Econ 522
Economics of Law
Dan Quint
Fall 2013
Lecture 2
Logistics
 TA sections begin this Friday
 “Fake homework” for Wednesday on website
 First real homework due next Thursday (Sept 19)
 If you want to read ahead, look at Coase, “The Problem of
Social Cost,” but we probably won’t get to it till next week
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 infer 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
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 Pontiac Grand
Am…




Maybe I prefer the money
Maybe I prefer the car
Maybe I’m truly indifferent between the two
But one of these must be the case
11
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
So now, we build toward efficiency
 next, we define a Kaldor-Hicks improvement
 Informally: any change to the economy which increases the total
value…
 …where value is measured by everyone’s willingness to pay
 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…
…me getting the car is a Kaldor-Hicks improvement
14
So now, we build toward efficiency
 A Pareto improvement only creates winners
 A Kaldor-Hicks improvement can create some winners
and some losers…
 …but the winners’ gains must be bigger than the losers’
losses




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
15
So now, we build toward efficiency
 formally: a Kaldor-Hicks improvement is a change to the
economy which could be turned into a Pareto
improvement with monetary transfers

also called potential Pareto improvement
 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 – it makes you and your guests better off, makes me worse off
 Is the party a Kaldor-Hicks improvement?


Yes – because the party, combined with the appropriate money
transfers, would be a Pareto improvement
(Example: you throw the party, you give me $40, each of your guests
gives me $3 – that’s a Pareto improvement)
17
To check if something is a Kaldor-Hicks
improvement, we can…
 look for transfers that turn it into a Pareto-improvement…
 …or, just count up the gains of the winners and the
losses of the losers, and see which is bigger
 a change in the economy is a Kaldor-Hicks improvement
if the winners’ gains outweigh the losers’ losses







if you have the party…
I’m $100 worse off
You’re $50 better off
30 guests are each $5 better off
– $100 + $50 + 30 X $5 = $100 > 0
Gains outweigh losses, so party is a Kaldor-Hicks improvement
(“the party created $100 in value”)
18
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
19
Is it 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 or not you compensate me
Even if “my slice of the pie” is smaller, overall pie is bigger…
…which is all that efficiency is concerned with
20
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”
21
Another 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
22
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’”
23
What forces lead to
inefficiency
24
To see whether something’s efficient…
 Compare gains to everyone in society (total social
benefit)…
 …to costs to everyone (total social costs)
 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
25
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
26
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
27
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 an
externality on everyone else
So everyone ends up fishing
more than the efficient amount
28
Tragedy of the Commons – example



20 fishermen
Cost of fishing is 8 fish per hour
Notation



Total fish
caught
H (260 – H)
Efficient
Level of
Fishing
h = how many hours I fish
H = combined hours everyone fishes
H = hours everyone but me fishes
“Maximum
Sustainable Yield”
“Equilibrium”
Level of
Fishing

Fishermen catch 260 – H fish per hour
(a)
What is the efficient level of fishing? How much utility does that
give to each fisherman?
6.3 hours per day per fisherman; 793.8 fish/day
Left to their own devices, how much will each person fish? How
much utility will each person get?
12 hours per day per fisherman; 144 fish/day
(b)
0
3
6
9
12
Hours fishing, per day, per fisherman
29
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
30
So externalities can lead to inefficiency
 Without some sort of regulation/intervention…


Activities which impose a negative externality will be done more
than the efficient amount…
…and activities which impose a positive externality will be done
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”
31
Other forces which
lead to inefficiency
32
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 Cuba 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…)
33
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 if income tax is 25%, then it won’t happen




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
34
Another example of taxes leading to
inefficiency
 This is a new BMW that’s been cut in half
 Taxes distort behavior away from efficiency
35
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
36
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 get
companies to innovate
 But also, we’ve defined “efficient”, but we haven’t claimed
that “efficient = good”
 Which brings us to…
37
Is efficiency a good
goal for the law?
38
Important distinction: positive versus
normative economics
 positive statements are statements of fact



can be descriptive: “in 2007, U.S. GDP was $13.8 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”
39
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
40
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
41
But…
 This answers the question, “Why is it interesting to study
efficiency?”
 Not the question, “Should the law be designed with the
goal of achieving efficiency?”
 To answer this latter question…
42
Posner gives us one argument why the law
should aim to be efficient
 Richard Posner (1980), The Ethical and Political Basis of
Efficiency Norm in Common Law Adjudication
 Starts with the observation: if you buy a lottery ticket and
don’t win anything, you can’t complain
 Imagine before we all started driving, everyone in the
world got together and negotiated a liability rule for traffic
accidents
 If one rule is more efficient than another, we’d all vote for
that rule ex-ante – ex-ante consent
43
Ex-ante consent – simple example
 Suppose there are two candidate rules for accident liability
 One favors pedestrians, one favors drivers
 The one favoring car drivers is more efficient
Expected
Expected Expected payoff if you
payoff,
payoff,
don’t know which one
drivers
pedestrians
you’ll be
Strict liability rule
-100
0
-50
Negligence rule
-20
-60
-40
 Posner’s point: before we know who we’ll be, everyone
would unanimously agree to the second rule
44
Things are a little more complicated…
 People without cars would prefer a less efficient system
if it meant drivers were responsible
 Posner deals with heterogeneity with a different example
 Landlord-friendly versus tenant-friendly laws




Might think tenants would prefer pro-tenant laws
But rents are determined competitively
If laws become more tenant-friendly, rents might go up to
compensate
And if tenant-friendly law is less efficient, it could make both
sides worse off!
45
Example: new law requiring landlords to pay
for their tenants’ heat







Suppose tenants get $1000 value from apartment, minus rent
Landlords pay $100 for heat, $600 in other costs
Without this law, tenants would pay for their own heat
They’d 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…
So both landlords and tenants do better under the old 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
46
Ex-ante consent, ex-ante compensation
 Posner’s basic argument: if we choose the most efficient
legal system, everyone is “compensated ex-ante” for the
choice, and should willingly accept the outcome they get
 Of course, all this consent is hypothetical…
 …and it does have certain limitations
47
Limitations to Posner’s argument
 The “lottery ticket” analogy requires risk neutrality


50% chance at $1,000,000 is just as good as 50% chance at
$900,000 and 50% chance at $100,000
If $100,000 is “worth more to you” when you’re broke than when
you already have $900,000, this argument doesn’t work
 Counterpoint to Posner: Hammond (1982)



Efficiency is really a special case of utilitarianism, and subject to
the same limitations
“Value” = “willingness to pay”
$1 worth the same to everyone
48
This highlights some of the things efficiency
is not
 efficiency is not equity
 efficiency is not fairness
 efficiency is not maximizing happiness
“Suppose that pituitary extract is in very short supply… and is
therefore very expensive. A poor family has a child who will be a
dwarf if he doesn’t get some of the extract, but the family cannot
afford the price [or borrow the money].
A rich family has a child who will grow to normal height, but the
extract will add a few inches more, and his parents decide to buy it
for him.
In the sense of value used in this book, the pituitary extract is more
valuable to the rich family… because value is measured by
willingness to pay, but the extract would confer greater happiness in
the hands of the poor family.”
- Posner, Economic Analysis of Law
49
A more pragmatic defense of efficiency as a
goal for the law
 Cooter and Ulen (textbook ch. 1)
 Efficiency should not necessarily be the goal of society
 But efficiency should be the goal of the legal system
 If redistribution is desirable, it’s better to make the legal
system efficient, and address distribution through taxes

Cooter and Ulen offer four reasons why the tax system is a better
way to redistribute wealth than the legal system
50
Four reasons the tax system is a better way
to redistribute wealth than the legal system
1.
Taxes can target “rich” and “poor” more precisely than the
legal system can
2.
Distributional effects of legal changes are harder to
predict
3.
Lawyers are more expensive than accountants
4.
More narrowly-targeted taxes cause greater distortion
than broad-based taxes
51
So, summing up… is efficiency a good goal
for the law?
 We’ve seen two arguments in favor


Posner: it’s what we all would have agreed on ex-ante
C&U: if you want to redistribute, it’s better to do it through taxes
 But there are definitely some problems with efficiency

Distribution matters; not everything is monetizable; people might
care about procedural fairness
 My take


In this class, we’ll mostly focus on the positive questions
But in the background, I think of efficiency as a “pretty good”, but
definitely imperfect, measure of “goodness”
52
For Wednesday…
 One argument from C&U for why law should focus on
efficiency, redistribution should be done through taxes:
“narrow taxes cause more distortion than broad taxes”


Wednesday, we’ll work through an example of this
“Optional homework problem”
 If you want to read ahead, look at
Ronald Coase, “The Problem of Social Cost”
(although we probably won’t get to Coase till next week)
 See you Wednesday!
53