Econ 522
Economics of Law
Dan Quint
Fall 2009
Lecture 23
Logistics
 Solutions to HW3 at end of lecture
 Remaining lectures
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Today: finish “core material” of class (everything on final)
Thursday: interesting digressions (not on exam)
Tuesday: practice problems
 Office hours
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Thursday instead of Wednesday this week (details by email)
Extra office hours Tues and Wed next week
 Final: Thursday December 17
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10:05-12:05, Social Science 5206
Cumulative, more weight on second half of semester
1
Efficiency
revisited
2
What have we done this semester?
 Efficiency

Property law: efficient allocation of rights/resources

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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?
3
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

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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)
4
This leads us back to two questions
 Is efficiency the right goal for the law?
 Should we expect the common law to naturally tend
toward efficiency?
5
Is efficiency the right goal for the law?
 Posner
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Once you’ve already been hit by a car, you’d prefer a strict liability
rule to a negligence rule
But suppose we all agree a negligence rule is more efficient
Then we’d all have agreed to it ex-ante (before the accident)
“Ex-ante compensation” / “ex-ante consent”
6
Is efficiency the right goal for the law?
 Posner

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Once you’ve already been hit by a car, you’d prefer a strict liability
rule to a negligence rule
But suppose we all agree a negligence rule is more efficient
Then we’d all have agreed to it ex-ante (before the accident)
“Ex-ante compensation” / “ex-ante consent”
 Even if people are asymmetric…
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Landlords wouldn’t like inefficient tenant-friendly law…
…but rents are set competitively, would go up to compensate…
…so tenants wouldn’t like the law either
 Ex ante, everyone would agree to most efficient laws
7
Is efficiency the right goal for the law?
 Cooter and Ulen
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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?

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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?

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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 common law to
naturally tend toward being efficient?
9
Should we expect common law to naturally
tend 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
tend toward efficiency?
 Cooter/Ulen: three ways the common law may naturally
tend toward efficiency

By implementing social norms/existing industry practices
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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
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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
tend 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
tend toward efficiency?
 So that’s two yeses:
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Posner: even politically influential will want efficient laws
Cooter/Ulen: three ways common law evolves toward efficiency
 But an opposing view:
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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
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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
tend toward efficiency?
 Hadfield, “Bias in the Evolution of Legal Rules”
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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
tend toward efficiency? EXAMPLE
 Four levels of precaution: none, low, medium, high
 Accidents do $1,000 of harm
 Market has equal number of high- and low-cost firms
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
None
20%
$0
$0
$200
$200
$200
Low
10%
$60
$30
$160
$130
$145
Medium
5%
$120
$60
$170
$110
$140
High
1%
$180
$90
$190
$100
$145
15
Should we expect common law to naturally
tend 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
None
20%
$0
$0
$200
$200
$200
Low
10%
$60
$30
$160
$130
$145
Medium
5%
$120
$60
$170
$110
$140
High
1%
$180
$90
$190
$100
$145
16
Should we expect common law to naturally
tend 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
None
20%
$0
$0
$200
$200
$200
Low
10%
$60
$30
$160
$130
$145
Medium
5%
$120
$60
$170
$110
$140
High
1%
$180
$90
$190
$100
$145
 Efficient levels of precaution

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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
tend toward efficiency?
 Hadfield: this bias will occur in any situation where courts
adjust legal rule based on what appears efficient

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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
18
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
19
Three recurring themes
from the semester
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To get efficient outcomes, design the law to
make people internalize externalities
 Determining efficient action/outcome requires comparing
social cost and social benefit of each activity

Activity should occur when social benefit > social cost
 We expect self-interested decision-makers to consider
private cost and private benefit
 If private cost < social cost, activity imposes a negative
externality, and will naturally occur too much

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Tragedy of the commons
Breach on contract in a world without remedies
Reckless driving in a world without liability
 If we can set private cost = social cost, people will
naturally take efficient actions
21
To get efficient outcomes, design the law to
make people internalize externalities
 If we set private cost = social cost and private benefit =
social benefit, people naturally choose efficient action

Contract law
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Tort law
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Breach of contract imposes externality on promisee
Expectation damages = anticipated benefit = harm done by breach
So then we get efficient breach
Liability causes injurer to internalize harm his actions lead to
Leads to efficient precaution, efficient activity level
Nuisance law
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Suppose I have a legal right to quiet enjoyment of my apartment
You value making noise at $100, I value quiet at $50
If rights are tradable, silence costs me $100 in opportunity cost
Tradable entitlements also lead to internalization, therefore efficient
22
allocation
Protecting a right versus an interest
 A right is protected if nobody can violate it without my
permission
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Really, if violation is punished severely
Injunctive relief protects rights
 An interest is protect if violation must be compensated

Interests are protected by damages
23
Protecting a right versus an interest
 Property law generally protects rights
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Trespassing on my land is punished severely, as a crime
Theft: if you steal my iPhone, you don’t owe me $300, you go to jail
But there are exceptions
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Private necessity
Eminent domain
 Contract law generally protects interests

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Expectation damages protect promisee’s interest in performance of
a promise, not their right to performance
But again, there are exceptions

Remedy of specific performance protects promisee’s right to a promise,
is often used for contracts to sell unique good
24
Protecting a right versus an interest
 Tort law generally protects interests

Nobody asks permission to break your arm in a car accident
 Instead, they hit you, then have to compensate you
 Key difference between criminal law and civil (tort) law
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Crimes are intentional, so we may want to deter them
Give you a right not to get stabbed, protect that right with
severe punishment for assault
Torts are accidental, impossible to eliminate them
Just want to reduce them to efficient level
So we price them, to get injurer to internalize externality
This is same as protecting an interest
25
Tradeoff between cheaper/simpler rule and
better incentives
 Designing efficient legal system means maximizing social
surplus
 Which is same as minimizing social costs

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Think about starting at most efficient outcome
Costs are any deviations away from that
 Costs typically take two forms:
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Direct costs of implementing some part of legal system
Indirect costs: any flaws in system lead to imperfect incentives,
and therefore inefficient outcomes
(“Administrative costs” and “error costs”)
 Often tradeoff between cheaper/simpler system, and
more costly/extensive system giving better incentives
26
Tradeoff between cheaper/simpler rule and
better incentives
 Demsetz: private land ownership among native Americans

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Private ownership has higher direct costs: boundary maintenance
Public ownership has high indirect costs: inefficient use of land
(overhunting)
 Whaling
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“Fast fish/loose fish” simpler rule, fewer disputes

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“Iron holds the whale” creates more efficient incentives for
faster/more violent whales

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Lower direct costs
Lower indirect costs
Which is more efficient depends on situation
27
Tradeoff between cheaper/simpler rule and
better incentives
 Injunctions versus damages
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Damages more costly for court to calculate – higher direct costs
Injunctions rely on bargaining – inefficient outcomes (high indirect
costs) if transaction costs are high
 Filing fees to initiate a lawsuit

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Higher filing fees  fewer lawsuits  lower direct costs
But more harms “unpunished”  weaker incentives to avoid 
higher indirect costs
 Crime

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Catching more criminals is more costly (higher direct costs)
But deterrence leads to fewer crimes (lower indirect costs)
28
The semester
in review
29
Begin with Coase
 Coase: when there are no transaction costs:
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
Just define property rights and make them tradable…
…then sit back and let people trade till we get efficient allocation
 But with transaction costs, this won’t work; we can either:


try to reduce transaction costs, or…
…try to get the allocation right to begin with
 Some sources of transaction costs

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Search costs
Private information
Large numbers of parties
Hostility
Enforcement costs
30
Branches of the law and transaction costs
 Property/nuisance law

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Clarify peoples’ rights/entitlements so they can enter into voluntary
exchange
Initial allocation matters when transaction costs are high enough
that efficiency isn’t reached “automatically”
 Contract law


Costs of ex-ante negotiations not too high…
…but renegotiation costs enough that we want to avoid it
 Tort law

Accidental situations, strangers – costs of ex-ante negotiations
prohibitively high
 Criminal law
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Ex-ante negotiations impossible for other reasons
“Public bad” – many parties harmed, so transaction costs are high31
Property Law
 Why do we need it?

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Without private property, publicly-owned resources will be
overutilized (tragedy of the commons)…
and people will waste resources on “possessory acts”
 Four key questions:
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What can be owned?
What can/can’t owners do with their property?
How are property rights established?
What remedies are provided when rights are violated?
32
Property Law
 What can be owned?

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For efficiency: private goods should be privately owned
Tradeoff between efficiency gain and boundary maintenance costs
Intellectual property (patents, copyrights, trademarks, trade
secrets), organizations versus corporations
 What can/can’t owners do with property?
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For efficiency: maximum liberty
Even with externalities, low transaction costs  initial allocation
affects distribution but not efficiency
High transaction costs  initial allocation (and remedy) do impact
efficiency – Normative Coase versus Normative Hobbes
Limitations: inalienability; unbundling; perpetuities; private
necessity; eminent domain; government regulation
33
Property Law
 How are property rights established?



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Examples: fugitive property (whales, foxes, underground gas)
Tradeoff between simple “bright-line” rule versus rule that’s harder
to enforce but gives better incentives
First possession versus tied ownership
Proving ownership; losing ownership (adverse possession, estray)
 What remedy is provided when rights are violated?

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Injunctive relief (property rules) versus damages (liability rules)
Calabresi and Melamed: injunctions more efficient when transaction
costs are low; damages when transaction costs are high
Temporary versus permanent damages
Public versus private nuisances
34
Contract Law
 Agency game, contracts as a way to enforce promises and
enable cooperation
 Bargain Theory – offer, acceptance, consideration
 Efficiency: a promise should be enforced if both parties
wanted it to be when it was made
 Contract law can promote efficiency by…


Enabling cooperation
Encouraging efficient disclosure of information
35
Contract Law
 Agency game, contracts as a way to enforce promises and
enable cooperation
 Bargain Theory – offer, acceptance, consideration
 Efficiency: a promise should be enforced if both parties
wanted it to be when it was made
 Contract law can promote efficiency by…






Enabling cooperation
Encouraging efficient disclosure of information
Securing efficient breach
Securing efficient reliance
Providing efficient default, and regulations
Encoruaging enduring relationships/repeated interactions
36
Contract Law
 Remedies: expectation damages, opportunity cost
damages, reliance damages, specific performance
 Effect on breach, reliance, threat points for renegotiation
 Paradox of compensation, foreseeable reliance
 Formation defenses and performance excuses

Incompetence (but not drunkenness); duress and necessity;
unconscionability; derogation of public policy; bad information
37
Contract Law
 Remedies: expectation damages, opportunity cost
damages, reliance damages, specific performance
 Effect on breach, reliance, threat points for renegotiation
 Paradox of compensation, foreseeable reliance
 Formation defenses and performance excuses

Incompetence (but not drunkenness); duress and necessity;
unconscionability; derogation of public policy; bad information
 Efficient default rules

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Impute terms parties would have chosen
Allocate risk to low-cost avoider
Unite knowledge and control
Ayres and Gertner: penalty defaults
38
Tort Law

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Traditional theory: harm, causation, breach of duty
Simple model of precaution and incentives
Various negligence rules
Effect of rules on activity levels
39
Tort Law



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

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Traditional theory: harm, causation, breach of duty
Simple model of precaution and incentives
Various negligence rules
Effect of rules on activity levels
Hand Rule for required level of care
Effect of errors
Tort law with sellers and consumers in competitive market
40
Tort Law








Traditional theory: harm, causation, breach of duty
Simple model of precaution and incentives
Various negligence rules
Effect of rules on activity levels
Hand Rule for required level of care
Effect of errors
Tort law with sellers and consumers in competitive market
Irrationality, judgment-proofness, regulation, insurance,
litigation costs
 Vicarious liability, joint and several liability, evidentiary
uncertainty
41
 McDonald’s coffee cup case, punitive damages
Legal process itself
 Efficient legal process minimizes sum of administrative
costs and error costs

Error costs depend on whether errors affect production or only
distribution
 Out-of-court settlement, pre-trial exchange of information
 Nuisance suits
42
Legal process itself
 Efficient legal process minimizes sum of administrative
costs and error costs

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
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Error costs depend on whether errors affect production or only
distribution
Out-of-court settlement, pre-trial exchange of information
Nuisance suits
Who pays costs of trials, fee-shifting rules
Burden of proof, standard of proof
Appeals process
43
Criminal law
 Differences from civil law:

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intent; cases brought by state; public harms; higher standard of
proof; punishment vs. civil remedies
Punishments generally inefficient
Are crimes always inefficient?
Marginal cost of deterrence could be positive or negative
Optimal level of deterrence (optimal level of crime)
44
Criminal law
 Differences from civil law:









intent; cases brought by state; public harms; higher standard of
proof; punishment vs. civil remedies
Punishments generally inefficient
Are crimes always inefficient?
Marginal cost of deterrence could be positive or negative
Optimal level of deterrence (optimal level of crime)
Social stigma
Fines varying with wealth
Incapacitation and rehabilitation
“Efficient” criminal system, and arguments against efficient
punishments
45
Today, back to efficiency
 Should the law aim to be efficient?


Posner: yes, ex-ante consent
Cooter and Ulen: yes, better to handle distribution through taxes
 Will common law naturally tend toward efficiency?


Posner: yes, even the politically influential want efficient laws
Cooter and Ulen: yes




Common law enforces norms and industry practices, which are likely
efficient
Judges may be more likely to overturn inefficient precedents
Inefficient laws may lead to more litigation
Hadfield: no

Court gets biased sample of cases, leading to “biased” laws
46
That’s basically the class
End of material on final exam
 Lecture on Thursday:



Behavioral economics and the law
Some other fun stuff
Kind of a digression – not on final exam
 To wrap up the “core material”, a few final thoughts…
47
What I hope you’ll remember after
December 17
 Economics is a set of tools, not a set of answers

Friedman: “Economics is neither a set of questions nor a set of
answers; it is an approach to understanding behavior”
 Point of class



Not to memorize 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
 Santa Monica, CA City Council banned ATM fees in 1999


They were shocked the next day, when ATMs stopped giving money
to other banks’ customers
I’d like to think you all would have been smarter than that
48
Thank you all
for being here
49