1. Econ 522 Economics of Law
Dan Quint
Spring 2011
Lecture 3

2. HW1 is online (due 5 p.m. Fri Feb 4) Also lecture notes – try View  Notes Page

3. Monday, we defined efficiency
Efficiency: “no available Kaldor-Hicks improvements”
roughly, maximizing total value, or total surplus, or total payoffs, to everyone in society…
…where everything is translated into dollars, so we can add/compare across people
Means that…
each scarce resource is owned by whoever values it most
goods are produced whenever their value is greater than their cost
and so on

4. And we discussed some forces that lead to inefficiency
Externalities
People make choices based on private cost and private benefit
Efficiency is based on social cost and social benefit
When social cost > private cost, negative externality  people will do something more than efficient amount
When social benefit > private benefit, positive externality  people will do something less than efficient amount
Barriers to trade, taxes
Monopoly/private information

5. And we asked: Should efficiency be the normative goal of the law?
Posner: yes – ex-ante, we would all have agreed to efficient laws
Analogy to lottery ticket with highest expected value
Example for asymmetric situations (landlords and tenants)
Limitations of efficiency as measure of societal “goodness”
Ignores distribution of wealth ($1 = $1)
Ignores procedural fairness (only considers outcomes)
Value = willingness to pay
Then we ran out of time

6. Cooter and Ulen give a more pragmatic defense of efficiency as a goal for the law
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
Cooter and Ulen (textbook ch. 1)
Efficiency should not necessarily be the goal of society
Redistribution/supporting the poor may be an important social goal
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 the tax system
Cooter and Ulen offer four reasons why the tax system is a better way to redistribute wealth than the legal system

7. Four reasons the tax system is a better way to redistribute wealth than the legal system
1. Taxes can target “rich” and “poor” more precisely than the legal system can
Distributional effects of legal changes are harder to predict
Lawyers are more expensive than accountants
More narrowly-targeted taxes cause greater distortion than broad-based taxes
1.Taxes can target “rich” and “poor” more precisely than legal system can
If we tried to redistribute wealth through the legal system, we’d have to target broad classes of people
For example, we could pass laws that favor consumers over corporations, or patients over plastic surgeons
But some consumers are rich, and some shareholders in corporations aren’t that rich
Taxes are based on income or assets – tied directly to wealth
2.Distributional effects of legal changes are harder to predict
Example we saw before: suppose we try to redistribute wealth by passing laws which are more favorable to tenants
But rental prices might go up to compensate, leaving tenants worse off than before
3.Lawyers are more expensive than accountants
4.More narrowly-targeted taxes cause greater distortion
Laws designed to redistribute wealth would be more narrowly targeted: liability laws that are unfavorable to drivers with expensive cars, or to plastic surgeons
These would function like narrowly-targeted taxes – a tax on Lamborghinis, or a tax on being a plastic surgeon
Income taxes tax wealth directly (very broad)
The ponit: narrow taxes cause greater distortion  greater deadweight loss
If you tax bagels, people start eating donuts instead
So if you want to raise money taxing bagels, you have to tax them even more
But then even more people get pushed into eating donuts instead – even people who really prefer bagels
This distortion leads to a greater loss of utility than if you taxed everything, and people just consumed a tiny bit less of everything
Next, we’ll see an example of how this works

8. To make this last point, an example
Two goods: beer (x), pizza (y)
One consumer, with $60 and utility u(x,y) = x0.5 y0.5
a. Given prices p for beer and q for pizza, calculate demand.
(x,y) = (30/p, 30/q)
Beer and pizza are produced at $1 per unit, and perfectly competitive markets
So without any taxes, p = q = $1
b. Calculate demand, and utility, with no tax.
(x,y) = (30, 30) u(x,y) = = 30
c. Calculate demand and utility with $0.50 tax on beer.
(x,y) = (20, 30) u(x,y) = = » 24.49
d. How much revenue does $0.50 tax on beer raise?
20 X $0.50 = $10
e. Calculate demand and utility with $0.20 tax on both goods.
(x,y) = (25, 25) u(x,y) = = 25
f. How much revenue does $0.20 tax on both goods raise?
25 X $ X $0.20 = $10
g. Which is the better way to raise revenue? 7 7

9. So, summing up… is efficiency a good goal for the law?
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”

10. Before we move on, a quick digression…
I don’t have many “absolute beliefs” about economics
Some people do
I hope that doesn’t make things too confusing
If you read Posner, he believes very strongly that efficiency is the right way to design the law, and that the common law will naturally evolve in the direction of efficiency
Posner offers some rational arguments for these positions, but at times, he also seems to take them almost as an act of faith
That’s pretty reasonable – Posner has been a law professor for 40 years, and a judge for almost 30; he knows a lot more than me about a lot of things
But to me, there are very few certainties about economics
If you give me something – the notion that efficiency is the “right” measure to try to get the law to conform to – I can always think of arguments in favor and arguments against
And I have a tendency to make this class more confusing than it has to be, by giving you both
This class would be a lot simpler if I just said, “Efficiency means X. In this class, we want the law to be efficient. Here’s why. Let’s move on.”
But that’s not how I see the world.
I hope that it isn’t too confusing when I do things like this: give both the principle (what efficiency is, and how we’ll use it in this class) but also the reasons for skepticism

11. Before we move on, a quick digression…
I don’t have many “absolute beliefs” about economics
Some people do
I hope that doesn’t make things too confusing
Relatedly, if I don’t see economics as a set of rules to memorize, how do I know what I know?
I need to see a model, or an example, that demonstrates it
This brings me to my other point: Since I don’t see economics as a bunch of certainties, how do I know the things I know?
Well, the way I believe something is true in economics is to see how it works
That is, to see a model, or an example, that demonstrates it
Tuesday, I made the claim that narrower taxes cause greater distortion, and therefore greater inefficiency (or deadweight loss)
But I know this not because someone told me; I know it because I can give a simple model that shows it
And so that was the purpose of the example I showed – to try to SHOW you that narrower taxes cause greater distortion, rather than just asking you to believe me
I’ll often try to do this – introduce an example to prove a point
I sometimes go through these examples a bit fast – please feel free to ask me to slow down, or ask questions if you miss a step
(Also, as some of you have probably discovered, I post my lecture notes online after each lecture, so hopefully this helps if you missed a step) 10 10

12. Rest of today:
introduce some basic game theory
begin property law

13. Some basic game theory

14. A brief introduction to game theory
Today, we focus on static games
Also known as simultaneous-move games
A static game is completely described by three things:
Who the players are
What actions are available to each player
What payoff each player will get, as a function of
his own action, and
the actions of the other players
Any complete description of these three things fully characterizes a static game
We’ve already used a little bit of game theory in this class – in the fishing example we did on Monday
Think about the logic of the fisherman we discussed
“I don’t have any control over how much the rest of the village fishes; all I control is how much I fish.”
“And what I’m going to do is decide how much I should fish, given what everyone else is doing, to maximize my own payoffs.”
That’s exactly the logic of game theory.

15. A classic example: the Prisoner’s Dilemma
(Story)
Players: player 1 and player 2
Two actions available to each player: rat on the other, or keep mum
Payoffs:
u1(mum, mum) = -1
u1(rat, mum) = 0
u1(mum, rat) = -10
u1(rat,rat) = -5
Same for player 2
(Story)
Players: player 1 and player 2
Two actions available to each player: rat on the other, or keep mum
Payoffs:
If both keep quiet, both convicted of a lesser crime, both get payoffs of -1 (1 year in jail)
If one rats, he goes free, his friend gets payoff of -10 (10 years in jail)
If both rat, both are convicted, each gets -5
So u1(mum, mum) = -1, u1(rat, mum) = 0, u1(mum, rat) = -10, u1(rat,rat) = -5
And player 2’s are similar

16. In two-player games with finite actions, one way to present game is payoff matrix
Always Player 1
Player 2’s Action
Mum
Rat
-1, -1
-10, 0
Mum
Player 1’s Action
0, -10
-5, -5
Rat
Player 1’s Payoff
Player 2’s Payoff

17. Nash Equilibrium We solve a game by looking for a Nash equilibrium
Nash equilibrium is a strategy profile (an action for each player) such that:
No player can improve his payoff by switching to a different action…
…given what his opponent/opponents are doing
In most games, players won’t have a single move that’s always best
Best move will sometimes depend on what other player (or players) is doing
We solve a game by looking for a Nash equilibrium
Nash equilibrium is a strategy profile (an action for each player) such that no one player can do better by switching to a different action (given what everyone else is doing)
So playing Mum is never part of an equilibrium
Whatever your opponent is doing, you could improve by switching to Rat

18. A strategy profile is a Nash Equilibrium if no player can gain by deviating
If any player can improve his payoff by changing his action, given his opponents’ actions, then it is not a Nash equilibrium
Is (Mum, Mum) an equilibrium?
No, if player 2 is playing Mum player 1 gains by deviating
Player 2’s Action
Mum
Rat
-1, -1
-10, 0
Mum
Player 1’s Action
0, -10
-5, -5
Rat

19. In two-player games, we find Nash equilibria by highlighting best responses
My best response to a particular play by the other player is whichever action(s) give me the highest payoff
To find Nash Equilibria…
Circle payoff from player 1’s best response to each action by his opponent
Circle payoff from player 2’s best response to each action
Any box with both payoffs circled is an equilibrium
Because each player is playing a best-response to his opponent’s action…
…so neither one can improve by changing his strategy
Player 2’s Action
Mum
Rat
-1, -1
-10, 0
Mum
Player 1’s Action
0, -10
-5, -5
In the Prisoner’s Dilemma game, (Rat, Rat), or “Both players play Rat”, is the only Nash equilibrium
Hence the name – only equilibrium is for both to Rat, but both would do better if both kept Mum
Rat

20. Some games will have more than one equilibrium
Another classic: Battle of the Sexes
(Story)
Circle player 1’s best responses
Circle player 2’s best responses
We find two equilibria: (ballgame, ballgame) and (opera, opera)
Game theory usually doesn’t have that much to say about which equilibrium will get played when there are more than one
Player 2’s Action
Baseball Game
Opera
6, 3
0, 0
Baseball Game
Player 1’s Action
0, 0
3, 6
Opera

21. Sometimes, there will be a “good” and a “bad” equilibrium
Growth model
(Story)
Circle player 1’s best responses
Circle player 2’s best responses
Two equilibria: (invest, invest) and (consume, consume)
Some papers explain differences in growth across countries by saying some are in “good” equilibrium and some are in “bad” one
Player 2’s Action
Invest
Consume
2, 2
0, 1
Invest
Player 1’s Action
1, 0
1, 1
Consume

22. Some games don’t have any equilibrium where players only play one action
Scissors, Paper, Rock for $1
Look for Nash Equilibria by circling best responses
No square with both payoffs circled
No equilibrium where each player plays a single action
In this class, we’ll focus on games with a pure-strategy Nash equilibrium
Player 2’s Action
Scissors
Paper
Rock
0, 0
1, -1
-1, 1
Scissors
-1, 1
0, 0
1, -1
Player 1’s Action
Paper
1, -1
-1, 1
0, 0
Rock

23. That’s a very quick introduction to static games
Now on to…

24. Property Law

25. Why do we need property law at all?
In a sense, same question as,
why do we prefer organized society of any sort to anarchy?
Suppose there are two neighboring farmers
Each can either farm his own land, or steal crops from his neighbor
Stealing is less efficient than planting my own crops
Have to carry the crops from your land to mine
Might drop some along the way
Have to steal at night  move slower
If I steal your crops, I avoid the effort of planting and watering
We’ve already seen one reason why we might want private property: the Tragedy of the Commons example from Monday

26. Why do we need property law?
Suppose that planting and watering costs 5, the crops either farmer could grow are worth 15, and stealing costs 3
With no legal system, the game has the following payoffs:
We look for equilibrium
Like Prisoner’s Dilemma
both farmers stealing is the only equilibrium
but that outcome is Pareto-dominated by both farmers farming
Player 2
Farm
Steal
10, 10
-5, 12
Farm
Player 1
12, -5
0, 0
Steal

27. So how do we fix the problem?
Suppose there were lots of farmers facing this same problem
They come up with an idea:
Institute some property rights
And some type of government that would punish people who steal
Setting up the system would cost something
Suppose it imposes a cost c on everyone who plays by the rules

28. So how do we fix the problem?
ORIGINAL GAME
MODIFIED GAME
Player 2
Player 2
Farm
Steal
Farm
Steal
10, 10
-5, 12
10 – c, 10 – c
-5 – c, 12 – P
Farm
Farm
Player 1
Player 1
12, -5
0, 0
12 – P, -5 – c
-P, -P
Steal
Steal
If P is big, and c is not too big, then 12 – P < 10 – c
In that case, (Farm, Farm) is an equilibrium
Payoffs are (10 – c, 10 – c), instead of (0, 0) from before

29. So the idea here… Anarchy is inefficient
I spend time and effort stealing from you
You spend time and effort defending your property from thieves
Instead of doing productive work
Establishing property rights, and a legal process for when they’re violated, is one way around the problem
Keep in mind, though, that there is still inefficiency here – the cost c of administering the system
That is, payoffs of (10-c, 10-c) are better than payoffs of (0,0), but not as good as (10,10)

30. Overview of Property Law
Cooter and Ulen: property is
“A bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others”
Property rights are not absolute
Appendix to ch. 4 discusses different conceptions of property rights
Any system has to answer four fundamental questions:
What things can be privately owned?
What can (and can’t) an owner do with his property?
How are property rights established?
What remedies are given when property rights are violated?
Cooter and Ulen define property as “a bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others.”
Of course, property rights aren’t absolute. In the appendix to chapter 4, they give examples of different conceptions of property rights. Without getting into the philosophy behind a property rights system, it’s clear that a conception of property rights has to answer four fundamental questions:
What things can be privately owned?
Clearly not everything can be owned – nobody owns the ocean, can’t own another person, etc.
Ancient Jewish law – ownership over sold land was not permanent, it reverted to its ancestral owner after 50 years
Cultural artifacts; Intangible property – copyrights, patents, trademarks
What can (and can’t) an owner do with his property?
Again, not everything - property rights can’t be absolute, because my exercising my rights might interfere with you exercising your rights – I want to sleep, you want to have a party next door
Typically, you can’t use your own property in a way that creates a nuisance to others
Many of the examples when we discuss Coase will have to do with limiting what a person can do with his property.
I own my kidneys, but I can’t sell one
If I own a building that has historical significance, I can’t necessarily destroy it or change it in certain ways.
How are property rights established?
In the whaling example, what does it take to establish ownership?
In many cases when government wanted to encourage migration into new areas, free land, conditional on you farming it or developing it.
And on the flip side, when can property rights be revoked?
Eminent domain – the government’s right to seize private property
Negligent landlords.
What remedies are given when property rights are violated?
Rights – my right to use my property in certain ways – and prohibitions – other people can’t interfere – have no meaning unless they are enforced
So how do I get compensated if my property rights are violated?

31. Answers to many of these seem obvious
BUT…
What’s my point?
Not that it matters much who ended up with ownership of a guy’s severed leg. (Matters a lot to Wood, a little to Whisnant, they had their 15 minutes.)
My point is that even if most things in property law seem obvious – this is my iPhone, you can’t steal it, I can use it however I want – the law has to deal with the unexpected, off-the-wall cases as well as the anticipated, obvious ones
So we’d better try to come up with some principles we want our property law system to satisfy, so we know how to deal with the unexpected
(In 2007, Whisnant and Wood went on Judge Mathis, who gave the leg back to its original owner.)
source:

32. Monday: Coase Please see me if you’re not yet registered
Take a look at Coase, “The Problem of Social Cost”
Have a good weekend