Review What is economics? What does it have to do with law? Economic efficiency The simple solution and its problems Externalities: Pigou and Coase Designing legal rules: Spaghetti Economics of risk Ext Post/Ex Ante Game Theory Value of Life

General Perspective Rationality Rules make sense … Maybe And maybe my kind of sense, or not …

In a complicated world Actions are interdependent, We all need inputs from many other people to achieve our goals. Solutions –Decentralized violence –Centralized control — doesn ’ t scale –Decentralized control with suitable legal rules Could arise, as norms do, with decentralized legal system, but … We are mostly looking at a unified system of legal rules to coordinate decentralized actors. Why each person doing whatever he wants doesn ’ t work? –Because individuals are not rational? Rejected by economic approach –Because individual rationality doesn ’ t automatically lead to group rationality. –So we want legal rules under which it does.

Which leads both to Understanding existing legal rules, on the conjecture that they are supposed to do this, and … Deciding what legal rules to create … If “ group rationality ” aka economic efficiency is what we want. –Where economic efficiency –Is an imperfect but useful measure of the degree to which everyone achieves his objectives. –Defined by summing the value of each outcome to everyone, defined by willingness to pay

Starting point Private Property and trade Should move all goods to their highest valued uses, but …. Problems arise with –Costs of enforcing property rights –Transactions costs of trade –Ambiguities in defining rights, and …

Externalities The problem –If I do not bear all costs of my actions –And do not have to have permission of the others who do to take them –I may take actions that on net are not worth taking. –The inefficiency is the net cost of such actions Benefit to me minus cost to you Which can be a loss since I ignore the cost in making my decision Administrative solution –Usual problems of centralized control (within decentralized system) –Controller needs information it cannot get, and … –Incentives it does not have. Pigouvian Solution –One step more decentralized — actor does the calculation –Solves part of the information and incentive problem –But leaves part of each

Coasian Critique Costs are jointly caused, so.. –Pigouvian solution is unnecessary if the person who bears the cost is the one who can solve the problem at lowest cost –Indeed, may make the situation worse –Cannot use the Pigouvian solution unless you already know the lowest cost avoider –And there may not be one. Inefficiency would be bargained away in the absence of transaction cost, so … In deciding how to define the initial rights, you need to think both about who is likely to be the high cost avoider (give him the right, so the other party has to adjust) and … How easily your initial definition of rights can be changed by the parties if necessary.

Solutions to Externality Problems Administrative — impose the right answer (no murder) Pigouvian — impose the cost on one actor –Effluent fees –Speeding tickets Coaseian — define rights, bargain to the efficient outcome Coaseian2 — In defining rights, take account of transaction costs and lowest cost avoider

Coasian2: Application Spaghetti diagram approach –Consider each possible initial definition of rights –The transaction costs blocking the move to each final outcome –The probability of each final outcome being the efficient one –Pick the initial that minimizes the sum of … Cost of getting to the efficient outcome, plus Cost of not getting to the efficient outcome. –In principle, a machinery for figuring out how rights should be defined, if only we knew enough.

Property rights vs Liability rights –Liability rights have problems of detecting act, measuring damage, litigating –Property rights problems of private transactions –This oversimplifies because even property rights must be enforced. Takings clause –I build a house where the highway will go through in five years –Takings without compensation give government the wrong incentive, but … –With compensation gives me the wrong incentive –Typically, my incentive is unimportant, because I face a small risk of expropriation, but … –Government, when it makes the decision, chooses where to put the road. This looks a lot like the coming to the nuisance defense –When I build my pig farm, I am very unsure what the best value of surrounding land will be in ten years. So being subject to “ expropriation ” doesn ’ t much improvement my incentives, doesn ’ t much change my actions. –When you build your housing development, where you put it will depend largely on the legal rule. But … fact dependent.

Economics of Risk Risk aversion Moral hazard –Externality problem all over again –Put the incentive where it does the most good. Adverse selection –Comes from assymetric information –Inefficient because some cars don ’ t get sold that are worth selling, some people don ’ t get insured who are worth insuring. –Solve either by eliminating assymetric information (genetic testing example) or … –By arranging liability so that the well informed party bears the relevant risk With three different criteria –Minimize cost of risk aversion –Optimize incentive to prevent risk –Minimize costs of adverse selection –Each of which tells you how to assign risk. No guarantee all go the same way, so have to balance. In designing a contract, or a rule of liability law.

Ex Post/Ex Ante General distinction: –charge for inputs to bad outcome –or for outcome if it happens Ex Post utilizes actor ’ s private information (like effluent fee) –Good since the actor knows more about what he is doing than anyone else, but … –The actor might be mistaken about the causal links between what he does and what happens But may require small chance of large cost — inefficient punishment Punishment for attempts a special case

Game Theory Idea: General solution –To all games, including –Chess, poker, economics, diplomacy, war, courtship … Several informative but inadequate theoretical approaches Two interesting games –Bilateral monopoly Bargaining range commitment strategies Try to avoid bilateral monopoly with large ranges, because likely to be expensive. Hence liability rather than property rule in some nuisance situations. –Prisoner ’ s dilemma Simplest case of individual rationality not leading to group rationality. Still holds with fixed number of repetitions. So people avoid that game where possible Or get their opponents into it

Value of life Matters –For tort law –Building highways –Punishing murderers, … Revealed preference gives two drastically different answers, one arguably infinite Because the alternative experiments have drastically different values for the dollars value is measured in Use the one where marginal utility of income corresponds to its usual value –Meaning a situation where the actor –Probably survives to spend the money –Hence choices involving only a low probability of dying Inconsistency between insurance function and deterrence function of tort –So use tort for deterrence and … –Insurance for insurance –Better insurance, but … –Have to be able to sell insurance on yourself as well as to buy it.

Questions?