Law and Economics: First Midterm

(You may leave any question blank and receive 20% credit on it)


I. Expain briefly, in your own words, what it means in this course to say that a change is an economic improvement. (5 points)

If you measure gains and losses to those affected in dollars by willingness to pay, the summed gain is positive.

Give two examples of ways in which a change might be an economic improvement and yet be regarded by many people as undesirable. (5 points)

[Note that this asks for two examples of ways, not just two examples. So if you give two examples that depend on the same problem, that is only one example]


A. We are doing interpersonal comparison in dollars, not utiles, so a change that benefits a wealthy man by $9 and harms a poor man by 8$ counts as an improvement.

B. We are accepting revealed preference, so a change that provides a heroin addict with a syringe of heroin that he would pay $100 for and deprives a hungry man of twenty meals that he would pay $4 eachfor counts as an improvement.

C. We are summing effects over everyone; many people in practice count only effects to themselves and those close to them. So we count abolishing an auto tariff as a net gain if the summed benefit is positive, although people in the auto industry might consider it undesirable.

II. Explain the difference between controlling behavior by ex ante and by ex post enforcement. (5 points)

Ex ante enforcement punishes actions that we believe have a probability of creating an undesirable outcome (such as speeding), ex post enforcement punishes the outcome (such as running into things).


What are the advantages of each approach? (5 points)

Ex post has the advantage of giving the actor an incentive to use his private information, both about what he is doing (I know I'm not paying attention to my driving, even if the traffic cop doesn't) and about connections between what he does and the outcome, since if the undesirable outcome occurs he will suffer for it.

Ex ante has the advantage of imposing lower punishments (with higher probability), thus allowing more efficient punishments (fines rather than jail terms, for example). It has the disadvantage of requiring more enforcement activity (traffic cops). It has the advantage (or disadvantage) of making it possible for the enforcers to force the actor to use their information instead of his--by, for example, punishing speeding even if the driver believes he is a very good driver who can speed safely.


Which approach would be more efficient for offenses which did relatively minor damage? Explain. (5 points)

Probably ex post, since minor damage can be punished with small punishments even ex post, permitting fines, and that eliminates one major argument for ex ante.

III. Airplanes make noise that disturbs residents of homes near the flight path. Suppose that the airline can, at some cost, reduce the noise to an insignificant level. Home owners can get the same reduction by soundproofing their homes. For simplicity ignore the possiblity of different levels of noise reduction--there either is or is not a noise problem.

There is one airline; it owns the airport. There are two thousand homes near the flight path. Reducing noise costs the airline a million dollars a year. Sound proofing a house costs $400/year. Airport noise (if there is neither soundproofing nor noise reduction by the airline) reduces the value of the house to its owner by $600/year

A. What is the efficient solution? (5 points)

The airline should (reduce/not reduce) noise:

The homeowners should (soundproof/not soundproof:


Cost of soundproofing: $800,000/yr

Cost of noise reduction: $1,000,000/yr

Cost of doing nothing: $1,200,000/yr

Note that the question did not specify what the property rights were, since that is irrelevant to which solution is efficient.


In answering parts B and C, describe first what happens if there is no bargaining between airline and homeowners, and then whether bargaining will change the outcome. Explain briefly.


B. The airline has no legal obligation to reduce noise. (5 points)

No bargaining. The airline doesn't reduce (no incentive to do so), the homeowners do soundproof ($400<$600)

With bargaining, the outcome remains the same, since even if the homeowners could overcome the public good problem of raising the money to pay the airline to reduce noise, it wouldn't pay them to offer more than $800,000, which the airline would not accept.


C. Each homeowner has the right to a reasonable level of quiet, so if the airline does not reduce noise, it must pay each home owner for any resulting reduction in the value of his house. (5 points)


No bargaining: If the airline doesn't reduce, it must pay $1,200,000/year in fines. So the airline reduces noise.

With bargaining: The airline offers each homeowner $400/year + a little to soundproof, for a total of less than $1,000,000/year. Any homeowner who refuses gets $600/damages. Since accepting the offer makes the homeowner somewhat better off, each homeowner accepts.

IV. New genetic tests make it possible to predict, at low cost and with considerable accuracy, whether someone will get cancer, die young of a heart attack, etc. Consider three alternative scenarios:

1. Insurance companies are forbidden to condition their rates on an individual's willingness to be tested or on the results of such tests; whether an individual has been tested is not public information.

Adverse selection. Everyone gets tested, only the ones who have bad genes buy insurance--at a price appropriate for people with bad genes. Less insurance is bought, people are worse off so far as insurance is concerned, although they may be better off because of other gains from the information (better medical precautions).


2. Insurance companies are permitted to condition rates on test results, and to require a test as a condition of insurance; whether an individual has been tested is not public information.

People with good genes get cheap insurance, people with bad genes get expensive insurance. The risk of having bad genes is now uninsurable (since if you try to buy insurance before being tested, the insurance company will suspect that you have been tested and got a bad result, and will charge you a bad gene price). This is an improvement over case 1, since good gene people can at least buy insurance at a good gene price, but (with regard to insurance only) a worsening compared to a world without testing. We would expect less insurance.


3. Insurance companies are permitted to condition rates on test results, and to require a test as a condition of insurance; whether an individual has been tested is public information.

This is the best case. People who want to insure against bad genes buy insurance before being tested, at a price appropriate for someone who might or might not have bad genes (since the insurance company knows they haven't been tested). Everyone has the option he had in the world without testing, plus any benefits from testing (after buying insurance), so it is an improvement over the world without testing. Each person has the option of testing before buying insurance (although it is not clear that anyone will), so it is an improvement over the other two cases as well. We would expect less insurance, since the risk of being uninsured is now somewhat lower--you can find out whether you won or lost your genetic bet immediately, and adjust your life accordingly, instead of only finding out when you drop dead. Also, people who definitely want the testing and are unsure whether they will at some point want insurance may get tested, making insurance against the genetic risk no longer an option.


What will happen in each case?

Will people choose to be tested?

Will people buy more or less life and health insurance than before the testing was invented?

Is either scenario an economic improvement (in terms of efficiency as we have defined it) over a world without testing? Is either an improvement over the other? (15 points)