Econ 522
Economics of Law
Dan Quint
Fall 2010
Lecture 23
Logistics
 Remaining lectures
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Today: some interesting digressions
Wednesday: efficiency, recap
Next Monday: review session (Fran and Joanna)
Next Wednesday: practice problems (me)
 Homework 4 due Friday, 5 p.m.
 Final: Monday Dec 20
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12:25-2:25, 6210 Social Science
Cumulative, more weight on second half of semester
1
Models in
Economics
2
Imagine you’re a physicist
(Not drawn to scale)
3
Economists (at least theorists) work the
same way
 The world is too complicated to study “as is”
 So we make a simple model
 Try to leave in the “important parts” for studying a particular
question
 Realize that our results follow from the assumptions that
we made, and may or may not be relevant to the real world
4
Many assumptions get made differently in
different situations
 “Are people risk averse?”

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Ask a sociologist, you get an answer
Ask an economist, he’ll say, “It depends on what type of problem
you’re studying”
 For some questions, risk aversion is important

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How people choose investment portfolios
How people save for retirement if they don’t know how long they’ll
live
 For other questions, risk aversion plays no role
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Including risk aversion complicates model, without adding insight
So we assume agents are risk neutral – not because they are, but
because we’re focusing on something else
5
What does it take to do economic theory?
Reduce a
situation to
a tractable
model

Judgment

(Which
assumptions to
make)
Solve
the
model

Technical ability
Interpret
the
model

Judgment

(How much to
“trust” results,
given the model/
assumptions
behind them)
6
One way to think about this:
 Models are sometimes (often) useful…
 …and always wrong
7
The idea of a “standard” model
 We said: some assumptions (risk neutrality) get made
differently in different settings
 Other assumptions get made so consistently that they
become a part of the “standard way” that economists look
at the world…

…almost become a part of conventional wisdom
 And then we start to forget that they were assumptions in
the first place
8
Basically all mainstream microeconomics is
based on two premises
 People have preferences

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Allowed to like whatever they like…
…but assumed to understand all their options, and how they rank
them
 And people optimize

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People pick whichever option they like most…
…subject to what they can afford
 To put it another way, people are rational
9
We’ve been assuming this throughout the
semester
 “People respond to incentives according to what they
correctly perceive to be their own rational best interest”
 Property/nuisance law

each knows own threat point, can bargain with each other to
transfer ownership of entitlements to whoever values them most
 Contract law

can negotiate efficient contracts, courts can enforce them correctly
 Tort law

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people react rationally to incentives
courts can assign liability and assess damages correctly
 Criminal law

even criminals react rationally to incentives, commit crimes when
benefit outweighs expected cost
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But rationality is a strong assumption
 Very useful assumption

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Led to lots of predictions about how laws affect behavior…
…and therefore what types of laws would lead to efficient outcomes
 But conclusions are only as valid as the assumptions
 Today:
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How these assumptions sometimes fail in real life…
…and therefore why we may be skeptical about some of the
semester’s conclusions
But, you’re still being tested on those conclusions!
Think of today as a digression
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Behavioral Law
and Economics
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Behavioral economics
 How peoples’ actual behavior differs from predictions of
“standard model”
 Started out ad-hoc
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Take a prediction of the standard model, e.g., expected utility
maximization
Do an experiment – put a bunch of undergrads in a room and make
them play a game
Or look for instances in real world where prediction was violated
 Over time, generated some fairly robust conclusions

Systematic ways behavior differs from perfect rationality in a
number of different situations
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Behavioral economics
 What’s important is that deviations from standard
predictions of economics are not random

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Not random errors
But consistent, systematic biases
 At its best, behavioral economics holds itself to a “higher
standard” than traditional economics

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Traditional economics: makes assumptions (rationality and
optimization), derives predictions
Asks whether predictions seem right, but doesn’t spend much time
questioning the assumptions
Behavioral economics looks to justify the assumptions as well
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Behavioral economics – sources
 Two recent “pop economics”
books that are supposed to
be pretty good:
 Effect of behavioral
economics on law and
econ:
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Jolls/Sunstein/Thaler on three different
“uses” for economics
 Positive

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“An increase in expected punishment will lead to a decrease in
crime”
Or an explanation for the laws that do exist, as outcomes of some
process (evolutionary, legislative, etc.)
 Prescriptive

“To achieve efficiency, the law should specify injunctive relief when
transaction costs are low, and damages when TC are high”
 Normative
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What should be the goal of the legal system?
(For this class, we’ve assumed it’s efficiency)
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Behavioral economics has implications for
all three “uses” for economics
 Positive
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Goal of any positive model is to mirror actual behavior
 Prescriptive
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If people respond differently to laws than the standard model would
predict…
…then the law should be designed differently to account for this
 Normative
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If people seem to make “incorrect” choices, should we force them to
choose “correctly”?
If people do not optimize based on stable preferences, even the
definition of efficiency becomes unclear
17
(An example of how behavioral economics
makes meaning of “efficiency” unclear…)
 One observation of behavioral economics: people value
things more once they have them

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My office doesn’t have a lake view, I don’t think it’s that big a deal,
I’d only pay $100 to switch offices with someone
If I were given an office with a lake view, I’d come to love it – I
wouldn’t be willing to sell it for less than $500
My colleague has a lake view, which he values at $300
 Coase breaks down

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If I start with the lake view, I keep it
If he starts with the lake view, he keeps it
So initial allocation matters, even without transaction costs
 Which of us is the efficient owner?
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The goal of behavioral law and economics
 To give a more accurate model of how people actually
behave…
 …and use that model to reconsider the positive,
prescriptive, and normative conclusions of law and
economics
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So, how does behavior typically differ from
the standard model?
 Bounded rationality


We make mistakes…
…and use simple heuristics or “rules of thumb” to make choices
 Bounded willpower
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Even when we know what we “should” do, don’t always do it
Means commitment devices can have value
 Bounded self-interest

People aren’t totally selfish, even in anonymous situations with
strangers
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Examples of
bounded rationality
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Trading experiment from Cornell
 Similar to the first experiment we did in this class
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44 students in an advanced undergrad Law and Econ class
Half were given tokens
Each was given a number – how much they could exchange a
token for at the end of the experiment
Given an opportunity to trade
As you’d expect, people with high token values bought them from
people with low token values
This was with tokens – which had objective, artificial value
 Reran experiment with coffee mugs
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Half the students were given Cornell mugs
Then they were given opportunity to trade
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Trading experiment from Cornell
 Since the mugs were given out randomly…
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If each person knew exactly what a mug was worth to them…
…we’d expect half the mugs to change hands
Since half the mug owners would have above-average values, and
half would have below-average values
Instead, only 15% of the mugs were traded
On average, people who got a mug asked more than twice as much
money for them as people who didn’t get a mug were willing to pay
And the effect remained if the experiment was repeated
23
Endowment effect
 Conclusion from the Cornell experiment: having something
makes you value it more

If you have a mug, you value mugs more than if you don’t
 “Endowment effect”
 Existence of this bias seems robust

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One of the chapters in Sunstein book shows 12 studies where
Willingness To Pay for something is compared to Willingness To
Accept an offer for something people already have
Every time, people who have something value it more than people
who don’t – typically by 3X or more!
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Endowment effect – so what?
 Seems to contradict Coase
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Coase: without transaction costs, initial allocation shouldn’t affect
final allocation, since whoever starts with something, it will get
traded to whoever values it most
But endowment effects mean initial allocation does matter in
predicting final allocation
And, if preferences change depending on who starts with the
object, it’s not even clear how to define efficiency!
 Recall why we argued for injunctive relief for private
nuisances

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When TC are small, injunctions clarify two sides’ threat points and
allow them to bargain to efficient outcome
Endowment effect: initial allocation effects preferences, outcome 25
Endowment effect – so what?
 What about calculating damages?
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Ask someone beforehand how much money they’d accept to lose
an arm – huge number
After someone loses an arm, ask how much money it would take to
make them as well-off as before – much smaller number
Suppose someone with two arms thinks losing one would be a
catastrophe, like a $10,000,000 loss
Someone with one arm realizes he’s OK that way, thinks damage
done was $500,000
How much damages should a construction company owe if a
worker lost an arm?
And should they take precautions that cost $3,000,000 per lost arm
saved?
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Context dependence
Cheap
Quality/features
 “Second-cheapest wine” effect
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Hindsight bias
 Once something happens, people overestimate what its
likelihood was
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Think back to one year before last election, guess what probability
was at the time that Obama would be elected
In November 2007, Intrade had Obama at 7%
 So what?
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Determining negligence (Hand Rule) requires figuring out the
probability something would happen, after it happens
Example: risk of factory fire is 1 in 1,000, harm is $1,000,000,
company chooses not to install $10,000 sprinkler system
Fire occurs, jury thinks risk was 1 in 50, finds company negligent
Publicly-owned companies must disclose “material risks” to
investors
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Hindsight bias
 Effect of hindsight bias

Judges/juries will find negligence more often than they “should”
 Jolls/Sunstein/Thaler ideas for dealing with this all seem
flawed

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Keep jury in the dark about what happened
Raise standard of proof for finding negligence
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Similar bias – perception of probability
based on availability and salience
 People overestimate probability of a certain type of
accident if they’ve recently observed a similar accident

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“Availability” – memory of a recent accident is available in your
mind, colors your judgment
“Salience” – how vivid the memory is
 Explains environmental/safety regulations covering “hot
topic” without regard for cost-benefit
 Made worse because some people may deliberately keep
the accident available for private gain

“Availability entrepreneurs” – think of U.S. politicians after 9/11/01
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“Self-serving bias”
 Relative optimism when both sides have same information
 Students randomly assigned to roles of plaintiff and
defendant, would be asked to negotiate a settlement
 Asked to write down a guess as to actual damages
awarded in the case, and what a “fair” settlement would be

These answers would not be used during negotiations
 Students chosen to be plaintiffs guessed $14,500 higher
for actual damages, $17,700 higher for “fair” settlement
 Suggests pre-trial settlement may be rare, sharing
information may not solve problem
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Bounded
willpower
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How people discount the future
 Peoples’ choices do reflect discounting of future events…
 …but not in the way standard model predicts


Standard model: if discount factor is 11%,
$100 today = $90 in a year = $81 in two years = $73 in three = …
 Actually, dropoff between “now” and “later” is more severe
than between two future times
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Example: $100 today versus $150 in six months…
…or $100 in six months versus $150 in a year
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Bounded
self-interest
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“Ultimatum game”
 Player 1 proposes a way to divide up $10
 Player 2 says yes or no
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Yes: they each get the proposed share
No: they both get nothing
 Backward induction: only equilibrium is for 1 to keep almost
everything, 2 to say yes
 Experiments: offers less than $3-4 are often rejected, many
people offer fairly even split
 Shocking to economists, obvious to everyone else:
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People sacrifice their own well-being to help those who are being
kind to them
And sacrifice their own well-being to punish those who are unkind
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One interpretation of bounded self-interest
 People care not only about their own payoff, but also about
“fairness”
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But fairness is not objective – not all offers < $5 rejected
 Preference for fairness could explain lots of rules we see:
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Rules against scalping tickets
Rules against predatory pricing during emergencies
Rules against usury (very high interest rates)
Any voluntary transaction should be a Pareto-improvement…
…but prices which are too “unfair” are sometimes illegal
36
Jolls/Sunstein/Thaler
prescriptive and normative
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Jolls/Sunstein/Thaler
 Lots of interesting stuff on positive aspects
 Less on prescriptive and normative
38
One prescriptive suggestion
 How people respond to information depends on how it’s
presented

Example: choosing between safe and risky retirement investments
 So if government is putting out information, should think
about how “framing” changes its effect
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Safe driving ads used to be, “Drive carefully, or you’ll kill someone”
But everyone believes they’re a good driver
When ads changed to, “Drive carefully, there are other BAD
DRIVERS out there you have to watch out for!”
They started having more of an effect
39
Jolls/Sunstein/Thaler’s conclusion: the case
for “anti-antipaternalism”
 Antipaternalism

Government shouldn’t tell people what to do
 J/S/T stop short of advocating paternalism

If behavioral bias leads individuals to make mistakes, could also
lead government bureaucrats to make mistakes in telling people
what to do!
 “Anti-antipaternalism”

We shouldn’t automatically reject paternalism, since it may have a
role sometimes
40
Unenforced
laws
41
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
42
However…
 There are a lot of old laws in many states that seem
inefficient

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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
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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.”
44
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.”

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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: several cities where police chiefs or DAs have
announced they won’t prosecute possession

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Philadelphia law will treat possession as a ticketable offense
Medical marijuana in California and elsewhere
45
Wu’s second example: pornography
 Apparently, there’s porn online
 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.”
46
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 and 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.”
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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 regulated

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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 concensus among prosecutors, FCC, FBI,
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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 of 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
49
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
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So what’s my point for today?
 Throughout the semester, we’ve been assuming rationality

Of individuals, of businesses, etc.
 This has led to a number of conclusions
 Today: like with all economics, our conclusions are
only as strong as our faith in our assumptions

When we apply these conclusions to the real world, need to be
aware of how they depend on assumptions, how robust they are
when assumptions are violated
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