ECO 320
Economic Analysis of Law
Test I
Thursday, June 6, 2019
6:10 PM to 8:00 PM – KN L1220
SOLUTION
Students may use a non-programmable calculator. All work should be in pen
written on the lined portions of the test booklets. Full marks will only be awarded to fully
explained answers accompanied by a fully labelled diagram or diagrams where
appropriate. Please read all questions carefully before answering them.
(10 marks)
QUESTION
1
When people strongly disagree, they may try to harm each other, or they may walk
away from a potentially profitable exchange. What does the Normative Hobbes Theorem
suggest the response of the law should be to these two possibilities? Why?
The Normative Hobbes Theorem (NHT) has greater application in the case of strong
disagreements, due to the possibility of harm. “Structure the law so as to minimize the
harm caused by failures in private agreements.”
If an exchange is potentially profitable, the Normative Coase Theorem more likely
applies as this usually means that an impediment like transaction costs is likely the
problem – the parties can still see potential profits – so “structure the law so as to
remove the impediments to private agreements.”
For full marks it was sufficient just to deal with NHT and how it applies in two (2)
situations where people who cannot contract either ignore each other or apply
harmful tactics.
(10 marks)
QUESTION
2
Doctors who form a partnership may say nothing in the partnership agreement
concerning its future dissolution. The parties may deliberately avoid discussing
dissolution for fear of breeding distrust. Explain when and why this behaviour could be
efficient? Provide and explain some other examples of gaps left in contracts for strategic
reasons.
The parties expect to save transaction costs by leaving gaps in contracts whenever the actual
cost of negotiating explicit terms exceeds the expected cost of filling a gap.
The doctors expect to save transaction costs by leaving gaps in contracts whenever the actual
cost of negotiating explicit terms exceeds the expected cost of filling a gap.
For example, uncertainties as to why partnerships might break up can vary – so expectation
damages might vary, so keep these possibilities open because default rules cover these
eventualities. Text pp. 292 -293.
(Students can use two (2) of several examples.)
A deliberate gap may be left in a contract for psychological reasons, as when a couple
promises to marry and remains silent about dividing property in the event of divorce.
Gaps in contracts may be deliberate because parties believe that the event is too remote. A
construction contract may not mention the possibility of zoning officials rejecting the
construction plan the parties both believed that this possibility is too remote.
(The students may use other examples as well.)
(10 marks)
QUESTION
3
Prior to 2000, in Ontario, governments limited non-smoking prohibitions to public
places. Municipalities, then the province (May, 2006), extended the prohibition to private
businesses such as restaurants and bars. Using microeconomics, compare and contrast
this regulation with the willingness of some businesses to voluntarily segregate
customers and staff into smoking and non-smoking areas without regulation as some
businesses did prior to the municipal and provincial rules.
The key point is externalities and who should regulate them. In the US, the
issue of second hand smoke was deemed important enough to require
investigation and potential regulation at the national level.
There is a potential double externality. There is SHS effecting non-smokers.
There are inconveniences to smokers.
The message of the theorem of Coase (based as it is on the case of Sturges
v. Bridgman) is that the more localized the bargaining, the more efficient
the outcome. So initially, railroads designated smoking cars, airlines and
restaurants had smoking sections, and employers had smoking areas.
As greater knowledge about negative side effects of SHS increases, the
smoking bans become wider and private choice may not be adequate in
internalizing the broader harms. So municipal bans and provincial bans
become more popular.
(10 marks)
QUESTION
4
A house built on a flood plain has a fair market value of $50,000. When a
government plan to insure the house against floods applies, the fair market value of the
house increases to $150,000. Now the government wants to expropriate the house in
order to preserve the environmental quality of the flood plain. What is the socially
efficient price the government should offer? $50,000? $150,000? Another price? Explain
your answer.
The best answer is a price greater than $150,000.
Firstly, in expropriation cases fair market value tends to underestimate the subjective value
that an owner places on his or her property. Factors such as sentimentality, rootedness in the
land, etc. are not always captured in fair market value. In economics, a socially efficient or
socially optimal price reflects this subjective value.
Secondly, there is a public goods externality when one tries to offset the loss to an owner
with the gains public users place on the owners’ loss. For example, there may be a social cost
to converting a private good to a public (environmental good) where the government cannot
exclude users of it who do not pay their share of the costs. Text p. 104.
Thirdly, to the point that the “insurance gain” should be offset – this might apply if the
insurance gives rise to identifiable or quantifiable moral hazards, these “costs” could be
applied to offset the expropriation price. See Text pp. 181 – 184.
(10 marks)
QUESTION
5
Electric Company E emits smoke, dirtying the wash at Laundry L. E earns $1,000 if
it does not install scrubbers. L loses $200 if E does not install scrubbers. L earns $300 if
E does install scrubbers. E can abate its pollution by installing scrubbers that would cost
E $500. L can eliminate E’s externality by installing filters that would cost L $100. (Each
part is worth 2.5 marks)
(a) Set up the social contract game showing the four possible outcomes of this
problem?
(b) Which outcome is socially optimal? How this is determined?
Sum the profits in each quadrant and chose the quadrant with the
highest sum.
No scrubber for the electric company and filters for the laundry is the
socially optimal outcome in the absence of regulation.
(c) If damages liability is imposed on E for L, how will bargaining proceed if there are
no transaction costs? Which outcome will result?
By the Theorem of Coase, the “no scrubber” for E and filter for L is
still the most optimal bargaining result, so through bargaining E will
transfer $100.00 to L to compensate for the filter, and $50.00
representing an equal share of the co-operative surplus, leaving E
with $850 and L with $350, reaching the most optimal level of social
surplus of 1,200.
(d) How will your answer in (c) change if transaction costs become too high to make a
contract feasible?
By the Normative Hobbes Theorem, the pollution damages would
force E to pay L damages of $200. Laundry earns profit of $100 + $200 =
$300. Social surplus is sub-optimal at $1100 because the “efficient”
filter technology is not applied.
(10 marks)
QUESTION
6
Explain how the Theorem of Coase relates to the theory of expectation damages
for breach of contract
Expectation Damages awards compensation for breach of contract. Awarding
perfect expectation damages restores the Principal (promise) to the position that
he or she would have enjoyed if the Agent (promisor) had performed.
The rule is the actual amount the Agent has to pay the Principal in compensation
to put the Principal in the same economic position it would have been in if the
contract had been performed.
The rule of expectation damages is efficient because it is a trade-off between the
cost to the Agent of taking the necessary actions to avoid non-performance of the
contract and the cost to the Principal on non-performance.
This is Pareto improving to both parties in accordance with the Theorem of Coase.
The expectation damages rule also optimizes joint social surplus and saves the
contract - these are elements of the Theorem of Coase.
See Cooter – Chapter 9 – Part I (B) p. 330 (6th ed.)
(10 marks)
QUESTION
7
(a)
An investor considers investing $1 million with a broker, expecting that the
surplus of an additional $1 million will be divided 50% between the investor and the
broker. If there is no contract between the parties, draw the agency game diagram. What
is the outcome of this agency game? (5 marks)
•
In the agency game, the principal decides whether or not to put a valuable asset
under the possession and control of an agent
•
If the principal invests, the agent receives more by appropriating the investment
•
This move by the agent is the best move against any of the Principal`s moves – a
dominant strategy
•
The Principal anticipates this conduct – so will not invest
•
As this diagram indicates – the solution to the agency is both a Nash equilibrium,
but not Pareto optimal, because the investor anticipates that the broker will
appropriate its investment.
(b)
Now assume the investor and broker in (a) enter a contract and the expectation
damages rule applies. Draw the contract game diagram. What is the outcome of this
contract game? (5 marks)
outcome of this contract game?
As this diagram indicates – the solution to the agency is both a Nash equilibrium,
and Pareto optimal, because the investor anticipates that the broker will not
appropriate its investment – if the broker did so, it would be liable to the investor.
(10 marks)
QUESTION
8
Two (2) slum landlords own rows of houses on opposite sides of the street. Each
would gain if the other upgraded his own property. Neither slum landlord wants to
upgrade until the other does.
(a)
Explain the rent results in terms of the bargaining potential and the existence of a
Nash equilibrium, where R = renovate and NR = no renovation by the landlords. (5
marks)
(NR, NR) – Nash Equilibrium
(R, R) – Pareto Optimum
Looking at the table below, even though R1 > NR1 and R2 > NR2,
Landlord 1 believes it could achieve higher net rents by not
renovating, NR1* > R1 provided Landlord 2 renovates. However,
Landlord 2 will not renovate if it believes Landlord 1 will not renovate
because it could achieve higher net rents since NR2 > R*2.
So in the absence of a contract or zoning regime, (NR1, NR2) is the
stable Nash equilibrium
(NR1, NR2)
(NR1*, R*2)
(R*1, NR2*)
(b)
(R1, R2)
Will the slum landlords upgrade? Why or why not? (5 marks)
Each landlord is motivated not to renovate, hoping its rival will. Neither landlord
will renovate, leaving both of them worse off than if they had both renovated.
(Nash Equilibrium)
(10 marks)
QUESTION
9
Should a contract signed when one of the parties is drunk be enforced?
Economists strive for efficiency – so an impaired person is at a
disadvantage – so a less efficient result occurs – but conceivably a legal
application of efficiency might view people who became impaired as still
competent – and therefore in a position to avoid the harm their impairment
could case at least cost. See Cooter – Chapter 9 – p. 343 (6th ed.)
(10 marks)
QUESTION
10
When should disclosure in a contract be enforced?
•
The second purpose of contract law is to encourage the efficient disclosure of information
within the contractual relationship.
Part of the role of contract bargaining is to craft terms and conditions in
contracts about what private information must be disclosed to the other
party and what private information may remain private.
•
Information is a public good
•
Efficiency dictates that there be no legal or other barriers to its availability
to economic agents.
•
However, without exclusive property rights to the information there will be
underproduction of information.
•
The common law has historically gone in the opposite direction, rarely requiring disclosure
(buyer beware) unless expressly stated in the contract or in a statute.
•
•
•
According to Kronman, regardless of the productive or the redistributive
effects, information acquired by its owner at a cost should remain private –
at the discretion of its owner.
•
According to Cooter, information acquired by its owner at a cost should
remain private – at the discretion of its owner – only if the effects are
productive.
See Cooter – Chapter 9 – at pp. 355 - 360 (6th ed.)
Total Marks = 100
ECO 320
Economic Analysis of Law
Test I
Tuesday, November 19, 2019
11:10 AM to 1:00 PM – IB 140
Students may use a non-programmable calculator. All work should be in
pen written on the lined portions of the test booklets. Full marks will only be
awarded to fully explained answers accompanied by a fully labelled diagram or
diagrams where appropriate. Please read all questions carefully before
answering them.
(20 marks) QUESTION 1
A farmer can fence his land for a cost of $500.00. A neighboring rancher can
fence her land for a cost of $750.00. Without fences, wandering cattle will cause
$1,000.00 damage to the farmer’s crops.
(a)
If there is no liability, what outcome will occur with respect to the
wandering cattle? Why? (5 marks)
Under no liability, the farmer cannot claim against the rancher for losses to his crops,
or force the Rancher to take any other preventative action. The farmer will build a
fence costing $500.00 around his farm, thereby avoiding $1,000.00 in damages not
incurred from wandering cattle and achieving a net saving of $500.00.
(b)
If the rancher faces a property law imposing a rule that the rancher
must compensate the farmer for damage to crops, what is the most
optimal strategy for the rancher? Why?
(5 marks)
Under strict liability, the farmer can claim against the rancher for losses to his crops,
or force her to take preventative action such as build a fence. The rancher could build
a fence costing $750.00 around her farm or pay the farmer $1,000.00 in compensation.
Building the fence achieves a net saving of $250.00 for the rancher.
More optimally, the rancher could contract with the farmer to build a fence costing
$500.00 around the farmer’s farm, thereby saving $500.00.
The additional savings of $250.00 is likely going to be divided, possibly but not
necessarily, 50/50 between the parties so that the net gain to the farmer is $125.00 +
$500.00 over the result in (a). The maximum loss to the rancher would be $500.00 +
$125.00.
(c)
From the point of view of society what is the most optimal rule in
(a) and (b)? Why? (5 marks)
(a) or (b) is the optimal rule when the cheaper fence is built.
(b) Under which rule would we expect to see a contract made
between the rancher and farmer? What would this contract
say? (5 marks)
The contract emerges under (b). The contract would include terms allowing the
rancher on to the farm to build the fence, or having the rancher reimburse the farmer
if the farmer builds the fence. There would be a further term for the additional savings
of $250.00 being divided, possibly but not necessarily 50/50 between the parties.
(20 marks) QUESTION 2
Think of an example of a landlord and tenant problem (slum tenancies, chronic
disrepairs, illegal or unsafe basement suites, cock roaches, bedbugs or
homelessness). Are these problems linked to a problem of rent controls (price
ceiling on rents). If so, how? Think this through – using diagrams that show the
landlord operating as a firm and the supply and demand for apartments.
Diagram:
In the diagram, the “shortage” caused by the rent ceiling, not only shows itself in fewer
apartments, but also as a reduction in services to maintain the existing supply of apartments.
Disrepairs are neglected, sometimes necessitating the issuing of work orders by the
appropriate authority against the landlord.
When disrepairs are neglected, insect infestations are more likely.
Fewer apartments can lead to a “grey market” based on discrimination. A landlord that
cannot extract market rent from a tenant will “compensate” in non-monetary ways – tenant
has to have a high paying job, good references, high credit-rating score, etc.
This “grey” market contributes to homelessness among low income or precariously employed
tenants.
(10 marks) QUESTION 3
Explain the important distinction between private marginal cost and social
marginal cost for property rights. Use a diagram to illustrate your answer.
Figure 2.15 shows the cost structure in a firm.
If the firm is producing output, there might be an external cost being generated. This
is a cost not born by the firm, but instead is imposed on anther party. The marginal
cost curve is PMC.
When the external cost is transferred to the firm, one says this cost is internalized.
The marginal cost curve becomes SMC. This output level called a social optimum.
It is not optimal to have no external cost, because production would be 0.
The point at which (social) marginal cost equals (social) marginal benefit is the tradeoff between efficiency and external costs and social surplus for society is optimal here.
See pages 39 to 40 of the Text.
(10 marks) QUESTION 4
If everyone has free access to a public beach, who, if anyone, has the power to
control the use of this resource?
The answer should first identify what elements of a public beach make it a public good and what
elements of a public beach are a private good. Although a public beach – like other land – could be
privatized – the cost of making a beach rivalrous and exclusive could be so high as to make preserving
its public good cheaper. Those costs involve high transaction costs.
Public ownership of the beach imposes transaction costs in terms of public administration and
collective decision making. The private property approach is to grant each property owner the right to
control access to their part of the beach, protected by the remedy of compensatory damages.
Alternatively, the public property approach would declare that access to the beach as a public good,
and assign the task of maintaining the beach to a government agency.
The choice between private and public ownership should depend on whether the costs of private
enforcement and exchange are more or less than the costs of public administration.
(Text – pp. 104-105)
(10 marks) QUESTION 5
Discuss the relationship of deductibles in insurance contracts to the problems of
private information and expectation damages.
In an insurance contract – a deductible means part of the loss suffered by the insured (agent) is born
by the insured. From the vantage point of the insurer (principal) the insured has private information
such as actions hidden (moral hazard) from the insurer. An insured buying theft insurance without
deductibles would be more inclined to leaving his car unlocked, parking it in unsafe areas, or even
leave the keys in the ignition. Deductibles motivate insured to reduce these hidden actions.
See Cooter – Chapter 2 – p. 48 (6th ed.)
(10 marks) QUESTION 6
Explain the difference between foreseeable events and foreseen events in
contracts.
Foreseen events are contrasted in the Hadley case - pp. 336 - 337 and are events
foreseen by the parties and usually included in the contract.
Foreseeable events are events that ought to have been foreseen by reasonable or rational
parties but might not be included in the contract. When a foreseeable risk is ignored and
leads to a breach of contract, then liability is imposed.
When an unforeseen risk is missed, liability is imposed under strict liability, but not under
breach of contract unless the unforeseen risk was also foreseeable. These events can be
placed in the contract as terms or conditions. See Text pp. 336-337 and Question 9.15
Under the expectation damages rule, a system of standards reaches precision through
precedents. When a case arises, its resolution precisely specifies the standard’s application to
the circumstances. The novel application of the standard in a case constitutes this precedent.
(20 marks) QUESTION 7
Suppose there are only two people in a remote location. The demand curve for
person A for mosquito control is given by
qA = 100 – P
For person B, the demand curve for mosquito control is given by
qB = 200 – P
(a) Suppose mosquito control is a nonexclusive good – that is, once it is
produced everyone benefits from it. What would be the optimal level
of this activity if it could be produced at a constant marginal cost of
$50 per unit? (10 marks)
Marginal valuation for person A:
P = 100 – qA;
Marginal valuation for person B:
P = 200 – qB;
Because of the public good nature of mosquito control these should be
added "vertically."
Marginal value = 300 – 2q
Set Marginal value = 300 – 2q equal to marginal cost of 50,
$50 = 300 – 2q gives q = 125.
(b) If mosquito control were left to the private market, how much might
be produced? Does your answer depend on what each person assumes
the other will do? (10 marks)
Free rider problem could result in having no production.
Each person would let the other do it.
Total Marks = 100
ECO 320
Economic Analysis of Law - Test 2
Thursday, July 18, 2019
Kaneff Building – Room L1220
6:10 PM to 8:00 PM
No Aids Allowed
Solution Set Guide
Students may use a non-programmable calculator. All work should
be in pen written on the lined portions of the test booklets. Full marks will
only be awarded to fully explained answers accompanied by a fully labelled
diagram or diagrams where appropriate. Please read all questions carefully
before answering them.
________________________________________________________________
QUESTION 1:
(15 Marks)
(a)
What are five (5) things a victim must show to prove breach of a
simple negligence liability rule?
(5 Marks)
Clearly identify the victim and defendant(s)
Prove the link of causation between defendant and claimant
Prove that there was a monetary loss flowing from the action of the
defendant
Must identify the standard of care (Hand rule) that applies to the case
That this standard was not met (the defendant(s) activity levels fell short)
(b)
Draw and explain the “simple negligence liability rule” curve being
careful to label it.
(5 Marks)
(c)
How might the availability of liability insurance effect the amount of
compensation for a victim if there is more than one defendant found liable
under a comparative negligence rule?
(5 Marks)
When two or more defendants with limited wealth are subject to the joint and
several liability (common law) rule, the defendents’ insurance decisions are the
outcome of a game of bilateral positive externalities.
The “Deep-Pockets” Effect:
As Defendent1 buys more insurance, it confers a positive externality on
Defendengt2
Defendant2 believes a claimant-victim will go after Defendent1 first because there
is a “deeper pocket”
The “Cascade” Effect:
But Defendent1 sees what Defendent2 is doing and decides it will reduce its
exposure as well. Defendent1 does not want to be the “deep pocket”
Defendent1 instead wishes to receive a “positive externality” from Defendent2
being the “deep pocket”.
QUESTION 2:
(15 Marks)
What are the economic reasons for the common law rule of joint and several
liability – allowing a plaintiff to sue multiple defendants either individually or
together? Is this rule effective? Why or why not?
When legislators in most common law jurisdictions passed comparative
negligence laws that allowed apportionment of damages among plaintiffs and
defendants, some defendants would “free ride” on the insurance of others or free
ride on the “perceived” liquidity of co-defendants – resulting in an exhaustion of
available moneys for victims.
Courts attempted to curb these losses by imposing “joint and several liability” –
this enabled courts to award 100% judgments against co-defendants – who would
normally pay only a portion of damages – but for the lack of funds from uninsured
or bankrupt co-defendants. It assisted plaintiffs to assert their claims against
several defendants – in effect – shifting the burden of evidentiary costs to the
defendants – to “sort out” their liabilities.
If anything, these measures exacerbated the “deep pockets effect”. Those
potential defendants fearing this effect may retreat from the insurance market
outright or adopt strategies – bankruptcy or limited liability measures – to further
reduce their liability. This reduces available compensation overall. [See Text - pp.
383 – 385]
QUESTION 3:
(15 Marks)
(a)
Argue that if intellectual property such as copyright is unprotected,
how will this affect the production of substitute goods between two rivals
relying on the unprotected copyright?
(5 Marks)
The free riding effect allows non-producers to “copy” the good free of
charge – a mismatch of incentives.
The result is under-supply of the goods in the market – another version of
public good’s externality and the prisoners’ dilemma – for which only
credible collusion will correct.
(b)
What are the economic arguments for and against the extension of
copyright protection to copyright owners against internet down loaders
who do not intent to resell the downloaded material?
(5 Marks)
One argument against the extension of copyright protection turns on it
being too costly to extend infringement or prosecutorial remedies beyond
commercial uses or public web sites to include the private computers of
private users.
Instead, technology such as encryption or some form of “cyber-barrier”
might be the best and the cheapest defence against this kind of
infringement in many cases.
An argument for extension of copyright protection would argue that the
market includes both types of users so it means the problem in (a) applies
and must be rectified by a form of control that is all inclusive.
(c)
Supposing a country has no intellectual property law. What impact
would this have on the production of goods relying on intellectual property
as the main input?
(5 Marks)
The domestic market of such a country (US – 1800s, China -1990s) would
exhibit the Nash equilibrium of under-supply described in part (a). Such a
country might also provide a regulation free environment for out of country
firms - especially on the Internet – who attempt to bypass the IP remedies
against them in countries with intellectual property law. This weakens the
IP enforcement aspect by, for example, raising transaction costs.
QUESTION 4:
(a)
(15 Marks)
Define and explain a plea bargain?
(5 Marks)
A plea bargain is the outcome of a bargaining game, a contract, between a
defendant, usually his or her lawyer, and a crown attorney. (Canada)
It is an important application of the Theorem of Coase, since a plea bargain
divides the surplus between the accused and Crown attorney that arises
through cost savings of not having a trial.
(b)
How does do the Crown office and defendant each benefit? (5 Marks)
The defendant gains from having his sentence reduced and from foregoing
the cost of a trial.
The crown attorney receives a lower expected sentence, but saves the cost
of a trial.
(c)
Explain how increasing the severity of punishment might increase
the frequency of plea bargains?
(5 Marks)
When the severity of punishment is increased, the costs of trial increase
This places additional pressure on the Crown attorney’s resource or
budget constraint. Crown attorneys find themselves required to make more
frequent and sometimes more generous plea bargains
This may result in decreasing expected sentences for any given potential
criminal.
QUESTION 5:
(10 Marks)
Explain how the strict liability rule requires a seller to provide the customer with a
joint product – soda and insurance. What inefficiencies arise?
SEE TEXT - QUESTION
6:24
p. 226
Strict liability as a cost curve emphasizes that a seller subject to this rule would
want to be at the lowest point on the curve. This cost minimization process will
include the cost of liability. The extra cost paid by the producer is like an
insurance premium that the producer might may for actual insurance as an
alternative to investing in extra precaution.
In a perfectly competitive market it is not likely that a seller could sell insurance –
or even be able to add a premium of insurance to the cost of producing the soda –
the consumer will opt for buying a cheaper soda – without the extra insurance
cost.
Even a monopoly seller, charging the insurance premium – would be generating
more inefficiencies through lower production and higher dead weight loss to
social surplus.
QUESTION 6:
(10 Marks)
(a)
Define insider trading. Which institutions and individuals are
normally affected by insider trading regulation? (5 Marks)
When corporate insiders such as officers, key employees, directors, or holders of
more than a minimum percentage of the firm's shares trade those shares – this
raises the possibility of insider trading.
Buying and selling shares of stock or other securities based on special
knowledge not available to others, such as information about new products not
yet public known – this raises the possibility of insider trading.
Insider trading rules, generally, do not apply to all corporations - only those
corporations whose share are traded on a public stock exchange
(b)
For “outsiders” or non-insider trading shareholders, how might the
value of their shares be affected and why, if a majority shareholder (owner
of more than 50%) wants to offer to buy their shares? (5 Marks)
Lowers the value of the shares
Makes more risk averse shareholders avoid the stock market.
Under-valuation of the shares owned by outsiders due to the fear that full value is
minimized because of withheld information
Volatile buying and selling is more frequent due to informational asymmetry
QUESTION 7:
(10 Marks)
Explain why counterfeiting money is a crime. Who is the victim? How would
Becker apply his model to counterfeiting?
SEE TEXT - QUESTION
12:2
p. 458
There is a private bad and a public bad component to the crime. The private bad
might appear to be minor. It might be no more than the actual amount of the
money counterfeited.
Counterfeiting has led to additional social costs such as increasing the
transaction costs of money itself – in the form of costs created by increased
security and printing precautions as well as non-cash alternatives and credit
checks at banks.
Becker`s approach would focus on the elements of punishment and policing. Risk
adverse criminals would be concerned with both factors, but be certain the
punishment was more probable and is therefore motivated not to take the risk due
to the seriousness of the punishment.
Risk neutral offenders are indifferent to the risk of punishment and arrest.
Risk preferring types would place more emphasis on policing, so would tend to
target areas or victims that they feel are least likely to have security or protection.
QUESTION 8:
(10 Marks)
For theft, the loss of the victim usually exceeds the gain of the thief. Why?
For breach of contract, the loss of the victim is less than the gain of the person
breaking the contract. Why? Compare and contrast optimal compensation and
punishments in each case?
In breach of contract, damages are generally assessed on the basis of
compensation, not punishment. For breach of contract, perfect
compensation is a sum of money that leaves the victim indifferent between
the breach of contract with compensation and no breach of contract.
A rational agent would only breach the contract if they could gain more
than would be necessary to fully compensate the principal to the point of
indifference between performance and breach. Because we can
reasonably expect sophisticated business actors to be rational, we would
only expect breach to occur in such situations, necessarily making the
injurer’s gain greater than the victim’s loss.
In the case of theft, the probability of being caught and punished lowers
the expected payoff to the injurer. Even if the person valued the object
only at its resale value (i.e. attached no personal significance to the item
stolen and no damage was done to other property in the theft) the loss
exceeds the gain.
For crime, punishment goes beyond perfect compensation. Punishment in
criminal law makes the injurer worse off without directly benefiting the
victim.
The explanation contrasting civil and criminal compensation is on p. 460.
ECO 320
Economic Analysis of Law - Test 2
Tuesday, February 11, 2020
Instructional Building – Room 140
11:10 AM to 1:00 PM
Students may use a non-programmable calculator. All work should
be in pen written on the lined portions of the test booklets. Full marks will
only be awarded to fully explained answers accompanied by a fully labelled
diagram or diagrams where appropriate. Please read all questions carefully
before answering them.
________________________________________________________________
QUESTION 1:
(15 Marks)
(a)
What are three (3) things a victim must show to prove breach of a
strict liability rule?
(3 Marks)
(b)
it.
(i)
Clearly identify the victim and defendant(s)
(ii)
Prove the link of causation between defendant and claimant
(iii)
Prove that there was a monetary loss flowing from the action
of the defendant
Draw and explain the “strict liability rule” curve being careful to label
(4 Marks)
(c)
Draw and explain the comparative negligence rule?
(4 Marks)
Explanation should explain and make reference to the diagram.
(d)
How might the availability of liability insurance effect the amount of
compensation for a victim if there is more than one defendant found liable
under the comparative negligence rule?
(4 Marks)
When two or more defendants with limited wealth are subject to the joint and
several liability (common law) rule, the defendents’ insurance decisions are the
outcome of a game of bilateral positive externalities.
The “Deep-Pockets” Effect:
(2 Marks)
As Defendent1 buys more insurance, it confers a positive externality on
Defendent2
Defendant2 believes a claimant-victim will go after Defendent1 first because there
is a “deeper pocket”
The “Cascade” Effect:
(2 Marks)
But Defendent1 sees what Defendent2 is doing and decides it will reduce its
exposure as well.
Defendent1 does not want to be the “deep pocket”
Defendent1 instead wishes to receive a “positive externality” from Defendent2
being the “deep pocket”.
QUESTION 2:
(10 Marks)
What are the economic motivations for a law regulating insider trading?
When corporate insiders such as officers, key employees, directors, or holders of
more than a minimum percentage of the firm's shares trade those shares – this
raises the possibility of insider trading.
Buying and selling shares of stock or other securities based on special
knowledge not available to other shareholders, such as information about new
products not yet publicly known – this raises insider trading inefficiencies.
Insider trading can lower the value of the shares. This can make more risk averse
shareholders avoid the stock market.
Under-valuation of shares by outsiders due to the fear that full value is minimized
because of withheld information may occur.
Panic buying and selling occur more frequently due to the informational
asymmetry of insider trading.
A law could counter act these inefficiencies.
QUESTION 3:
(15 Marks)
(a)
Show that if intellectual property such as copyright is unprotected,
how will this affect the production of substitute goods between two rivals
relying on the unprotected copyright?
(4 Marks)
The free riding effect allows other producers to “copy” the good free of
charge – a mismatch of incentives.
The result is under-supply of the goods in the market – another version of
the prisoners’ dilemma – for which only credible collusion will correct.
(b)
What are the economic arguments for and against the extension of
copyright protection to copyright owners against internet down loaders
who do not intent to resell the downloaded material?
(4 Marks)
One argument against the extension of copyright protection turns on the
extent to which high transaction costs would make it too costly to extend
infringement or prosecutorial remedies beyond commercial uses or public
web sites to include the private computers of private users.
Instead, technology such as encryption or some form of “cyber-barrier”
might be the best and the cheapest defence against this kind of
infringement in many cases.
An argument for extension of copyright protection would argue that the
market includes both types of users so it means the problem in part (a)
applies and must be rectified by a form of control that is all inclusive.
(c)
Supposing a country has no intellectual property law. What impact
would this have on the production of goods relying on intellectual property
as the main input?
(4 Marks)
The domestic market of such countries (US – 1800s, China -1990s) would
exhibit the Nash equilibrium of under-supply described in part (a). Such a
country might also provide a regulation free environment for out of country
firms - especially on the Internet – who attempt to bypass the IP remedies
against them in countries with intellectual property law. This weakens the
IP enforcement aspect by, for example, raising transaction costs.
(d)
What strategies does the input supplier have?
(3 Marks)
Lower production. Seek self-help encryption measures. Form a credible
cartel with other input suppliers. Seek remedies through joint action in
collective works bodies like SOCAN (in Canada).
QUESTION 4:
(a)
(15 Marks)
Define and explain a plea bargain?
(5 Marks)
A plea bargain is the outcome of a bargaining game, a contract, between a
defendant, usually his or her lawyer, and a crown attorney. (Canada)
It is an important application of the Theorem of Coase, since a plea bargain
divides the surplus between the accused and Crown attorney that arises
through cost savings of not having a trial.
(b)
How does do the Crown office and defendant each benefit?
(5 Marks)
The defendant gains from having his sentence reduced and from foregoing
the trial in exchange for a guilty plea.
The crown attorney receives a lower expected sentence in exchange for a
guilty plea, but saves the cost of a criminal trial.
(c)
Explain how increasing the severity of punishment might increase
the frequency of plea bargains?
(5 Marks)
When the severity of punishment is increased, more accused opt to go to
trial.
The total costs of trials increase with the total number of trials.
This places additional pressure on the Crown attorney’s resource
constraint. Crown attorneys find themselves required to make more
frequent and sometimes more generous plea bargains
This results in decreasing the average expected sentences for any given
potential crime.
QUESTION 5:
(10 Marks)
Why is it efficient to limit the duration of patents and copyrights?
A diagram revealing the difference between monopoly profit – obtained under
copyright or patent - with the zero long run profit condition for no IP – is useful
here. (See p. 31 – Text for an illustration.)
The student may also use the arguments outlined in Question 3(b).
This way, the student can identify the social dead-weight loss and lower
production that justifies putting limits on IP protection.
A counter-argument emphasizes the predictable duration of monopoly profit as a
payoff for innovation.
QUESTION 6:
(10 Marks)
Explain how the strict liability rule requires a seller to provide the customer with a
joint product – soda and insurance. What inefficiencies arise?
Strict liability as a cost curve emphasizes that a seller subject to this rule would
want to be at the lowest point on the curve. This cost minimization process will
include the cost of liability. The extra cost paid by the producer is like an
insurance premium that the producer might may for actual insurance as an
alternative to investing in extra precaution.
In a perfectly competitive market, it is not likely that a seller could sell insurance –
or even be able to add a premium of insurance to the cost of producing the soda –
the consumer will opt for buying a cheaper soda – without the extra insurance
cost.
Even a monopoly seller, charging the insurance premium – would be generating
more inefficiencies through lower production and higher dead weight loss to
social surplus.
QUESTION 9:
(15 Marks)
Explain why counterfeiting money is a crime. Who is the victim? How would
Becker apply his model to this issue?
There is a private bad and a public bad component to the crime. The private bad
might appear to be minor. It might be no more than the actual amount of the
money counterfeited.
Counterfeiting has led to additional social costs such as increasing the
transaction costs of money itself – in the form of costs created by increased
security and printing precautions as well as non-cash alternatives and credit
checks at banks.
Becker`s approach would focus on the elements of punishment and policing. Risk
adverse criminals would be concerned with both factors, but be certain the
punishment was more probable and is therefore motivated not to take the risk due
to the seriousness of the punishment.
Risk neutral offenders are indifferent to the risk of punishment and arrest.
Risk preferring types would place more emphasis on policing, so would tend to
target areas or victims that they feel are least likely to have security or protection.
QUESTION 10:
(10 Marks)
For burglary, the loss of the victim usually exceeds the gain of the burglar. Why?
For breach of contract, the loss of the victim is less than the gain of the person
breaking the contract. Why? What are the implications for relative dollar values of
compensation and punishment?
Compensation for burglary in civil law aims to restore the victim’s welfare at
the expense of the injurer.
Punishment for burglary in criminal law makes the injurer worse off without
directly benefiting the victim.
Punishment may be imposed on top of compensation, as when criminal
prosecution follows recovery in tort for assault.
The combination of these measures exceeds the gain of the burglar.
In breach of contract, damages are generally assessed on the basis of
compensation, not punishment. For breach of contract, perfect compensation is a
sum of money that leaves
the victim indifferent between the breach of contract with compensation and no
breach of contract.
A rational agent would only breach the contract if they could gain more than
would be necessary to fully compensate the principal to the point of indifference
between performance and breach. Because we can reasonably expect
sophisticated business actors to be rational, we would only expect breach to
occur in such situations, necessarily making the injurer’s gain greater than the
victim’s loss.
Total Marks = 100