1. Econ 522 Economics of Law Dan Quint Spring 2014 Lecture 2

2. 1  TA sections and office hours begin this week  “Fake homework” for Wednesday on website  First real homework also up, due next Thursday (Feb 6)  If you want to read ahead:  Richard Posner, “The Ethical and Political Basis of Efficiency Norm in Common Law Adjudication”  For a counterpoint to Posner: Peter Hammond, “Review: The Economics of Justice and the Criterion of Wealth Maximization”  Both have links on syllabus, and both are on Learn@UW Logistics

3. 2  defined law and economics  saw some brief history of the common law  and the civil law  and discussed ownership of dead whales Last week, we…

4. 3  quick review of rational choice  what is efficiency?  is efficiency a good goal for the law? Today: efficiency

5. 4 Rationality, optimization, revealed preference

6. 5  People have preferences…  They understand their options, and how much they like each one  …and they optimize  They choose the option they like the best  This is what economists mean when we talk about rationality or rational behavior  Behavior that is consistent with someone having well-defined, consistent preferences  And this is what we’ll be assuming throughout the semester Most microeconomics is based on the premise of rational choice

7. 6  If I see you choosing something…  …I infer you like it more than your other alternatives  We assume people succeeded in doing what they like, rather than screwing up and doing the wrong thing  And this allows us to learn peoples’ preferences from their choices (to some degree) This leads to the idea of revealed preference

8. 7  If we assume that people have coherent preferences…  …and that we might be able to learn those preferences…  …then we can try to use those preferences to judge when one societal outcome is “better” than another All this is useful if we want to judge what are “good” outcomes

9. 8  a Pareto improvement is any change to the economy which leaves…  everyone at least as well off, and  someone strictly better off  example  you prefer $3,500 to your car  I prefer your car to $3,500  I buy it for $3,500 – Pareto improvement  an outcome is Pareto superior to another, or Pareto dominates it, if the second is a Pareto improvement over the first One way to do this: Pareto criterion Vilfredo Pareto (1848-1923)

10. 9  Pareto improvements are “win-win”  but most new laws create some winners and some losers  so the Pareto criterion usually can’t tell us whether one policy is “better” than another  even the car example might not be a true Pareto-improvement  so we need another way to compare outcomes Pareto superiority is not that useful a measure for evaluating a legal system

11. 10 Kaldor-Hicks and Efficiency

12. 11  Given any two options, I can figure out which one I like more (or else I truly don’t care)  Given two options – say, $4,000, or a 2002 Grand Am…  Maybe I prefer the money  Maybe I prefer the car  Maybe I’m truly indifferent between the two  But one of these must be the case We generally assume preferences are complete

13. 12  If you don’t like it, you can always burn it…  …but we generally assume everyone prefers more money to less money “Everybody needs money. That’s why they call it money.” -Danny DeVito, in Heist We also assume more money is better…

14. 13  If I prefer your car to $3,000…  …but I prefer $5,000 to your car…  …then there must be some amount in between that makes me indifferent  We can say that’s my value for the car  If I’m exactly indifferent between $4,000 and your car…  …we can say I value your car at $4,000 And finally, we assume preferences are continuous

15. 14  Informally: a K-H improvement is any change to the economy which increases the total value achieved by everyone in society…  …where the “value” some gets from something is measured by their willingness to pay for it  Going back to the car example  suppose your car is worth $3,000 to you and $4,000 to me  government seizes your car and gives it to me  I’m better off, you’re worse off  But since I value the car more than you…  …this is a Kaldor-Hicks improvement Next, we define Kaldor-Hicks improvement

16. 15  Unlike a Pareto improvement, a Kaldor-Hicks improvement can create some winners and some losers…  …as long as the winners gain more than the losers lose  If I get your car for free…  I end up better off by $4,000 (my value for the car)  You end up $3,000 worse off (your value for the car)  $4,000 > $3,000, so this is a K-H improvement Another way to think about Kaldor-Hicks improvements

17. 16  a change to the economy is a Kaldor-Hicks improvement if it could be turned into a Pareto improvement with monetary transfers  K-H improvements also called potential Pareto improvements  I get your car for free  If we combined this change with me giving you $3,500…  …then it would be a Pareto improvement  So even without the transfer, it’s a K-H improvement Formal definition of a Kaldor-Hicks improvement

18. 17  You and I are neighbors, you want to throw a party  The party would make me $100 worse off…  …and make you $50 better off…  …and make each of your 30 guests $5 better off  Is the party a Pareto improvement?  No – can’t be, because it makes me worse off  Is the party a Kaldor-Hicks improvement?  Yes – it increases total value: $50 + $150 – $100 = $100 > 0  (Or: you could throw the party, plus you give me $40 and each of your guests gives me $3 – that would be a Pareto improvement, so just having the party is a K-H improvement) Another example

19. 18  we will call a change to the economy efficient if it is a Kaldor-Hicks improvement  we’ll say law A is more efficient than law B if moving from B to A is a Kaldor-Hicks improvement  and we’ll say a situation is efficient if there are no available Kaldor-Hicks improvements  an efficient situation is when there’s no way to make some people better off, without making some others worse off by more  we’re already getting maximal value out of all available resources Efficiency

20. 19 Pareto vs Kaldor-Hicks improvements “good for society as a whole” may make some people worse off, but increases total surplus/value “good for everyone” makes some people strictly better off, doesn’t make anybody worse off Kaldor-Hicks improvementPareto improvement

21. 20 Pareto vs Kaldor-Hicks efficiency no available K-H improvements impossible to help someone without hurting someone else more (impossible to increase total payoffs realized by everyone) no available Pareto improvements impossible to help someone without hurting someone else efficiencyPareto efficiency kind of useless for comparing different policies what we’ll be focusing on this semester

22. 21 Is it efficient for you to have the party?  Makes you $50 better off  Makes 30 guests $5 better off  Makes me $100 worse off  $50 + $150 – $100 = 100 – party “creates $100 of value”  So it’s efficient for you to have the party  True whether you compensate me or not  Even if “my slice of the pie” is smaller, overall pie is bigger…  …which is all that efficiency is concerned with

23. 22 What we’ve really done here  In a sense, what we’ve done here is created a way to add up different peoples’ utility functions…  …by equating utility with willingness to pay  We said the party made me $100 worse off  We equated my disutility from you making noise with the amount of money that would replace the inconvenience – if you threw the party and gave me $100, I’d be just as well off as before  Once we’ve done that, what’s efficient is whatever configuration of the economy “creates the most value”

24. 23 Another example: is it efficient for me to drive to work instead of taking the bus?  Bus to campus from where I live is free  Driving is more convenient, but costs me $1 (gas)  Driving also imposes costs on other people: there’s more traffic, less parking, more pollution  Suppose when I drive to work, it makes 1,000 other people worse off by $0.01 each  By driving to work, I create $11 of total costs  It’s efficient for me to drive to work if the benefit I get is more than $11  If the benefit is less than $11, it’s inefficient for me to drive

25. 24  our definition of efficiency: actions are taken when total benefits outweigh total costs  “goal” is to achieve all Kaldor-Hicks improvements  Ellickson: efficiency is “minimizing the objective sum of (1) transaction costs, and (2) deadweight losses arising from failures to exploit potential gains from trade”  Posner: “wealth maximization”  Polinsky: “Efficiency corresponds to ‘the size of the pie’” Some other, similar measures

26. 25 What forces lead to inefficiency

27. 26 To see whether something’s efficient…  Compare gains to everyone in society (total social benefit)…  …to costs to everyone (total social costs)  Example we already saw (me driving to work):  Total social cost = $1 (gas) + 1,000 X $0.01 = $11  Total social benefit = whatever benefit I gain by driving to work  So we just said: it’s efficient for me to drive to campus whenever the value I get from driving is more than $11

28. 27 How do we expect people to actually behave?  When people decide how to act…  …they consider the cost and benefit to themselves, not to everyone  private benefit and private cost  Driving only costs me $1  so I’ll drive whenever benefit to me is more than $1  On days when value I get from driving is more than $1 but less than $11, I drive to work even though that’s inefficient

29. 28 So externalities cause inefficiency  I’ll do something whenever private benefit > private cost  Efficiency depends on whether social benefit > social cost  If I was the only one affected by my choices, then social benefit = private benefit and social cost = private cost  when I’m deciding which movie to watch on Netflix, nobody else is affected by my choice, so my choice will be efficient  But when my choices affect other peoples’ payoffs…  social benefit  private benefit, or social cost  private cost  so actions I choose to take may not be efficient

30. 29 A classic example of this: the Tragedy of the Commons  Hardin (1968), “The Tragedy of the Commons”  Picture a small fishing village on a lake  The more fish I catch, the fewer fish are left in the lake…  …and the harder it is for everyone else in the village to catch fish  So my fishing imposes a cost (externality) on everyone else  So everyone ends up fishing more than the efficient amount

31. 30 Tragedy of the Commons – example  20 fishermen  Cost of fishing is 8 fish per hour  Notation  h = how many hours I fish  H = combined hours everyone fishes  H = hours everyone but me fishes  Fishermen catch 260 – H fish per hour (a)What is the efficient level of fishing? How much utility does that give to each fisherman? 6.3 hours per day per fisherman; 793.8 fish/day (b)Left to their own devices, how much will each person fish? How much utility will each person get? 12 hours per day per fisherman; 144 fish/day Hours fishing, per day, per fisherman Total fish caught 012639 “Maximum Sustainable Yield” Efficient Level of Fishing “Equilibrium” Level of Fishing H (260 – H)

32. 31 What’s going on here?  Fishing imposes a negative externality on other fishermen  Each one ignores this externality when deciding how much to fish…  …so they all end up fishing more than the efficient amount  Same thing happens with other communal resources  Cattle grazing, whaling, overhunting, oyster beds  Aristotle: “That which is common to the greatest number has the least care bestowed upon it”  Elinor Ostrom, who shared the 2009 Nobel Prize in Economics, studies how different societies solve this problem  Positive externalities work the opposite way  Activities which create positive externalities are naturally done less than the efficient amount

33. 32  Without some sort of regulation/intervention…  Activities which impose a negative externality will tend to happen more than the efficient amount…  …and activities which impose a positive externality will tend to happen less than the efficient amount  One recurring theme we’ll see in this class: if we want the law to lead to efficient outcomes, we can try to design the law to eliminate externalities!  “Internalization” So externalities can lead to inefficiency

34. 33 Other forces which lead to inefficiency

35. 34  Cuban cigars  Suppose I’d pay $15 each for Cohibas  They cost $2 each to make, and another $3 each to transport from Cuba to Madison  Clearly, it’s efficient for me to smoke Cohibas  But trade embargo on Cuba makes it illegal for me to buy them  Anything that prevents me from buying something I want can be a source of inefficiency  One approach to property law: make it as easy as possible for people to trade among themselves  (This may seem like an obvious point; but then, there are lots of things we’re not allowed to sell…) Another thing that leads to inefficiency: barriers to trade

36. 35  I value my free time at $40/hour  Working in a factory, I can build things worth $50/hour  Clearly, it’s efficient for me to work  Each hour I work creates $10 of new value  Doesn’t matter who gets it – it’s efficient for me to work  But if income tax is 25%, then it won’t happen  Factory owner can’t pay me more than $50/hour  But $50/hour pre-tax is only $37.50 after-tax…  …and I’d rather stay home than earn $37.50 an hour  So I don’t get hired, which is inefficient Another thing that leads to inefficiency: taxes

37. 36  This is a new BMW that’s been cut in half  Taxes distort behavior away from efficiency Another example of taxes leading to inefficiency

38. 37 CS Profit  Example  Demand for some good given by P = 100 – Q  Monopolist can produce good for $40/unit  Monopoly price is 70, demand is 30  Deadweight loss is inefficiency  Customers willing to pay more than marginal cost but unable to trade Another thing that leads to inefficiency: monopoly P * = 70 P = 100 – Q Q * = 30 MC = 40 DWL (or private information)

39. 38  For example  we just said taxes lead to inefficiency…  …but without taxes, there’s be far too few public goods, which is also inefficient  we just said monopoly leads to inefficiency…  …but we’ll study patents, which are legal monopolies used to get companies to innovate  But also, we’ve defined “efficient”, but we haven’t claimed that “efficient = good”  Which brings us to… But, saying these things lead to inefficiency doesn’t automatically mean they’re bad

40. 39 Is efficiency a good goal for the law? Jump

41. 40  positive statements are statements of fact  can be descriptive: “in 2007, U.S. GDP was $13.8 trillion”  can be theoretical predictions: “if prices rise, demand will fall”  “economics of what is”  normative statements contain value judgments  for example, “less inequality is better”  or, “government should encourage innovation”  “economics of what ought to be” Important distinction: positive versus normative economics

42. 41  Predicting behavior, and outcomes, that follow from a law or legal system is positive economics  “Law X will lead to more car accidents than law Y”  “Law X will lead to more efficient outcomes than law Y”  But in the background, we’d like some sense of what is the normative goal of the legal system  “Law X is better than law Y”  One candidate for that normative goal is efficiency Most of this class will be positive analysis

43. 42 “The central question [in this book]… is a simple one: what set of rules and institutions maximize the size of the pie? What legal rules are economically efficient? There are at least three reasons why that is the question we ask. The first is that while economic efficiency… is not the only thing that matters to human beings, it is something that matters quite a lot to most human beings. The second reason is that there is evidence that considerable parts of the legal system we live in can be explained as tools to generate efficient outcomes… It is a lot easier to make sense out of a tool if you know what it is designed to do. A final reason is that figuring out what rules lead to… efficient outcomes is one of the things economists know how to do – and when you have a hammer, everything looks like a nail.” - Friedman, Law’s Order, p. 312 Friedman gives a few arguments for studying efficiency

44. 43  This answers the question, “Why is it interesting to study efficiency?”  Not the question, “Should the law be designed with the goal of achieving efficiency?”  To answer this latter question… But… Jump

45. 44  Richard Posner (1980), The Ethical and Political Basis of Efficiency Norm in Common Law Adjudication  Starts with the observation: if you buy a lottery ticket and don’t win anything, you can’t complain  Imagine before we all started driving, everyone in the world got together and negotiated a liability rule for traffic accidents  If one rule is more efficient than another, we’d all vote for that rule ex-ante – ex-ante consent Posner gives us one argument why the law should aim to be efficient

46. 45  Suppose there are two candidate rules for accident liability  One favors pedestrians, one favors drivers  The one favoring car drivers is more efficient  Posner’s point: before we know who we’ll be, everyone would unanimously agree to the second rule Ex-ante consent – simple example -40-60-20Negligence rule -500-100Strict liability rule Expected payoff if you don’t know which one you’ll be Expected payoff, pedestrians Expected payoff, drivers

47. 46  People without cars would prefer a less efficient system if it meant drivers were responsible  Posner deals with heterogeneity with a different example  Landlord-friendly versus tenant-friendly laws  Might think tenants would prefer pro-tenant laws  But rents are determined competitively  If laws become more tenant-friendly, rents might go up to compensate  And if tenant-friendly law is less efficient, it could make both sides worse off! Things are a little more complicated…

48. 47  Suppose tenants get $1000 value from apartment, minus rent  Landlords pay $100 for heat, $600 in other costs  Without this law, tenants would pay for their own heat  They’d heat apartment less, get $980 value and pay $60 for heat  Might think tenants would prefer inefficient tenant-friendly law…  But rents are set competitively, would go up to compensate…  So both landlords and tenants do better under the old law! Example: new law requiring landlords to pay for their tenants’ heat 760 – 600 = 160 980 – 60 – 760 = 160 rent – 600980 – 60 – rent Tenant pays for heat 850 – 600 – 100 = 150 1000 – 850 = 150 rent – 600 – 1001000 – rent Landlord pays for heat LandlordsTenants Landlords’ payoffs Tenants’ payoffs

49. 48  Posner’s basic argument: if we choose the most efficient legal system, everyone is “compensated ex-ante” for the choice, and should willingly accept the outcome they get  Of course, all this consent is hypothetical…  …and it does have certain limitations Ex-ante consent, ex-ante compensation

50. 49  The “lottery ticket” analogy requires risk neutrality  50% chance at $1,000,000 is just as good as 50% chance at $900,000 and 50% chance at $100,000  If $100,000 is “worth more to you” when you’re broke than when you already have $900,000, this argument doesn’t work  Counterpoint to Posner: Hammond (1982)  Efficiency is really a special case of utilitarianism, and subject to the same limitations  “Value” = “willingness to pay”  $1 worth the same to everyone Limitations to Posner’s argument

51. 50  efficiency is not equity  efficiency is not fairness  efficiency is not maximizing happiness “Suppose that pituitary extract is in very short supply… and is therefore very expensive. A poor family has a child who will be a dwarf if he doesn’t get some of the extract, but the family cannot afford the price [or borrow the money]. A rich family has a child who will grow to normal height, but the extract will add a few inches more, and his parents decide to buy it for him. In the sense of value used in this book, the pituitary extract is more valuable to the rich family… because value is measured by willingness to pay, but the extract would confer greater happiness in the hands of the poor family.” - Posner, Economic Analysis of Law This highlights some of the things efficiency is not

52. 51  Cooter and Ulen (textbook ch. 1)  Efficiency should not necessarily be the goal of society  But efficiency should be the goal of the legal system  If redistribution is desirable, it’s better to make the legal system efficient, and address distribution through taxes  Cooter and Ulen offer four reasons why the tax system is a better way to redistribute wealth than the legal system A more pragmatic defense of efficiency as a goal for the law

53. 52 1.Taxes can target “rich” and “poor” more precisely than the legal system can 2.Distributional effects of legal changes are harder to predict 3.Lawyers are more expensive than accountants 4.More narrowly-targeted taxes cause greater distortion than broad-based taxes Four reasons the tax system is a better way to redistribute wealth than the legal system

54. 53  We’ve seen two arguments in favor  Posner: it’s what we all would have agreed on ex-ante  C&U: if you want to redistribute, it’s better to do it through taxes  But there are definitely some problems with efficiency  Distribution matters; not everything is monetizable; people might care about procedural fairness  My take  In this class, we’ll mostly focus on the positive questions  But in the background, I think of efficiency as a “pretty good”, but definitely imperfect, measure of “goodness” So, summing up… is efficiency a good goal for the law?

55. 54  One argument from C&U for why law should focus on efficiency, redistribution should be done through taxes: “narrow taxes cause more distortion than broad taxes”  Wednesday, we’ll work through an example of this  “Optional homework problem”  If you want to read ahead, look at Ronald Coase, “The Problem of Social Cost” (although we probably won’t get to Coase till next week)  See you Wednesday! For Wednesday…

56. 55  If you want to read ahead: Richard Posner, “The Ethical and Political Basis of Efficiency Norm in Common Law Adjudication”  If you want a counterpoint to Posner: Peter Hammond, “Review: The Economics of Justice and the Criterion of Wealth Maximization”  If you want to see a problem we’ll do on Wednesday: I’ll be showing an example of how “narrow taxes distort more than broad-based taxes” The example is online as a “fake homework”  See you Wednesday! For Wednesday