Econ 522
Economics of Law
Dan Quint
Spring 2014
Lecture 25
Efficiency
revisited
1
We’ve focused on efficiency throughout the
semester
 Efficiency

Property law: efficient allocation of rights/resources




Coase Theorem says this is easy…
Contract law: efficient breach, efficient reliance, efficient disclosure
of information, etc.
Tort law: efficient precaution to avoid accidents, efficient levels of
risky activities
Civil and criminal law: minimize combined cost of administering
system and living with its errors
 With each branch of law, we asked:


What would efficient system look like?
How do the rules in place measure up?
2
The focus on efficiency has made our lives
much easier
 We could focus on final outcomes only

No worries about process, procedural fairness, etc.
 We could ignore transfers when considering efficiency


Paying damages has no effect on efficiency ex-post
So we can ignore the “direct” effect of most remedies, consider only
the impact on incentives
 Goal was always to maximize total social surplus (or
total wealth)
3
This leads us back to two questions
 Is efficiency the right goal for the law?
 Is there any reason to expect the law to be efficient?
4
Is efficiency the right goal for the law?
 Simple example of bilateral precaution and car accidents





If nobody takes precaution, $160 in expected harm
Injurer precaution costs $20, cuts expected harm in half
Victim precaution costs $20, cuts expected harm in half
Strict liability  precaution by injurers but not victims
Simple negligence  precaution by both
Expected
payoff,
injurers
Expected
payoff,
victims
Strict liability rule
-100
0
Negligence rule
-20
-60
5
Is efficiency the right goal for the law?
 Posner




Once you’ve already been hit by a car, you’d prefer a strict liability
rule to a negligence rule
But if a negligence rule is more efficient…
…then we’d all have agreed to it ex-ante (before the accident)
“Ex-ante consent” / “ex-ante compensation”
Expected
payoff,
injurers
Expected
payoff,
victims
Expected payoff if you
don’t know which one
you’ll be
Strict liability rule
-100
0
-50
Negligence rule
-20
-60
-40
6
Is efficiency the right goal for the law?
 Even if people are asymmetric…







Consider a law: landlords must pay for heat
Tenants get $1000 value from apartment, minus rent
Landlords pay $100 for heat, $600 in other costs
Without this law, tenants would pay their own heat
Would heat apartment less, get $980 value and pay $60 for heat
Might think tenants would prefer inefficient tenant-friendly law…
But rents are set competitively, would go up to compensate…
 Posner: “everyone would prefer the efficient law”
Landlord pays for heat
Tenant pays for heat
Tenants’
payoffs
Landlords’
payoffs
Tenants
Landlords
1000 – rent
rent – 600 – 100
1000 – 850
= 150
850 – 600 – 100
= 150
980 – 60 – rent
rent – 600
980 – 60 – 760
= 160
760 – 600
= 160 7
Is efficiency the right goal for the law?
 Cooter and Ulen


Society may have goals other than efficiency…
…but it’s cheaper to design law to be efficient, and address the
distribution of wealth through the tax system
 Why is tax system better way to control distribution of
wealth?




More directly targets high/low incomes, rather than rough proxies
(“consumers” vs “investors”, “doctors” vs “patients”)
Effects of changes in legal system harder to predict
Lawyers more expensive than accountants
Redistributive laws would be like taxes on particular activities;
narrow taxes have greater deadweight loss
8
That answers the first question
 Should the legal system aim to be efficient?


Posner: it’s what we’d all have agreed to ex-ante
Cooter/Ulen: if we want to adjust distribution of wealth, better to do
it through taxes
 Second question: should we expect the law be efficient?



Civil law: written at one point in time (late 1700s), meant to be static
Common law: rooted in existing norms/practices, changed by
legislation and new precedents – meant to evolve over time
Some believe this evolutionary process will naturally bring common
law toward greater efficiency
9
Should we expect common law to naturally
evolve toward efficiency?
 Posner

Some believe government, and courts, respond to politically
powerful interest groups

Landlords might be more politically connected than tenants, so
might influence laws…

…but like we just saw, even landlords probably don’t want
inefficient pro-landlord laws, since they’d just lead to lower rents

So well-connected groups generally won’t resist efficient rules
10
Should we expect common law to naturally
evolve toward efficiency?
 Cooter/Ulen: three ways the common law may naturally
tend toward efficiency

By implementing social norms/existing industry practices



Whaling example: industry norms were well-suited to each environment
Common law judges enforced industry norms, making law efficient
Judges may deliberately try to make law more efficient


Hand Rule: incorporated efficiency into legal standard for negligence
Judges may be more willing to reverse inefficient precedents, as in
Boomer v Atlantic Cement
11
Should we expect common law to naturally
evolve toward efficiency?
 Cooter/Ulen: three ways the common law may naturally
tend toward efficiency

By implementing social norms/existing industry practices



Judges may deliberately try to make law more efficient



Whaling example: industry norms were well-suited to each environment
Common law judges enforced industry norms, making law efficient
Hand Rule: incorporated efficiency into legal standard for negligence
Judges may be more willing to reverse inefficient precedents, as in
Boomer v Atlantic Cement
Inefficient laws may lead to more litigation

More opportunities to get them overturned
12
Should we expect common law to naturally
evolve toward efficiency?
 So that’s two yeses:


Posner: even politically influential will want efficient laws
Cooter/Ulen: three ways common law evolves toward efficiency
 But an opposing view:




Gillian Hadfield, “Bias in the Evolution of Legal Rules”
Cases are different, but law must be consistent
So at best, courts can try to be “right on average”
But courts will see a biased sample of all possible cases


Situations that lead to litigation are different from those that don’t
So court will have biased view of what rules are efficient
13
Should we expect common law to naturally
evolve toward efficiency?
 Hadfield, “Bias in the Evolution of Legal Rules”








A given rule will have different effects on different individuals/firms
Some will find it easy to follow rule: compliers
Some will find it very costly to follow rule: violators
(Others may drop out of market entirely)
Being “right on average” means doing what’s efficient given the true
mix of compliers and violators in market
But court will mostly see cases involving violators
So it might choose rule that’s efficient for market containing only
violators…
…which is different than the efficient rule
14
Should we expect common law to naturally
evolve toward efficiency? EXAMPLE




Three levels of precaution: low, medium, high
Accidents do $1,000 of harm
Two types of firms, high- and low-cost
Equal number of high- and low-cost firms in market
Level of
Precaution
Cost of Precaution
Total Social Cost
(Accidents + Precaution)
Probability
of Accident High-cost Low-cost High-cost Low-cost “Average”
Firm
Firm
Firm
Firm
Firm
10%
$60
$30
$160
$130
$145
Medium
5%
$120
$60
$170
$110
$140
High
1%
$180
$90
$190
$100
$145
Low
15
Should we expect common law to naturally
evolve toward efficiency? EXAMPLE
Level of
Precaution
Cost of Precaution
Total Social Cost
(Accidents + Precaution)
Probability
of Accident High-cost Low-cost High-cost Low-cost “Average”
Firm
Firm
Firm
Firm
Firm
10%
$60
$30
$160
$130
$145
Medium
5%
$120
$60
$170
$110
$140
High
1%
$180
$90
$190
$100
$145
Low
16
Should we expect common law to naturally
evolve toward efficiency? EXAMPLE
Level of
Precaution
Cost of Precaution
Total Social Cost
(Accidents + Precaution)
Probability
of Accident High-cost Low-cost High-cost Low-cost “Average”
Firm
Firm
Firm
Firm
Firm
10%
$60
$30
$160
$130
$145
Medium
5%
$120
$60
$170
$110
$140
High
1%
$180
$90
$190
$100
$145
Low
 Efficient levels of precaution



High-cost firms: low precaution is efficient
Low-cost firms: high precaution is efficient
One rule for all firms: medium precaution is most efficient
17
Should we expect common law to naturally
evolve toward efficiency? EXAMPLE
Level of
Precaution
Cost of Precaution
Total Social Cost
(Accidents + Precaution)
Probability
of Accident High-cost Low-cost High-cost Low-cost “Average”
Firm
Firm
Firm
Firm
Firm
10%
$60
$30
$160
$130
$145
Medium
5%
$120
$60
$170
$110
$140
High
1%
$180
$90
$190
$100
$145
Low
 If we must have one rule that applies to all firms…

efficient rule requires medium precaution level to avoid liability
 If mostly high-cost firms get sued…

court will think it’s efficient to only require low precaution level
18
Should we expect common law to naturally
evolve toward efficiency?
 Hadfield: this bias will occur in any situation where courts
adjust legal rule based on what appears efficient






Whatever the existing rule, there will be some “compliers” and
some “violators”
Courts will mostly see cases involving violators
Law will evolve toward rule that would be efficient if only
violators existed
But if compliers and violators are different enough, this won’t be
the efficient rule
All this requires is enough heterogeneity in cases…
…and courts that can only learn from the cases that go to trial
19
So… should we expect common law to
naturally tend toward efficiency?
 Posner: yes

Everyone, including the politically connected, wants efficient laws
 Cooter/Ulen: yes



Common law courts enforce existing norms/practices
Courts may be more likely to overturn inefficient precedents
Inefficient laws may lead to more litigation, and have more
chances to be overturned
 Hadfield: no


Courts see biased sample of cases
If they adjust the law based on the cases they see, this will not
lead to efficient laws
20
Unenforced
laws
21
We saw last week…
 Optimal criminal system will not detect/punish every crime,
for two reasons


Some crimes may be efficient (rare)
When cost of deterrence is positive, it’s not worth paying enough to
deter every crime
 But we still assumed most crimes are inefficient, and main
reason not to punish them all is cost
22
However…
 There are a lot of old laws in many states that seem
inefficient


Massachusetts: can’t buy alcohol on Sundays
Many states still have laws passed a long time ago
 In some cases, law is enforced
 Tim Wu, “American Lawbreaking” – many laws that we, as
a society, have basically decided not to enforce at all
23
(Example I found online a couple years ago)
24
Tim Wu, “American Lawbreaking” (Slate)
http://www.slate.com/id/2175730/entry/2175733/
 Begins with New York prosecutors sitting around office, choosing
celebrities (John Lennon, Mother Theresa) and coming up with obscure
crimes they could be charged with

“obstructing the mails,” “false pretenses on the high seas”
 “Full enforcement of every last law on the books would put all of us in
prison for crimes such as “injuring a mail bag.” No enforcement of our
laws, on the other hand, would mean anarchy. Somehow, officials
must choose what laws really matter.”
 “Tolerated lawbreaking is almost always a response to a political failure
– the inability of our political institutions to adapt to social change or
reach a rational compromise that reflects the interests of the nation and
all concerned parties. That’s why the American statutes are full of laws
that no one wants to see fully enforced – or even enforced at all.”
25
First example doesn’t perfectly fit premise,
but interesting
 “Over the last two decades, the pharmaceutical industry
has developed a full set of substitutes for just about every
illegal narcotic we have.”



Rather than legalizing street drugs…
…society has developed Ritalin, vicodin, oxycontin, clonazepam,
etc…
…which may serve legitimate medical purposes in some instances,
but also mimic highs of cocaine and other drugs
 Marijuana…
26
Wu’s second example: pornography
 Apparently, there’s porn on the internet
 And it’s basically all illegal
 Federal law prohibits using a “computer service” to
transport over state lines “any obscene, lewd, lascivious, or
filthy book, pamphlet, picture, motion-picture film, paper,
letter, writing, print, or other matter or indecent character.”
27
Wu’s second example: pornography
 In 1968, Congress set up a commission to investigate


Commission recommended we repeal all obscenity laws, replace
them with laws to protect children and control public display
Nixon and other politicians condemned report as “morally
bankrupt”, insisted they would continue war on pornography
 A few well-publicized prosecutions in 70s/80s, halted in 90s
 2005: Attorney General Alberto Gonzalez tried to pressure
local prosecutors to crack down, but nothing happened

One Miami attorney: “compared to terrorism, public corruption, and
narcotics, [pornography] is no worse than dropping gum on the
sidewalk.”
28
Wu’s second example: pornography
 So pornography is technically illegal, rarely prosecuted
 What’s developed is unofficial zoning system – rather than
prohibiting behavior, it’s implicitly regulated





Prosecuted when it crosses certain lines
Ignored otherwise
Super Bowl wardrobe malfunction – when something gets on primetime network TV, people freak out
Child pornography still prosecuted
But “mainstream” porn left alone, so functionally legal
 So as a society, we’ve functionally legalized porn…


Not through legislation or courts…
…but through general consensus among prosecutors, FCC, FBI,
29
local police, etc., to do nothing about it
Wu’s other examples: copyright law, illegal
immigration, Amish and Mormons
 Amish refuse to pay Social Security taxes, do not accept
benefits, do not educate children past eighth grade
 Mormons to some degree still practice polygamy
 Wu discusses history of legal treatment
 Again, what’s emerged is de facto zoning



Mormon polygamist went on Sally Jessy and Springer to discuss
his lifestyle, he was tried and convicted
But when it’s done quietly, in scattered communities outside big
cities, polygamy still goes on and is basically tolerated
Amish are open about how they live, but keep to themselves, and
nobody worries about it
30
This all doesn’t really fit into our framework
of criminal law
 You’d think crimes are crimes because society wants them
to be crimes
 But in some cases, society doesn’t care whether something
is a crime, but doesn’t care enough to make it legal either
 Or, political system is “broken” enough that some things
can’t be fixed, we adapt by ignoring certain laws
 More obvious example: speeding
 (May support Hadfield’s view that the law won’t
“automatically” evolve to be efficient)
31
Recap of a few of
the semester’s big ideas
or,
“What do I hope you’ll remember
after next Monday?”
32
Economics is tools, not answers
 Friedman: “Economics is neither a set of questions nor a
set of answers; it is an approach to understanding
behavior”

Keynes’ imaginary “dentist” does not exist
 Point of class



Not to memorize facts like which liability rules leads to efficient
injurer activity…
…but to understand why
To understand how people respond to incentives, and be able to
predict how a law or policy will affect peoples’ behavior
 What other big-picture ideas do I hope you’ll remember?
33
Six big ideas to remember in law and econ
1.
Incentives matter…
 Effects aren’t always easy to
measure, but…


Evidence greater tort liability
does reduce accidents
Evidence greater expected
punishment does deter crime
 Laws (and norms) create
incentives


Define payoffs of the “game”
people play…
…and people respond
strategically (in own interest)
34
Six big ideas to remember in law and econ
1.
Incentives matter…
not always in the obvious way
 Unintended consequences



Make cars safer 
maybe people drive more
recklessly
Punish robbery severely 
maybe more murders
Prevent accidents at nuclear
plants with strict liability rule,
harsh punishments 
maybe managers cover up
small leaks
35
Six big ideas to remember in law and econ
1.
2.
 Not the only thing we should
Incentives matter…
care about as a society…
not always in the obvious way
Efficiency: a good starting point  But maximizing total
resources/wealth generally a
good thing

Can always redistribute later
 Studying efficiency is
something economists do well

When you have a hammer…
 Starting with efficiency forces
honesty about other goals

If you’re defending an
inefficient policy, need to
explain why – and whether that
goal is worth the social “cost” it
36
would take
Six big ideas to remember in law and econ
1.
2.
3.
 Coase Theorem
Incentives matter…
 But transaction costs matter
not always in the obvious way
Efficiency: a good starting point  Normative Hobbes
 Farnsworth paper: no
Can we depend on people to
bargaining after judgment
bargain to efficient outcomes?

Self-serving bias: settlements
may be hard to reach
 When failure to agree would
be particularly disastrous,
may want to design law to
not rely on bargaining



Private necessity
Necessity/duress
Eminent domain
37
Six big ideas to remember in law and econ
1.
2.
3.
4.
 Nuisance law, contract law, tort
Incentives matter…
law – largely about getting
not always in the obvious way
people to internalize
externalities they cause
Efficiency: a good starting point
Can we depend on people to
bargain to efficient outcomes?  Intellectual property
Efficiency requires incentives
 Letting people profit from
for socially valuable activities
private information leads to
incentives to acquire it

Unilateral mistake
 But, better not to reward purely
redistributive actions

Problem with first possession
rules
38
Six big ideas to remember in law and econ
1.
2.
3.
4.
5.
 Paradox of compensation
Incentives matter…
 Single rule, multiple incentives
not always in the obvious way
 can’t always get all right
 Damages for breach of
Efficiency: a good starting point
contract with reliance
Can we depend on people to
investments – can’t get
efficient reliance and breach
bargain to efficient outcomes?
 (Friedman tugboat example)
Efficiency requires incentives
 Liability in tort cases – can’t
for socially valuable activities
get efficient activity level by
both injurers and victims
A perfect rule may not exist
even in theory…
 Focus on the incentives which
matter most


Which actions/decisions are
most sensitive to incentives?
Which have largest effect on
efficiency?
39
Six big ideas to remember in law and econ
1.
2.
3.
4.
5.
 Direct costs vs error costs
Incentives matter…
 Whaling: fast fish/loose fish
not always in the obvious way
versus iron-holds-the-whale
 Demsetz: boundary maintEfficiency: a good starting point
enance costs vs overhunting
Can we depend on people to
 Nuisance remedies:
bargain to efficient outcomes?
injuncations vs damages
 Filing fees: fewer lawsuits vs
Efficiency requires incentives
less precaution
for socially valuable activities
 Criminal law: deterrence is
costly, reduces crimes
A perfect rule may not exist
even in theory…
 Right answer depends on
…and when it does, still may
circumstances
not be the rule we actually want
 How sensitive are peoples’

actions to incentives?
How much does an action
affect efficiency?
40
Six big ideas to remember in law and econ
1.
2.
3.
4.
5.
6.
 Example: rationality
Incentives matter…
 Throughout semester, we’ve
not always in the obvious way
assumed rationality
 Recent exceptions: behavioral
Efficiency: a good starting point
econ; ordeals; unenforced laws
Can we depend on people to
 Can we hope to design laws
bargain to efficient outcomes?
that still work well when people
are not perfectly rational?
Efficiency requires incentives
for socially valuable activities
 More generally…
A perfect rule may not exist
 World is a complicated place –
can’t model it without
even in theory…
simplifying assumptions
…and when it does, still may
 Need to think what happens
not be the rule we actually want
when these are violated
 And design rules that are
Need to know how conclusions
“robust”
depend on assumptions
41
Six big ideas to remember in law and econ
1.
2.
3.
4.
5.
6.
Incentives matter…
not always in the obvious way
Efficiency: a good starting point
Can we depend on people to
bargain to efficient outcomes?
Efficiency requires incentives
for socially valuable activities
A perfect rule may not exist
even in theory…
…and when it does, still may
not be the rule we actually want
Need to know how conclusions
depend on assumptions
42
But mostly…
 I hope you’ll remember how to think about laws or policies
through the lens of incentives…
 …that is, to think about the effects of a law or policy based
on peoples’ likely responses to the change in incentives
 In 1999, city council of Santa Monica CA banned banks
from charging a fee to non-customers withdrawing money



Next morning, ATMs stopped serving other banks’ customers
City Council was shocked
I’d like to think you all would have seen it coming
43
Thank you all
for being here!
44