1. Recht und Ökonomie (Law and Economics) LVA-Nr.: 239.203 SS 2011 Prof. Dr. Friedrich Schneider Institut für Volkswirtschaftslehre http://www.econ.jku.at/schneider (3) The Coase Theorem and Behavioral Economics 1 of 39

2. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 2 of 39 1. Assumptions and premises (1)  “People respond to incentives.”  Law is a method of ordering society to further social goals. Law creates incentives for people to behave in certain ways. Law can help people by facilitating their achievement of their legitimate goals.  Economics provides both theoretical and empirical techniques for examining law’s likely and actual effects in the world.

3. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 3 of 39 1. Assumptions and premises (2)  So, to discourage a particular activity, law should increase the “price” for engaging in that activity. E.g., by increasing the sanction for engaging in undesirable behavior. Or by increasing monitoring and enforcement of the undesirable activity. If legal sanctions increase or become more likely, people will “consume” less of the sanction-triggering activity.

4. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 4 of 39 2. Coase Theorem  Ronald A. Coase, “The Problem of Social Cost,” 3 J.L. & Econ. 1 (1960).  If transaction costs are zero, bargaining will lead to an efficient allocation of resources, regardless of the law.  Law is only necessary to induce efficient behavior when transaction costs are positive.  An implication: assign legal entitlements to the party who would have ended up with the entitlement (that is, to the person who values it the most).

5. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 5 of 39 3. The Economics of Contract Law  Law should seek to reduce the costs of concluding and enforcing consensual agreements.  Law does so by providing a set of default and mandatory rules that contracting parties can use as a template for concluding an agreement. Default rules. Mandatory rules.

6. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 6 of 39 3. The Economics of Contract Law  Why do private parties need help in forming, relying upon, and completing consensual agreements? Time-intensive transactions—i.e., those that take time to complete. Coordination, commitment, and cooperation. Risk allocation. Information exchange.

7. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 7 of 39 4. The Economics of Tort Law  Minimize the social costs of accidents. Precaution costs. Accident losses. Administrative costs.  Continue to assume that potential victims and injurers are rational decisionmakers.

8. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 8 of 39 4. The Economics of Tort Law  Tort law holds out the prospect of liability for accident losses so as to create incentives for parties to choose levels of precaution and activities in which to participate in order to minimize their liability, And thereby to minimize the social costs of accidents.

9. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 9 of 39 5. Precaution costs  How does a rational potential injurer decide how much precaution to purchase? Assume provisionally that the injurer will be liable for the victim’s losses if there is an accident.  But recognize that most parties are acting “behind a veil of ignorance”—they do not know if they will be a victim or an injurer. A rational potential injurer takes all cost- justified precaution—i.e., precaution for which the cost of the last unit of precaution taken is just equal to the benefit provided by that precaution.

10. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 10 of 39 5. Precaution costs  The expected benefit of a unit of precaution equals the probability of an accident’s occurring times the anticipated accident losses.  Suppose that one more unit of care will reduce the probability of an accident’s occurring by 0.005 and that if an accident occurs, given that amount of precaution, the losses are likely to be $100,000.  The expected benefit of that unit of precaution is (0.005) x $100,000 = $500.  So, if that unit of precaution costs less than $500, society would like a potential injurer to purchase the precaution because the cost is less than the expected benefit.

11. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 11 of 39 6. Additional topics in the economics of tort liability  Different tort liability standards.  The relationship between administrative agency safety regulation and tort liability. Should regulatory compliance be a defense in a private tort action?  “Who are these rational people you’re talking about?” If injurers and victims are not fully rational, then a situation that might seem to be one of bilateral precaution may be, instead, one of unilateral precaution.

12. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 12 of 39 7. Crime and Punishment  Becker’s rational-choice theory of the decision to commit a crime: Criminal compares the expected costs and expected benefits of a crime. Expected costs (EC) include the probability of detection, arrest, and conviction times the value of the sanction imposed. Expected benefits (EB) include the monetary value of the crime plus any non-monetary satisfaction the criminal receives.

13. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 13 of 39 7. Crime and Punishment  A rational potential criminal commits the crime if EB > EC and refrains if EB < EC.  Society can reduce crime by raising the expected costs of crime. Raise the probability of detection, arrest, and conviction or, Increase the criminal sanction or, Do both.

14. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 14 of 39 8. Recent U.S. Statistics on Crime  Since the mid- and late 1980s a decline in non-violent crime. There is now less auto theft in the U.S. than in much of Western Europe. Property crimes down 30 percent in the 1990s.  Since 1991 a precipitous decline in violent crime, with homicide at the lowest level since the 1930s. Homicide rates down 40 percent in the 1990s.

15. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 15 of 39 9. Why the Decline in Crime?  “Deterrence works.” Increasing incarceration rates. More police and improved policing strategies.  Decline in crack cocaine.  A robust economy.  Increased victim precaution. Alarms and security procedures. Faster and more effective trauma treatment.  The legalization of abortion?

16. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 16 of 39 10. Donohue & Levitt, “The Impact of Legalized Abortion on Crime”  Donohue and Levitt attribute half of the decline in crime since 1991 to the legalization of abortion in 1973. Roe v. Wade led to a significant increase in the number of abortions. (1.6 million per year by 1980; 1 abortion per 2 live births.) Therefore, relatively fewer 18 year-olds in the population beginning in 1991. All the other factors together account for the other half of the decline.

17. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 17 of 39 10. Donohue & Levitt, “The Impact of Legalized Abortion on Crime”  What’s the evidence for legalized abortion’s effect on crime?  (1) Broad consistency with the prevailing pattern—namely, most crime is committed by 18-24 year-old males; because of legalized abortion, there are fewer 18 year-olds exactly 18 years after Roe, and that’s when the downturn in crime began.  (2) Five states legalized abortion in 1970 (before Roe v. Wade), and they experienced a decline in crime before the rest of the country did.

18. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 18 of 39 10. Donohue & Levitt, “The Impact of Legalized Abortion on Crime”  (3) “Higher rates of abortion in a state in the late 1970s and early 1980s are strongly linked to lower crime [in that state] for the period from 1985 to 1997.”  (4) “There is no relationship between abortion rates in the mid-1970s and crime changes between 1972 and 1985.”  (5) Almost all of the decline in crime in the 1990s can be “attributed to reduction in crime among the cohorts born after abortion legislation; there is little change in crime among older cohorts [over the last 30 years].”

19. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 19 of 39 10. Donohue & Levitt, “The Impact of Legalized Abortion on Crime”  The other hypotheses are unlikely to explain the drop in crime in the 1990s.  (6) The greater use of imprisonment, more police, and changes in police strategies have been going on for a long time. It’s unlikely that they could cause a sudden and sharp drop in crime just in the 1990s. And the drop occurred in places, such as Los Angeles, where there was no particular improvement in the police force.  (7) Similarly for the decline in the crack cocaine trade. That was largely a phenomenon of major urban areas. But the crime drop occurred not just in major urban areas but everywhere.

20. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 20 of 39 10. Donohue & Levitt, “The Impact of Legalized Abortion on Crime”  (8) The robust economy has been with us since the early 1980s, not just in the 1990s. And, moreover, there is a relatively weak correlation between macroeconomic activity and crime levels. Indeed, there is some evidence that much crime is anti-cyclical, increasing when the economy is doing well and declining when it is doing poorly.  (9) Donohue and Levitt identify two components that make up the total effect that legalized abortion had on crime: ► The “cohort size” effect When the cohort reaches the late teens—the prime years for committing crimes, there are fewer of them and, therefore, less crime.

21. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 21 of 39 10. Donohue & Levitt, “The Impact of Legalized Abortion on Crime” ► The “cohort quality” effect “Children born after abortion legalization may on average have lower subsequent rates of criminality.”  “Women who have abortions are those most at risk to give birth to children who would engage in criminal activity.” Teenagers, unmarried women, and the economically disadvantaged.  “Women may use abortion to optimize the timing of childbearing.” Through abortion women may delay childbearing till later if their current conditions are suboptimal. Children tend to be born into better environments.

22. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 22 of 39 10. Donohue & Levitt, “The Impact of Legalized Abortion on Crime” (10) Of the half of the drop in crime in the 1990s that Donohue & Levitt attribute to the legalization of abortion, about half of that total effect is attributable to the “cohort size” effect and about half to the “cohort quality” effect.

23. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 23 of 39 11. New developments in law and economics (1)Empirical research. (2)Behavioral law and economics. (3)The impact of law and economics on the legal academy.

24. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 24 of 39 12. Law and empirical economics  Natural experiment: damage done to property by unsupervised cattle in Shasta County, California. In part of the county the owners of cattle were responsible for damage done by their unsupervised cattle. In the other half of the county, owners were not responsible.

25. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 25 of 39 12. Ellickson and Social Norms  Should there be a difference between the two halves of the county in terms of the number of cattle and other indicators of efficiency? Not necessarily, if the Coase Theorem is true.  There was no difference in behavior between the two halves, even though the liability rules were different. Why?

26. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 26 of 39 12. Ellickson and Social Norms  Not because neighbors were bargaining to the most efficient result, regardless of the law.  Rather, because neighbors were not paying attention to the law.  They sought to conform their behavior to the prevailing social norms, not to the law.

27. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 27 of 39 13. Behavioral law and economics  Recall the close connection between rational choice theory and traditional law and economics.  Social and cognitive psychologists have found some systematic deviations from the predictions of RCT.  Taking these deviations into account in analyzing law leads to changes in the economic analysis of that flowed from RCT.

28. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 28 of 39 13. Behavioral law and economics  Consider four examples: Endowment effect / status quo bias. The ultimatum bargaining game experiments. Loss aversion. Difficulties with probabilistic reasoning.

29. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 29 of 39 13.1. Endowment effect / status quo bias  People seem to place a very high value on the things they have and the way things are.  Systematic difference between the willingness-to-pay (WTP) price to acquire something one doesn’t have and the willingness-to-accept (WTA) price to give up that same thing if one already possesses it.

30. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 30 of 39 13.1. Status quo bias  WTA ≈ 2 WTP.  Not experience-related.  Applies to pens, coffee mugs, and other trivially valuable items.  Implication: Far more difficult to change the way things are than one might anticipate. Change may not just be a matter of transaction costs.

31. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 31 of 39 13.1. Status quo bias WTAWTP Person A$8$6 Person B$10$4

32. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 32 of 39 13.2. The ultimatum bargaining game  Two parties are to split $20. This is a pure cooperative surplus. The players are not allowed to talk or meet.  Player 1 makes an offer for division of the $20.  Player 2 can accept the offer, in which case they each get the proposed division, or reject the offer, in which case neither player receives anything.

33. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 33 of 39 13.2. Results of the game  The game has been played in over 100 countries with thousands of players of all ages and socio-economic circumstances.  The modal result is a 50-50 split.

34. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 34 of 39 13.2. Results of the game  An unexpected finding (although not necessarily inconsistent with rational choice theory) is that if Player 1 proposes a split that give him or her more than 70 percent of the surplus, Player 2 almost always rejects the offer. People have a strong sense of what is fair. Interestingly, if Player 1 is selected on some seemingly meritorious criterion, Player 2 will tolerate Player 1’s receiving more of the surplus than if Player 1 is selected randomly.

35. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 35 of 39 13.2. Implications  Perhaps we need not worry overly about how parties divide up cooperative surpluses. They seem to do it equitably.  But we need, perhaps, to pay attention to the fact that overreaching can cause otherwise mutually beneficial transactions to fail. The Normative Hobbes Theorem.

36. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 36 of 39 13.3. Loss aversion  The standard social science theory of decisionmaking under uncertainty is that of subjective expected utility (SEU). Individuals are thought to maximize expected utility rather than expected value. The difference arises from attitudes toward risk: risk-neutrality, risk- preferring, and risk-aversion.

37. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 37 of 39 13.3. Loss aversion  Kahneman and Tversky found that most people are risk-averse with respect to gains but risk-seeking with respect to losses. Option A:$50 with certainty Option B:$100 with probability 0.5 or $0 with probability 0.5  Same expected value.  Most people prefer Option A.

38. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 38 of 39 13.3. Loss aversion  Option C:-$50 with certainty  Option D:-$100 with probability 0.5 or $0 with probability 0.5 Same expected value. Most people prefer Option D.  Implication: In civil actions, defendants may be less likely to settle than plaintiffs. The standard law-and-economics theory of litigation versus settlement is that trial almost always results from mistaken and inconsistent estimates of the likelihood of prevailing at trial.

39. Recht und Ökonomie SS 2011 The Coase Theorem and Behavioral Economics Prof. Dr. Friedrich Schneider 39 of 39 13.4. Difficulties with probabilistic reasoning  Many legal situations imply that decision-makers make probabilistic calculations. Rational criminals are thought to compare expected costs and expected benefits of crime. Tortfeasors and victims are imagined to compare precaution costs with expected liability.