Econ 522
Economics of Law
Dan Quint
Fall 2015
Lecture 2
Logistics
 TA sections begin this Friday
 “Fake homework” for next Monday on website
 First real homework also up, due next Thursday (Sept 17)
 If you want to read ahead:
 Richard Posner, “The Ethical and Political Basis of Efficiency
Norm in Common Law Adjudication”
 For a counterpoint to Posner: Peter Hammond, “Review: The
Economics of Justice and the Criterion of Wealth Maximization”
 Both have links on syllabus, and both are on Learn@UW
1
Last week, we…
 defined law and economics
 saw some brief history of the common law
 and the civil law
 and discussed ownership of dead whales
2
Today: efficiency
 quick review of rational choice
 what is efficiency?
 is efficiency a good goal for the law?
3
Rationality, optimization,
revealed preference
4
Most microeconomics is based on the
premise of rational choice
 People have preferences…
 They understand their options, and how much they like each one
 …and they optimize
 They choose the option they like the best
 This is what economists mean when we talk about
rationality or rational behavior
 Behavior that is consistent with someone having well-defined,
consistent preferences
 And this is what we’ll be assuming throughout the semester
5
This leads to the idea of revealed preference
 If I see you choosing something…
 …I infer you like it more than your other alternatives
 We assume people succeeded in doing what they like,
rather than screwing up and doing the wrong thing
 And this allows us to learn peoples’ preferences from their
choices (to some degree)
6
All this is useful if we want to judge what are
“good” outcomes
 If we assume that people have coherent preferences…
 …and that we might be able to learn those preferences…
 …then we can try to use those preferences to judge when
one societal outcome is “better” than another
7
One way to do this: Pareto criterion
 a Pareto improvement is any change to
the economy which leaves…


everyone at least as well off, and
someone strictly better off
 example



Vilfredo Pareto
(1848-1923)
you prefer $3,500 to your car
I prefer your car to $3,500
I buy it for $3,500 – Pareto improvement
 an outcome is Pareto superior to another,
or Pareto dominates it, if the second is a
Pareto improvement over the first
8
Pareto superiority is not that useful a
measure for evaluating a legal system
 Pareto improvements are “win-win”
 But most new laws create some winners and some
losers


so the Pareto criterion usually can’t tell us whether one policy is
“better” than another
even the car example might not be a true Pareto-improvement
 So we need another way to compare outcomes
9
Kaldor-Hicks
and Efficiency
10
We generally assume preferences are
complete
 Given any two options, I can figure out which one I like
more (or else I truly don’t care)
 Given two options – say, $4,000, or a 2002 Grand Am…
 Maybe I prefer the money
 Maybe I prefer the car
 Maybe I’m exactly indifferent between
the two
 But one of these must be the case
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We also assume more money is better…
 If you don’t like it, you can always burn it…
 …but we generally assume everyone prefers more money
to less money
“Everybody needs money. That’s
why they call it money.”
-Danny DeVito, in Heist
12
And finally, we assume preferences are
continuous
 If I prefer your car to $3,000…
 …but I prefer $5,000 to your car…
 …then there must be some amount in between that makes
me indifferent
 We can say that’s my value for the car
 If I’m exactly indifferent between $4,000 and your car…
 …we can say I value your car at $4,000
13
Next, we define Kaldor-Hicks improvement
 Informally: a K-H improvement is any change to the
economy which increases the total value achieved by
everyone in society…
 …where the “value” someone gets from something is
measured by their willingness to pay for it
 Going back to the car example





Suppose your car is worth $3,000 to you and $4,000 to me
Government seizes your car and gives it to me
I’m better off, you’re worse off
But since I value the car more than you…
…this is a Kaldor-Hicks improvement
14
Another way to think about Kaldor-Hicks
improvements
 Unlike a Pareto improvement, a Kaldor-Hicks
improvement can create some winners and some losers…
 …as long as the winners gain more than the losers lose




If I get your car for free…
I end up better off by $4,000 (my value for the car)
You end up $3,000 worse off (your value for the car)
$4,000 > $3,000, so this is a K-H improvement
 We can think of it as a net creation of value


We created $4,000 of value (me getting the car)
And destroyed $3,000 of value (you losing it)
15
Formal definition of a Kaldor-Hicks
improvement
 a change to the economy is a Kaldor-Hicks improvement
if it could be turned into a Pareto improvement with
monetary transfers

K-H improvements also called potential Pareto improvements
 I get your car for free



If we combined this change with me giving you $3,500…
…then it would be a Pareto improvement
So even without the transfer, it’s a K-H improvement
16
Another example
 You and I are neighbors, you want to throw a party



The party would make me $100 worse off…
…and make you $50 better off…
…and make each of your 30 guests $5 better off
 Is the party a Pareto improvement?

No – can’t be, because it makes me worse off
 Is the party a Kaldor-Hicks improvement?


Yes – it increases total value: $50 + $150 – $100 = $100 > 0
(Or: you could throw the party, plus you give me $40 and each of
your guests gives me $3 – that would be a Pareto improvement, so
just having the party is a K-H improvement)
17
Efficiency
 we will call a change to the economy efficient if it is a
Kaldor-Hicks improvement
 we’ll say law A is more efficient than law B if moving from
B to A is a Kaldor-Hicks improvement
 and we’ll say a situation is efficient if there are no available
Kaldor-Hicks improvements


an efficient situation is when there’s no way to make some people
better off, without making some others worse off by more
we’re already getting maximal value out of all available resources
18
Pareto vs Kaldor-Hicks improvements
Pareto improvement
Kaldor-Hicks improvement
• “good for everyone”
• “good for society as a whole”
• makes some people strictly
better off, doesn’t make
anybody worse off
• may make some people
worse off, but increases total
surplus/value
not that interesting,
because they wouldn’t
be controversial
we’ll often be
looking for these
19
Pareto vs Kaldor-Hicks efficiency
Pareto efficiency
efficiency
• no available Pareto
improvements
• no available K-H
improvements
• impossible to help someone
without hurting someone else
• impossible to help someone
without hurting someone else
more
kind of useless for
comparing different
policies
• (impossible to increase total
payoffs realized by everyone)
what we’ll be focusing
on this semester
20
We said it’s efficient for you to have the party
 Makes you $50 better off
 Makes 30 guests $5 better off
 Makes me $100 worse off
 $50 + $150 – $100 = 100 – party “creates $100 of value”
 So it’s efficient for you to have the party



True whether you compensate me or not
Even if “my slice of the pie” is smaller, overall pie is bigger…
…which is all that efficiency measures
21
What we’ve really done here
 In a sense, what we’ve done here is created a way to
add up different peoples’ utility functions…
 …by equating utility with willingness to pay


We said the party made me $100 worse off
We equated my disutility from you making noise with the amount
of money that would replace the inconvenience – if you threw the
party and gave me $100, I’d be just as well off as before
 Once we’ve done that, what’s efficient is whatever
configuration of the economy “creates the most value”
22
One more example: is it efficient for me to
drive to work instead of taking the bus?
 Bus to campus from where I live is free
 Driving is more convenient, but costs me $1 (gas)
 Driving also imposes costs on other people: there’s more
traffic, less parking, more pollution

Suppose when I drive to work, it makes 1,000 other people worse
off by $0.01 each
 By driving to work, I create $11 of total costs
 It’s efficient for me to drive to work if the benefit I get is
more than $11

If the benefit is less than $11, it’s inefficient for me to drive
23
Some other, similar measures
 our definition of efficiency: actions are taken when total
benefits outweigh total costs

“goal” is to achieve all Kaldor-Hicks improvements
 Ellickson: efficiency is “minimizing the objective sum of
(1) transaction costs, and
(2) deadweight losses arising from failures to exploit
potential gains from trade”
 Posner: “wealth maximization”
 Polinsky: “Efficiency corresponds to ‘the size of the pie’”
24
What forces lead to
inefficiency
25
To see whether something’s efficient…
 Compare gains to everyone in society (total social
benefit)…
 …to costs to everyone (total social cost)
 Example we already saw (me driving to work):



Total social cost = $1 (gas) + 1,000 X $0.01 = $11
Total social benefit = whatever benefit I gain by driving to work
So we just said: it’s efficient for me to drive to campus whenever
the value I get from driving is more than $11
26
How do we expect people to actually behave?
 When people decide how to act…
 …they consider the cost and benefit to themselves, not
to everyone

private benefit and private cost
 Driving only costs me $1

so I’ll drive whenever benefit to me is more than $1
 On days when value I get from driving is more than $1 but
less than $11, I drive to work even though that’s
inefficient
27
So externalities cause inefficiency
 I’ll do something whenever private benefit > private cost
 Efficiency depends on whether social benefit > social cost
 If I was the only one affected by my choices, then social
benefit = private benefit and social cost = private cost

when I’m deciding which movie to watch on Netflix, nobody else is
affected by my choice, so my choice will be efficient
 But when my choices affect other peoples’ payoffs…


social benefit  private benefit, or social cost  private cost
so actions I choose to take may not be efficient
28
A classic example of this: the Tragedy of the
Commons
 Hardin (1968), “The Tragedy of the Commons”
 Picture a small fishing village on a lake




The more fish I catch, the fewer
fish are left in the lake…
…and the harder it is for everyone
else in the village to catch fish
So my fishing imposes a cost
(externality) on everyone else
So everyone ends up fishing
more than the efficient amount
29
Tragedy of the Commons – example



10 fishermen
Cost of fishing is 12 fish per hour
Notation


“Maximum
Sustainable Yield”
Total fish
caught
H (100 – H)
h = how many hours I fish
H = combined hours everyone in the
village fishes
Efficient
Level of
Fishing

Fishermen catch 100 – H fish per hour
(a)
What is the efficient level of fishing? How much utility would that
give to each fisherman?
4.4 hours per day per fisherman; 193.6 fish/day
Left to their own devices, how much will each person choose to
fish? How much utility will each person get?
(b)
0
2.5
5
7.5
10
Hours fishing, per day, per fisherman
30
Tragedy of the Commons – example



10 fishermen
Cost of fishing is 12 fish per hour
Notation


“Maximum
Sustainable Yield”
Total fish
caught
H (100 – H)
h = how many hours I fish
H = combined hours everyone in the
village fishes
“Equilibrium”
Level of
Fishing
Efficient
Level of
Fishing

Fishermen catch 100 – H fish per hour
(a)
What is the efficient level of fishing? How much utility would that
give to each fisherman?
4.4 hours per day per fisherman; 193.6 fish/day
Left to their own devices, how much will each person choose to
fish? How much utility will each person get?
8 hours per day per fisherman; 64 fish/day
(b)
0
2.5
5
7.5
10
Hours fishing, per day, per fisherman
31
What’s going on here?
 Fishing imposes a negative externality on other fishermen


Each one ignores this externality when deciding how much to fish…
…so they all end up fishing more than the efficient amount
 Same thing happens with other communal resources



Cattle grazing, whaling, overhunting, oyster beds
Aristotle: “That which is common to the greatest number has the
least care bestowed upon it”
Elinor Ostrom, who shared the 2009 Nobel Prize in Economics,
studies how different societies solve this problem
 Positive externalities work the opposite way

Activities which create positive externalities are naturally done
less than the efficient amount
32
So externalities can lead to inefficiency
 Without some sort of regulation/intervention…


Activities which impose a negative externality will tend to happen
more than the efficient amount…
…and activities which impose a positive externality will tend to
happen less than the efficient amount
 One recurring theme we’ll see in this class:
if we want the law to lead to efficient outcomes,
we can try to design the law to eliminate externalities!

“Internalization”
33
Other forces which
lead to inefficiency
34
Another thing that leads to inefficiency:
barriers to trade
 Cuban cigars




Suppose I’d pay $15 each for Cohibas
They cost $2 each to make, and another
$3 each to transport from Havana to Madison
Clearly, it’s efficient for me to smoke Cohibas
But trade embargo on Cuba makes it illegal for me to buy them
 Anything that prevents me from buying something I want
can be a source of inefficiency


One approach to property law: make it as easy as possible for
people to trade among themselves
(This may seem like an obvious point; but then, there are lots of
things we’re not allowed to sell…)
35
Another thing that leads to inefficiency:
taxes
 I value my free time at $40/hour
 Working in a factory, I can build things worth $50/hour
 Clearly, it’s efficient for me to work


Each hour I work creates $10 of new value
Doesn’t matter who gets it – it’s efficient for me to work
 But suppose there’s a 25% income tax




Factory owner can’t pay me more than $50/hour
But $50/hour pre-tax is only $37.50 after-tax…
…and I’d rather stay home than earn $37.50 an hour
So I don’t get hired – which is inefficient
36
Another example of taxes leading to
inefficiency
 This is a new BMW that’s been cut in half
 Taxes distort behavior away from efficiency
37
Another thing that leads to inefficiency:
monopoly (or private information)
 Example




Demand for some good
given by P = 100 – Q
Monopolist can produce
good for $40/unit
Monopoly price is 70,
demand is 30
Deadweight loss is
inefficiency

Customers willing to pay
more than marginal cost
but unable to trade
P* = 70
CS
Profit
P = 100 – Q
DWL
MC = 40
Q* = 30
38
But, saying these things lead to inefficiency
doesn’t automatically mean they’re bad
 For example




we just said taxes lead to inefficiency…
…but without taxes, there’s be far too few public goods, which is
also inefficient
we just said monopoly leads to inefficiency…
…but we’ll study patents, which are legal monopolies used to
encourage innovation
 But also, we’ve defined “efficient”, but we haven’t claimed
that “efficient = good”
 Which brings us to…
39
Is efficiency a good
goal for the law?
Jump
40
Important distinction: positive versus
normative economics
 positive statements are statements of fact



can be descriptive: “2014 U.S. GDP was $17 trillion”
can be theoretical predictions: “if prices rise, demand will fall”
“economics of what is”
 normative statements contain value judgments



for example, “less inequality is better”
or, “government should encourage innovation”
“economics of what ought to be”
41
Most of this class will be positive analysis
 Predicting behavior, and outcomes, that follow from a law
or legal system is positive economics


“Law X will lead to more car accidents than law Y”
“Law X will lead to more efficient outcomes than law Y”
 But in the background, we’d like some sense of what is
the normative goal of the legal system

“Law X is better than law Y”
 One candidate for that normative goal is efficiency
42
Friedman gives a few arguments for
studying efficiency
“The central question [in this book]… is a simple one: what set of
rules and institutions maximize the size of the pie? What legal
rules are economically efficient?
There are at least three reasons why that is the question we ask.
The first is that while economic efficiency… is not the only thing
that matters to human beings, it is something that matters quite a
lot to most human beings.
The second reason is that there is evidence that considerable parts
of the legal system we live in can be explained as tools to generate
efficient outcomes… It is a lot easier to make sense out of a tool if
you know what it is designed to do.
A final reason is that figuring out what rules lead to… efficient
outcomes is one of the things economists know how to do –
and when you have a hammer, everything looks like a nail.”
- Friedman, Law’s Order, p. 312
43
Indeed, focusing on efficiency will make
things much easier for us in some ways
 All we care about is “final outcomes” – who ended up
with what – not why
 We can ignore the direct effect of monetary transfers
 Suppose the law says if I hit you with my car, I owe you $3,119
 Me paying you that money has no impact on efficiency
 So we can ignore the transfer itself, and think only about its
effects on our incentives
44
Another argument why policy evaluation
should at least start with efficiency…
Let’s first dispense with the straw man. I’ve never heard of an
economist who believes that every efficient policy is good, and I’ve
heard of very few who believe that every inefficient policy is bad.
It’s true that most economists do seem to believe that any good policy
analysis should start by considering efficiency. That doesn’t mean it
should end there.
I think economists are right to emphasize efficiency, and I think so for
(at least) two reasons. First, emphasizing efficiency forces us to
concentrate on the most important problems. Second,
emphasizing efficiency forces us to be honest about our goals.
– Steven Landsburg
http://www.thebigquestions.com/2010/08/30/efficiency-experts
45
“Emphasizing efficiency forces us to be
honest about our goals”
Politician: Here’s my program to make the health care system work better by
subsidizing health care for the poor.
Economist: Your program costs a billion dollars and delivers half a billion
dollars worth of benefits. That’s inefficient.
Politician: So what?
Economist: Well, the “so what” is that maybe you could take that billion
dollars and deliver a full billion dollars worth of benefits instead if you spent it a
little differently. Why not just hand the cash out to poor people?
Politician: Because I don’t want to help all poor people. I only want to help
sick poor people – and this is the only way I can think of to do that.
Economist: Ah. So your goal here is not to make the health care system work
better at all. Instead it’s to transfer resources to sick poor people.
Politician: I guess so.
Economist: That’s fine. Now we can have a healthy debate about whether
that’s what we want to do.
46
But…
 This answers the question, “Why should we study
efficiency?”
 Not the question, “Should the law be designed with the
goal of achieving efficiency?”
 To answer this latter question…
Jump
47
For next week
 Where we’re headed next:
Richard Posner, “The Ethical and Political Basis of Efficiency Norm
in Common Law Adjudication”
 For a counterpoint to Posner:
Peter Hammond, “Review: The Economics of Justice and the
Criterion of Wealth Maximization”
 After that, we’ll get to:
Ronald Coase, “The Problem of Social Cost”
 Monday, I’ll be showing an example of how “narrow taxes distort
more than broad-based taxes”
The example is online as a “fake homework”
 See you next week!
48