Spring 2001, Economic Analysis of Law, Wachter
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Methodology of Law and Economics
Goals:
1. unity of common law
2. develop notion of economic damages, separate from issues of liability
3. jurisprudential – explain debate btw/of law and economics
Legal Reasoning
(inductive  bottom-up thinking, very fact-specific)
Economic Reasoning
(deductive  top-down thinking)
holding
facts
model
precedents
case
assumption
hypotheses
conclusion
In law and economics (L/E), holding and conclusion reach the same result.
1. largely descriptive of what law is.
a. Examine legal structure
b. Understand how they develop
Conclusion/holding
c. AND look at what incentives are created for the parties
2. is L/E inherently conservative?
a. No but more easily used by conservatives
b. Looks at cost and benefits
i. Largely adopted by liberal govts in 1960s as way to justify greater govt intrusion on
private lives
c. It’s a tool more than a set of conclusions.
Efficiency and Equity
Efficiency – the relationship btw the aggregate benefits of a situation and the aggregate costs of the situation
 Pareto efficiency/Pareto optimality
Equity – the distribution of income among individuals
Is there a conflict btw the pursuit of efficiency and the pursuit of equity?
 This is where you make a POLICY choice!
 Depends on how important efficiency is relative to equity
 Conflict may exist IF income can’t be costlessly redistributed
 If income CAN be costlessly redistributed, goal is to MAXIMIZE the size of the pie b/c the pie can be
sliced in any way desired.
Assumptions made to discuss legal system:
 Costless redistribution of income (no transaction costs)
 Common denominator – all benefits and costs to be measured in dollars
 Consumer sovereignty – individuals themselves determine the dollar values to place on their benefits
and costs
 Exogenous preferences – values that individuals place on their benefits and costs are “stable”
 Utility maximization – indiv (and firms) maximize their benefits less costs
Spring 2001, Economic Analysis of Law, Wachter
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First fundamental theorem of welfare economics – In a world of perfect competition, society would produce
as much wealth as it could.

All points along WPF are allocatively efficient
(i.e. society is as wealth as it can be)
B
WPF = welfare possibility frontier
A
1 = 150 - 
D

C
Pareto superiority (P-S) – a point is P-S to D if and only if
at least ONE of the parties is made better off WITHOUT
making the other worse off.
ex.
A is P-S to D  (100,100) v. (75,75)
C is not P-S to D  (200,0) v. (75,75)
Pareto superior points are all points within the right angle
coming out of point D (shaded area).
All points in shaded area = domain of contract law
(what parties would agree to
if bargaining in good faith. Anything
outside is nonconsensual.)
Pareto optimality (P-O) – every point on WPF is pareto optimal.
 If you’re on P-O point, then there are no pareto superior moves or improvements to make.
 Conversely, if you’re NOT on P-O point, there is a P-S point which will improve your situation.
Welfare economics – govt should not be limited to pareto moves.
 1950s/60s economists K-H  benefit-cost analysis
o any policy that moves you from point D such that the winners could compensate the losers is a
K-H improvement.
o All P-S points are K-H points, but not all K-H moves are P-S moves. (More K-H than P-S pts.)
o All points above line 1 are K-H points.
o Focus on making societal wealth higher – make pie as big as possible regardless of income
distribution. (Note: could compensate people made worse off, not have to.)
 Thinking of the Chicago school (Scalia, Easterbrook, Posner).
 Normative Posner (what law OUGHT to do) – ct should give entitlement to party that values it most.
 Positive Posner (DESCRIPTIVE) – what courts do DO in area of property and torts
Second fundamental theorem of welfare economics – If a govt can costlessly redistribute income, then govt
policy should be bifurcated into 2 parts:
 Make pie bigger – Govt should do everything it can to improve size of the pie. (all K-H improvments)
 Restribute income to point that society favors
o Govt (legislature) should have responsibility to redistribute through taxes, soc security, welfare
Question: When is fairness consistent with K-H points and when not?
Posner:
1. Courts should make pie as big as possible and then let legislature redistribute.
2. Court are passive. Cases are brought before them.
Criticisms of Posner school:
1. Right-wing (wt minimal govt; libertarians)  Posnerians are much more interventionist than desired.
What’s desirable is only pareto points.
2. Left-wing  wealth isn’t everything. Need more fairness/equity.
Spring 2001, Economic Analysis of Law, Wachter
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3. The incentives for buying and selling does not necessarily lead to what we think of. Doesn’t always lead
to good results. (Grumby who hates rap music and doesn’t wt his daughter to listen to rap music so
spends the money to listen to it himself v. Sharpy who loves rap music)
4. Circularity in some very important cases
a. Fundamental property rights
b. Entitlements are large or fundamental
c. In a world where neither party will sell the entitlement, then K-H doesn’t give the answer.
i. For K-H, think in terms of “would the loser sell the entitlement?”
The Coase Theorem
Coase’s theorem (for ZTC and PTC):
 Zero Transaction Costs – If ZTC, the EFFICIENT outcome will occur rgdless of the choice of the
legal rule.
o The legal rule affects the REDISTRIBUTION of income. Best choice is to redistribute income
by the amount of the least-cost solution to the conflict.
 Positive Transaction Costs – If there are PTC, the efficient outcome may not occur under every legal
rule. In these circumstances, the preferred legal rule is the rule that MINIMIZES the effects of
transaction costs. These effects include actually incurring transaction costs as well as the inefficient
choices induced by a desire to avoid transaction costs.
Five pillars of Coase:
1. Coase’s theorem – in a zero transaction cost, it doesn’t matter who the court decides to give the
entitlement to as long as the two parties can freely bargain w/ each other.
2. Harm is reciprocal – goes both ways.
3. Legal rules embody a lot of economic theory  law does efficiency! Party who bears lower cost!
4. In real world, transaction costs do matter so legal regimes matter.
5. Court ought to do efficiency. (normative Coase)
What’s the role of legal regulation if we have economically efficient results?
1. Coase’s them only works where ZTC.
2. Defines who has the initial right (sets boundaries) which in turn makes bargaining easier and  parties
are more likely to reach agreement.
3. If there are transaction costs, parties may not trade. In this case, initial entitlements do matter.
4. Need to decide what’s the appropriate legal remedy for negative externalities.
Question: Is the economically efficient result also the just result?
Sturges v. Bridgman (Supp. 8) – “coming to the nuisance” 1879 English case. Candymaker in area for long time.
Area becoming more residential. Doc moves in, builds extension and sues Candymaker b/f of too much
vibrations. Property right given to the doctor  courts effectively are “zoning” the area.
 Coase says it’ doesn’t matter what the legal resolution is b/c the parties can bargain for entitlement.
 Example 1:
If doc wins
If CM wins

Doc
150
20
CM
0
125
Tot Wealth
150
145
If doc wins, he’ll sell entitlement if he can get $150 or
more for it. CM won’t buy b/c the max he gets is $125.
(wealth maximing party pretty much never sells
entitlement.)
Doc
100
20
CM
0
130
Tot Wealth
100
150
Here, CM is wealth maximing party. If CM wins, will sell
entitlement at 130 (min price where he won’t be worse
off) or more. Doc won’t buy b/c can only pay 100 max.
Example 2:
If doc wins
If CM wins
o
o
If Doc gets entitlement, max price CM will pay is $130 – point where CM is no worse off whether the buys or not.
(indifferent!) Min price CM can buy entitlement is $100-20 = $80.
If Doc gets damages and CM wins, he gets 100 – 20 = $80 (loss the doc suffers.)
Spring 2001, Economic Analysis of Law, Wachter
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
Damages gives plaintiff the minimum price for the entitlement.
When people bargain, they often split the gains from trade. So if P(max) = 130 and P(min) = 80, then P(avg) = 105.

Doc gets entitlement:
CM gets = max – P(avg) = 130 – 105 = $25
Doc gets = min + P(avg) = 20 + 105 = $125
Still end up w/ total wealth = 25 + 125 = 150 (wealth max result!)

CM wins:
CM = 130  won’t sell b/c he can’t be made better off
Doc = 20
Cooke v. Forbes (Supp. 10) – hypersensitive weaver using unusual manufacturing process. Sues ammonia
factory for damages to fabric. Weaver prone to damages b/c of the process. Held for D (mfr of ammonia)  ct’s
decision affects the initial distribution of wealth.
 Here, jmt for D is the economically efficient and just result. P is hypersensitive so he can best guard
against the offenses to himself.
 Note that another option is for the firms to merge, i.e. for P to buy-out D so loser now has control to do
what he wants.
Bryant v. Lefever (Supp. 11) – smoke nuisance. P and D are neighbors. D rebuilt wall that blocks P’s chimney.
Held for D  nuisance is always two way street. P, by lighting fire, is causing the nuisance that harms himself.
 Ct really saying that D had legal right to build a bigger house and  it’s P who’s causing his own
nuisance.
Bass v. Gregory (Supp. 14) – P is bar that cust shaft thru cellar for air circulation. Air is vented onto D’s
property and smells bad. D covers up well to stop ventilation. Held for P  adverse possession; air venting
happened for a long time w/o D complaining.
 By deciding who has the legal right first, court then determines who creates the nuisance.
The Calabresi Framework
Calabresi Framework
 Differentiates between property and liability rules
o Property rules – entitlement determined by state but value is determined by the seller.  any
transaction is consensual.
o Liability rules – both entitlement and value are determined by the state. Drawback is that
liability rules only approximates seller’s value of entitlement and it involves greater govt role.
 Two questions must be asked:
o Who gets the entitlement – P or D?
o How to protect the entitlement – injunction or damages?
Property rule
 wins
Rule 1: injunction
Liability Rule
Rule 2: damages
 wins
Rule 3: no liability
(injunction is denied)
Rule 4: buy an injunction
( pays ’s damages  equiv.
to buying an injunction since 
gets $ and  is enjoined.)
Inalienability rule


Rule 1 and 3 are consensual. Bargaining can occur with any of the rules????
Rule 4 –  can’t refuse the injunction.
Spring 2001, Economic Analysis of Law, Wachter
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Example (from Polinsky Ch. 4):
Factory
Output
0
1
2
3
Profits
0
10,000
14,000
16,000
Change in
profits
–
10,000
4,000
2,000
Damages to
Residents
0
1,000
16,000
36,000
Change in
damages
–
1,000
15,000
20,000
Total Wealth =
profits – damages
0
9,000
-2,000
-20,000
The efficient outcome in ZTC world is for Q = 1, where total wealth = 9,000
 Under property rule 1,  wins injunction (entitlement) so can sell injunction to factory such that we
end up at Q = 1.
P(min) = min damages to residents = 1,000
P(max) = min profits of factory = 10,000
10,000  1,000
= 4,500 therefore,
2
Factory gets P(max) – P(avg) = min profits – P(avg) = 10,000 – 4,500 = 5,500
Residents get P(avg) – P(min) = P(avg) – min damages = 4,500 – 1,000 = 3,500
 total wealth = 5,500 + 3,500 = $9,000, Q = 1 (which is the efficient outcome!)
P(avg) = price where R and F split the profits =



Under property rule 3, factory wins entitlement, no liability/injunction denied to residents. So factory
can produce as much as it wants to max of Q = 3. But residents will try to bargain with the factory to get
to Q = 1.
P(min) = max profits – min profits of factory = 16,000 – 10,000 = 6,000
P(max) = max damages – min damages to residents = 36,000 – 1,000 = 35,000
P(avg) = P(min) – P(max) / 2 = (35,000 – 6,000)/2 = 14,500 therefore,
Since we want to get to Q = 1:
Factory gets profits(q = 1) + P(avg) = 10,000 + 14,5000 = 24,500
Residents get damages(q = 1) – P(avg) = -1,000 – 14,500 = -15,500
 total wealth = 24,500 – 15,500 = 9,000, Q = 1 (still efficient outcome!)
Note: in ZTC world, both R and F want to maximize their wealth which is at Q = 1.
Under rules 1 and 3, bargaining occurs. But since we don’t live in a zero (or very low) transaction cost
world, bargaining may not always succeed so court will sometimes use the damage remedy (liability
rules) instead. Transaction costs include:
o Bargaining costs
o Monetary costs – Discovery of underlying facts; Compliance costs
o Strategic costs
 Hold-out problem – “tough bargaining” where 1 pty tries to get to its max soln
 Free-rider problem – 1 pty in group doesn’t wt to pay and hopes to benefit from others’
actions
Under liability rule 2,  wins entitlement of damages.
(damages) =
actual damage suffered by  
depends on what factory produces
note, factory will end up at Q = 1 (where it’s most efficient!)
(damages) = minimal victory under property rule 1


Under liability rule 4,  wins so  gets damages, i.e. buys an injunction  factory retains right to
continue production; residents can try to pay F to produce less by paying loss profits for  production.
(damages) = loss profits from output of 3 to output of 1 = 16,000 – 10,000 = 6,000
(damages) = minimum victory under property rule 3
Another problem is imperfect information. (If court had perfect information, that can serve as a
substitute for a ZTC world.) W/ imperfect information, depending on whether court overestimates or
underestimates some numbers, the result will change.
o Here, if court thought profit at Q = 3 is 50,000, then Q = 3 becomes wealth maximing outcome
since 50,000 – 36,000 = 14,000. But court gets it wrong! So in this case, injunction may be the
better solution  allows parties to bargain to get efficient outcome.
Spring 2001, Economic Analysis of Law, Wachter
When we want property rules:
 Property rules  harm is forward-looking
 Can get to pareto superior condition
 Settle property disputes to encourage investment in
the property
 In civil disputes, favor group whose civil rights are
affected
 Idiosyncratic violation of land/relative valuation of
land
 Irreparable harm so injuncction
 Court doesn’t know administrative cost
 Damages are inadequate b/c loser is jmt proof (ex.
can’t pay or immunity)
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When we want liability rules:
 Liability rules  harm has already occurred
 Parties can’t bargain
 Opposite situations of propery rules
When might transaction costs themselves dictate who wins?
 Multiple  and one , and not a class suit  high TC amongst plaintiffs.
o Injunctions won’t work b/c s can’t settle on a price among themselves  no property rule
o Rule 4 susceptible to free-rider problem
o So court will use rule 2 (damages)
 One  and multiple ,, and  wins  end up at rule 4????
Application: Coase Thm and Nuisance Law
Nuisance cases – incompatible land usage typically involving a small number of individuals bargaining with
each other.
 Resolution is a two-step process:
o Entitlement must be chosen  determination must be made re: who is entitled to prevail
o Decide how to protect the entitlement  injunction or damages
Issue: Can the efficiency criterion determine which entitlement to choose and which remedy to use to protect it?
1. Zero Transaction Cost World – If ZTC (the parties bargain cooperatively), then every choice of
entitlement and remedy will be efficient.
2. Strategic Behavior – If the parties are likely to act strategically, then the efficient outcome still can be
achieved under both remedies if the court has adequate information.
a. Injunction – can overcome strategic behavior by choosing the entitlement that corresponds to
the efficient outcome, which can be determined only if the court knows the injurer’s benefits
from engaging in the harmful activity and the victim’s damages.
b. Damages – can overcome strategic behavior by giving an absolute entitlement to the victim and
setting liability equal to actual damages, which requires knowledge of the victim’s damages.
3. Imperfect Information
a. Court only knows victim’s damages
i. Injunctive remedy generally will fail b/c the court cannot accurately set the entitlement
equal to the efficient outcome.
ii. Damage remedy can still guarantee the efficient outcome.
b. Court underestimates victim’s damages
i. Damage remedy generally leads to excessive output and may be less desirable than the
injunctive remedy.
4. Even where there is some uncertainty about which entitlement and remedy to choose in the real world,
efficiency analysis of nuisance law is still helpful.
Spring 2001, Economic Analysis of Law, Wachter
Boomer v. Atlantic Cement (Supp. 32) – cement factory pollution.  wants injunction b/c factory decreases
property value s.t. it became total loss.  doesn’t wt to be found liable. Factory was brought to area for jobs.
Residents were there first.
 Held: temporary injunction for  that will be vacated when  (factory) pays damages. (Rule 2)
o Changed existing precedent of permanent injunction.
o Damages = value of house (total loss)
 Note that if  pays full damages,  essentially bought the house from . So the factory can
now go into the real estate business and rent out the homes to people who won’t complain.
 Rule: balance the equities between compensating the residents and the needs of jobs for the community.
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