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?

VII. Law

I. Externalities: The conventional Analysis

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 information

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 Hazard.

VI. The other problem with insurance: Adverse Selection.

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 tort liability?

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 work?

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

I. Contract Law:

II. But contracts can be enforced in other ways than by law--and are.

III. Damages

IV. Consumer fraud, liability, etc. [I will be covering this material Monday 11/4]

V. Duress

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 packet):

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 overpopulation.

VI. Regulation of Sex. Why do we do it? Adultery laws, fornication laws, ...

I. Tort Law:

II. "Wrongful"

III. Causation complications

IV. Liability

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 Damages" articles]

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 all?

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 monopoly?

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

I. Looking at how other societies did it.

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 web]

III. 18th century England. [This is given in much greater detail in my article 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]

V. Summary:

VI. Efficiency and the common law:

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

VII. Property

VIII. Contract Law

IX. Family law

X. Tort law

XI. Criminal Law

XII. Monopoly

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 Course:
  • 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 assigned.
    • 3. An outline of the lecture, which will be handed out each week for the preceding week, deus volenti. You're reading it.
    • 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 DDFr@Best.com
  • C. There will be a midterm at about 10/24.
  • 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 course:
  • A. This week--introduction
  • B. Part I: Economic Analysis of Law, organized by ideas.
  • C. Part II: Organized by legal field.
• III. What is economics? [For a longer discussion, see chapter 1 of Price Theory ]
  • A. An approach to understanding behavior, based on the assumption that Individuals have objectives and tend to choose the correct way of achieving them. "Rationality."
  • 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 project.
      • 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 criminals.
      • 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 anything.
      • 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 rules.
    • 1. If we impose the maximum possible penalty for armed robbery, ...
      • 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 murder
      • 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 and convicted.
      • 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 rules.
    • 1. The Posner Conjecture: Common Law tends to be economically efficient.
    • 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 concretise them.
    • 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 underneath?
      • 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 actually done?
    • 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 their interest.
• 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 detail.
  • 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 tantrum.
  • 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 Theory .]
  • 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 those affected.
      • 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 course.
    • 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 legislature
      • 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 disagreement.
    • 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 inquisitorial.
    • 2. Jury is available for both criminal and civil (U.S. only)
    • 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 correct verdict.
  • 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; injunction/punishment)
      • 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 owns it.
    • 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 an injury?
  • 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 found innocent?
    • 4. Enforcement strategies
      • a. How to punish criminals
      • b. How hard to try to catch them

http://www-leland.stanford.edu/~ddfr1/Econ154.html

Second Week: Externalities

Pigou, Coase, Railroads, Candy Makers, and All That

• I. Externalities: The conventional Analysis
  • A. The simple argument for efficiency:
    • 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 mine)
  • 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 quantity
    • 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, worth doing.
  • C. Simple solution--direct regulation.
    • 1. The EPA or equivalent decides who can pollute how much where, what methods of pollution reduction have to be used, etc.
    • 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 pollution.
    • 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 efficient alternative.
  • 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 outcome.
    • 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 this point.
• II. Externalities in the law
  • A. Direct regulation of pollution--EPA
  • B. Laws as effluent fees: Speeding tickets.
    • 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 law.
    • 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 fees.
    • 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 inefficient crimes.
    • 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 necessity."
    • 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 prison.
    • 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 important.
• III. Coasian critique of externality theory: An argument in three acts.
  • A. Nothing works: Two sided causation.
    • 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 doctor sues.
    • 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 Theorem
    • 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 precisely:
    • 3. The Coase Theorem: If transaction costs are zero, any initial allocation of property rights will lead to an efficient outcome.
    • 4. Here "transaction costs are zero" means "if there exists a transaction that benefits all parties, it will happen."
  • 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 throw sparks.
      • 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 each:
      • 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 implications:
  • A. We should include other alternatives:
    • 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 spark arrester.
    • 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 diagram.
    • 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 sorts.
      • 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 outcome.
• V. Damages vs fines:
  • 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 losing money.
    • 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 bargaining--auto accidents.
    • 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 total.
    • 4. At which point they have an incentive not to report the accident.
• VI. Fines vs Damage Payments in summary:
  • A. Strategic argument for damage payment--where parties are identifiable and one side has a big commitment advantage.
  • B. "Coase+Pigou is too much" argument for liability.
  • 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 stories:
  • 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 out.
  • 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 people.
  • 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 Pigou--a summary:
  • 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 are low.
  • 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 transact.
  • 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 value.
  • 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 damages.
    • 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 damages.
    • 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 have taken.
  • 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 outcome?
  • 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.

   

• Third Week: Insurance
•  
• 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 analysis.
•  
• 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, advertising, ...).
  • 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 $90,000.
•  
• 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 doesn't.
  • 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 is small.
•  
• 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 income.
  • 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 income."
  • 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 precautions.
  • D. We have been here before:
    • 1. Moral hazard is another name for an externality-voluntarily adopted.
    • 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 transaction:
      • 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 safety design:
        • 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 Federal government.
        • 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 in output.
      • 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 manufacturer.
      • 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 prices.
    • 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 creampuff.
      • 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 car.
      • 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 your strategy.
  • 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 believe.
  • 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 information.
  • 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 can).
      • 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 their insurance.
      • 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 loss.
•  
• VII. Application to product liability. Who is liable for damage done by exploding Coke bottles?
  • A. Consider two alternative legal rules:
    • 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 bills.
    • 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 customer cannot.
    • 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 product.
    • 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 emptor.
    • 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 insurance companies.
    • 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 insurance?
    • 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 consider suing.
      • 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 litigation cost.
•  
• 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 not?
  • 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 sufficiently serious.
    • 4. This is a public approach analogous to a group policy, which is a private way of controlling adverse selection.
•  
• IX. Why not apply the same analysis to tort liability?
  • A. Instead of asking "when should the firm be liable"
  • 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 contract.
  • 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 terms:
    • 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 venditor.
    • 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 and 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 your rule.

     

• Week 4: Ex Ante/Ex Post, Strategic Behavior, Etc.

   

• I. Review: Marginal vs average.
  • 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 one person?
    • 1. Very low, if it means nine people instead of eight.
    • 2. Pretty high (in labor) if it means one person instead of none.
  • C. Two hunters in the woods. If either or both shoot the third, he is dead.
    • 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.

   

• II. Ex Ante, ex Post:
  • 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 murder:
    • 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 it.
    • 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 driving?
    • 3. Other punishment costs--can't collect ten million dollar fines.
    • 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 enough.
  • 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 cannot work?
  • 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 work.
    • 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 it?
    • 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 impossible method.
  • E. My article on Payne v Tennessee discusses the ex post , ex ante issue in a somewhat different context.
    • 1. Should murderers be punished more severely (for example, execution instead of life imprisonment) for killing particularly valuable victims--for example, a mother with young children?
    • 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 her).
    • 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 chapter)
  • 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 revenge.
    • 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 less).
    • 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 a strategy.
      • 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 property?
  • A. we take the institution for granted--for familiar things
  • 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. Implicit is:
    • 1. he can have it back when he wants
    • 2. If you give it to someone else, the owner can still claim it.
  • D. You ask a friend for information on a good dentist.
    • 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 forgets.
    • 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 breach.
  • 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 house?
  • 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 will.
    • 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 questions:
  • 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 moment.

   

• VII. Property rules--including Intellectual Property (I.P.), primitive societies, et multae caetera:
  • 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."
  • B. 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 large changes.
    • 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