What does Economics have to do with law? Law as incentive –If we have this law –And rational individuals take it into account in deciding how to act –What will the consequences be? Explaining what the law is Recommending what the law should be

What Is Economic Efficiency? We would like some way of evaluating legal rules –Does this change help more than it hurts –In terms of letting people achieve their objective –Does it increase the size of the pie? The problem: –Any change in legal rules (or anything else) –Affects lots of people in different ways –Making some better off and some worse off –Is there any way of summing? Marshall ’ s answer –Determine, for each person –How much he would pay to get the change (+) or prevent (-) –Sum those numbers –If positive, an improvement

Conclusion Considered as a normative criterion, efficiency is a proxy for utility/happiness –Used because it is much easier to implement Both because dollar value is easier to measure than utility And because it is easier to create rules to maximize it As we will see –And the legal rules that maximize it are usually close to those that would maximize happiness. Considered as a predictive criterion, efficiency is probably better than happiness –What affects legislatures is how much money they are offered to vote for a bill –What affects litigation is how much people are willing to spend –Only if judges are deliberately trying to do good might happiness make more sense, assuming they could separately maximize it.

Summary Economics –Approach to understanding behavior –That assumes individuals have objectives and –Tend to take the actions that best achieve them Economic analysis of law –What are the consequences of a legal rules, allowing for how rational individuals respond? –Explaining observed rules. Posner conjecture –Choosing rules. Design for efficiency. Or …? Economic efficiency: Size of the pie –Marshall’s definition: Sum of $ value to all affected Not “how many dollars do they get” but How many dollars would they pay to get or prevent –Problems with that definition Accepts individual evaluations of value Only counts value to people as revealed in actions. Trees, or Mother Earth, don’t count. Treats a dollar as of the same value to everyone –Defense of the definitions My action is the best available measure of value to me Only people are available to control the system Individual variations average out (Marshall) or … Tweaking the legal system a poor way of redistributing

Externalities: First Pass What they are: –Positive or negative cost on someone else which for one reason or another –You don’t have to get his permission to impose. Or... –Can’t make him pay for (benefit, aka “positive externality”) –That something is an externality is partly A statement about physical reality –There is no way to require permission or charge at any reasonable cost –Can’t require permission of everyone on earth before I breath Partly a statement about the legal system. –If we didn’t have private property in land, clearing ground or planting crops would be an externality –Since someone else would harvest them, benefit by my work –Patent law converts invention from externality to property –Radio broadcast is an externality--but »not with enough spies to make you pay for what you listen to »Or an adequate scrambling system--you pay to unscramble Why the result is inefficient –Cost of production doesn’t include external cost, so produce in the wrong way. A stack scrubber might reduce pollution by more than it cost, but the savings goes to someone else Using low sulphur coal reduces pollution--but it costs more –Price of final good doesn’t include the whole cost, so Price you sell it for is a misleading signal of actual cost And people use an inefficiently large amount of what you produce (negative externality) Or inefficiently small (positive externality)

Externalities that don’t Count Suppose my action imposes –A cost on one other person, and –An equal benefit on another –I take the action if my benefit is greater than my cost –Which is the efficient choice, since the other effects cancel –Seems unlikely, but … Pecuniary Externality –I become the 101 st physician; each sees ten patients a day –The price of a visit drops from $50 to $49 –Costing the other physicians $1000/day—externality? –But it saves their patients the same amount –So if I ignore both effects I get the right answer Which is why competition is not a tort

Review what we Just Did Why the market is efficient in the simple case –Price system transmits human costs in dollar form –So the least cost way of producing an automobile is the least human cost way Costs being labor forgone, or … Alternative uses (really the same) –Everything is produced if and only if it is worth producing, and in the least costly way –Everything goes to the person who values it most Externalities mess it up twice: –External cost is not included, so the result is only “ least private cost ” production –And price of output no longer accurately measures the cost of producing it, only the private cost Can solve the first with regulation –Provided the regulator is sufficiently benevolent –And sufficiently well informed –But that still leaves the second problem Pigouvian tax solves both –But still leaves the cost to be determined by a regulatory agency or –Court –One way of viewing tort law is as a Pigouvian tax Tortfeasor must makes his victim whole I.e. pay damages equal to the externality he imposes--the Pigouvian rule Are there problems with this as a description of tort law? Pecuniary externalities don ’ t count, rent seeking does. –Because with rent seeking the transfer provides an incentive –To take actions not worth taking--a standard externality problem –Litigation seen as rent seeking is an argument for leaving costs where they fall.

Coase’s critique of Pigou Nothing works –Because an externality isn’t “A imposes cost on B” –But “A and B take actions which result in a cost” –Consider airport noise. It might be reduced –With quieter planes--or people not living next to the airport Everything works –Because if externalities produce an inefficient result –It’s in the interest of the parties to bargain it away It’s all transaction costs –Too costly to get everyone living under the flight path to pay the airlines to make their planes quieter –So doesn’t happen even if efficient –So the real problem is the transaction costs that block the efficient outcome

Conclusion The Pigouvian solution is a special case –Where we know the least cost avoider –And can measure damage externally The Coase Theorem is a special case –Where transaction costs are sufficiently low –In which case we don ’ t have to measure damage externally –Just define property rights and then leave it to the market. Coaseian analysis gives us the general case –With some definition of rights –And some transaction costs making some moves costly or blocking them –What inefficiency will result? –Among possible definitions, which leads to the least bad result? –Note that options include property and liability rules. And others.

Designing a Legal System: The General Procedure If we start with this rule, how do we Get to whichever result is efficient And what makes it costly or prevents it

Spaghetti Diagram Complete

Summary Problem: Externalities –If you don’t pay all the cost or receive all the benefit –Of your acts, you will sometimes Do things that reduce efficiency, or Fail to do things that increase it Solution: Pigou. Critique: Coase –Costs and benefits depend on decisions by two or more people So problem is not “I impose costs on you” but We act in ways that don’t maximize our combined benefit – Pigou’s solution requires you to know Who should alter what he is doing And that only one person should –Alternative (Coasian) approach Define who has a right to do what Then let the parties bargain from there If transaction costs are low enough, they will always get to an efficient result Wherever they start Implications for the law –Try to find initial definitions of rights that, averaged over many cases –Minimize the costs of getting to the efficient outcome –Plus the costs of failing to do so –Worked out in agonizing detail for our simple example

Insurance Idea of risk aversion in money. –Not dislike of risk, but –Declining marginal utility of income. –Provides one reason to have insurance. Moral hazard is a reason not to have it –Since insurance creates an externality –Which leads to inefficient choices –Which you eventually pay for But also a reason to have it, since –Sometimes insurer can control risk better –Put the incentive where it does the most good. Insurance company vs big firm with lots of factories. Sears vs the individual owner of an appliance Or to control adverse selection. Auto repairs. Adverse selection –Assymetric information means that –Some worthwhile transactions don ’ t happen Can ’ t sell a cream puff Unless you are willing to accept a mostly lemon price

Ex Post, Ex Ante The idea — control input vs control output The advantage to controlling output –It's easier to measure actual damage than expected damage –Controlling output gives the actor an incentive to monitor himself –To use his private information about what he does, should do, but … –That might be a liability if his private information is wrong. The advantage to input –Can use smaller punishments, which may be more efficient Note that efficiency concerns punishment cost Relative to the amount of punishment –Can impose the court ’ s view of the causal relationships — which could be good or bad. In practice, often do both — speed limit and tort liability. Also, since the output of one act is the input of another, same law might be both –Speed limit is ex ante in our sense, but … –Ex post if you think of controlling speed by brake, accelerator, ….

Game Theory There is a large body of mathematical theory that attempts to –Create ways of precisely describing games –Create a clear definition of the solution to a game –Show how to find it. What would the solution to a game mean? –A description of how every player –Should? Will? Play –Typically assuming he plays perfectly –Thus chess is a simple and solved game –Given enough computing power How can one describe a game? –In a sufficiently general way to work –For all games

Strategy Matrix Each player chooses a strategy, a complete description of how he will play Player 1 picks a column Player 2 picks a row The intersection shows the payoffs to the two players What is their sum?

Subgame perfect equilibrium For sequential games –View game as a tree diagram –Look at the last decision See what the person making it would do Cut off the other branch Move down the tree accordingly Consider the “put to bed” game –If the child will make good his threat to throw a tantrum and spoil the parents’ dinner party –The parent should give in, let the child stay up, but … –If the parent doesn’t give in –It isn’t in the child’s interest to throw a tantrum –So parent knows child won’t throw a tantrum, can put child to bed? Not so clear when it is a repeated game –And it is –Commitment strategies--for both players

More Games we will Discuss Bilateral Monopoly –I have the only apple, only you want it –Selling it to you produces a one dollar gain –If we can agree on a price Prisoner’s Dilemma –My confessing helps me a little, hurts you a lot –Your confessing ditto for me, so.. –We both confess –And are both worse off than if we both stayed silent

Bilateral Monopoly A very simple two player non-fixed sum game –Hence threats, bargains, bluffs possible “I won’t give you more than $.25” “I won’t take less than $.75” –May lead to bargaining breakdown –i.e. child does throw a tantrum. Or apple isn’t sold Commitment strategy is one way to “win” Doomsday Machine as one example Hawk/Dove (or Bully/Wimp) a human version –The more bullies, the less profitable the strategy –In equilibrium, there are just enough bullies to make “Bully” and “Wimp” equally attractive strategies –The higher the cost of a bully/bully fight, the fewer bullies it takes to get to equilibrium, hence … –“Crimes of passion” may be deterrable!

Implications of Game Theory Not rigorous — real world doesn ’ t come with rules, but … Suggests the importance of –avoiding games with PD structure, or … –Getting other people into them –For example, getting an army to run away By arranging things so that each soldier Is better off running than standing. Suggests the importance of commitment strategies Suggests bargaining costs associated with surplus to be divided up. –So avoid legal rules with very large bargaining range –Such as an injunction where damage is much less than cost of prevention. –Compare to litigation cost over the amount of the damage. So gives us a partial handle on transaction costs.

Value of Life Matters –Tort law—damages for tortious loss of life How are they calculated in the law? How should they be? –Criminal law damage done is relevant to punishment, standard of proof, etc. And some crimes kill people –Regulation In deciding how safe highways or cars should be How much we should be willing to give up to reduce pollution When new drugs should be allowed on the market One of the relevant costs is measured in lives And must be converted to something else to compare costs to benefits –Your private decisions How fast to drive What car to own How often see the doctor Whether to give up sky diving

Is life infinitely valuable? Judged by private decisions, clearly not –We routinely do things that risk death--a little –In exchange for other values But if someone wants to buy your heart? Turning down his offer shows –Not that your life is infinitely valuable to you –But that money is useless to a corpse –And people do sometimes accept a near certainty of death, for a benefit to other people they value An extreme example of our problem of measuring by dollars –Dollars are worth less to rich than poor –And much less to dead than alive –Making “ how many dollars would you give for it ” A poor measure of utility In extreme cases Get around the problem by thinking in terms of risks –Which is the right answer since –Money saved will go to you when alive, at your utility for income then –Or to other people, who are alive to spend it, if you die

Value of life in Tort Law Old rule: value of life was zero –Because the tort claim for damages was yours –And died with you Newer rule: Value of your life to other people –Loss of your value as a wage earner for your family –Loss of consortium –So if you have no family or close friends –Your life is worthless? Hedonic damages: Still pretty academic –You have lost the value of the pleasure of the rest of your life –That is a cost someone else imposed on you –And along Pigouvian lines, even if you can no longer be compensated –He can still be charged, to give him the right incentive

Summary If we want people to have the correct incentive in imposing risks on others The same as in imposing risks on themselves Make them liable for the ex post damages –Where value of life is calculated as –A thousand times what you would accept –For a one in a thousand chance of death And make damage claims marketable. That provides full ex ante compensation –My act has a one in a thousand chance of killing you –And you can sell your future claim for 1/1000 –Times the value of your life to you Proper disincentive –I will only impose the risk if doing so saves me –More than it costs you And lets people adjust what they actually receive if killed, crippled, etc. –On the insurance market –In either direction