Econ 522
Economics of Law
Dan Quint
Fall 2009
Lecture 2
Logistics
 Chao’s office hours: Mondays, 11-1
 My office hours: Wednesdays, 1:30-3:30
 If you’re not registered (and want to be), see me after
lecture
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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
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Today: efficiency
 what is efficiency?
 is efficiency a good goal for the law?
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What is “efficiency”?
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What is efficiency?
First concept: Pareto improvement
 a Pareto improvement is any change to
the economy which leaves…


everyone at least as well off, and
someone strictly better off
 example of a Pareto improvement


Vilfredo Pareto
(1848-1923)
your car is worth $3,000 to you, $4,000 to me
I buy it for $3,500
 an outcome is Pareto superior to another,
or Pareto dominates it, if the second is a
Pareto improvement over the first
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What is efficiency?
Pareto superiority is not that useful a
measure for evaluating a legal system
 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 Paretoimprovement
 so we need another way to compare outcomes
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What is efficiency?
Next concept: Kaldor-Hicks improvement
 a Kaldor-Hicks improvement is any change to the
economy which could be turned into a Pareto
improvement with monetary transfers
 car example again


your car is worth $3,000 to you and $4,000 to me
government takes your car and gives it to me  Kaldor-Hicks
improvement
 a Kaldor-Hicks improvement may make some people
better off and others worse off, but “the gains outweigh
the losses”

also known as potential Pareto improvements
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What is efficiency?
To check whether something is a Kaldor-Hicks
improvement…
 we could look for the transfers that would make it a
Pareto-improvement
 or, we can just count up the gains of the winners and the
losses of the losers, and see which is bigger
 the car example (again)
 Kaldor-Hicks improvements may make some people
better off and others worse off, but “the gains outweigh
the losses”
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What is efficiency?
Efficiency
 a situation is Kaldor-Hicks efficient, or just efficient, if
there are no available Kaldor-Hicks improvements
 (Pareto efficiency: no way to make some people in the
economy better off without making some others worse off)
 Efficiency: no way to make some people in the economy
better off, without making some others worse off by more
 we’re already getting maximal value out of all available
resources
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What is efficiency?
Some other, similar measures
 our definition of efficiency: all possible Kaldor-Hicks
improvements have already been done
 Ellickson: “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’”
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What is efficiency?
We can also consider the efficiency of a single
action, in isolation
 an action is efficient if its total social benefits are
greater than its total social costs

same as saying, a change is efficient if it is a Kaldor-Hicks
improvement
 example: is it efficient for me to drive to work?
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What forces lead to
inefficiency?
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What forces lead to inefficiency?
We can better understand efficiency by
considering what forces lead to inefficiency
 Externalities
 Barriers to trade
 Monopoly power
 Taxes
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What forces lead to inefficiency?
1. Externalities lead to inefficiency
 Efficiency weighs social benefits and social costs
 But individual decision-makers consider only their
private benefits and private costs
 Externalities are whenever people not involved in
making a decision are affected by it
 Example: is it efficient for me to drive to work?
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What forces lead to inefficiency?
1. Externalities lead to inefficiency (cont’d)
 In general,


actions that impose a negative externality will tend to be done
more than the efficient level
actions that impose a positive externality will tend to be done
less than the efficient level
 In contract and tort law, we will try to design the law to
make people internalize their externalities
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What forces lead to inefficiency?
2. Barriers to trade lead to inefficiency
 If some guy in Canada owns something worth $100 to
him, and worth $150 to me, then it’s a Kaldor-Hicks
improvement for him to sell it to me
 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…)
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What forces lead to inefficiency?
3. Monopoly power leads to inefficiency
 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

P* = 70
CS
Profit
P = 100 – Q
DWL
MC = 40
Customers willing to pay
more than marginal cost
but unable to trade
Q* = 30
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What forces lead to inefficiency?
4. Taxes lead to inefficiency
 I value my free time at $40/hour
 Working in a factory, I can build things worth $50/hour
 Clearly, it’s efficient for someone with a factory to hire me
 But if income tax is 25%, then it won’t happen
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What forces lead to inefficiency?
Of course, that doesn’t mean these things
are always bad…
 For example


we just said taxes lead to inefficiency
but without taxes, there’s no way to fund public goods, and not
having public goods is also inefficient
 But also, we’ve defined “efficient”, but we haven’t claimed
that efficient = good
 Which brings us to…
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Is “efficiency” a good
goal for the law?
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Is efficiency a good goal for the law?
Important distinction: positive versus
normative economics
 positive statements are statements of fact



“economics of what is”
can be descriptive: “in 2007, U.S. GDP was $13.8 trillion”
can be theoretical predictions: “if prices rise, demand will fall”
 normative statements contain value judgments



“economics of what ought to be”
for example, “less inequality is better”
or, “government should encourage innovation”
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Is efficiency a good goal for the law?
Most of this class will be positive
 Predicting behavior, and outcomes, that follow from a law
or legal system is positive analysis


“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 the
goal of the legal system would be

“Law X is better than law Y”
 Posner, and many others, argue that efficiency should be
that goal
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Is efficiency a good goal for the law?
Richard 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
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Is efficiency a good goal for the law?
Things are a little more complicated…
 Even ex-ante, bad drivers might prefer a less efficient
system if it meant drivers weren’t responsible
 Posner deals with heterogeneity with a different example
 And of course, this consent is all hypothetical
 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
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Is efficiency a good goal for the law?
Posner’s argument does have its limitations…
 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)
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
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Efficiency is really a special case of utilitarianism, and subject to
the same limitations
“Value” = “willingness to pay”
$1 worth the same to everyone
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Is efficiency a good goal for the law?
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
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Is efficiency a good goal for the law?
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
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Is efficiency a good goal for the law?
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
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Is efficiency a good goal for the law?
(Example of why narrowly-targeted taxes
cause greater distortion)
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Is efficiency a good goal for the law?
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”

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That’s it for today
 Next class, we’ll see some numerical examples of some
of what we did today, introduce some basic game theory,
and begin property law
 See me if you’re not yet registered
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