1. Econ 522 Economics of Law Dan Quint Spring 2011 Lecture 23

2. 1  Remaining lectures  Today: some interesting digressions  Monday: efficiency, recap  Next Wednesday: practice problems (me)  Homework 4 due tomorrow, 5 p.m.  Final: Thursday May 12  12:25-2:25, 6210 Social Science  Cumulative, more weight on second half of semester Logistics

3. 2 Models in Economics

4. 3 Imagine you’re a physicist (Not drawn to scale)

5. 4  The world is too complicated to study “as is”  So we make a simple model  Try to leave in the “important parts” for studying a particular question  Realize that our results follow from the assumptions that we made, and may or may not be relevant to the real world Economists (at least theorists) work the same way

6. 5  “Are people risk averse?”  Ask a sociologist, you get an answer  Ask an economist, he’ll say, “It depends on what type of problem you’re studying”  For some questions, risk aversion is important  How people choose investment portfolios  How people save for retirement if they don’t know how long they’ll live  For other questions, risk aversion plays no role  Including risk aversion complicates model, without adding insight  So we assume agents are risk neutral – not because they are, but because we’re focusing on something else Many assumptions get made differently in different situations

7. 6 What does it take to do economic theory? Solve the model Reduce a situation to a tractable model Interpret the model  Technical ability  Judgment  (Which assumptions to make)  Judgment  (How much to “trust” results, given the model/ assumptions behind them)

8. 7  “All models are wrong, but some are useful.” – George Box (Statistician) Another way to think about this:

9. 8  We said: some assumptions (risk neutrality) get made differently in different settings  Other assumptions get made so consistently that they become a part of the “standard way” that economists look at the world…  …almost become a part of conventional wisdom  And then we start to forget that they were assumptions in the first place The idea of a “standard” model

10. 9  People have preferences  Allowed to like whatever they like…  …but assumed to understand all their options, and how they rank them  And people optimize  People pick whichever option they like most…  …subject to what they can afford  To put it another way, people are rational Basically all mainstream microeconomics is based on two premises

11. 10  “People respond to incentives according to what they correctly perceive to be their own rational best interest”  Property/nuisance law  each knows own threat point, can bargain with each other to transfer ownership of entitlements to whoever values them most  Contract law  can negotiate efficient contracts, courts can enforce them correctly  Tort law  people react rationally to incentives  courts can assign liability and assess damages correctly  Criminal law  even criminals react rationally to incentives, commit crimes when benefit outweighs expected cost We’ve been assuming this throughout the semester

12. 11  Very useful assumption  Led to lots of predictions about how laws affect behavior…  …and therefore what types of laws would lead to efficient outcomes  But conclusions are only as valid as the assumptions  Today:  How these assumptions sometimes fail in real life…  …and therefore why we may be skeptical about some of the semester’s conclusions  But, you’re still being tested on those conclusions!  Think of today as a digression But rationality is a strong assumption

13. 12 Behavioral Law and Economics

14. 13  How peoples’ actual behavior differs from predictions of “standard model”  Started out ad-hoc  Take a prediction of the standard model, e.g., expected utility maximization  Do an experiment – put a bunch of undergrads in a room and make them play a game  Or look for instances in real world where prediction was violated  Over time, generated some fairly robust conclusions  Systematic ways behavior differs from perfect rationality in a number of different situations Behavioral economics

15. 14  What’s important is that deviations from standard predictions of economics are not random  Not random errors  But consistent, systematic biases  At its best, behavioral economics holds itself to a “higher standard” than traditional economics  Traditional economics: makes assumptions (rationality and optimization), derives predictions  Asks whether predictions seem right, but doesn’t spend much time questioning the assumptions  Behavioral economics looks to justify the assumptions as well Behavioral economics

16. 15  Two recent “pop economics” books that are supposed to be pretty good: Behavioral economics – sources  Effect of behavioral economics on law and econ:

17. 16  Positive  “An increase in expected punishment will lead to a decrease in crime”  Or an explanation for the laws that do exist, as outcomes of some process (evolutionary, legislative, etc.)  Prescriptive  “To achieve efficiency, the law should specify injunctive relief when transaction costs are low, and damages when TC are high”  Normative  What should be the goal of the legal system?  (For this class, we’ve assumed it’s efficiency) Jolls/Sunstein/Thaler on three different “uses” for economics

18. 17  Positive  Goal of any positive model is to mirror actual behavior  Prescriptive  If people respond differently to laws than the standard model would predict…  …then the law should be designed differently to account for this  Normative  If people seem to make “incorrect” choices, should we force them to choose “correctly”?  If people do not optimize based on stable preferences, even the definition of efficiency becomes unclear Behavioral economics has implications for all three “uses” for economics

19. 18  One observation of behavioral economics: people value things more once they have them  My office doesn’t have a lake view, I don’t think it’s that big a deal, I’d only pay $100 to switch offices with someone  If I were given an office with a lake view, I’d come to love it – I wouldn’t be willing to sell it for less than $500  My colleague has a lake view, which he values at $300  Coase breaks down  If I start with the lake view, I keep it  If he starts with the lake view, he keeps it  So initial allocation matters, even without transaction costs  Which of us is the efficient owner? (An example of how behavioral economics makes meaning of “efficiency” unclear…)

20. 19  To give a more accurate model of how people actually behave…  …and use that model to reconsider the positive, prescriptive, and normative conclusions of law and economics The goal of behavioral law and economics

21. 20  Bounded rationality  We make mistakes…  …and use simple heuristics or “rules of thumb” to make choices  Bounded willpower  Even when we know what we “should” do, don’t always do it  Means commitment devices can have value  Bounded self-interest  People aren’t totally selfish, even in anonymous situations with strangers So, how does behavior typically differ from the standard model?

22. 21 Examples of bounded rationality

23. 22  Similar to the first experiment we did in this class  44 students in an advanced undergrad Law and Econ class  Half were given tokens  Each was given a number – how much they could exchange a token for at the end of the experiment  Given an opportunity to trade  As you’d expect, people with high token values bought them from people with low token values  This was with tokens – which had objective, artificial value  Reran experiment with coffee mugs  Half the students were given Cornell mugs  Then they were given opportunity to trade Trading experiment from Cornell

24. 23  Since the mugs were given out randomly…  If each person knew exactly what a mug was worth to them…  …we’d expect half the mugs to change hands  Since half the mug owners would have above-average values, and half would have below-average values  Instead, only 15% of the mugs were traded  On average, people who got a mug asked more than twice as much money for them as people who didn’t get a mug were willing to pay  And the effect remained if the experiment was repeated Trading experiment from Cornell

25. 24  Conclusion from the Cornell experiment: having something makes you value it more  If you have a mug, you value mugs more than if you don’t  “Endowment effect”  Existence of this bias seems robust  One of the chapters in Sunstein book shows 12 studies where Willingness To Pay for something is compared to Willingness To Accept an offer for something people already have  Every time, people who have something value it more than people who don’t – typically by 3X or more! Endowment effect

26. 25  Seems to contradict Coase  Coase: without transaction costs, initial allocation shouldn’t affect final allocation, since whoever starts with something, it will get traded to whoever values it most  But endowment effects mean initial allocation does matter in predicting final allocation  And, if preferences change depending on who starts with the object, it’s not even clear how to define efficiency!  Recall why we argued for injunctive relief for private nuisances  When TC are small, injunctions clarify two sides’ threat points and allow them to bargain to efficient outcome  Endowment effect: initial allocation effects preferences, outcome Endowment effect – so what?

27. 26  What about calculating damages?  Ask someone beforehand how much money they’d accept to lose an arm – huge number  After someone loses an arm, ask how much money it would take to make them as well-off as before – much smaller number  Suppose someone with two arms thinks losing one would be a catastrophe, like a $10,000,000 loss  Someone with one arm realizes he’s OK that way, thinks damage done was $500,000  How much damages should a construction company owe if a worker lost an arm?  And should they take precautions that cost $3,000,000 per lost arm saved? Endowment effect – so what?

28. 27  “Second-cheapest wine” effect Context dependence Price Quality/features

29. 28  Once something happens, people overestimate what its likelihood was  Think back to one year before last election, guess what probability was at the time that Obama would be elected  In November 2007, Intrade had Obama at 7%  So what?  Determining negligence (Hand Rule) requires figuring out the probability something would happen, after it happens  Example: risk of factory fire is 1 in 1,000, harm is $1,000,000, company chooses not to install $10,000 sprinkler system  Fire occurs, jury thinks risk was 1 in 50, finds company negligent  Publicly-owned companies must disclose “material risks” to investors Hindsight bias

30. 29  Effect of hindsight bias  Judges/juries will find negligence more often than they “should”  Jolls/Sunstein/Thaler ideas for dealing with this all seem flawed  Keep jury in the dark about what happened  Raise standard of proof for finding negligence Hindsight bias

31. 30  People overestimate probability of a certain type of accident if they’ve recently observed a similar accident  “Availability” – memory of a recent accident is available in your mind, colors your judgment  “Salience” – how vivid the memory is  Explains environmental/safety regulations covering “hot topic” without regard for cost-benefit  Made worse because some people may deliberately keep the accident available for private gain  “Availability entrepreneurs” – think of U.S. politicians after 9/11/01 Similar bias – perception of probability based on availability and salience

32. 31  Relative optimism when both sides have same information  Students randomly assigned to roles of plaintiff and defendant, would be asked to negotiate a settlement  Asked to write down a guess as to actual damages awarded in the case, and what a “fair” settlement would be  These answers would not be used during negotiations  Students chosen to be plaintiffs guessed $14,500 higher for actual damages, $17,700 higher for “fair” settlement  Suggests pre-trial settlement may be rare, sharing information may not solve problem “Self-serving bias”

33. 32 Bounded willpower

34. 33  Peoples’ choices do reflect discounting of future events…  …but not in the way standard model predicts  Standard model: if discount factor is 11%,  $100 today = $90 in a year = $81 in two years = $73 in three = …  Actually, dropoff between “now” and “later” is more severe than between two future times  Example: $100 today versus $150 in six months…  …or $100 in six months versus $150 in a year How people discount the future

35. 34 Bounded self-interest

36. 35  Player 1 proposes a way to divide up $10  Player 2 says yes or no  Yes: they each get the proposed share  No: they both get nothing  Backward induction: only equilibrium is for 1 to keep almost everything, 2 to say yes  Experiments: offers less than $3-4 are often rejected, many people offer fairly even split  Shocking to economists, obvious to everyone else:  People sacrifice their own well-being to help those who are being kind to them  And sacrifice their own well-being to punish those who are unkind “Ultimatum game”

37. 36  People care not only about their own payoff, but also about “fairness”  But fairness is not objective – not all offers < $5 rejected  Preference for fairness could explain lots of rules we see:  Rules against scalping tickets  Rules against predatory pricing during emergencies  Rules against usury (very high interest rates)  Any voluntary transaction should be a Pareto-improvement…  …but prices which are too “unfair” are sometimes illegal One interpretation of bounded self-interest

38. 37 Jolls/Sunstein/Thaler prescriptive and normative

39. 38  Lots of interesting stuff on positive aspects  Less on prescriptive and normative Jolls/Sunstein/Thaler

40. 39  How people respond to information depends on how it’s presented  Example: choosing between safe and risky retirement investments  So if government is putting out information, should think about how “framing” changes its effect  Safe driving ads used to be, “Drive carefully, or you’ll kill someone”  But everyone believes they’re a good driver  When ads changed to, “Drive carefully, there are other BAD DRIVERS out there you have to watch out for!”  They started having more of an effect One prescriptive suggestion

41. 40  Antipaternalism  Government shouldn’t tell people what to do  J/S/T stop short of advocating paternalism  If behavioral bias leads individuals to make mistakes, could also lead government bureaucrats to make mistakes in telling people what to do!  “Anti-antipaternalism”  We shouldn’t automatically reject paternalism, since it may have a role sometimes Jolls/Sunstein/Thaler’s conclusion: the case for “anti-antipaternalism”

42. 41 Unenforced laws

43. 42  Optimal criminal system will not detect/punish every crime, for two reasons  Some crimes may be efficient (rare)  When cost of deterrence is positive, it’s not worth paying enough to deter every crime  But we still assumed most crimes are inefficient, and main reason not to punish them all is cost We saw last week…

44. 43  There are a lot of old laws in many states that seem inefficient  Massachusetts: can’t buy alcohol on Sundays  Many states still have laws passed a long time ago  In some cases, law is enforced  Tim Wu, “American Lawbreaking” – many laws that we, as a society, have basically decided not to enforce at all However…

45. 44  Begins with New York prosecutors sitting around office, choosing celebrities (John Lennon, Mother Theresa) and coming up with obscure crimes they could be charged with  “obstructing the mails,” “false pretenses on the high seas”  “Full enforcement of every last law on the books would put all of us in prison for crimes such as “injuring a mail bag.” No enforcement of our laws, on the other hand, would mean anarchy. Somehow, officials must choose what laws really matter.”  “Tolerated lawbreaking is almost always a response to a political failure – the inability of our political institutions to adapt to social change or reach a rational compromise that reflects the interests of the nation and all concerned parties. That’s why the American statutes are full of laws that no one wants to see fully enforced – or even enforced at all.” Tim Wu, “American Lawbreaking” (Slate) http://www.slate.com/id/2175730/entry/2175733/ http://www.slate.com/id/2175730/entry/2175733/

46. 45  “Over the last two decades, the pharmaceutical industry has developed a full set of substitutes for just about every illegal narcotic we have.”  Rather than legalizing street drugs…  …society has developed Ritalin, vicodin, oxycontin, clonazepam, etc…  …which may serve legitimate medical purposes in some instances, but also mimic highs of cocaine and other drugs  Marijuana: several cities where police chiefs or DAs have announced they won’t prosecute possession  Philadelphia law will treat possession as a ticketable offense  Medical marijuana in California and elsewhere First example doesn’t perfectly fit premise, but interesting

47. 46  Apparently, there’s porn online  And it’s basically all illegal  Federal law prohibits using a “computer service” to transport over state lines “any obscene, lewd, lascivious, or filthy book, pamphlet, picture, motion-picture film, paper, letter, writing, print, or other matter or indecent character.” Wu’s second example: pornography

48. 47  In 1968, Congress set up a commission to investigate  Commission recommended we repeal all obscenity laws, replace them with laws to protect children and control public display  Nixon and other politicians condemned report as “morally bankrupt”, insisted they would continue war on pornography  A few well-publicized prosecutions in 70s and 80s, halted in 90s  2005: Attorney General Alberto Gonzalez tried to pressure local prosecutors to crack down, but nothing happened  One Miami attorney: “compared to terrorism, public corruption, and narcotics, [pornography] is no worse than dropping gum on the sidewalk.” Wu’s second example: pornography

49. 48  So pornography is technically illegal, rarely prosecuted  What’s developed is unofficial zoning system – rather than prohibiting behavior, it’s regulated  Prosecuted when it crosses certain lines  Ignored otherwise  Super Bowl wardrobe malfunction – when something gets on prime- time network TV, people freak out  Child pornography still prosecuted  But “mainstream” porn left alone, so functionally legal  So as a society, we’ve functionally legalized porn…  Not through legislation or courts…  …but through general concensus among prosecutors, FCC, FBI, local police, etc., to do nothing about it Wu’s second example: pornography

50. 49  Amish refuse to pay Social Security taxes, do not accept benefits, do not educate children past eighth grade  Mormons to some degree still practice polygamy  Wu discusses history of legal treatment  Again, what’s emerged is de facto zoning  Mormon polygamist went on Sally Jessy and Springer to discuss his lifestyle, he was tried and convicted  But when it’s done quietly, in scattered communities outside of big cities, polygamy still goes on and is basically tolerated  Amish are open about how they live, but keep to themselves, and nobody worries about it Wu’s other examples: copyright law, illegal immigration, Amish and Mormons

51. 50  You’d think crimes are crimes because society wants them to be crimes  But in some cases, society doesn’t care whether something is a crime, but doesn’t care enough to make it legal either  Or, political system is “broken” enough that some things can’t be fixed, we adapt by ignoring certain laws  More obvious example: speeding This all doesn’t really fit into our framework of criminal law

52. 51  Throughout the semester, we’ve been assuming rationality  Of individuals, of businesses, etc.  This has led to a number of conclusions  Today: like with all economics, our conclusions are only as strong as our faith in our assumptions  When we apply these conclusions to the real world, need to be aware of how they depend on assumptions, how robust they are when assumptions are violated So what’s my point for today?