative of
not buying the good at all--which is why monopolists to not
charge an infinite price.
- 5. Although the argument does not always hold in the
case of a monopolist, since (inefficient) contract terms
might be a device for profitable discriminatory
pricing--charging a higher (pecuniary plus nonpecuniary)
price to those consumers who will still buy at a higher
- 6. Courts sometimes refuse to enforce the terms of form
contracts on the grounds that they represent a sort of
duress. These arguments suggest the courts are wrong.
- 7. Although we have not considered the separate issue of
contracts sufficiently complicated so that the consumer does
not really know what he is signing.
- C. "Duress" due to nature, not to the other
- 1. A ship is sinking, another ship shows up, and the two
captains start bargaining over how much the latter will be
paid to rescue the former. Is the "duress" any more real
than other cases?
- 2. This is not analogous to the mugger case--the tug
didn't sink the ship.
- 3. the right price is the full value of the ship--from
the standpoint of incentives to the tug to be in a position
to save ships, but ...
- 4. That is too high a price from the standpoint of
incentives to the ship to take precautions, since the cost
of a wreck is the loss of a ship only if nobody is around to
- 5. So there is no simple price that gives the right
incentive to both parties--just like the auto accident
problem. The salvor should receive the full value but the
ship owner should pay only the salvor's cost of saving the
ship, that being the social cost of a shipwreck when the
ship gets salved.
- 6. If we believe that supply elasticity for salving
services is low--that it would rarely pay tugs to cruise
around during a storm in the hope of saving a ship, even if
they could get the full value--the best solution may be a
price not much above the actual cost of salving the ship.
- 7. Also, freedom of contract here leads to large
transaction costs due to bilateral monopoly and tight time
constraints--while you bargain, the ship is sinking.
- 8. That is an argument against freedom of contract, but
does not tell us where, between the value of the ship and
the cost of saving it, the court should set the price.
- 9. The actual legal rule is that the salvor is entitled
to a reasonable fee, but that contracts made while the ship
is going down are not in general enforceable.
- VI. Information
and Incentives: Laidlaw v
- A: Organ, with advance news of the treaty
of Ghent which ended the war of 1812, ordered lots of tobacco
from Laidlaw, at a low price reflecting the effect of the war
on tobacco prices.
- 1. When the news of the end of the war--and the end of
the blockage of New Orleans--became public, Laidlaw tried to
cancel the contract.
- 2. The Supreme Court didn't let him.
- 3. Did Organ, by not telling Laidlaw why he was buying
the tobacco, commit fraud? Should the contract have been
- B. The argument for the court's position is
that producing information is a useful activity, and you can't
make money doing it if, once the information is produced, you
have to give it away.
- C. Consider the more general case of
- 1. Speculation produces a social benefit by reallocating
resources from times when they are plentiful to times when
(an expert can predict that) they will be scarce--the
successful speculator buys low and sells high.
- 2. By buying grain before other people anticipate the
coming shortage he drives up the price early, giving other
people an incentive to use less grain (slaughter hogs early,
for example, to save their feed for human consumption),
produce more food of other sorts, etc.
- 3. So when the shortage hits and the speculator puts the
grain he bought back on the market, the famine is less
severe and the price does not go up as high as if he had not
- D. This only works if the speculator has
secure property rights.
- 1. If, when the famine happens, a mob seizes his barn
full of grain, or the government confiscates it, speculation
won't pay and won't happen.
- 2. And when there are bad harvests, people will starve
- 3. Which suggests that the belief that speculators cause
famine may be one of the most lethal errors in human
- 4. It is a result of applying a useful rule of thumb in
an inappropriate context.
- a. The rule is "cui bono"--to find out who is
responsible for something happening, first figure out who
benefits by it.
- b. It doesn't work in the case of production, since
producers benefit by high prices but the act of producing
increases supply and so makes prices lower than they
would otherwise have been.
- E. The successful speculator produces a
benefit and gets a reward, but the latter is not equal, or even
closely related to, the former. The relation between the
private value of his activity and the social value of his
activity is correct qualitatively (if he makes money he is also
doing good) but not quantitatively (he might do a little good
and make a lot of money, or vice versa).
- 1. Even in a case where elasticities are low, so that
the speculator produces only a small reallocation and a
small benefit, he might still get a large profit--since his
speculation means that resources belong to him instead of to
someone else at the instant when their price goes up.
- 2. So we might get inefficient speculation--spending
$1000 dollars to get information whose private value is
$1100 but whose social value is only $100.
- 3. aka rent seeking
- VII. Contracts, a
- A. It is useful to be able to commit
yourself to binding agreements.
- 1. Legally enforceable contracts are one way of doing so
- 2. Reputational enforcement is an alternative in many
- a. In some contexts it does not work
- b. It is dependent on reliable information about who
was in the wrong
- c. But has the advantage of providing market
incentives to judge correctly.
- B. Figuring out what is the efficient
contract arises in three different contexts.
- 1. Drafting contracts. Efficiency improvements increase
the size of the pie, giving a gain to be divided between the
- 2. Filling in blanks in contracts, by court or
- a. Argument B1 above implies that the efficient rule
is what they would have agreed to
- b. And it is also the rule that makes the world a
- 3. Modifying contracts contrary to their language
- a. On the grounds that the modified version is more
efficient, which makes the world a better place
- b. The problem being that B1 above implies that the
parties have already agreed to the efficient rules, and
since they probably know more about what rules are
efficient than you do, you are likely to be making the
world a worse place
- c. Unless you have good reason to think that the
argument for efficiency does not apply in this
case--fraud, for example, or mistake.
- C. Two important (and closely related)
issues in designing the efficient contract are who should bear
the risk if something goes wrong amd what happens if one party
breaches the contract.
- D. Another important issue is whether the
contract was formed in a fashion that leads to a valid (and
presumptively efficient) contract--i.e. the issue of
- E. We have omitted some other important
legal issues, such as:
- 1. One sided contracts. What if I make a general offer
(a reward for whoever finds my dog) and you act in reliance
on it, even though there is no contract between us? Am I
bound to fulfill my offer?
- 2. What defines whether a contract exists and ...
- 3. What the terms are if parties disagree as to what
they were agreeing to (I thought the price was $100, you
thought it was [[sterling]] 100).
(I have put this after the rest of contract law in the
notes; in the lecture it occurred in the middle)
- I. Divorce: Lloyd
- A. My way of putting it: Women perform
early, men late.
- 1. In a traditional marriage, a major contribution of
women is bearing and rearing children; most of the cost of
that is done in the first two decades.
- 2. A major contribution of men is income; their earning
power generally rises until retirement.
- 3. So women are putting more into the marriage than they
get out in the early years, and getting paid back in the
- B. His way: Women depreciate faster than
men on the marriage market.
- 1. Nearly equivalent: "depreciate" means "has already
- 2. Because people have only one lifetime, thus one
stream of services to give.
- 3. But putting it that way is less tactful if you wish
not to offend feminists.
- 4. In part because depreciation of women on the marriage
market also embodies the facts of male taste.
- C. Either way, there is an incentive for
the husband to default on the contract.
- D. Making the contract unenforceable
- 1. In the short run, husbands default: men gain, women
- 2. In the long run, people adjust the contract to
protect themselves by putting performance more nearly in
sync--bearing children later, for example
- 3. And by investing less in relation specific capital:
having a job and hiring somewhat else for a lot of the
housekeeping, child care, etc.
- E. What about having the contract be
- 1: If we knew the right terms, and everything was
observable and enforceable, perfect solution. but ...
- 2. Version 1: No divorce ever.
- a. Locks people into their early mistakes, and ...
- b. Might be evaded by separation, extramarital
affairs, desertion, ...
- c. Or result in large bargaining costs within
- 3. Version 2: Divorce with penalty to breaching party?
- a. But how do you measure performance?
- b. Party that wants to breach can degrade performance
to get consent.
- c. Or one party can degrade performance in order to
force the other party to breach--and pay the penalty!
- II. Why has
marriage become a less stable contract over the past
- A. Marriage is a long term contract because
of firm specific capital in two respects
- 1. The existence of firm specific capital creates the
potential for serious bargaining costs
- a. Which a contract can prevent to the extent that it
can specify terms
- b. A contract may be enforceable by an internal
bargaining equilibrium, even if outsiders cannot observe
performance well enough to enforce it. If either party is
clearly not doing his/her job, the other objects, making
the marriage an unpleasant one, but ...
- c. This only works if the duties of marriage are well
defined in the society (or parties can clearly define the
duties they agree to in advance).
- 2. Also, long term contracts are less costly when there
is a lot of firm specific capital, because that makes it
less likely that breach is efficient.
- B. There is much less firm specific capital
now than there used to be because:
- 1. Drop in infant mortality greatly decreases household
production input of wife.
- 2. Increased division of labor somewhat decreases
household production input of wife.
- C. So less long term contracting, more
living in sin, more divorce.
- These issues are also discussed in chapter
21 of my Price Theory textbook
- III. The
economics of wedding rings-argument from an article by Margaret
Brinig (not in the packet):
- A. Fact: diamond engagement rings became
common only starting in the 30's, peaked in 50's, declined
- B. Men preferred wives who have never slept
with anyone else.
- C. Men and women like sex.
- D. This creates a problem for those not yet
- 1. For woman, who knows that sex lowers her value on the
- 2. For men, who can't find women willing to sleep with
them, because ...
- E. Solution?
- 1. Each generation believes it invented sex, despite the
evidence, but previous generations managed somehow.
- 2. Part of the solution is sex after engagement but
- 3. Which creates a problem of opportunistic breach.
Seduce and abandon.
- F. One way of controlling this used to be
the legal action for breach of promise of marriage. The victim
could collect damages, in large part for her reduced marital
- G. Between 1935-1945 the action was
abolished in U.S. states containing half the U.S. population;
it has now entirely vanished.
- H.The custom of the male giving a valuable
engagement ring, which the woman could keep if he walked out on
her, arose--arguably to solve this problem. Think of it as a
- I. More recently, the custom has
declined--along with the importance of virginity on the
- IV. Adoption
- A. Currently, it is illegal for the
adoptive parents to pay the natural mother for her consent to
the adoption. It is legal to pay the lawyers who arrange the
adoption, the mother's medical costs, etc. One consequence
seems to be high transaction costs (as potential adopters bid
via lawyers), and a market that shifts between surplus and
- B. One argument against payments by
adopting parents to the natural mother in exchange for her
giving up her child to them for adoption is that the rich will
be buying and the poor selling.
- 1. This is surely a serious oversimplification; most
buyers will be (most Americans are) neither rich nor poor.
- 2. In any case, what is wrong with that? Would they ban
the markets for housecleaning and child care on the same
- 3. Is it better for the (richer, on average) adoptive
parents to get the child from the (poorer, on average)
biological mother, and not pay her?
- C. A more interesting argument, although
not one that convinces me.
- 1. How we act and observe other people acting affects
how we think. If we treat something as a commodity, we and
others will think of it as a commodity, which might have bad
- a. If babies can be openly bought and sold, perhaps
we will think of them more as possessions and less as
- b. If sex can be openly bought and sold (legalized
prostitution) perhaps men will think of women more as sex
objects and less as people.
- c. So perhaps this is an argument for banning certain
acts, not because the acts are bad, but because they
teach a bad lesson--"commodify" things that ought not to
be thought of as commodities.
- 2. But this argument has an odd feature,
- a. We have an act which is both an act and speech.
- b. As an act it ought to be permissable (transaction
with prostitute or baby seller)
- c. We ban it because we disapprove of it as speech
- d. Which seems to violate the first amendment.
- 3. As one student pointed out, a similar argument would
seem to apply to laws that impose special penalties for
"hate crimes." If you punish a crime more because, in
addition to doing injury, it also conveys the message "group
X are bad people who should be hated," isn't the additional
punishment a punishment for speech? After all, you couldn't
punish someone (in the U.S.) for a speech or a book arguing
that "group X are bad people who should be hated."
- V. It is often
claimed that, when I have a child, I impose net costs on others,
so that leaving people free to decide how many children they have
will result in overpopulation.
- A. But it is not clear what the sign of the
net externalities from my having another child is. Positive
- 1. My child may find the cure for cancer and
- 2. Will reduce the amount of the national debt your
child must bear
- 3. And the amount your child must pay for national
defense, or scientific research, or any other government
service whose costs is roughly independent of the
- B. This argument is one example of an error
common in political discussions in many areas. You calculate
net externalities considering only the externalities of one
sign (negative if you want to ban something, positive if you
want to subsidize it) and ignoring those of the other
- C. How in principle do we define the
optimal level of population?
- 1. If we measure it by per capita income, utility, or
something similar, we commit a fallacy of composition.
- a. Consider one additional person, who will impose
neither net costs nor benefits on the rest of us. How can
we say that his life (utility 10) is a good thing if the
rest of us have an average utility of 9, but the same
life is a bad thing of the rest of us have an average
utility of 11?
- b. Mead's example: Consider a world with two
communities, A and B. Both are attractive places filled
with happy people, but A is a little happier than B. Is
the world a better place if B is wiped out by a plague?
Average happiness goes up.
- 2. If we measure it by total utility, we need to define
a zero point, so as to know if an individual contributes
positive or negative utility to the total.
- a. The obvious zero point is death, but ...
- b. That leads to a rule very favorable to large
- c. Two unhappy people are better than one happy one
unless they would be willing to flip a coin: heads they
get to be the happy one, tails they die. They will have
to be pretty unhappy to agree to that.
- VI. Regulation of
Sex. Why do we do it? Adultery laws, fornication laws,
- A. Contract enforcement? Like copyright--it
makes it easier to enforce the contract against infringement
involving partners not party to it.
- B. Overenforce to protect third
- 1. Children--who may be injured if adultery leads to
- 2. Keep down VD, AIDS
- 3. Law against prostitution can be viewed as a way in
which wives enforce the marraige contract by making it
harder for husbands to break it.
- I. Tort Law:
- A. What it is: a private action for a
wrong, typically for damages, although injunctions are also
- B. Differs from criminal law in being a
private rather than a state action.
- C. And from contract law in not being based
on any contract between the parties.
- D. Four issues arise:
- 1. What makes it wrongful: Competition is not a tort.
Some system of rights assumed.
- 2. Causation: What does it mean to say A caused the
- 3. Liability--strict liability, negligence, contributory
- 4. Damages--how calculated?
- E. One can think of all these issues in
terms of economic efficiency, although whether doing so
describes how the law actually works is an open
- II. "Wrongful"
- A. Tort damages are a version of a
Pigouvian tax, so ...
- 1. We want to treat as wrongful only acts that impost a
- 2.And are worth the trouble of dealing with through the
- a. We can use injunctions or punitive damages to
enforce a property rule, where it is the injured party
who owns the property.
- b. Where the injuring party owns the property and is
using it within his rights, we solve the problem by a
- 3. And can be dealt with better in this fashion than by
a property rule.
- B. Should competition be a tort?
- 1. When I become the 101st physician in San Jose, the
wages of the first 100 physicians fall--should they be able
to sue me?
- 2. No, because their loss is their patients' gain.
- 3. So I have imposed only a pecuniary externality--a
transfer between two other people, not a net injury to other
- III. Causation complications:
- A. Coincidental causation.
- 1. I stop my friend for a moment in the street to talk,
he then continues on and is killed by a falling safe.
- There is a real case along these lines.
- A tree fell on a bus.
- The plaintive demonstrated that in order for the bus
to be where it was, the driver had to have been driving
above the speed limit, and ...
- Breaking the law is per se negligence, meaning
that it automatically classifies as negligent even if it
- 2. Should I be held liable? If I had not stopped him he
would not have died.
- 3. No. My stopping him does not affect the probability
of his dying--it might just as easily have resulted in his
not being under the safe.
- 4. A different way of putting this is that if I do not
get rewarded when I produce the positive externality (my
stopping him happened to save him) I should not get punished
when I produce the negative one.
- B. Dual causation: The victim is
accidentally shot by two hunters; each bullet would have been
sufficient to cause death by itself. Should they be
- 1. This puzzle is based on a somewhat less dramatic real
case: Summer v Tice.
- 2. The benefit of my taking a precaution that reduces
the chance I will shoot him is not the reduction in
probability of shooting him but the reduction in probability
of killing him (times the value of his life). Shooting a
corpse does no damage.
- 3. When I change my probability of shooting him, I
should benefit only by the resulting change in probability
that he will die, so ...
- 4. I should not be liable in the two bullet case case!
- 5. This ignores possible problems of proof, etc. It also
ignores the possibility of agreements in advance between two
hunters; I am assuming both were independently responsible
for the accident.
- C. Probabilistic injury.
- 1. Suppose a radiation leak increases the number of
cancer cases in the surrounding area over the next 20 years
from 100 to 110. Is the reactor liable, for what, to whom?
- a. If we must show that it is more likely the death
is due to the radiation leakage than that it is not, the
defendant always wins and the reactor pays nothing for
- b. If we accept a much lower standard of proof, the
plaintiff always wins and the reactor pays much too
much--the cost of all the cancers, most of which it did
- 2. One solution: Make the reactor liable for the
increased risk to everyone, using a class action.
- a. But diffuse costs are hard to litigate--class
actions are driven by the interest of the lawyers, not
- b. And immediately after the risk has been imposed,
evidence on how large it is will not be very good--nobody
has actually died, so we cannot start looking for
evidence of increased cancer rates.
- 3. What about giving each one who dies 1/11th damages?
- a. When they start dying, we have at least some data.
- b. Fewer cases to try.
- 4. Real world equivalent--DES cases.
- a. DES was a fertility drug which turned out to have
serious side effects.
- b. By the time the effects were discovered, it was no
longer possible to determine which pharmaceutical company
had manufactured the DES that a particular patient had
- c. So if a victim sued a company, the company could
(correctly) claim that it had probably not been
responsible for that woman's injury.
- d. Solution--divide the liability among the companies
in proportion to what fraction of DES each had produced.
- IV. Liability
- A. Optimal supply of accidents: The
accidents we would get if everyone took all and only
- B. Strict liability gives you the right
answer with unicausal accidents.
- C. Negligence applied to unicausal
- 1. Negligence is defined (by economists, but not
necessarily by legal scholars) by the Hand formula (named
after Judge Learned Hand, who applied it in a famous case)
- a. Hand says that you are negligent if you failed to
take a precaution whose cost was less than the expected
benefit in accident reduction, in other words ...
- b. If you failed to take all cost justified
- 2. The rule "you are liable if negligent" gives the
right answer if everything is observed by the court,since:
- a. Either you take all cost justified precautions and
are not liable, or ...
- b. You don't take all cost justified precautions and
are liable, and since you are liable you bear the full
cost of the accident, and since you bear the full cost of
the accident it is in your interest to take all cost
- c. So you do take all cost justified precautions,
which is the outcome we want, but ...
- 2. What if the efficiency of some classes of precautions
is observable by the actor but not the court?
- a. The usual example is "activity level." The court
may be able to observe how many trips you take, but not
how much it is worth to you to take them.
- b. Another example would be how much attention I pay
to my driving.
- c. Under a negligence rule, you take the optimal
level of the observable precautions, you will therefore
not be found negligence, you therefore ignore costs to
other parties in choosing the level of the unobservable
- 3. Negligence could lead to either more or less
litigation cost than strict liability.
- a. More because there is one more question to be
- b. More because there are more accidents, due to the
problem of activity level and unobservable precautions
- c. Less because accidents where the party responsible
was obviously not negligent do not result in
lawsuits--the plaintiff has no claim.
- V. Complications
in tort damage analysis.
- A. Double sided injury in a literal
sense--both cars are dented.
- 1. True of auto torts, but ...
- 2. Not of most others--pollution, nuisance, ....
- 3.We could include the problem by treating each such
collision as two torts, one each way.
- 4. We will avoid this problem for the moment by
considering collisions between a tank and a car--in which
only the car is injured.
- B. While literal double injury is a special
case that applies to auto collisions but not to most other
torts, it is generally true that there are possible harms to
both parties in a very different sense--avoiding injury to you
is costly to me.
- C. Double sided causation--a much more
- 1. We can solve the problem by a legal rule of
negligence or strict liability with contributory
negligence--provided the court knows enough to properly
implement such a rule.
- 2. Or we can avoid it by having each party bear the full
cost--i.e. A fine rather than a damage payment, so the tank
pays the cost of the damage done to the car, but the owner
of the car doesn't get the money, and must pay fir his
- 3. In which case the tank owner bribes the car owner not
to report the accident--and we have left tort law for
criminal law, where enforcement is by the state rather than
- VI. Liability alternatives
- A. No liability--the tank pays nothing, the
car owner pays for his own repairs.
- B. Strict liability--the tank pays for
fixing the car it ran over, whether or not its driver was
- C. Negligence liability--the tank pays if
its driver was negligent (i.e. Did not take all cost justified
precautions), but not otherwise.
- D. Strict liability with contributory
negligence--the tank pays unless the car driver was
- E. Note that A and B are really the same
rule, with tank and car exchanged.
- F. As are C and D.
- VII. Summary of implications:
- A. Assume one dimension (care) is
observable by the court, another (activity level) is
- 1. Note that "care" and "activity level" are merely
- 2. The real categories are "activities with regard to
which the court can tell whether or not the actor was
negligent" and "activities with regard to which the court
cannot ... ."
- B. A sketch of the implications of the
Is There An Optimal Level of?
Strict with Contributory Negligence
Care by Tank
Tank Act Level
Care by Car
Car Act Level
- C. Why are there accidents? In general,
because our assumption that both courts and individuals have
perfect information is not true.
- 1. The court might be wrong about either what precautions
the tortfeasor took or what precautions he should have taken,
and so find him negligent when he was not.
- 2. The tortfeasor might be wrong about what precautions he
should have taken, and so really be negligent. Or ...
- 3. The tortfeasor might gamble on the court thinking he
wasn't negligent when he really was--and lose.
- D. The "reasonable man" standard.
- 1. One form that imperfect information by the courts takes
is the rule that negligence is judged according to what
precautions would be cost effective for an imaginary
"reasonable man" rather than for the actual tortfeasor, since
the court doesn't know whether the tortfeasor has better or
worse reactions, higher or lower alcohol tolerance, etc. than
- 2. Suppose you have much better reflexes than the average:
- a. One half of the argument for keeping down to what the
court considers a safe speed is that if you don't, you will
be liable for damages if you run into someone. That argument
still applies to you.
- b. The other half is that if you are liable, it is then
in your interest to take all cost-justified precautions. But
keeping down to what the court considers a safe speed is not
cost-justified for you.
- c. So you either keep down to the court's speed, in
order to make sure that if there is an accident you won't
have to pay for it, or
- d. Drive at the efficient speed, which is faster than
the court things, knowing that you will be liable if there
is an accident.
- E. Effects of court error depend on the form
of the error:
- 1. Suppose the court correctly measures your precautions
but sometimes overestimates or underestimates the efficient
level of precautions. The higher the level of precautions you
take, the greater your chance of not being found negligent,
hence liable. This tends to push you to a greater than optimal
level of precautions.
- 2. Suppose the court simply makes mistakes at random--a
third of the time it decides that the tortfeasor was not
negligent, whether or not he actually was. The result is like a
strict liability rule, with a punishment equal (on average) to
2/3 of the damage done. So tortfeasors are underdeterred, and
take less than the efficient level of precaution.
- 3. So it is hard to work out a theory that takes account of
court error--the effect depends on the details of what sort of
mistakes the court makes.
- VIII. Amount of
damage payment awarded:
- A. "Enough to make good the injury." Or in
other words, enough to make the victim as well off as if the
tort had not occurred.
- 1. This is the right rule if we catch, sue, and win
- 2. Otherwise it gives too little expected punishment
since sometimes tortfeasors don't end up paying damages, so
there is too little deterrence.
- 3. Why is this the standard rule in tort damages?
- B. Punitive damages--more than enough to
- 1. Very uncommon until recently.
- a. N.H. Supreme Court, and others, argued that
"punitive damages" were ...
- b. A misunderstanding of damages for non-pecuniary
- 2. They are supposed to be awarded for a "deliberate or
reckless" tort, and the amount is up to the court.
- 3. Old examples:
- a. King's messenger case:
- i. The King's messengers forced their way into
someone's house, held him prisoner while they searched
his papers in an (illegal) attempt to find out if he
was the author of articles in a newspaper they
- ii. He sued, they argued that they only owed him
for actual damages, which were small.
- iii. He got punitive damages.
- b. Insult case.
- i. One landowner swore he would shoot birds on his
neighbor's property without permission
- ii. And did
- iii. And the neighbor was awarded punitive
- B. Non-economic explanations:
- 1. To express condemnation
- 2. Punitive damages are really just compensation for
hard to measure injuries--reputation, etc. Shooting on your
enemy's land without his permission shames him, makes him
unhappy, lowers his reputation, ... .
- C. Other people's economic
- 1. Punitive damages are a probability multiplier.
If so, why not base punitive damages on how large a fraction
of those who commit a particular tort get away with it,
rather than on whether the tort was "deliberate or
reckless?" A reckless tort should be very likely to result
in a successful suit.
- 2. Punitive damages are a way of playing safe if
damage is hard to measure but efficient torts are
- a. A deliberate tort requires a positive cost to
commit. So the optimal level is likely to be zero. But it
doesn't have to be--there might be a large benefit.
- b. An accidental tort requires a cost to avoid, so
the optimal level is likely to be >0.
- c. A deliberate tort, unlike an accidental one, can
usually be replaced by a market transaction--the
tortfeasor knows who he is going to injure and should be
able to buy permission if the tortfeasor's gain is more
than the victim's loss.
- d. Or in other words, punitive damages are a way of
enforcing a property rule within the legal framework
normally used to enforce liability rules.
- IX. My
Explanation 1: Punitive damages are for very deterrable
- A. Economic theory of optimal damages with
litigation etc. costs
- 1. Without such costs, expected punishment (<P>)
should = damage done. In civil law, <P> is the damage
award times the probability that the victim will sue and
- 2. Deterring the marginal tort at that point does no
good, so ...
- 3. If detering it is costly, don't do it.
- 4. Cost depends on elasticity, because increased award
decreases nbr of cases but increases cost per case.
- 5. If supply very inelastic, there is a positive cost to
deter. So you only want to deter very inefficient offenses,
so you set <P> < damage done
- 6. If supply is very elastic, you want to deter even
offenses that are (slightly) efficient, in order to avoid
the cost of prosecuting them, so you set <P> >
- 7. So the optimal expected punishment is below or above
the damage done according to how elastic the supply of
- 8. This is worked out in more detail in my
damages piece and my
- B. A deliberate tort is very deterrable, so
the supply of offenses is elastic, so you should
- C. An accident may be not very deterrable,
so the supply of offenses is inelastic, so you should
- D. The case where it is efficient to
overpunish a lot, deterring almost all offenses and leaving
almost none to be punished, brings us to a property rather than
a liability rule.
- X. My explanation
2: Punitive damages are for strategic torts.
- A. Why did I beat him up, even though I
knew I would have to pay damages?
- B. To deter other guys from going out with
- C. This only works if ordinary damages
undercompensate, since otherwise he doesn't mind being beaten
up--and paid damages.
- 1. But they do undercompensate.
- 2. Since they have no probability multiplier and ignore
pain and suffering (until recently)
- 3. And they should undercompensate, since ordinary
damages are for offenses with an inelastic supply curve (or
so I have just argued above).
- D. So we want extra damages in such cases,
to deter strategic torts.
- E. This makes sense where the tortfeasor is
a repeat player.
- 1. The insult cases--maybe the two landowners were
really fighting over local political control and the like.
Perhaps one of them was trying to shame the other so as to
prove to other locals that they had better support his
candidate for parliament--or else.
- 2. The real first case--king's messenger, North British
Enquirer. The crown wanted to discourage people from writing
for subversive newspapers.
- 3. But it does not work against our equivalent of the
king's messengers--law enforcement agents.
- a. Governments are protected from tort liability by
the principle of Sovereign Immunity
- b. The federal torts act waives sovereign immunity in
some cases, but not to the extent of permitting punitive
- XI. Why pay tort damages to the victim?
- A. So he will sue.
- 1. But he could threaten to sue in order to be paid by
the offender to drop charges.
- 2. This may be what actually happened in 18th century
(and earlier) English criminal law, where prosecution was
private but punishment was by the state.
- B. To affect the incentives of the
- 1. That is a good reason in the strategic with one
tortfeasor who, if damages go to the state instead of the
victims, can get the many victims to take precautions if he
- 2. But just the opposite is true in the non-strategic
case (auto accidents). Paying the damages to the victims
reduces their incentive to take precautions below the
- 3. Note the difference between anonymous tort (auto
accident, many small players) and named tort (deliberate
- a. Named tort introduces strategic problems, but also
- b. Possibility of Coase Theorem bargaining
- c. Moving us towards a property rule instead of a
- XII. One way of
thinking of the problem of controlling accidents-Three steps to an
- A. If only we knew what everyone should do,
we could command them to do it. Direct regulatory
- B. If we knew the consequences of all
actions, we could use a full system of Pigouvian taxes on
actions (driving fast, for instance) to internalize all
externalities and let individuals use their private information
on their costs to choose what actions to take.
- C. Since we don't, one solution is to
evaluate by results. If my dangerous driving does not cause an
accident I don't get punished, if it does cause an accident I
pay the full cost.
- 1. The expected social cost of my dangerous driving is
the probability it will cause an accident times the damage
- 2. The private cost to me of my dangerous driving is the
probability it will cause an accident times the amount of
punishment if it does.
- 3. So if we set punishment equal to damage done (i.e.
the victim sues me for his costs--I am already paying for my
own injuries), my private cost equals the social cost, so it
is in my private interest to make the right decision.
- XIII. The problem
of measuring and compensating damages for loss of earning
capacity, death, injury. [For a much
more detailed discussion, see my article on this subject]
- A. Lump sum vs periodic payments
- 1. A lump sum reduces disincentive effect, but
- 2. By the same token lowers the cost of fraud. Once the
money is paid you get a ticket to Lourdes and come back
without your crutches.
- B. Triple effect of injury
- 1. On income (readily dealt with)
- 2. On utility (compensate with cash)
- 3. On Marginal Utility of Income. This makes
compensating for the loss of utility difficult, expensive,
inefficient, perhaps impossible.
- 4. And explains why the price of a life seems infinite
if you try to buy one. It is not that the value of life is
infinite but that the value of money to a corpse is zero.
- C. Full compensation vs Optimal insurance
vs optimal deterrence.
- 1. Suppose it takes $100 million to make up to you for
loss of your sight.
- 2. You would not insure yourself for that amount.
- 3. You would not take the precautions, in a case where
your actions may risk your sight, that are implied by that
- 4. So full compensation over insures and over deters.
- 5. But what if you would not insure at all (death for
someone with no dependants)? Does it follow that the optimal
deterrence price is zero? Obviously not.
- 6. So these are three different values here ...
- D. Correct solution in principle:
- 1. Set damages at a level that makes people as well off
ex ante with the risk as without, as judged by risk
premia for jobs and similar criteria.
- 2. Allow the sale of inchoate tort claims. Now if my
tort claim leaves me "overinsured" I can sell part of it, so
as to consume some of the money now when I am not
- E. My article which discusses this at much
greater length is available from me.
- I. The nature of
the criminal law:
- A. Crimes are enforced by police,
prosecuted by the D.A. The case takes the form of "The state of
California vs X."
- B. Punishment: fine, imprisonment,
execution, to and by the state.
- C. High level of proof required ("beyond a
- D. Why have criminal law? Why not do
everything with tort law? Some possible answers:
- 1. Crimes do damage to the "society" as well as the
- 2. Low probability of conviction and judgement-proof
offenders mean that there is little incentive to sue (since
you won't collect much), so tort law does not work.
- 3. Criminal law is intended to impose moral stigma.
- 4. For some offenses, a fine gives the right incentives,
damage payments give the wrong incentive.
- 5. We will return to these questions.
- II. Economist's
view of what should be a crime and why.
- A. Actions that impose costs on
- B. We don't want to eliminate all
such--consider the lost hunter breaking into a cabin in the
woods to get food and use the phone.
- C. We could either "regulate" such
behavior, permitting it when we think it is efficient (the
defense of necessity in tort law) or
- D. Price it--impose a fine that reflects
the costs imposed by the crime. Let the offender choose whether
to commit the crime and pay, or not commit it.
- E. If we set the expected punishment
(<P> defined as probability of being punished times
amount of punishment)=damage done, then efficient crimes will
occur, since committing them is worth more than the expected
punishment for doing so, and inefficient crimes will not
- F. This assumes criminals are rational--and
they are. Football players rarely get mugged
- III. If this is
how we set our punishments, then the reason we do not make them
higher is that we are afraid of deterring efficient crimes.
Can that be right? Is the reason we do
not increase the punishment for murder that we are worried that we
would then have too few murders? [This set of issues is discussed
in more detail in my "Payne v
Tennessee" and "Punitive
- A. In the case of speeding, perhaps, but
- B. In the case of murder and other serious
crimes, surely not.
- C. Some crimes, such as theft, have a
superior market substitute.
- 1. If my car is worth more to you than to me you don't
have to steal it--you can buy it.
- 2. So the only transfers prevented by making theft
illegal are the inefficient ones--stealing a car that is not
worth enough to make you willing to buy it.
- 3. So we don't have to worry that making the punishment
too high will deter efficient thefts.
- 4. The obvious exception to this argument is the case
where the market transaction is not possible--such as the
- D. And there are other crimes where there
is no market substitute, but where we believe efficient
offenses are rare to nonexistent.
- 1. Murder may be an example. Although one can imagine
- 2. A market transaction for murder. A wealthy hunter who
believes that human beings are the only game dangerous
enough to be worth hunting offers ten adventurers $100,000
each in exchange for their agreeing that he may choose one
of them at random and try to kill him.
- 3. Should such a transaction be legal? It appears to be
efficient, since the victims are receiving enough
compensation to make them willing to accept the deal.
- 4. If not, why not?
- E. What limits our punishment of such
offenses is cost--we permit offenses that are inefficient in
that we would like to eliminate them, but efficient in that the
cost of eliminating them is more than the benefit.
- IV. The cost of
- A. We are choosing a combination of a
probability of punishing an offender (p) and an amount of
- B. We want to get a particular level of
expected punishment aka deterrence at the lowest cost, where
the cost is punishment cost plus enforcement cost.
- C. Enforcement cost is obvious, and
increases with number of offenses and with the fration of
offenders to be apprehended.
- 1. It costs more to catch twenty criminals out of two
hundred than to catch ten out of a hundred.
- 2. And it costs more to catch eleven criminals out of a
hundred than to catch ten.
- D. Punishment cost--cost to the convicted
criminal minus gain to others from the punishment.
- 1. Costlessly collected fine. Punishment cost =0
- 2. Execution: punishment cost = 100% of punishment. One
life is payed, none received
- 3. Imprisonment: cost is more than 100%. The criminal
loses his freedom and we must pay for the prison.
- E. Why not go to the corner of infinite
punishment with infinitesimal probability? As long as we hold
expected punishment constant, deterrence and cost to criminal
are constant, and catching fewer offenders costs less.
- F. Because as we shift to more severe
punishments we must use less efficient ones--criminals can pay
a $100 fine but not a $100,000 fine.
- V. If punishment
were costless, the optimum level would be expected punishment
equal to damage done, deterring all and only inefficient offenses.
How do we calculate the optimal punishment taking account of the
cost of imposing it?
- A. For each expected punishment (=level of
deterrence), find the lowest cost combination of p,P that
- B. Start at zero, keep raising the expected
punishment as long as the gain in offenses deterred>= cost
in additional expenditure.
- C. Gain = (nbr of offenses
deterred)x(damage that an offense does to the victim - gain
that the offense produces for the offender)
- D. Offender's gain, for marginal offense
(an offense deterred by a slight increase in expected
punishment) equals the expected punishment.
- 1. Because if his gain were less than that, the offense
would already have been deterred before we increased the
- 2. And if his gain were more than that, the current
expected punishment would not deter him.
- 3. So the offense just barely deterred at the current
level of expected punishment is one for which the offender's
gain equals that expected punishment.
- E. So at any level of <P>, gain=nbr
- F. So if an extra $X deters one more
offense and we are at the optimum:
- <P>=D-$X (Equation 1)
- G. Intuition for that: It is worth
deterring offenses as long as the benefit from deterring is
greater than the cost, so we increase expected punishment until
we reach the point where the benefit of deterring one more
offense (cost to victim-benefit to offender) just equals the
cost in increased punishment and enforcement costs of deterring
- H. The argument still works if $X<0,
i.e. the cost of deterring one more offense is negative.
- 1. The reason that can happen is that as you increase
the expected punishment you decrease the number of
offenses--so there are fewer offenders to be apprehended and
punished. You are spending more per offense, but spending it
on fewer offenses. So an expected punishment of $1000 might
cost less to impose than one of $900.
- 2. In the case where the marginal cost of deterrence is
negative, equation 1 above implies an expected punishment
higher than damage done. You are deterring some efficient
offenses--in order to save the cost of punishing them.
- 3. Two intuitions: "Enough to deter" vs "equal to damage
- a. "Equal to damage done" is the right intuition if
catching and punishing criminals is costless.
- b. "Enough to deter" is the right intuition if there is
some level of punishment below which you have lots of
offenses and above which very few. You keep increasing
expected punishment until you reach the point where the
payoff to additional increases becomes very low because
there are very few offenses left to be deterrred.
- I. The mathematics of this are worked out in an
to my punitive damage article and in my Payne v Tennessee
The latter also has a
discussion of the argument.
- VI. Why count the
criminal's costs at all?
- A. Because our analysis is supposed to
cover everything from murder down to parking violations, and
- B. Because ignoring costs to criminals
require that we know in advance what should be considered a
crime--which is one of the things the economic analysis is
supposed to be telling us.
- A point discussed in my Punitive Damages
- VII. Rich vs
Poor--should they pay the same fines? In some cases yes, but in
others no, because:
- A. For crimes with a payoff in time or
utility, the supply curves are different--it takes a higher
expected $ punishment to deter the richer offender.
- B. It is cheaper to punish richer
offenders, since they can pay fines, but ...
- C. On the other hand, they can also hire
good lawyers so as to make it costly to convict them.
- D. The issue is discussed in part of my Payne v Tennessee article.
- VIII. Marginal
deterrence: My article (with William Sjostrom) is accessible from
the web page.
- A. If armed robbery gets the maximum
possible punishment, then the additional punishment to an armed
robber for killing the victim is zero.
- B. More generally, in setting optimal
punishments we must allow for the possibility that we may deter
someone out of one crime and into another.
- C. Which makes the calculation of an
optimal set of punishments more complicated.
- IX. The Paradox of
- A. Why not hang them all?
- 1. Argument for efficient punishments.
- a. If we shift to a lower cost punishment probability
combination giving the same deterrence ...
- b. The expected cost to the criminals is the same
- c. The crime rate, hence the cost to the victims is
- d. And the enforcement system saves money.
- 2. What would such an efficient system look like?
- a. Fine if collectable.
- b. Make it collectable by threat of worse punishment
if they can't pay.
- c. Temporary slave labor if they cannot pay a fine.
- d. Execution if they cannot produce more as slave
labor than they cost to feed and guard.
- e. And after you execute them, use their organs for
- 3. English 18th century example.
- a. No imprisonment for serious crime.
- b. Hang, transport, or pardon.
- c. No imprisonment for serious crime.
- d. Costs of slave labor too high to make imprisonment
an efficient crime... It looks as though galley slaves
(easy to guard and monitor) more than paid their costs,
other forms of slavery for violent criminals did not. The
English didn't use galleys, because the Atlantic is too
rough for them. So their only cheap imprisonment option
was transportation. For more details, see my
on 18th c. English law.
- 4. If the sort of efficient system of punishments I have
described is a bad idea, as most people believe, why?
- B. Why we should not hang them all.
- 1. The old mistake:
- a. Economists in the past have frequently answered
the question "what would I like the government to do?"
instead of the question "what should the legal rules be,
given how government will act if those are the legal
- b. In other words, the government was being treated
as a philosopher king rather than as a human institution
controlled by people with the same sort of limitations
and incentives as the rest of us.
- c. Optimal punishment theory makes the same mistake
by ignoring the incentives of the enforcers: police,
- 2. The costs of efficient punishment--other side of the
- a. An efficient punishment, such as a fine, provides
a benefit to someone on the other side, who is collecting
- b. That is an incentive to convict or punish someone,
whether or not he is actually guilty.
- 3. Rent seeking: In a world of really efficient
punishments, everyone's human, biological and economic
capital is up for grabs all the time.
- a. If I can properly manipulate the legal system, I
get to seize you and your property.
- b. So we all spend lots of resources defending
ourselves and trying to expropriate others.
- 4. Civil forfeiture and punitive damages for product
liability are modern examples of this problem.
- 5. Larry Niven offers a fictional example: a society
where the organs of those executed forfeit to the state to
be used for transplants.
- a. It looks like an unambiguous improvement--why let
organs that could save lives rot?
- b. But it produces an incentive to increase the
number of capital offenses so as to get more organs and
save more lives.
- c. The protagonist of the story has been sentenced to
be executed for his third (I think?) dangerous driving
- 6. The application of the argument to the question of
whether to hang them all is more difficult, since nobody
gains--hanging simply eliminates most of the cost of
punishment to those other than the criminal.
- a. If government institutions are driven by a
weighted average of citizen values, with the weighting
somehow depending on political influence, then a cheap
punishment imposed on uninfluential people might be badly
- b. A cheap punishment might be transmuted into a
profitable punishment, if the threat of execution is used
to extort a (legal or covert) out of court settlement.
- X. Some more
points involving crime:
- A. Why have criminal law? Since the central
difference between criminal law and tort law is in who enforces
the law for what reason (government employees or victims and
their agents), the answer should involve incentives to
- 1. "Tort law vs Criminal law" is the wrong question.The
general version of the problem is:
- a. Why bundle rules as we do in the legal systems we
call "criminal" and "civil."
- b. Why sort offenses as we do into criminal or civil
- c. Or, more generally, "How should we bundle rules
and sort offenses ?" Our Criminal and Civil are not the
only possible alternatives.
- d. Who controls prosecution? Who owns the offense?
Does conviction result in moral stigma?Is our ultimate
objective (if we could afford it) to prevent offenses or
to regulate offenses--i.e. price them so that only the
efficient ones occur..
- e. 18th c. English example. Medieval English. Traffic
In the following table, different offenses and legal categories are
classified by who prosecutes the offense, whether the outcome is
designed to transfer or only to punish, whether the objective is to
prevent offenses or price them, and whether convictim produces moral
stigma. The four medieval examples are four different ways in which
the same offense might be handled in the English legal system c.
Appeal of Felony
Indictment of Felony
Appeal of Trespass
Writ of Trespass
- 2. A few fragmentary answers:
- a. No probability multiplier in the civil law because it
would be an invitation to fraudulent suits, and since there is
no probability multiplier the civil law works best for offenses
where the probability of apprehension and conviction is high.
- b. The civil law uses more efficient punishments, so false
positives (convicting innocent defendants) are less socially
costly than in the criminal law, so we have a lower standard of
proof in civil law.
- c. Private prosecution is a reason to have the punishment
be a fine paid to the prosecutor (as in our civil system),
since otherwise you have to worry about preventing out of court
settlements--which convert the punishment into a fine paid to
- d. If the prosecutor collects the fine there may be a
conflict over who prosecutes, so we need some property rule to
determine who "owns" the right to prosecute and collect.
- e. Ownership by the victim, as in our civil law, may make
sense because he is the one most likely to have evidence, and
uniting ownership of evidence and claim reduces transaction
costs of prosecution.
- f. But ownership by the victim reduces his incentive to
prevent the crime--if it occurs, he gets a (possibly valuable)
claim. Consider the simple case with costless enforcement and
punishment, pollution vs burglary.
- 1. A fine gives the right incentive for pollution, auto
accident, sound pollution, ... because a damage payment
would eliminate the victim's incentive to prevent or reduce
the cost. If I soundproof my house I can't collect damages
- 2. A damage payment gives the right incentive for
robbery--since it does no net damage, we don't want to give
the victim an incentive to prevent it.
- 3. The essential difference is that in the first set of
offenses, the victim, by protecting himself, does not make
the tortfeasor worse off--the airline doesn't want your
living room to be noisy.
- 4. But the burglar does want to succeed in stealing from
you, so the victim's defensive expenditures do make the
burglar worse off.
- g In an
on private enforcement, I show that (given some simplifying
assumptions), a system of privately enforced criminal law (i.e.
the equivalent of tort law for burglary) gives victims the
optimal incentive to protect their houses.
- h. In fact, our legal system gets this one backwards! We
use tort damages where we should use fines, and vice versa.
- i. But remember, this is true only in terms of one of the
relevant arguments--the effect on the damages/fine choice on
victims' incentives to protect.
- B. Economics of drug laws? Does making it
harder to smuggle drugs into the country increase or decrease
- 1. One possible model: the violence comes from fighting
over the territory of local monopolies.
- a. Think of it as the dissipation of monopoly rents
through rent seeking.
- b. In which case the amount of violence will be larger
the larger the rents.
- c. Raising costs reduces rents, so will reduce violence.
- 2. An alternative model: people in the business have lots
of portable wealth and can't call the police if they are
robbed, so there is violence due to attempts to seize and
protect money and drugs.
- a. The amount of violence should be roughly proportional
to the value of money and drugs flowing through the system.
- b. So violence will decrease with increased enforcement
if demand for drugs is elastic (increasing theprice
decreases total expenditure on them)
- c. But increase with increased enforcement if demand is
- C. Cannibalism after shipwreck; is this an
- 1. Cannibalism and the Common Law discusses a real
case, in which shipwrecked mariners were rescued, confessed to
having killed and eaten one of their number and, much to their
surprise, were charged and convicted.
- 2. Sailors believed the traditional rule was that you drew
straws to decide who got killed and eaten in such
circumstances. That seems an efficient form of murder--ex ante,
everyone is better off than if they simply all starved to
- 3. The case was an attempt by the English legal
establishment to establish a legal rule (the defense of
necessity does not apply to such situations) inconsistent with
customary norms. From the book's description, they succeeded
only by a certain amount of fraud against the jury, which was
sympathetic to the norms and the defendants.
- 4. Note that the argument for why cannibalism is taboo
under ordinary circumstances in all or almost all societies
parallels my argument for why we might not want efficient
- a. Eating corpses instead of burying them seems, on the
face of it, an obvious net gain--just like harvesting the
organs of the people we execute.
- b. The problem is that it gives us an incentive to kill
each other, which raises the costs of both potential
victims, who have to avoid giving other people an
opportunity to kill and eat them, and to potential
murderers, who spend time looking for such an opportunity.
- c. So the costs of rent seeking in both direction may
greatly outweigh the gains from the more efficient disposal
- d. Which may explain why cannibalism is such an
unpopular form of behavior.
- XI. Criminal law
- A. Most broadly, criminal law exists to
control inefficiency due to externality ...
- B. It differs from tort in being enforced
by the state.
- C. One line of analysis: What would the
optimal pattern of enforcement and punishment be for a
philosopher king government?
- 1. Pick the combination of probability and punishment
that minimizes the sum of enforcement and punishment costs
for any level of deterrence.
- 2. Find the level that minimizes all costs, including
net costs of crime.
- 3. The effect of including enforcement and punishment
costs may be to increase or decrease optimal expected
- C. Another line--how is this modified by
considering the enforcers' incentives?
- 1. Efficient punishment has problems.
- 2. Low probability of conviction leads to judgement
proof defendants (and fake offenses) if we scale up the
punishment to match, and leads to underdeterrence if we
- 3. Or in other words, we have to worry about problems of
both too much incentive to prosecute, and too little.
- D. Another: Why do the legal rules we have
- 1. Criminal law requires a higher standard of proof for
conviction because it employs more inefficient punishments,
making the cost of errors higher.
- 2. Intent is much more important in criminal law than in
- a. is this act a coerced transfer, hence almost
certainly inefficient? Yes if you intended to steal the
umbrella, no if you took it by accident, thinking it was
- b. How deterrable is the act? It is costly to avoid
accidents ("unintentional acts"), but easy to avoid
deliberately running someone down.
- c. Defense of insanity exists for criminal law, not
for tort law--because it is hard to deter someone who is
- d. Premediated murder vs act of rage is again a
distinction of intent.
- e. Intent may also affect probabilityof apprehension.
If you did it on purpose you probably also took
precautions not to be caught, so we need a higher
punishment to make up for the lower probability of
- 3. This pattern makes some sense. If criminal law
typically has higher punishment and enforcement costs, we
only want to use it where the payoff from deterrence is
sufficient to justify those costs, so we don't try to use
criminal law to deal with acts that are hard to deter.
- 4. Giving the victim ownership of the claim reduces his
incentive to prevent the cost, which is a good thing in some
contexts, a bad thing in others--and we don't seem to get it
I. The Issue of
Monopoly [See Chapter 10 of Price Theory for a more detailed explanation of much of this.]
- A. Why does a monopoly exist?
- 1. A natural monopoly exists because the cost curve keeps
falling--average cost is lower for a firm producing the entire
amount demanded by the market than for any smaller firm.
- 2. A government monopoly exists because it is against the
law to compete with it.
- 3. An artificial monopoly exists because it has somehow
driven out and kept out competitors even though their costs are
as low as its are. It is not clear if there are any such cases.
- 4. A cartel is an "almost natural monopoly" situation where
the efficient size of the firm is so large that there are only
a few such, and they get together to act like a
monopoly--restrict output and raise price.
- B.What is wrong with monopoly?
- 1. Classical welfare triangle (aka "deadweight loss" from
- a. The monopoly maximizes its profit at the quantity
where MR=MC, and
- b. Since MR<Price, that is a quantity where P>MC,
- c. Some consumers who value the good at more than the
cost of producing one more unit don't get it.
- d. Producing that unit and giving or selling it to such
a consumer would produce a net benefit, so ...
- e. The outcome of a private single price monopoly is
- 2. Rent seeking argument from Tullock
- a. If there are monopoly profits to be made
- b. Firms will compete to become the monopoly and make
- c. Competing away the monopoly profit, perhaps in
wasteful ways such as starting the industry early, losing
money in the early years, in order that, when the monopoly
develops, you will be it.
- 3. But not commonsense inefficiency
- a. It pays a monopoly to produce the goods at the lowest
possible cost, since a reduction in cost is an increase in
- b. Remember that "monopoly" is not equivalent to "big
firm." Some very big firms (MacDonalds) are only a small
part of their industry, and some monopolies (the one general
store in a small village fifty miles from the next town) are
- c. So the question of whether big firms are inefficient
is separate from the question of whether monopolies are.
- C. Price discrimination.
- 1. A monopoly can both reduce the deadweight loss and
increase its profits if it can find a way to sell at a lower
price to customers not willing to buy at the high price, while
maintaining a high price for those willing to pay it.
- 2. Such discriminatory pricing provides a possible
explanation for a lot of things: Cheap theater tickets for
children, lower prices for old people, hardcovers costing a lot
more than paperbacks (arguably more than the difference in
production cost), selling a book for a lower price in England
than in the U.S., ... .
- 3. It might increase or decrease the inefficiency of
- a. It decreases it by "filling in" the welfare
triangle--moving towards the efficient quantity by selling
goods at a low price to the low demand customers.
- b. It increases it by allocating a given quantity of
output less efficiently. The American willing to pay $20 for
the book doesn't get it (U.S. price $25), the Englaishman
willing to pay $18 does (U.K. price $15--in [[sterling]] s.)
- c. And firms may do costly things in order to transfer
money from their customers to themselves via discriminatory
- D. What can we do about monopoly?
- 1. Natural monopoly:
- a. leave it alone, regulate it, or have the government
- b. Turning it into a competitive industry isn't an
option, since it exists because small firms can't produce as
cheaply as big firms.
- 2. Government monopoly: Could abolish it, since a
competitive industry is an option (assuming it isn't also a
- 3. Artificial monopoly. We could (do) have legal rules
designed to make it harder to create and maintain such.
- a. Such as rules that sometimes forbid large firms in
the same industry from merging, and
- b. Laws against "predatory" pricing.
- c. How much sense this makes depends in part on whether
artificial monopolies are really a problem or not.
- 4. Cartel. We can:
- a. Make cartel agreements illegal (we do)
- b. Refuse to enforce them (we do, some European
- II. The Efficiency
and Inefficiency of Discriminatory Pricing: A XMas Tale
- A. Having recently moved to California from
Chicago, we have lots of friends east of here, and complicated
vacation plans: SJ-Denver-Boston-DC-Chicago-SJ.
- 1. The cost of doing it that way is about $1800/person,
for two adults and a child.
- 2. The cost of one round trip SJ-Denver-Chicago-SJ and
one Chicago-Boston-DC-Chicago is about $1100.
- 3. The cost of SJ-Denver-SJ + Denver-Chicago-Denver +
Chicago-Boston-DC-Chicago is about $800+
- 4. So we are taking the third option.
- B. Why are the prices like this?
- 1. No airline has anything close to a U.S. monopoly, but
on a given route there may be one or only a few, so there is
a fair amount of monopoly power in the system.
- 2. As well as other complications associated with joint
costs, which I will ignore.
- 3. And airlines engage in a good deal of discriminatory
- 4. Much of it intended to charge high prices to business
customers with inelastic demand, low prices to vacationing
families with elastic demand (less tight schedules,tighter
- C. Producing a deadweight cost, for me,
consisting of the cost of doing things in ways that don't save
the airlines money, but do make me look like a vacationing
family (which, as it happens, I am) rather than a business
- 1. Flying Denver-Chicago-Boston instead of Denver-Boston
direct, and ...
- 2. Chicago-Denver-SJ instead of Chicago-SJ direct
- 3. With two small children
- 4. Some of which might happen anyway due to scheduling,
hubs, etc., but might not.
- D. And an efficiency gain, inasmuch as a
single price covering the airlines costs might price many
vacationing families off of the airline into cars.
- E. Note that I am probably not part of that
efficiency gain, although I am a beneficiary of the
discriminatory pricing (after readjusting my flights
- III. Solving the
efficiency problem of natural monopoly by regulation:
- A. The obvious solution:
- 1. Compel a monopoly to act efficiently, which means ...
- 2. Charge marginal cost
- 3. And exist if at that price it produces net gains.
- B. The obvious problem:
- 1. If it has to charge marginal cost, the monopoly can't
cover is fixed cost and goes broke.
- 2. So subsidize the difference between AC and MC.
- 3. At which point the monopoly has no incentive to
minimize its costs, since whatever it loses is being made up
by the treasury.
- 4. So subsidize the difference between MC and what you
have calculated that AC should be.
- 5. But how do you get the information needed to estimate
what AC should be?
- 6. You could see what production cost last year, but ...
- a. If they knew you were watching, last year was a
very expensive year, and ...
- b. In any case, things change over time.
- C. Rate of return regulation of utilities
as an example of regulation of natural monopoly. The theory is
to allow them to charge a price which gives the investors a
fair rate of return on their capital.
- 1. This is average cost pricing, not marginal cost
pricing (except to the extent that the regulator permits
discriminatory pricing), so there is still some efficiency
loss, although not as much as at the profit maximizing
- 2. How do you measure the amount of capital?
- a. By the amount initially invested? But some
investements don't pan out and are lost, so how do you
figure out how much to give to the ones that succeed as
- b. Replacement cost of the physical plant? But there
may be some generators that would not be worth building
today, even though, having built them twenty years ago,
they are still worth operating.
- c. By the market price of the utility's stock? But
this is a circular argument--what is determining the
market price of the utility's stock is how much the
market believes the regulators will let the utility
- 3. If the regulators control the price the utility sells
its output at, one way the utility can evade the regulation
is by lowering the quality of its output.
- a. In the extreme case, one way of doubling the price
of milk is to sell the bottles half full. That can be
prevented, but it is harder to detect cheating on subtler
quality dimensions, ...
- b. Such as how fast a repairman shows up, how often
restrooms are cleaned, how likely a power failure is.
- D. Similar problems exist with state
- E. Note that we have now gotten back to the
sort of inefficiency we rejected in I B 3 above. We would
expect inefficient management and poor quality not in a private
monopoly but in a badly regulated private monopoly.
- F. In addition to these problems, there is
also the problem of how to make it in the interest of the
regulators of a private monopoly (or the officials running a
state monopoly) to try to produce the efficient outcome:
- 1. The regulators might find there was more to be
gained, politically and economically, by allying with the
regulated industry and helping it prevent competition, both
within the industry and from outsiders.
- 2. While claiming to be protecting the customers against
the industry. The industry, after all, is going to be much
better informed about what is really happening than the
- 3. A phenomemon that has become known as "regulatory
- 4. Similarly, a government run monopoly might find its
best policy was to make lots of monopoly profit and use it
to give good jobs to people who spend part of their time
getting out the vote for the politicians who appointed them.
- IV. What about legal rules to discourage
- A. Regulate mergers:
- 1. You would like to permit mergers that allow firms
with complementary assets to join, thus producing goods more
- 2. While banning mergers designed simply to create a
firm big enough so that it can reduce output, drive up
prices, and make monopoly profits, at least until other
firms have time to enter the industry.
- 3. But how do you tell which is which?
- 4. One solution proposed, not entirely seriously, is to
judge by the response of competitors:
- a. If the purpose of a merger is to form a monopoly
and drive up prices, competitors should be all in favor
of it--they can expand their output and make lots of
- b. If the purpose is to create a new firm that can
produce at lower cost, competitors should disapprove.
- c. So if two firms propose a merger and competitors
complain, permit the merger. If competitors don't
complain, forbid the merger.
- d. Of course, this depends on the competitors not
realizing what your policy is.
- B. Cartels: Don't enforce contracts in
restraint of trade--i.e. agreements by the firms in a cartel to
keep prices up, or allocate markets, or ...
- C. What about predatory pricing?
- a. The strategy. Big firm cuts prices below cost, drives
out little firm, can then raise prices and make monopoly
- b. But the bigger firm is losing money proportionally
faster--indeed more than proportionally, since it is
committed to produce enough to keep the price down. So it
goes bankrupt first.
- c. McGee looked at the whole record of the Standard Oil
anti-trust hearing, found no evidence Standard had engaged
in predatory pricing.
- d. Successful predatory pricing is not logically
impossible. If the big firm can commit itself so strongly
that it will obviously keep going till it goes bankrupt, it
may not be worth anyone else's coming in. On the other hand,
if a new entrant can commit itself, it isn't worth the big
firm trying to drive it out. This is an example of the
ambiguous results from trying to analyze strategic behavior.
- D. Ban resale price maintainance--contracts
by which a wholesaler sets a minimum price his goods may be
retailed at. The first question is why the wholesaler would do
- 1. To provide monopoly revenue for the wholesaler? But
he can push prices up by pushing up the price he sells at,
and let the retailers compete down their profit margins. Why
should he share his monopoly profit with the retailers?
- 2. To provide an incentive for retailers to offer
related sales services such as showrooms, since
- 3. Otherwise firms that do not provide those will cut
prices and free ride on the ones that do.
- 4. With a fixed price higher than the competitive price
would be for firms that don't provide sales services, firms
will compete for customers in non-price dimensions
- 5. By, for example, providing sales related
services--which is what the wholesaler wants.
- 6. But why are such services bundled with sales of the
good, instead of priced separately?
- E. Restrictions on tie-ins, vertical
integration, et. al.
- 1. Tie-ins: If you by your computer from IBM, you have
to use IBM punchcards.
- a. Why would IBM want to insist on that?
- b. In order to make a monopoly profit on cards as
well as on computers? But ...
- c. the high price of punchards lowers the amount
customers are willing to pay for the computer.
- d. You are taking money out of one of your pockets to
put it in another--at some cost.
- e. So why do they do it?
- 1. Perhaps they want to control the quality of
inputs, in order to maintain the reputation of their
computers for reliability, hold down the cost of
repairs that they have agreed to provide.
- 2. Or perhaps it is a device for price
discrimination. High demand customers also use lots of
cards. So by selling expensive cards and (somewhat
cheaper) computers, IBM is charging a high price to
the customers willing to pay a high price (on average,
the ones using a lot of punchcards) and a low price to
the customers who are not willing to pay a high price
(and are not using a lot of punchcards).
- 2. Vertical integration: cars and distributors,
refineries and gas stations.
- a. The argument is that the steel company, by using
its monopoly of steel to gain a monopoly of the auto
industry, can now collect monopoly profits on both
industries, but ...
- b. Why not just sell steel, let the auto companies
compete down their profit margin, and collect the
"monopoly profit" on the auto industry in the form of
high steel prices?
- c. One possible answer is that vertical integration
might reduce the monopoly inefficiency. If a steel
monopoly simply sells steel at a high price, car
companies will use an inefficiently low amount of steel
in making cars. If the steel firm owns the car companies,
it can use its internal cost of steel for deciding how to
build cars but still collect the monopoly profit on the
car price. This is a substitute for discriminatory
pricing against the car companies.
- V. As these examples show,
imprecise verbal arguments about monopoly behavior, or economic
behavior in general, often produces the wrong answer. There is
something to be said for precision--and for formal mathematical
- A. Predatory pricing--we expect the big
firm to win.
- 1. There is an implicit analogy to a battle, where the
bigger army wins
- 2. But in predatory pricing, being bigger also means
losing money faster
- 3. So it turns out that the small firm has the
- B. Resale price maintanance--we think that
the wholesaler can produce extra monopoly profits by helping
the retailers keep their prices up. But he can do that, at more
profit to himself, by simply charging a high wholesale
- C. Tie-ins--we think the computer company
is now collecting monopoly profits on two markets--computer
cards and computers. But the first profit is coming out of the
- D. Vertical integration similarly.
- E. General lessons:
- 1. Making money at artificial monopoly is harder than it
- 2. You need to be careful about verbal arguments
- 3. And you need to fig ure out why the behavior is
- VI. The English vs
the American Rule
- A. Query: What is the effect of the choice
of rule on litigation expenditures? On amount of
- B. Stylized version of the English rule:
Loser pays winner's legal costs.
- 1. It leads to larger litigation expenditures on cases
that are litigated because if you win you won't have to pay
for your legal costs.
- 2. And because the stakes are higher.
- 3. But it reduces the incentive to do things intended to
increase the other side's legal costs--since you might end
up paying for them--, and ...
- 4. it discourages low probability suits (suits that you
expect you will probably lose), encourages high probability
- C. Real version of the rule: Loser pays
what the judge things winner's legal costs ought to have
- 1. Leads to larger expenditures because the stakes are
- 2. Still discourages low probability suits
- 3. Is that a feature or a bug?
- a. Prevents harassment, extortion, via the legal
system, but ...
- b. Also suits that might push the envelope of legal
rules, by getting a court to rule that previous courts
- I. Looking at how
other societies did it.
- A. The general problem--using legal rules
to control the sorts of behavior that tort law and criminal law
- B. Other societies help us in two
- 1. They expand our ideas, by showing us alternative
approaches that we might not have thought of.
- 2. They give real world evidence on how problems get
- C. Can civil law absorb criminal law? If it
does, how does it deal with:
- 1. Judgement-proof defendants
- a. how to collect, or ...
- b. how to motivate prosecution when you can't
- 2. Poor victims who can't afford a lawyer.
- 3. Dangers of overenforcement
- D. Three different solutions:
- 1. Saga period Iceland--pure civil system, without any
- 2. 18th century England--Criminal law privately
- 3. Shasta County, CA today--norms as a substitute for
- II. Iceland. History.
Harald's unification of Iceland. [This is given in much greater
detail in my article "Private Production and Enforcement of Law: A
Historical Case" which you have, and which is also on the
- A. How the system was organized.
- 1. Four quarters, each with 9 Godar (chieftains). The
godord, the right to be a Godi, was a property right--it
could be inherited, sold, lent.
- 2. Anyone could be the thingman of any Godi.
- 3. Court determined by the location of the Godord of the
- 4. Legislature consisted of the Godar
- 5. Court gives a verdict, goes home.
- B. Why it worked:
- 1. If a convicted defendant does not pay his fine he
- 2. Killing an outlaw is legal, defending him is not.
- 3. Stability. Njalsaga episode. Even when the system
seems to be breaking down, the participants expect to
eventually have to pay for anyone they kill.
- C. How do the poor and powerless get
protected? Legal claims are transferable, so they can sell them
to someone with the power to enforce them.
- D. What about judgement-proof
- 1. The probability of catching an offender is high,
because concealing the crime is itself a serious crime (and
considered shameful). A high probability means that fines do
not have to be enormous in order to get a reasonably high
- 2. Informal coalitions existed for enforcing legal
claims, and could also pay fines for a member in exchange
for his obligation to do favor in the future.
- 3. Someone who could not pay his fine could become a
temporary slave--a debt thrall.
- III. 18th century
England. [This is given in much greater detail in my article on
18th century England]
- A. Puzzles: pattern of punishment,
- B. Punishment--for a serious offense, the
only punishment the court could impose was hanging. In
practice, some convicted defendants were then pardoned, some
were pardoned on condition of transportation, some (if there
was a war going on) were pardoned on condition of joining the
army or navy.
- 1. Transportation did not work in the 17th century,
without a subsidy, because many convicts were not worth
enough as indentured servants to cover the cost of
- 2. It worked with a subsidy of about 3 pounds per
convict starting about 1719 (for a 14 year sentence--the
convict was taken to the New World and sold as an indentured
servant for 14 years).
- 3. The cost of maintaining a prisoner in a French prison
at the time was about 4 pounds/year.
- 4. So transportation was a much cheaper alternative,
assuming that the cost in England was similar.
- 3. Why not use penal slavery?
- a. Because for most activities, guarding, feeding,
clothing potentially violent criminals cost more than
they could produce?
- b. The French had galley slaves, presumably because
that was an activity particularly well suited for
slavery--hard to escape, easy to monitor output.
- c. The English had no galleys--so used transportation
as the cheapest available alternative to hanging.
- d. But both are lumpy punishments. You can't hang
someone just a little, and it isn't worth transporting
him for six months.
- e. Which leads you to a high punishment/low
probability system, where the probability is low mostly
because you don't get caught, partly because you might
- C. Private prosecution. Why bother to
prosecute when you don't get a damage payment?
- 1. Vengeance?
- 2. Private deterrence. Prosecution associations..
- a. Note that vengeance can be seen as a version of
- b. I want a reputation as someone who is vengeful in
order that people won't injure me in the future.
- c. So I train myself to be the sort of person who
feels bad if he hasn't gotten back at someone who injures
- d. Other people observe what sort of person I have
made myself, and take appropriate precautions.
- e. Of course, I don't want to overdo it--or the
appropriate precaution might be shooting me in advance
for fear that some day you would accidentally step on my
toe and I would kill you.
- 3. Compounding? You start a prosecution in order to be
paid to drop it.
- a. This was illegal in the case of felonies, although
legal and approved of for misdemeanors
- b. I offer some, but not very much, evidence that it
happened anyway, and the rules against it were not very
- D. Problems with bounties. Bounties were
introduced in order to help solve the problem of inadequate
incentive to prosecute.
- 1. Very large bounty for highway robbery--100 pounds+
- 2. This led to scandals involving entrapment or framing.
- 3. Juries didn't believe the witnesses--with cause,
since the witnesses could get a share of the reward.
- 4. They abolished most of the bounty system in
- E. Pardoning: A significant minority of
felons got pardons. They were given out by a royal official,
based both on the judge's recommendation and on
- 1. Price discrimination on that market.
- a. Enough to deter. If five months waiting to be
tried plus the scare of being condemned to hang provides
a enough deterrent for a "good lad led astray," it is
unnecessary to hang him.
- b. Avoiding costly punishment: If hanging him means
that his family go on the parish (their equivalent of
welfare), maybe better not.
- 2. "Selling" pardons. Friends of the convict could "buy"
pardons by incurring obligations to local politically
influential people, whose petitions had a good chance of
getting a pardon.
- 3. These are all possible interpretations of what was
- 4. And they both have an efficiency element. Selling
pardons both means that people are less likely to hang if
they are of value to others, and converts execution into the
more efficient punishment of a fine.
- F. Did the system work?
- 1. They didn't think so--it was eventually converted
into something more like ours, but ...
- 2. Despite talk of rising crime rates, there is some
evidence against, none I know of for.
- G. Medieval Appeal of Felony. Indictment of
- 1. 1208 story.
- a. Pre -1208, a private party prosecuting an appeal
of felony--a private criminal suit--could drop charges in
exchange for compensation.
- b. Post-1208, if he dropped charges the grand jury
could take the case up as a royal suit--an indictment of
- c. The result was a sharp reduction in the fraction
of cases prosecuted as appeals of felony.
- d. Presumably because it reduced the incentive to
start such cases, since you could not guarantee the
defendant freedom from prosecution if he settled.
- 2. Medieval pardon selling. The crown sold pardons for
- H. Why the shift towards public enforcement
during the Middle Ages. In the 19th c.?
- 1. Because we learned more about how to enforce the law?
- 2. Because conditions changed, and private deterrence
doesn't work in large, mobile societies, where many crimes
- 2. A revenue grab by the crown, which wanted the revenue
from enforcing the criminal law--in cash (medieval) or
influence (19th century--when the crown still controlled
- I. Ideological reasons for keeping private
enforcement, as seen by 18th century Englishmen.
- 1. If the crown controls criminal prosecution, the
King's friends can get away with murder.
- 2. Better if any Englishman can prosecute any crime.
- 3. A system of public police and prosecutors is
tyrannical--just look at the French.
- J. France in the 18th century had a
"modern" system of professional police and public prosecutors.
England had an obviously unworkable system of private
prosecution of nominally public criminal cases. At the end of
the century it was the French system that collapsed.
From The Top:
A Summary of the Course
- IV. Twentieth Century California. [This is discussed in more detail in my review "Less
Law Than Meets the Eye," and in much more detail in Ellickson's
- A. Coase and Shasta County.
- 1. Do ranchers and farmers behave differently in open
than in closed range?
- 2. Coase says "no" because of transactions between them.
- 3. Ellickson observes that the answer is right but the
explanation is not--no side payments are happening.
- B. Informal norms, not laws, are determing
behavior with regard to trespassing cattle and many other
- C. Trespassing cattle and inefficient
- 1. If your cattle trespass and do damage, you are
expected to apologize, make up for serious damage.
- 2. If you don't, the victim retaliates by spreading true
gossip--the fact that you are not behaving in a neighborly
fashion. You start getting the cold shoulder from other
- 3. If that doesn't work, next time the victim retaliates
by driving your animals far away, where it is going to take
you time and trouble to find and retrieve them.
- 4. The victim does not go to court.
- 5. And does not use efficient punishment (slaughtering
one of the cattle)
- a. That would be more efficient than driving the
animals away, but ...
- b. Produces a temptation to overuse such a
punishment--since doing so is profitable.
- c. Locke: Every man is a biased judge in his own
- d. We are back with the inefficiency of efficient
- D. Fence building--the same story.
- E. But not accidents with motorists who run
into cattle. They are strangers, hence not a part of the system
of norms of neighborly behavior.
- F. Other norms Ellickson discusses:
- G. The economics of norms.
- 1. Locally efficient.
- 2. But not globally efficient.
- a. Whalers efficiently hunted one species after
another into near extinction.
- b. They would probably have been better off limiting
their catch so as to preserve their prey, but ...
- c. Any whaler or group of whalers who did so would be
bearing the cost of catching fewer whales, while sharing
the benefit of more whales in the future with everyone,
including the whalers who did not restrict their catch.
- H. Implications. Crime rates?
- 1. The facts about U.S. murder rates.
- a. Most of the U.S. has murder rates comparable to
those in European countries.
- b. The high national average reflects very high rates
in the inner cities.
- 2. Explanation? Perhaps ...
- a. Crime control is mainly by norms and reputation.
- b. And they break down in a society without marriage
- A. We looked at three+ different systems
for doing what we do with tort and criminal law:
- 1. Iceland: Private enforcement, full civil
- 2. 18th c. England: Private prosecution, punishment at
- 3. Shasta county: Norms as a substitute for law.
- 4. A little on medieval England.
- B. Some of what we learned:
- 1. Different allocations to tort/crime are possible:
Iceland, (Shasta), Medieval
- 2. Different bundling of legal rules, not fitting our
tort/crime distinction, are possible. Some of the relevant
- a. Who controls prosecution
- b. Who collects the punishment
- c. Price or prohibit behavior
- d. Moral stigma?
- 3. For example, we observed:
- a. Privately prosecuted law with "criminal"
punishments and government collection of the punishment
(it was the crown, not the victim, that could pardon the
convicted offender, transport him, etc) in 18th c.
- b.Privately prosecuted law with criminal punishments
and private collection in the medieval appeal of felony.
- c. Publicly prosecuted law with "civil" punishments
(plus criminal) in the medieval indictment of trespass.
- 4. Incentives to prosecute privately include not only
- a. Collecting damages, but also
- b. Reputation as a private good (18th c. England,
probably Iceland, Shasta County, Medieval England)
- c. Possibility of out of court settlement
(Medieval--there is evidence that the appeal of felony
declined in popularity after it became impossible for the
plaintiff to guarantee the defendant immunity in exchange
for a settlement. Probably 18th c. England)
- 5. Too much incentive can be a problem for private
- a. 18th c. reward system
- b. Why Shasta county uses inefficient punishments
- c. Note that b works precisely because it applies to
offenders unwilling to pay damages--or settle out of
- d. 18th c. England, at both the public and private
level, may have converted inefficient to efficient
(compounding a felony, selling a pardon)
- 6. Some of the ways of solving problems with private
enforcement that might not have occurred to us if we had not
observed them are:
- a. Punishing the offense of concealing an offense,
thus raising the probability of convictions, which
reduces the efficient punishment and thus the risk that
defendants will be judgement proof.
- b. Temporary slavery (Icelandic debt thralldom) as a
solution for judgement-proof defendants.
- c. Or giving them an incentive to raise the fine from
their friends and relations.
- d. Marketable torts as a way of making it possible
for poor people to get their rights enforced.
- 7. Distinction between locally efficient and globally
- a. Why norms give only local efficiency.
- b. This is related to the issue of efficiency of
common law. The law may embody pre-existing norms--and
their efficiency characteristics. Also, getting
individual judges to take account of the influence of
their precedents on people not before them is a problem
analogous to getting groups of individuals to take
account of the influence of their norms on people not in
- c. So is the problem of getting governments to take
account of the influence of what they do on people other
than those controlling the government.
- d. Was the shift from private law (common in lots of
primitive societies, not just Iceland--including
Anglo-Saxon England) to public law
- i. Improved form of law enforcement?
- ii. Adapting to changing circumstances
(urbanization might make private deterrence less
- iii. Or a revenue grab by the crown at the expense
- VI. Efficiency
and the common law:
- A. What is efficiency? For a detailed
answer, see my webbed Price Theory
chapter on efficiency.
- B. Efficiency as a normative, or at least
normatively interesting, criterion.
- 1. A large part of the course has consisted of asking
what legal rules would be efficient in various
- 2. Which makes sense if we consider maximizing the size
of the pie a disideratum, although not the only one.
- 3. And is an interesting lens through which to look at
- B. Efficiency as accurately descriptive:
- 1. If this were a law school class, and I was a legal
scholar instead of an economist, we might have spent more
time on the details of U.S. law in 1996, instead of more
- 2. Some fairly clear evidence in favor of the efficiency
of our legal rules:
- a. Property rules in general (transferable, bundling,
etc.) seem to make economic sense.
- b. As do liability rules.
- c. Our crime/tort distinction makes some sense in
terms (at least) of judgement-proof defendants.
- d. As does the general rule of freedom of contract.
- e. And many detailed rules
- i. defense of necessity,
- ii: different levels of proof for civil and
- iii. Only liable for reasonably foreseeable
damages (photo case)
- iv. No bargaining as the ship goes down
- v. Strict liability for ultrahazardous activities.
- vi. Many more in Posner.
- 3. Some fairly clear evidence against the efficiency of
our legal rules:
- a. Retreat from freedom of contract, as for instance:
- "Contracts of adhesion" etc.
- Refusal to enforce penalty clauses
- Refusal to enforce waivers re first party product
- b. Lack of transferability of torts (existed 1000
years ago in Iceland!) and inchoate torts.
- 4. Lots of fuzzy evidence:
- a. Crime/tort distinction is backwards with regard to
incentives to avoid by victim. To justify that you have
to argue that other considerations, such as
judgement-proof defendants and wanting to provide victims
incentives to report offenses, outweigh that
- b. Negligence, contributory negligence, strict
liability. The rules vary from state to state, and the
advantages of the different rules depend on things, in
particular what sorts of mistakes courts make, that we
don't know much about.
- C. Are there good reasons to expect
- 1. Efficiency is important to people, including judges, so
judges seek to maximize it. but ...
- a. There is a large public good problem to doing so,
since most of the benefit of efficient law goes to people
other than the judges who produce it, and ...
- b. not all economics is easy, so figuring out what rule
is efficient is sometimes hard, so why would judges bother?
- 2. Judges want to do good, and since the alternative values
are controversial and hard to produce, efficiency is the only
kind of good they can readily do. In particular, redistribution
is hard to do as a judge
- a. But you can do it for the particular case you are
ruling on, between that plaintiff and that defendant, and
- b. Inability to do it in general is far from obvious.
- c. If some classes of plaintiffs or defendants are
consistently people that judges want to help you might get
legal rules that "favor" those classes--for instance, rules
favorable to tenants, or poor people, or purchasers of
consumer goods, or ...
- d. Which is likely to be not only inefficient, but
against the interest of those classes of people, who can now
less able to sign binding contracts, since the other party
knows that the court may not enforce them.
- 3. Expenditure on litigation argument--the more the outcome
is worth, the more you spend to get it, so the efficient
outcome tends to win out in the long run, but ...
- a. The litigant only gets his gain, not the whole gain
of the new legal rule to all who benefit, so the amount each
side is willing to spend to get the precedents they want is
weighted by that side's ability to solve its internal public
good problem (raising money for litigation to extablish
precedents that will benefit everyone on that side), which
will be different for different sides, giving you
- b. Thus legal rules will tend to favor more concentrated
interest groups at the expense of less concentrated interest
- c. Consider, as an example, the conflict between the
interest of the plaintiff's bar (in legal rules that produce
lots of litigation) and the interest of the consumers who
ultimately bear the cost of that litigation.
- 4. Fossilized efficiency?
- a. Norms have some efficiency characteristics.
- b. As does a competitive court system where both parties
can opt in or out of a court's jurisdiction. To some extent,
the common law is based on such systems (Fair courts,
- c. So might retain some of their efficiency
- 5. Which suggests that common law should have some tendency
towards efficiency--but it might be declining over time, as the
law changes, and the efficient bits erode away.
- I. What is economics?
- A. Rationality. Individuals have objectives
and tend to choose the actions that best achieve them.
- B. Examples:
- 1. Rational criminals consider costs and benefits of
crime, commit only if there is a net gain.
- a. Gives you the argument for using punishment to
- b. And the argument for punishment equal to damage
done in the simple case.
- c. And for value of marginal offense = <P> in
the complicated case.
- 2. Rational Enforcers, private or public, use legal
rules if they gain by doing so
- a. Which gives you a problem with efficient
- b. Since they benefit someone, someone has an
incentive to impose the punishment, whether or not the
defendant is guilty.
- 3. Flip side:
- a. Rational enforcer do not prosecute if the gain is
not worth the trouble.
- b. So private prosecutors do not go after
- c. Unless they can privatise deterrence.
- d. And ditto for private prosecution of criminal law
(18th c. problem)
- e. Or, in our system, private individuals bothering
to press criminal charges.
- 4. Why does the victim own the claim?
- a. Justice--but not in the criminal context.
- b. Because he owns the evidence, and ...
- c. Has the private deterrence incentive.
- d. Hence in English case, crimes were typically
prosecuted by the victims.
- 5. Contract breach: Parties will breach if it is
profitable to do so, so ...
- a. Use damage rule to control inefficient breach
- b. Inefficient contracting (reliance)
- II. What is
economic analysis of law?
- A. Consequences of legal rules:
- 1. Easy divorce ->opportunistic breach, and women
taking precautions against it.
- 2. Marginal deterrence problem--the additional
punishment for an armed robber who kills his victim.
- 3. Risks of efficient punishment issue.
- 4. When the law changes one term of a contract in favor
of one party, that shifts the contract price (or other
terms) against that party, which makes redistribution via
- B. Predicting (post-dicting?) legal
- 1. Posner's efficiency conjecture.
- a. Explains some of the distinction between criminal
and civil law.
- b. And different standards of proof in criminal and
- c. And lots of detailed legal rules (see Posner's
- 2. My market for norms.
- a. Predicts local but not global efficiency.
- b. In particular, efficiently inefficient
- C. Recommending legal rules: Efficiency as
- 1. Argument for freedom of contract.
- 2. Analysis of optimal liability/contract rules for
- 3. Optimal punishment arguments.
- D. What kind of knowledge does economic
analysis of the law give us?
- 1. None of this gets to the point of a set of equations
where you can expect to fill in the numbers and turn the
- 2. But it tells you how you would do so if you had
enough information, and thus tells you what factors are
- 3. We can't prove "the right liability rule for
lawnmowers is X"
- 4. But we can give good reasons to believe that the
argument for caveat emptor is stronger for some goods
than for others.
- 5. Which is the kind of knowledge we have for most
things--getting married, betting on ballgames, choosing a
- E. Why is it an interesting subject?
- 1. Provides a single theory to make sense of the
diversity of law.
- 2. Pushes economists into thinking about theory by
- 3. Provides puzzles
- 4. And data. Resale price maintainance, etc. After we
have proved that it isn't happening, we have to rethink the
question to figure out why it is happening.
- III. Allocational
vs distributional issues: At the heart
of many political arguments, including the preception of economic
analysis of law as conservative.
- A. Allocation is how to make the pie,
Distribution is how it gets cut.
- B. Distributional effect of restraints on
contract tend to be wiped out by price shifts.
- C. A judge can benefit a particular tenant
at the cost of his landlord, but it is much harder to create
legal rules that benefit tenants in general at the expense of
landlords in general--because the parties know about the rules
when the decide whether to build apartment buildings, what
price to rent them at, etc.
- D. Similarly, rules making it hard to fire
minorities make it costly to hire them.
- E. An economy is a complicated system, and
- 1. The effect of regulating one dimension may well get
wiped out by another
- 2. Regulating all of it is hard, for the same reasons
that running a centrally planned economy is hard.
- F. Lesson for political discourse: A lot of
disagreements that seem to be distributional aren't, since the
parties do not agree what the distributional consequences would
- IV. Economic
- A. Size of the pie, loosely
- B. But how do we add up a "pie" consisting
of many very different things consumed by many people?
- C. Marshall's answer: Measure value by how
much someone would be willing to spend to get or keep something
(i.e. to cause or prevent some change), add up by dollars
(actually pounds in Marshall's case) across people.
- D. Critique:
- 1. We might reject individual values as a basis for
judging what is good.
- 2. Or reject revealed preference as a way of determining
what people really value
- 3. Or reject interpersonal comparison by dollar-measured
- 4. But can you do better? Is there an alternative
criterion that is both closer to what we want and
- V: What is
- A. Where it comes from:
- 1. Constitution
- 2. Legislature
- 3. Courts
- 4. The hierarchy of courts, appeals.
- 5. Why courts matter--inherent ambiguity of English. You
cannot write laws clearly enough to leave no hard cases, so
the courts (at least) fill in the details.
- B. Consistency/inconsistency.
- 1. In many areas, state laws differ.
- 2. Federal laws are the same everywhere in the U.S., but
different circuits may differ in their interpretation of
them until the Supreme Court hears the issue and settles the
- C. How are cases decided.
- 1. Adversary system (vs European inquisitorial system)
- 2. Jury is available for both criminal and civil (U.S.
- 3. Judge decides law, jury facts--supposedly.
- D. We have multiple legal systems
- 1. Federal, state
- 2. Criminal/Civil
- 3. Administrative law.
- 4. Property law:
- 5. Contract
- 6. Tort law
- E. Some interesting issues include
- 1. Why do civil and criminal law exist, and have the
form they do
- 2. Adversarial vs Inquisitorial systems for trying cases
- 3. Who pays the cost of litigation
- 4. How should law be enforced
- 5. ...
- VI. Essential economic concepts:
- A. Externalities:
- 1. The problem--inefficiency due to the existence of
externalities. Some goods worth producing don't get
produced, some pollution worth preventing doesn't get
- 2. Conventional solutions
- a. regulation
tax (aka effluent fee).
- c. b requires much less information than a--but still
more than the regulators are likely to have.
- 3. Coaseian three step
"Victim" is not well defined. If I can play my stereo, you
are the victim of my noise, if I can't, I am the victim of
your desire to sleep.
- a. Nothing works--because we might be imposing the
Pigouvian tax on the wrong party.
- b. Everything works--because parties can negotiate to
the efficient outcome.
- c. It all depends on transaction costs--which
sometimes block the agreements necessary to get to the
- 4. As we will see, for some legal problems the
conventional approach is still the most useful way of
thinking of them, for others not.
- 5. Lots of examples as we went through the law.
- B. Property rules vs liability
- 1. Not "property vs not-property" but "property
protected by ... rule."
- 2. Property rules are best if market transactions are
the best way of allocating (including the possibility that
the best outcome is leaving the property with the original
owner, which requires no transaction.).
- 3. Liability rules if "take and then be sued" is the
best way of allocating. Sounds odd, but consider pollution,
- C. Insurance is useful for thinking through
some relevant issues--because it is a context in which we are
deciding who will bear a particular cost.
- 1. Risk aversion--let whoever can best bear the risk
have it. Not an egalitarian argument, since you pay for your
insurance, but based on the same principle (declining
marginal utility of income) that generates the utilitarian
argument for egalitarianism.
- 2. Moral hazard argument: Starts as "insurance causes
moral hazard cost." But generalizes to "let whoever can best
control the occurence of the cost bear it," which really
means" "put the incentive where it will do the most good in
reducing the moral hazard inefficiency."
- 3. Adverse selection argument: With assymetric
information, efficient transactions don't happen.
- a. You can solve the problem by nobody knowing, or
- b. Everybody knowing, or
- c. Insurance so that the knowledge is only needed by
the person who has it.
- 4. Litigation cost--an argument for leaving damage where
it falls. One reason to have a policy with a deductible is
that, for small losses, making and investigating an
insurance claim cost more than the small reduction in risk
- D. Ex ante/ex
- 1. Ex post uses the actor's information about
what he is doing and what its consequences are, but ...
- 2. My involve a low probability of a high cost, which
gets into risk aversion and inefficient punishments ...
- 3. And assumes that the actor's information really is
better than the cop's.
- E. Strategic behavior:
- 1. Threats, commitments, coalitions, etc. become
- 2. When I am acting to influence your action and vice
- 3. Which makes the analysis very hard, dependent on an
(unknown) technology of commitment.
- 4. Which is why we try to set up problems in ways that
avoid such things, as by perfect competition.
- A. The idea: People control scarce things.
They trade to get to the optimum--move goods to their highest
- B. So why not solve all problems that
- 1. Propertise everything that is scarce and leave it to
the market to allocate it?
- 2. Because costs of creating, defining, protecting, and
transacting over property can be high.
- a. Propertise the atmosphere, gas by gas?
- b. Or the English language, word by word?
- 3. So some things should be left as commons, despite the
costs of treating them that way.
- C. Also--what we own are not things but
rights with regard to things.
- 1. How do you bundle them?
- 2. What rules protect the owner?
- 3. How do you get ownership?
- D. Contexts:
- 1. Property in land. What do you own?
- 2. Selling partial bundles of other things
- a. You can't sell a thing minus the right to use it
in certain ways.
- b. So to get that result, you have to use contract,
not property law.
- c. But you can sell a piece of land minus some of the
associated rights--for example with an easement allowing
a neighbor to cross it, or a restrictive covenant
limiting the ways it may be used.
- 3. Primitive peoples seem to establish pretty sensible
property rights, propertizing things roughly when they ought
to, from the standpoint of efficiency.
- 4. Intellectual property.
- 5. All involve the same set of issues. Worked out in
most detail for intellectual property in my article on
- E. Coase as one approach to all of
- 1. You can allocate your property either by using your
property or selling it.
- 2. So bundle the rights in the way that minimizes the
cost of doing so.
- 3. The simple property argument generalized to the fine
points--the individual rights within the bundle.
- 4. With attention paid to the transaction cost problem.
- VIII. Contract
- A. Need enforceable contracts to permit
transactions over time.
- 1. Building a house.
- a. If I pay and then you build, you can cheat me.
- b. If you build and then I pay, I can cheat you
(nobody but me is willing to bid for a house sitting on
my land, so you accept a price below what we agreed to
rather than losing everything).
- 2. Loss from not being able to enforce contracts is not
cheating but inefficiency due to the possiblity of cheating.
The house never gets built.
- 3. Enforcement mechanisms other than law exist, but law
is the one we are most interested in.
- B. There is never enough fine print to
specify the terms in full, so we solve by either ...
- 1. Court fills in what the parties would have agreed to
- 2. If circumstances change, parties can break or
renegotiate the contract. We then need rules specifying the
result of breach.
- C. One issue is how to allocate unexpected
- 1. By who can best insure.
- 2. By who can best control.
- 3. By who best knows the risk, so can include it in the
- D. Another issue is what happens if one
party breaches the contract.
- 1: Nothing. No enforceable contract.
- 2: Specific performance: No breach without the
permission of the other party.
- 3. Expectation damages: The breaching party must make
the victim as well off as if there had been no breach. This
gives the right incentive to breach, since the breaching
party bears all of the costs, and receives all the benefits,
- 4. Reliance damages: The breaching party must make the
victim as well off as if there had been no contract. If the
party that will breech is the one best informed about the
likelihood of events leading to breach, this gives the right
incentive to sign such contracts--the party with the
superior information is insuring the other party against the
loss from signing and then being the victim of breach.
- 5. Both of these give the wrong incentive to rely.
- 6. Liquidated damages: The parties agree in advance on
what the penalty for breach will be. This gives the right
incentive to rely; whether it gives the right incentive to
sign or to breach depends on how the agreed upon payment
compares to what expectation or reliance damages would be.
- 7. Courts will enforce liquidated damages if they think
they are reasonable, but not if they think they are a
- 8. Note that a penalty clause serves the same function
here as a property rule--instead of "pricing" breaches it
tries to eliminate them, forcing the party that wants to
breach to negotiate to get the permission of the other
party. To put it in contract language, the parties are
agreeing to a modified version of specific performance--up
to some maximum cost of performance (party can breach
without permission if he is willing to pay the penalty).
- E. These questions arise both in the
context of negotiating a contract (the parties want to find the
efficient terms) and filling in the blanks (the parties would
have chosen the efficient terms, so the court adds them). It
also arises where a court is trying to modify the terms agreed
to by the parties--subject to the argument that if the court
disagrees with the parties about what the efficient terms are,
the court may be wrong.
- F. Distinguish the argument for default
rules from the argument for non-waivable rules:
- 1. Default is what you think they would have agreed
to--and if you get it wrong, they will contract around you,
at some cost in additional negotiation.
- 2. Non-waivable is what you insist that they must be
bound by--whether or not they agree.
- 3. Consider fine print rules re fraud. If the contract
says even terms in four point type are binding--and that
passage is in four point type, hidden in the ornamental
border--it isn't binding.
- G. What is duress? Gun? No good
alternatives? Sinking ship?
- 1. Courts won't enforce contracts signed under real
duress so people won't point guns.
- 2. Contracts of adhesion are not a reason not to
enforce, since it is in the interest of the party who draws
up a form contract to take account of its cost for the other
side--it will show up in the price he will be willing to
- 3. Sinking ship might be--because bargaining costs are
- IX. Family
- A. The problem with no fault divorce (Cohen
- 1. If women perform early and men late
- 2. There is an opportunity for opportunistic breach by
- 3. Women will adjust by performing later (postponing
childbearing, for example) and investing less in
relationship-specific capital (work and hire a nanny).
- 4. All of which is costly--in foregone opportunities,
and middle aged people trying to cope with energetic
- B. But there are serious problems with the
- 1. No divorce locks partners into their early mistakes,
is hard to enforce, and may produce costly bargaining within
marriage, since there is no exit option to limit the stakes.
- 2. Divorce with fault gives one partner an incentive to
perform his or her obligations badly in order to force the
other to request the divorce.
- 3. Part of the problem is that it is a complicated
contract, making it hard to specify all the relevant terms,
and much of the performance is difficult for an outside
party to observe.
- C. Why has marriage become less stable over time? Because falling infant
mortality and increasing replacement of household production by
market production greatly reduced the amount of
relationship-specific capital required. [Other economic
explanations are also possible--for example, that improved
medicine has virtually eliminated death in childbearing,
substantially increasing the ratio of women to men in the
relevant ages and thus weakening women's ability to insist on
economic support as a condition for sex or
- D. The economics of engagement rings.
Arguably they became popular when states stopped awarding
damages for breach of contract, and served as a performance
bond for the promise to marry, reducing the "seduce and
abandon" risk to pre-marital sex by engaged partners.
- E. The adoption market: Why not allow
payments to natural mothers for their consent?
- 1. "Commodification" argument--doing so makes us think
of children as commodities.
- 2. Should it be illegal to do things that affect how
other people think about things?
- 3. Isn't making that illegal in violation of the first
- F. Do people have too many children?
- 1. Argument: By having a child I impose costs on others
(for his schooling, resources he uses, ...)
- 2. Counter-argument: If my child uses resources he (or
I) must pay for them--they aren't given away. There are some
negative externalities, but some positive externalities too,
and one must count both.
- 3. How in principle do we define the optimal level of
population? How do we apply ideas such as Pareto or Marshall
efficiency when we are comparing alternative futures with
different numbers of people in them?
- G. Why do we have laws the regulate
sex--laws against prostitution, adultery, fornication, ... ? To
help enforce the marriage contract? Protect children? Avoid
externalities associated with transmission of disease? Avoid
the "esternality" of A doing something B disapproves of?
- X. Tort
- A. What it is: Private action for a wrong
done to you.
- B. What is a wrong?
- 1. An act that causes harm
- 2. Is worth dealing with through the legal system
- 3. And can be dealt with better by a liability rule than
by a property rule (although punitive damages can be seen as
a property rule within tort law).
- C. What does it mean to say I "caused" the
- 1. It would not have happened "but for" my act runs into
coincidental causation problem--the falling safe.
- 2. Probabilistic injury (reactor leak) means nobody
caused anything (less than 50% chance that any given cancer
was due to the leak) or that total liability is many times
- 3. Two people might cause together but neither singly
(three hunter story)
- 4. The right answer is "it means that holding me liable
creates desirable incentives for me to modify my actions."
i.e. my action affects the expected cost to others
calculated with probabilities I do or reasonably might know.
- D. Liability: The law should be designed to
produce the optimal number of accidents--which, for bicausal
accidents, means the optimal precautions by both sides.
- 1. Strict liability--but that eliminates the victim's
- 2. Negligence--requires the court to know if you are
taking efficient precautions (if not you are negligent and
- 3. Both parties liable? Correct incentives--but it no
longer works as a tort, since neither party has an incentive
- E. Amount of damages.
- 1. Enough to make good is the usual rule. But as the law
is applied damages are less than that, since they do not
include attorney fees, may not include non-pecuniary
- 2. Punitive damages provide an indefinite amount more
than enough to make good, and are awarded for "deliberate or
- 3. Why do we want to deter apparently efficient torts?
Several answers were discussed. Mine involved the problem of
optimal punishment with costly enforcement, discussed at
greater length in the context of criminal enforcement.
- F. Why pay damages to the victim instead of
to someone else?
- 1. Incentive to sue
- a. Best given to him, who has the evidence
- b. And the additional incentive of deterrence.
- 2. But it reduces his incentive to prevent the injury.
- G. Compensating for death or injury: Loss
of both utility and of the ability to convert damage payment
- XI. Criminal
- A. Enforced by the state.
- B. Again we want all and only efficient
offenses, but ...
- C. Not at any price of getting them.
- 1. Expected punishment equal to damage done would be
right if catching and punishing criminals were costless, but
- 2. It involves enforcement and punishment costs
- 3. So the right rule is to produce an expected
punishment with the least costly combination of punishment
and probability, yielding a total cost curve for deterrence
(enforcement+punishment cost for producing any level of
deterrence via the least costly probability Punishment pair)
- 4. And then to calculate the optimal expected
punishment, taking account of the cost of imposing it.
- 5. Detailed version of this in punitive damage and
Payne v Tennessee papers.
- D. Why do the criminal's costs count? We
don't know what is a crime until we know what it is efficient
- E. Should rich and poor pay the same
punishment? In general no.
- F. Why not punish with an efficient suite
- G. One reason is that efficient punishments
provide enforcers with an incentive to punish even the
innocent, since someone collects what the victim loses.
- H. Why have criminal law?
- 1. Diffuse costs--doesn't explain the law.
- 2. Low probability+judgement proof defendant
- 3. Low probability+problem of fake offenses. In other
words, optimal fine for deterrence is more than for
- 4. To give the victim the right incentive--but that
mispredicts the pattern of what is a crime and what a tort.
- A. Produces an inefficient outcome
- 1. Because a single price monopoly produces too low a
- 2. Discriminatory monopoly solves some of this, but may
- B. One approach to solving is to prevent
monopolies from existing.
- 1. Not workable for a real natural monopoly.
- 2. But perhaps for preventing monopoly-by-merger or
- 3. Or artificial monopolies? But that assumes that
predatory pricing works, and it probably doesn't.
- C. Another is to regulate monopolies
(public utility regulation and the like) to try to make them
behave more efficiently. This has problems.
- 1. To make them produce the efficient quantity, you need
to know their cost curves, and don't.
- 2. You need a way of covering their losses to keep them
- 3. And we need a way of making it in the regulator's
interest to try to produce the efficient outcome.
- D. Some behavior has been regarded as
monopolistic, but perhaps incorrectly.
- 1. Resale price maintanance.
- 2. Vertical integration.
- 3. Tie-in sales (you have to use our punch cards with
- XIII. The
English vs the American rule:
- A. The English rule gives an incentive for
more expenditure on cases
- B. But fewer cases. In particular, it makes
low probability cases less attractive
- C. Which might be a good or bad
- XIV. Some interesting historical cases:
- A. Iceland.
- 1. All offenses treated as torts.
- 2. Tort claims transferable, so a weak victim could sell
his claim to someone with the power to enforce it.
- 3. Enforcement was entirely private.
- 4. Concealing an offense increased the punishment (and
was considered shameful)
- 5. Loans within groups, and temporary slavery, to keep
defendants from being judgement-proof.
- B. 18th century England.
- 1. Hang, transport, or pardon
- a. Why no imprisonment for serious crime? Because too
- b. Why a system where pardoning was common?
- c. A form of discriminatory pricing, or ...
- d. Selling pardons for non-pecuniary payments, thus
converting execution to a (more efficient) fine.
- 2. Crime privately prosecuted. Why bother--no damage
payment to collect.
- a. Deterrence as a private good: Associations for the
prosecution of felons.
- b. Out of court settlements to convert hanging to a
- 3. Rewards for successful prosecutions let to a problem
of entrapment, framing, perjury.
- C. 20th century Shasta County,
- 1. Norms substituting for laws.
- 2. Self enforced.
- 3. Avoiding efficient punishment that would give
"victims" an incentive to find other people guilty when they
- 4. Locally efficient, but not necessarily globally
- XV. Summary of
- A. We have a small number of central
- 1. Efficiency
- 2. Externalities as a problem for efficiency
- 3. Solutions such as Pigouvian taxes and property rights
to eliminate the inefficiency
- 4. Problems such as transaction costs and imperfect
information, by courts as well as actors, to prevent the
solutions from working
- B. We apply the analysis to a wide range of
- 1. Solving the problem with legal rules, so far as
practical, in many contexts.
- 2. Individual choices, such as contracts, designed to do
the same thing privately.
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