Law & Economics
SEMINAR 1
History of Law & Economics:
-
Common law systems (19th Century) – UK + 50 other countries applying the British rule 
o
Why? – it has been developed in society with a freedom of choice for the market, less regulation for creating
contractual relationships. Less constraint.  open and free societies.
o
Paradoxical – it is the engine of wealth maximization and economic freedom, but it is also ambiguous – e.g. for
lawyers it is incoherent, irrational and unfair.
-
Timeline of the history:
o
1870: Christopher Columber Langdell in Harvard Law School  observes case law and writes a thesis on
scientific approach of law. He chooses to teach with case law studies. Found it very mechanical.
o
1920: American legal realists (group of law professors and some judges)  criticize the American legal
education.  “fallacies” (a mistaken belief) that the case law test is a science.
o
1940: University of Chicago law school – 1st Law & Economics course for students by Dr. Henry Simmon (dean).
He dies but there is no law professor available to replace him  Professor Aaron Director comes from the
School of Economics and becomes dean of the law school. He started to read cases to understand the legal
education.
o
Economist is invited to co-teach antitrust law course. He taught a law course with economic terms for the first
time  very different approach.
o
Meanwhile – Chicago School of Economics (Dean: Milton Friedmann – Nobel Prize owner few years later) –
macroeconomics is taught with neoclassic “theory of the market” approach (while in the rest of the USA the
Keynesian approach is taught).  There is a heavy focus on price systems, individual transactions. Economics
became powerful for analyzing law.
o
Chicago criticised Keynes because perfect information was not real in transactions, market failures were
ignored etc.
o
Keynes started to lose influence in early 1960s (Milton Friedmann became famous and influenced
governments, banks etc.)
o
Computers appeared – computational work and mathematic models confirmed with statistics existence of
market failures, externalities etc.
o
Law & Economics became popular  started being taught at other universities
o
1960: article published “Economics & Property Rights” by Dr. Armen Alchian – “every rule of law is affecting
allocation of property rights (negative or positive)  what are the limits of property rights? = revolutionary
o
5 years later – Aaron Director retires after creating the Journal of Law & Economics (only very few articles)
o
Ronald Coase becomes Dean and publishes 5 major articles within 1 year – 1st article “The problem of Social
Cost”: a rule of law does not have an influence on allocation of property rights because there can be
agreements, this cost of transaction drives the model.
o
He found the model for analyzing all case laws = new innovative tool from Chicago
o
1970: Professor in Yale law school and judge Guido Calabresi writes on “cost of accident”
o
At the same time, teaching Law & Economics outside of the US started
o
1967: Richard Posner (very influential judge) in Chicago writes 1 st textbook “Economic Analysis of Law. –
covered every single field of law and made possible to analyse every case.
-
For an economist, when there is an intervention, an attack on a market for fixing a failure (a market failure), it is
enough for doing a political analysis.
-
In general, the notion of “perfectly competitive market” is used for assessing economic performances. If there is a
market failure, a government will intervene correcting the mistake.
o
Problem: this type of correction costs money
 It is naïve (according to economists) to think that a state
intervention can fix everything
-
Social costs: taking into account costs, distortions, inefficiencies of laws and governments.
-
Coase underlined a more important problem: thinking that we are in a perfect competition (=zero transaction costs)
Assumption that market never fails therefore no economic basis for choice of laws or economic system by
governments.
Main Economic Theories
-
Neoclassics
o
Actors:

Adam Smith – invisible hand: proposes more freedom, justice system should not be fully controller bby
the state (state is just one of many actors that have an effect on economy)
-
Keynesism
o
Criticism: perfect information isn’t real in transactions, market failures were ignored
o
Keynes starts losing influence in 60s – rise of Friedmann’s neoclassical approach
Coase Theorem
-
Provides that when bargaining is free, the market will efficiently allocate resources regardless of their initial
assignment.
o
Reason
 when transaction costs are absent, stakeholders will contract with one another such that owned
resources will move to their highest value-uses.
o
“In a world of zero transaction costs (where costs of use of the market can be neglected) the assignment initial
of property rights does not affect the efficient allocation of resources”
o
= if the costs of transaction are equal to zero and if the property rights are well defined, it will result in an efficient
allocation.
-
Provides an economic analysis of the law’s most fundamental concept
-
It was introduced in Ronald Coase’s 1960 article, “The problem of social cost”
-
The theorem is attractive for lawyers to illustrate the effects of legal rules
-
The legal notion of reasonableness in Common law – closest version of Kaldor-Hicks efficiency
o
2
 provides that if it is in the mutual interest of parties to bargain with one another, they will do so.
Coase theorem and externalities – Pigouvian Tax
Externalities = recurring market failure. They arise when an actor does not experience full benefit/costs of behaviour.
There are positive + negative externalities.
Traditional public policy response to externalities  “Pigouvian tax”. This is a fee that is equal to the externality. (a
positive externality can be rewarded with a Pigouvian subsidy)
Example:
-
A lively pub is located next to a residential building. Noise from the bar bothers neighbours. Whose interests should
give away?
-
Residents want quiet use of their property, including good night’s sleep. BUT owners of bar wish to run their business
by offering a service that customers value.  Conflicting property rights.
-
Traditional analysis  would recognise a property right in the party whom the externality “harmed” – so, the
neighbours next door.
-
Application of Coase theorem  (2) points:
-
(1) If the residents and bar owners can bargain freely, it does not matter who gets the property rights. - So  Bar
makes 10,000 euros a week, and the residents value their lack of noise at 7,000 euros a week. If the gov. gives
property rights to residents, they will sell that right to the bar for an amount of 7,000 – 10,0000 euros. If states vest
property rights in the bar owner, the rights will stay where it is.  outcome will be efficient either way.
-
(2) If parties cannot negotiate freely  traditional “Pigouvian tax” solution may be mistaken. It is inefficient for the
bar to close its doors because the owner derives greater value from operating it than the neighbours would enjoy
having it closed. Yet, if the state allowed the residents to enjoin (prevent/prohibit) the bar’s operations and if
transaction costs exceeded the 3,000 euro co-operative surplus that the parties could realise by striking a bargain,
the outcome will be undesirable.
*The Coase Theorem provides that markets will efficiently allocate resources only in the unrealistic case where all
stakeholders can bargain at zero cost.
Coase theorem – exposes 2 significant defects underlying the Pigouvian tax
(1) Concept assumes that taxed actor is the lowest cost avoider of the relevant harm. In fact, multiple actors are often
involved in harmful situations.
(2) A Pigouvian tax is unnecessary if gov. creates + recognises a property right and if transaction costs = zero. If these
conditions are satisfied, then the parties will bargain to the efficient outcome.
Coase theorem – reading CD: The Problem of Social Cost – R. H. Coase
Paper is concerned with actions of business firms which have harmful effects on others. – standard example = factory
with smoke which has harmful effect on neighbouring properties.
Standard approach  Applying Pigou principle – typical conclusion of Pigou analysis in this case  desirable to make
the owner of factory liable for damages caused to those injured by the smoke, or alternatively, to place a tax on the
3
factory owner varying with the amount of smoke produced and equivalent in money terms to the damage it would cause
OR to exclude the factory from residential districts (and presumable from other areas where the emission of smoke
would have harmful effects on others).
Coase contends that suggested course of action (as above) is inappropriate because they lead to
unnecessary/undesirable results.
Coase notes that the Q is commonly thought of as – A inflicts harm on B, so what has to be decided is how to restrain
A.  according to Coase this is wrong because we are dealing with a problem of reciprocal nature. Avoiding harm to B
would be inflicting harm on A and vice versa. – the problem is to avoid the more “serious” harm.
He gives example of straying cattle and crop grower on neighbouring lands. If we imagine that the two are working on
neighbouring properties without a fence in between, an increase in the size of cattle-raiser’s herd increases the total
damage to the farmer’s crops.
Real life application  case of Sturges v Bridgman
-
Doctor cannot make use of his visiting room properly due to noise from confectioner’s machines operating on
neighbouring property.
-
Court – decides that doctor has the right to prevent the confectioner from using the machinery
-
Coase  asserts that it would have been possible to modify the arrangements by means of a bargain between the
parties.
-
Doctor would have been willing to waive his right and allow the machinery to continue operating IF the confectioner
would have paid him a sum of money which was greater than the loss of income which he would suffer from having
to move to a more costly/less convenient location or from having to build an extra wall to block noise.
-
Confectioner would have been willing to grant this sum of money, if the amount he would pay to the doctor would
be less than the fall in income that he would suffer if he had to change his mode of operation at this location,
abandon his operation or move to a different location.
-
Solution of problem  depends essentially on whether the continued use of the machinery adds more to the
confectioner’s income than it subtracts from the doctor’s income.
History Cont.
-
1967: Guido Calabresi – the first systematic attempt by a lawyer to examine the law of torts (accident law) with an
economic perspective
o
“goal of accident law = to minimise the sum of the costs of accidents and the costs of preventing accidents.”
o
= normative theory of legal liability

The one who causes the accident is responsible for the loss and must pay the compensation to the
victim. There is a need for a “cheapest cost avoider”. – e.g. a law forcing to buy brakes in optimal
condition.  less costly than consequences of an accident with poor brakes.
-
Efficiency II
o
Kaldor-Hicks Efficiency

4
Situation is Kaldor-Hicks superior if winners can compensate losers and still be better off

Situation is Kaldor Kicks optimal or efficient if there is no situation which is Kaldor-Hicks
superior to it

Roughly equivalent to cost-benefit analysis where costs and benefits judged by willingness
to pay

o
Problems: willingness to pay is not always ethically attractive criterion
Wealth Maximization

Posner calls use of Kaldor-Hicks efficiency to choose among legal rules “wealth maximization”

Confusing because wealth usually refers to things like stock, bonds, jewels and real estate

But selling stock to go on vacation can be ‘wealth maximizing’ if person values vacation
more than stock
1970s: Richard Posner “a theory of negligence”
= positive theory designed to explain Common law
-
The fundamental logic of the common law is economic
-
Judges could approve a more efficient allocation of resources in their decisions
the idea that economics “unlocks” the Common law system became an attracted idea. – Simple economic concepts are
used for analyzing the law.
Check reading for more info on Posner’s contribution to Economics in law
Legal vs economic reasoning
Lawyers and economists have 2 different ways to think when crossing the studies – lawyers look at the past
(jurisprudence) and economists look at the future (models and theories)
Lawyers: there is a dispute and a loss to fix  find a solution to bring the charge of the loss on the shoulders of one of
the parties.  Restrictive use of law expected effects are not exploited by the lawyer.  a good law prevents a crime,
an illegal act, an accident... if good laws are in place there will be less work for lawyers.
Economists: past is a “sunk” cost. Law must set a system of incentives and constraints affecting future actions  more
effects of law, same effects for every case in the same circumstances.
Common Law: analyzing law with economics reveal actually a lot of politics (interventions) but also effects, costs,
advantages of laws and their alternatives.
One view on the Common Law

Calabresi and Melamed who used the concept of economic efficiency with distributive justice and corrective justice.

Basic legal rights, claims, obligations

Decisions based on economic considerations

Property rule
5

Liability rule

Inalienability rule
Economic efficiency
Cost, benefits, risk  Economic efficiency
-
Allocative efficiency = condition in which the price of the good/service that consumers pay = marginal cost of
producing the good. (What is marginal cost?)
o
So, the price which consumers are willing to pay is almost/is equal to marginal utility that they derive from the
good/service.
o
Marginal utility  The benefit gained from the product/service
-
Productive efficiency = exists when firms produce goods at the lowest average total cost of production
-
Efficient outcome = resources, goods, services allocation to their highest expected valued uses
-
Pareto efficiency = the welfare of one individual cannot be improved without reducing the welfare of others
-
Kaldor-Hicks efficiency = Pareto efficiency but with a hypothetical compensation
Pareto efficiency and improvement
An exchange is a pareto improvement if it satisfies at least one person’s preference without making any other individual
worse off. – e.g. a mutually beneficial contract that lacks any negative third-party effects.
Pareto efficiency/optimality = an economic state where resources cannot be re-allocated to make one individual better
off without making at least one individual worse off. Pareto efficiency implies that resources are allocated in the most
economically efficient manner but does not imply equality of fairness. – so, if there were perfect competition + resources
were used to their max. efficient capacity, then everyone would be at their highest standard of living.
Pareto optimum state = when no economic change can make one individual better off without making at least one other
individual worse off.
Kaldor-Hicks efficiency
A decision is Kaldor-Hicks “efficient”, as long as there is a net gain to society, enabling any potential “losers” to be
compensated from the net gain. Therefore, those who are made better off could hypothetically compensate those that
are made worse off.
-
Less stringent criteria than Pareto  it is applicable to a wider range of circumstances
-
NOTE – compensation does not actually have to take place – the possibility of compensation merely has to exist
Issue with Kaldor-Hicks efficiency  it abandons the principle of explicit consent upon which Pareto improvement
depends. If a contract benefits two parties more than it injures a third, who is to say that the third party would consent
to the arrangement in the absence of perfect compensation?
Difference between pareto v Kaldor-Hicks:
-
Pareto  requires everyone/all parties involved to be better off or at least no one to be worse off. It is a very narrow
concept. Many (if not all) changes in law will negatively affect at least one third party.
6
-
Kaldor-Hicks  compensation only has to be available. Does not necessarily have to take place. The act in question
can therefore leave people worse off and still be considered “efficient”.
3 qualifications (from slides):
-
The second best (constraints must be taken into account)
-
Efficiency-wealth distribution link
-
Static (give level of technology, ex: Sport league) vs Dynamic efficiency (the way resources are used to expand the
production possibilities and capabilities of the economy – R&D department in IP rights.
Second best theory
-
Kelvin Lancaster + Richard G. Lipsey
-
Treated problem of what to do when certain optimality conditions (to reach pareto efficiency) cannot be satisfied
-
Happens when one or more optimality conditions are not met/satisfied in an economic model
-
If one optimality condition cannot be fulfilled, an optimum situation can be achieved only by departing from all other
pareto conditions
Static v dynamic efficiency
-
Static = most efficient combination of existing resources at a given point in time. – single period’s net benefits are
maximised.
-
Dynamic = productive efficiency of a firm over a period of time. – obtained when present values of net benefits are
equal for all periods in a multi-period problem.
SEMINAR 2 – CONTRACTS AND THE COASE THEOREM
Contracts and elements affecting its economics
-
Contracts represent coase theorem in action  entering into mutually advantageous agreement
-
Frustration, impractibility, and impossibility
-
Mistake, duress, undue influence and misrepresentation
-
Limits on authority: unconscionable agreements
-
Third-Party Effects and Inefficient accords: Contracts against Public Policy
Breach and remedies:
-
Efficient breach and Optimal reliance
-
Effects of damages on breach and reliance decisions
-
Consequential damages
Contracts = exchange = Coase theorem in action
-
Mutually advantageous agreement, creation of value, correction of inefficient assignment of rights (allocation) and
remedies to externalities.
7
-
Informed parties  Pareto improvements, contracting parties better off without violating the preferences of anyone
else
-
Communication and affirmation (information) of the will of the parties to enter a contract
-
Unequivocal acceptance is not enough, there must be mutual benefit on what parties agreed
-
Consideration: the relevant promises confer value on all of the parties
= contracts have a critical economic function. Which role has the law on contracts (law means intervention of State)
Very little according to Coase Theorem. Law ONLY creates and recognise property rights
Enforcing contractual promises to remedy monopoly:
 Why contract law is needed if contracts are self-enforcing?
-
Self-enforcing depending on certain circumstances: example law needed when examination of items in the bargain,
law fights against vulnerability of parties in opportunistic behaviour of another one.
-
Problem = monopoly of power in contracts
 In a case of monopoly, the legal repercussions coming from the law
is needed to avoid the party having too much power to not deliver the promised good or service, to avoid party to
mislead on the quality of the value from the other party, or to avoid simply the lack of payment.
-
Violated contracts will result in diminished demand and supply, reduction of level of welfare.
-
Contract law protects against the monopoly that promisors enjoy once promises to have tendered performance
under the agreement.
Contracts as risk-shifting devices:
-
Law prevents promisors from avoiding to fulfil their agreed obligations. Governments with the law, enable people to
perform mutually beneficial agreements. Few disputes would arise:
-
In case of disputes: post hoc fairness determination in order to avoid incidents on agreements is not enough.
Economics offers consequential framework within which to resolve contractual disputes.
o
Example: if a party is sick and was supposed to perform a concert? Would the other party sue that party to
reimburse all the tickets immediately or would postpone the concert, for keeping finances up?
-
Humans can make mistake or not always be in the situation to perform a contract (source of market failure) and this
can be on the detriment of their welfare. – “If only I hadn’t agreed to that”
o
 Whether a contract, given the information then available, produced a positive expected return for each
party who was privy to it?
-
Only the fact of ex ante satisfaction expected is relevant, not ex post
-
Law allows ex post regrets in order to let the parties still maximise their satisfaction in another way (second better
choice)
Contract liability as an incentive mechanism:
Law serves two economic functions in regulating parties’ contractual obligations:
-
Ensure that contracts are welfare enhancing (possible to rescinding (canceling) the contract if the accord effected
a net welfare reduction).
8
o
Here it assumes that parties cannot be fully perfectly informed before entering a bargain and mechanisms
allows to invalidate agreements.
-
Incentives that lead to contracting parties to behave efficiently. Law binds the individual who was ignorant of the
operative facts of the contract if she could have done a proper investigation on them. Penalty system is the party
does not seek to be as much as possibly well-informed.
The law should bind the individual who was ignorant of operative facts to the contract if he could have learnt the relevant
truths through cost-justified inquiries.  liability is more a penalty system designed to inculpate desirable behaviour.
After seeing the role of law, now which role for judges, courts in interpretation of contracts?
Frustration, impractibility and impossibility
Intro:
-
Contracts in order to manage risks
o
-
Division of risks, insurance contracts, employment contracts, against bankruptcy etc.
Contracts in order to allocate the risks
o
Lack of certainty at the time of formation of the contract. The law is correct to hold that a party cannot rescind
a contract on the basis of an event as to which he assumed the risk.
Frustration of purpose:
= When unforeseen circumstances undermine the contract’s purpose
-
Traits that are common to all efficient contracts:
o
Performance worth more than the contract price to the promise
o
Price exceeds promisor’s costs in delivering that performance
What happens if events deprive the promise of the benefit of the bargain before the contract is executed?  enforcing
the contract may now be worthless – could lead to a welfare reduction.
-
Determining to know:
o
Occurrence of a risk that renders performance unprofitable for a party but does not justify rescission
o
Event that obviates the value of performance to the promise and that warrants undoing the contract comes
down to whether the party implicitly or explicitly embraced the danger of the events’ occurring.
 increase value of the agreement to the purchaser. If buyer
accepts to bear the risk  decrease value of the agreement to the seller.  This determines the price.
-
The seller agrees to bear the cost of potential peril
-
Role of courts: determining which party is best placed to minimise the chance of harmful events’ occurrence.
Provisions to be negotiated on who bears the costs of these events.
-
Rescission is economically appropriate on ground of frustration where neither party explicitly assumed the risk of
events occurrence and where neither party is better placed to minimise the probability of the event occurring.
-
Courts must make a close examination of the position of the parties and expression of will to bear the costs.
o
9
How do courts determine whether party assumed risk?

They identify the party best placed to minimise the chance of harmful event’s occurrence  finding the
contract enforceable against the lowest cost avoider of a harmful event, which diminishes or eliminates
value of a contract to one party, is essentially a form of strict liability that can induce efficient
behaviour.
Example of case – Kell v Henry  famous common law opinion concerning frustration
o
Defendant  rents flat to observe coronation of King Edward VII
o
King became ill – rescheduling of coronation procession
o
Flat owner  sues for rent on which parties had agreed
o
No mention of repercussions for agreement if gov. postpones event – did not anticipate disruptive events
o
If procession had proceeded as scheduled, contract would be socially effective.
o
In this case, the parties knew that the sole purpose in renting the room was to view the procession. However,
neither party had any more control over timing/details of event.
o
Court discharged defendant’s duty to pay agreed price
Impractibility:
= When unforeseen circumstances render fulfillment of obligation impractable.
-
 How US law calls the effect of frustration: if event was unexpected and the occurrence renders performance
commercially impractable.
-
UK law has conditions: such a change in the significance of the obligation that the thing undertaken would, if
performed, be a different thing from that contracted (Davis Contractors v Fareham 1956)
-
-
Impractibility linked with frustrations as its result.
o
Again, risk should lie with the party best able to avoid danger
o
Role of the judge to determine the elements of that impractibility as a limit to the execution of a contract.
Important element  “changes the nature of the outstanding contractual obligation so significantly”
Impossibility:
= When unforeseen circumstances render fulfillment of obligations impossible
-
Extreme cases of impractibility: obligations more expensive to fulfill to the point that there is no possibility to
execute them.  forecloses any possibility of obligation to be carried out.
-
Role of courts in finding incentives in a contract for finding a pecuniary equivalence to that impossibility (damages)
if finding a contract therefore still enforceable, it does not have to fulfilled through performance but rather through
monetary equivalent.
o
= lost opportunity, to be assessed in pecuniary equivalent loss
Now contacts mutually beneficial ex ante but not ex post: case where the Pareto efficiency failed.
Mistake, duress, undue influence and misrepresentation
Intro:
10
-
 Coase theorem: contracts are voluntary arrangements which efficiently reallocate entitlements between
contracting parties (= allocation of property rights)
-
Parties accept to restrict future freedom in going into a contract but sometimes ex post regrets occur, without
ground to back out of an agreement.
-
Competence: if a person is incapable arbiter of his/her own well-being, no satisfaction of stable and coherent
decision. Insane people cannot enter into legally enforceable contracts. These prohibitions are security for a
secure economic foundation.
 Avoiding market failures
Mistake:
-
Contract should mutually benefit parties if each knows all the relevant facts.
-
There are some cases when one party may be mistaken about the facts or circumstances.
-
Whether rescission is possible depends on the nature of the mistake:
o
If one party failed to invest money to investigate in getting information, then no rescission. Liability is
triggered for that party. The relevant information was accessible in a cost-justified way. Perform as
understood or pay expectation damages.
o
If both parties failed, then no liability to attribute on any party, the courts should rescind (invalidate) the
agreement (no contract existed).
Undue influence and duress:
-
Free consent is a predicate condition of presuming mutually valuable exchange.
-
Few of the routine choices that people make in life arise in a neutral vacuum, without emotion, stress, urgency or
third-party pressure.
-
Thus, a little pressure of one party on a contract rarely results in void agreement.
-
The judge must determine whether the circumstances surrounding a promise were such that the promisor’s
binding himself to a contractual obligation does not reflect his preference.
-
Here the person’s choice is not clear and stable in terms of preferences.
Duress:
-
Here person’s choice is stable and clear. It is a voluntary act, but third party manufactures a false choice for an
offeree, overriding preference without bearing the cost. It is a reduction in the long-term welfare of the party. The
“voluntary” character of the commitment is not pursuing the satisfaction at all of the party but from another person.
Misrepresentation and omission:
-
Lie, fail to disclose material truths. Law imposes liability when a party voluntarily deprived the other party to be
well informed in order to force to agree on a deal.
-
The judge imposes liability on the lowest cost avoider for manufacturing a mistruth to convince an offeree to
contract. The court should enforce the contract as understood by the lied-to party.
-
Condition: the recipient of misrepresentation should reasonably understand that the communication amounts to a
statement of fact.
11
-
Misrepresentation is different than omission!
-
Fraud is different than deceit. Definition of forgery = example of fraud and tool for deceit.
-
Law creates incentives for a prospective purchaser to investigate on an item and put pertinent questions to the
seller.
Problems in interpretation
Q: is it appropriate for law to inject a term to which parties did not agree?
-
Contractual disputes routinely arise when a post-formation event, for which the underlying agreement does not
provide, materially affects the nature, cost or effect of the relevant performance.
o
1st step: Understand why gaps and ambiguities arise. Positive transaction costs accompany all contractual
negotiations. The law, however, can alleviate this defect by implying provisions upon which the parties would
have agreed had bargaining costs been lower.
o
2nd step: The economic approach to implying terms and to extrapolating meaning from ambiguous provisions
assumes that the parties meant to maximize the aggregate value that their arrangement created. To achieve
the largest private gain from a contract, the 1st step is to maximize the net value of the arrangement. The
more profitable agreement, the greater the amount of wealth available for individual distribution. Law &
Economics seeks to give effect to that supposition by implying and interpreting terms to maximize value.
When a promisor and a promise agree to make a term an explicit part of their arrangement, they suffer the transaction
costs necessary to reach consensus on the point but gain a guarantee of mutual benefits. (Solution for tragedy of
commons)
When courts venture beyond terms that would obviously have enhanced the aggregate value of the relevant contract,
they engage in an increasingly speculative exercise which threatens to inject an incorrect default term.
For that reason, courts refuse to imply a term where the parties are clearly the lower-cost determinants of the relevant
provision. The quintessential common law example is the judiciary’s refusal to impute a price where the parties failed to
agree upon a figure themselves. The capacity for error here is severe, as a mistaken judicial estimate of the appropriate
price may create a welfare-reducing contract. The parties themselves have private information which is crucial for
determining the relevant price.
The courts promote goal of minimizing the combined resources and error costs of drafting and litigation only by implying
terms where they are confident that the implied provisions would have been a constituent part of a value-maximizing
contact ex ante.
Limits on autonomy – unconscionable agreements
-
Unconscionable: extremely unjust agreement or one-sided in favour of one party to the contract
-
How should the law treat “unfair” or “one-sided” contracts?
o

Dismiss perceived inequity as an irrelevant detail. A person should stand by her promises, even
improvident, or those that fail to seize a proportionate share of the wealth surplus that the contract generated.
In extreme case, the judge can refuse to enforce “unconscionable” bargains.
12
Procedural unconscionability:
-
This arises where a person innocently signs an agreement while oblivious to a draconian provision that the promise
later seeks to enforce against him.
-
If a promisor were justifiably ignorant of a punitive term enforcing the contract would carry two negative economic
effects:
(1) It could reduce the parties’ combined welfare, as the harm to the ambushed promisor may exceed the gain to
the promise
(2) Enforcing such terms would encourage drafters to devise novel ways of injecting harsh terms to catch unwary
promisors
 Induce promisors to take costly self-protection measures (new externalities)
Substantive unconscionability:
= “oppressive terms”, “inequality of bargaining power”
-
One party to a potential bargain may be able to walk away, while another cannot. The tension between distributive
justice and aggregate wealth maximization comes down to a conflict between two partially conflicting norms. The
manner in which different individuals weigh these norms gives rise to distinct preferences, on which of course the
law & economics framework generally takes no position.
-
Economists resolve the tension in this way: they acknowledge that many people prefer to live in a world in which at
least some horizontal equity exists between individuals, such that sharp differences in affluence can be a social ill.
Law is an inappropriate mechanism by which to achieve such equity. Courts decisions only affect the well-being of
the parties privy to the case; they represent an arbitrary monitory of a larger pool of similarly situated people.
-
Economists advocate using the tax system to redistribute wealth more efficiently. Proper designed taxed will distort
behaviour less severely than wealth-shifting legal rules.
An illustration: Council Directive 93/13/EEC on Unfair terms in Consumer contracts
-
Certain unfair contractual terms are unenforceable against consumers.
-
Fairness = subjective = it causes a significant imbalance in the parties’ rights and obligations arising under the
contract, to the detriment of the consumer.
-
Asymmetric bargaining positions
-
This Directive focuses on contracts of adhesion (consent is needed)
-
The risk that, in limiting the degree of asymmetric profit, the law may reduce the private value of some contracts to
sellers below their reservation level, thus preventing some efficient agreement from taking place.
Third party effects and inefficient accords: contracts against public policy
-
Agreements that, though privately beneficial to the parties, are nevertheless inefficient because of third party-effects.
Economists assume that contracts are welfare-enhancing when negative externalities are absent.
13
-
Many contracts carry negative consequences for third parties. Unless those affected individuals were privy to
contractual negotiations and had an ability to veto any agreement, one cannot presume that externality producing
contracts are invariably efficient.
-
The law generally assumes that the private benefits of agreements outweigh third-party effects. However, it tempers
the potential for inefficient contracting through liability in tort for certain damages caused by externality producing
agreements.
-
Thus, agreements to kill, injure or defame third parties are not enforceable. Such arrangements fall within the larger
rubric of contracts against public policy, which the courts will not recognise.
-
The externality issue is most vexing when the trade-off between negative third-party effects and the private gains
occasioned by the relevant agreement does not lead to a clear-cut conclusion.
-
As many agreements carry third-party effects, and because transaction costs preclude may stakeholders from
negotiating in the underlying arrangement, one cannot rely on the fact that a free market will always produce
contracts that maximise social welfare.
-
The law forbids horizontal competitors from entering into cartel agreements. Such arrangements yield significant
gains to the contracting parties but inflict disproportionate losses on society.
-
Economics provides a useful tool with which to determine whether the net welfare effect of an agreement is positive
or negative (Coase theorem).
Efficient breach and optimal reliance
Efficient breach = essential concept of contract law & economics
 A promisor should renege (withdraw) on his contractual obligation where a third party would benefit from his
performance more than the original promise.
= concept of Kaldor-Hicks efficiency appears here with the possibility of compensation on top of Pareto efficiency.
Damage for breach of contract can play the role of compensation here.
-
The manner in which parties bind themselves depend on the legal interpretation that the courts give the operative
contractual language. One may promise to paint another’s house, but if the law reads that assurance as being either
to paint or to pay, the painter has not in fact bound himself to perform.
-
Efficient breach accounts for half the story of law & economics treatment of remedies. The other significant issue is
reliance.
-
The conditional term “if” is important. There is no guarantees in life and a promisor’s performance is no different.
Efficiency, therefore, requires that a promise only expend as much capital on reliance as is cost justified in light of
the probability that the promisor will fail to fulfill his end of the bargain.
Expectation, reliance and restitution damages:
One must first specify the nature of those remedies.
-
Expectation damages seek fully to compensate a promise by rendering him indifferent to whether or not the promisor
performed. (in money of the full expected execution of the contract)
14
-
Reliance damages attempt to put the disappointed promise in the same position as if she had never entered into
the contract, by returning to her any expenditure that she incurred in its anticipation. (in money already perceived at
the moment)
-
Restitution damages return to the promise any benefits that he had conferred on the promisor prior to the latter’s
breach. (in money what has been already offered before the breach occurred)
Effect of damages on the breach and reliance
-
Expectation damages are equivalent to a Pigouvian tax, which corrects the negative externality inherent in a
promisor’s decision to breach. In making the decision in the absence of legal consequences, a promisor would
compare the private costs and benefits of deciding whether to abandon a contract and would not consider the
deleterious effects of its decision on the abandoned promisee. Expectation damages make the promisee’s losses
the promisor’s own.
-
 guaranteeing performance or its monetary equivalent under contract.
-
Reliance damages: damages do not cause promisors to experience the full social cost of their decision to breach.
They must merely return promises to their pre-contract states of well-being. A negative externality thus accompanies
the promisor’s breach decisions in the presence of reliance damages, and so one can expect excessive levels of
breach in agreements subject to contractual remedies = imperfect remedy for breach of contract.
Incentive effects of different damages:
-
Restitution damages bear significant advantage: they spur efficient reliance expenditures. The reason is that a
restitution award will not return any investment made in anticipation of the promisor’s performance. As a result, the
costs and benefits that a promised benefit align with the social optimum – a promisee will engage in such
expenditures only if the expected return is positive.
-
Important: mitigation  a promisee must take reasonable steps to minimise the extent of the losses it experiences
from a promisor’s breach. The reason is that, given the promisor’s decision to breach, abating the social cost of that
action fall on the promisee, who is then the lower cost avoider. The mitigation principle thus serves a clear economic
function.
Consequential damages
-
Where perfect, symmetric access to information surrounds a bargain, the parties will understand the consequences
of non-performance and, if transaction costs are sufficiently low, will agree on terms accordingly. Yet, asymmetric
information characterizes most contracts, as many promisees have private knowledge that they do not share with
promisors. The foreseeability limitation incentives high-damage promisees to inform promisors of that characteristic,
thus allowing the parties to decide who should bear the risk of non-performance. If the promisor agrees to accept
the danger of his failing to perform, one would expect an increase in the contract price. Alternatively, if the promisee
embraces that risk, the agreed-upon price would be lower.
-
The term upon which the parties are likely to agree will reflect the identity of the lowest cost avoider. This will often
be the promisor, who can typically control the probability of her non-performance better than the promisee, but this
15
will not always be the case. Sometimes a promisee, who stand to suffer unusually severe losses from a breach, can
more effectively insure against those losses.
SEMINAR 3 – COMPETITION LAW & ECONOMICS
Economic role of Competition Policy
-
Anti-trust law prohibits monopolization and anti-competitive agreements  prevent inefficient conduct that would
otherwise take place due to high transaction costs.
-
Economics including price theory and game theory, is indispensable to competition law because it allows judges
and regulators to determine whether a restraint on trade is likely to enhance market output (and thus be approved)
or to reduce it (and thus is condemned).
-
Legislation cannot solve all issues in economics - Nevertheless, economics cannot answer all anti-trust questions,
in particular those that require balancing long-term and short-term effects. For instance, to answer whether
competition law should require a dominant firm to “open” its platform to render it interoperable with its rival’s product,
one must weigh the static benefits of increased competition in the short term with the potential dynamic cost to
incentives to invest in future technologies and platforms. The information necessary to answer such question is
definitively unavailable.
Economics of competition and monopoly
-
The two models underlying price theory are those of perfect competition and monopoly
o
Perfectly competitive markets are allocatively and productively efficient. To arise there must be many sellers
and buyers of homogenous goods, with perfect access to information and zero cost of entry and exit.
o
Monopolies create deadweight loss and are thus allocatively inefficient. Furthermore, profit-maximising
monopolists do not produce at the minimum point on their long-run, average cost curves. For monopolies to
exist, there must only be one seller, many buyers who lack purchasing power, and entry barriers.
Industrial organisation: imperfectively competitive markets
-
Industrial organization is the field of economics that studies imperfectly competitive markets. It has produced several
classic models that relate the efficiency of outcomes to market structure.
-
The role of the state is to make sure more information is available
-
Prior to the 1970s industrial organisation economists produced a large volume of empirical work, finding that industry
concentration positively correlated with rates of return. This research supported the SCP (Harvard School, StructureConduct Performance) approach, which suggests aggressive anti-trust enforcement to reduce industry
concentration.
Role of the market: definition, power and self-correction
-
Market definition  most critical aspect of all anti-trust cases, other than those involving hardcore cartels. The
relevant market includes all products that are reasonably interchangeable with each other at competitive price levels.
-
 gain insight into the price elasticity of demand that the scrutinized firm would experience at the competitive price
level
16
-
If demand is elastic at that point, the firm lacks market power and the restraint of trade being scrutinized is unlikely
to harm competition
-
If demand is inelastic, however, the company may have significant power and be able to affect anticompetitive
outcomes
-
Assessing market power is more complicated in two-sided markets, where a platform or network links two groups
to one another.
-
Examples include: dating websites and video game platforms
-
Feedback effects can explain below-cost pricing on one side of the network and above-cost pricing on the other.
Any conclusion drawn by studying only one side of a two-sided market will be reliable.
Anti-trust limits on contracts
-
The cardinal rule of anti-trust is that horizontal competitors may not fix prices or allocate markets, save where those
restraints are ancillary to a larger, pro-competitive arrangement.
Horizontal restraints on competition
-
Agreements eliminating competition are a species of contract contrary to public policy. They are inefficient because
they create costs in excess of private gains to the conspirators. In a world without transaction costs, firms and
consumers would contract to the point that perfect competition prevailed. That outcome would be Pareto optimal.
Price-fixing and market-sharing conspirators violate that social contract, destroying value in the process.
-
Nevertheless, firms may tacitly collude without breaking the law. Although it may not explicitly agree to terms, an
oligopolist is free to raise its price to the monopoly level – a move that is contrary to short-term self-interest because
it is loss-making if other firms do not follow. If the other firms in the market follow the price lead, the result will be
monopoly price and output.
-
Competition law declines to condemn tacit collusion because it would be difficult to enjoin. In oligopolistic markets,
firms must factor their rivals’ anticipated reactions into their price-setting decisions. An injunction ordering a
company not to take account of its competitors’ prices would thus require irrational conduct. Entry may be the best
remedy for tacit collusion.
-
Static models in game theory suggest that tacit collusion is difficult to maintain. Implicit cartels should erode because
every firm has an incentive to “cheat” by undercutting its rivals. Dynamic models in which conspirators can “punish”
defectors through price wars, however, suggest that collusion may become a Nash equilibrium.
o
Solution conception of a non-cooperative game involving two or more players in which each player is assumed
to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his
or her own strategy
-
Monopsonist agreements (one buyer to multiple sellers) – those between purchasers that create buying power –
are equally destructive of efficiency as seller-side cartels. They cause output reductions upstream that also distort
outcomes in downstream markets.
Vertical restraints on competition
-
Vertical restraints occur between firms at different levels of the distribution chain. They are less likely to create
anticompetitive effects than horizontal restraints.
17
-
As a general rule, manufacturers wish to minimize the cost of the distribution and retail process, for which reason
restraints upon which they insist are likely to be efficient.
-
A producer may award its dealers exclusive sales territories. Although doing so limits intra-brand competition, it may
enhance inter-brand competition by compensating dealers for embracing risk in marketing the producer’s goods.
US law analyses such restraints under the rule of reason, while EU law takes a strong line against any vertical
contracts that divide markets by member state. The EU rule reflects the non-economic goal of market integration.
-
Vertically imposed minimum resale prices can protect a dealer against free riding, while maximum resale prices can
limit mark ups, thus stimulating demand for the manufacturer’s product. Where such restraints emanate from an
agreement between downstream retailers, however, they are likely to be anticompetitive.
-
The same is true if the motivation for them lies in concerted action between upstream manufacturers of competing
products.
Monopoly as elusive prize: the dilemma for competition regulators
-
While the economics case for condemning cartels between horizontal competitors is iron clad, the question when
to intervene to challenge unilateral conduct by dominant firms is hard to answer.
-
Monopolisation cases are protracted and expensive; whether alleged exclusionary practices harm efficiency is often
disputed; and industry developments can render a remedy defunct before a court imposes it.
-
Although monopoly is generally undesirable, competition law does not condemn it. Reason = prospect of attaining
a dominant position is the engine underlying capitalist economies  Driving firms to innovate and achieve efficiency
gains. Removing the prize would undercut the incentive to compete.
Product tying
-
Antitrust has long been concerned about tying arrangements imposed by dominant firms.
-
Fear = that tie-ins allow firms to leverage pricing power to otherwise-competitive tied markets, whilst depriving
consumers of choice and creating entry barriers.
-
Economic analysis of this business practice reveals them to be significantly more complicated.
-
Tying often realizes efficiencies, both on the selling and buying side, and can leverage market power only in certain
circumstances.
-
Although economic models show that product tying can be anti-competitive, current rules in both the US and EU
are too restrictive.
Anti-competitive pricing
-
Predatory pricing occurs when a firm sells below a measure of cost in the hope of forcing its rivals from the market
or denying them scale of economies.
-
Economic models suggest that it is often an irrational strategy because a predator-firm must suffer losses over a
large volume of sales, and its threat to price below cost against subsequent entrants is non-credible.
-
Simultaneously, condemning predatory pricing carries a large type of error cost. Erroneous condemnation would
blunt the most important incentive in competition law: to compete on price to consumer’s benefit.
-
EU law is quicker to outlaw below-cost pricing. Unlike US law, it does not require a plaintiff to show a dangerous
probability of recoupment.
Refusals to deal
18
-
One of the most controversial antitrust questions is whether the law should require dominant firms to share their
physical infrastructure or proprietary technology with rivals.
-
Imposing a duty to deal increases market competition, and hence static efficiency, but potentially undermines longterm incentives to invest in networks and technology, thus harming dynamic efficiency
-
The duty to deal in US law is minimal, though more expansive in Europe
Loyalty rebates
-
Loyalty rebates are one dimension on which firms routinely compete. Their ubiquity in competitive markets implies
efficiency. Nevertheless, dominant firms could conceivably use them to exclude their rivals.
-
The economic literature suggests that single product, above cost rebates are unlikely to be exclusionary save in
rare circumstances
Vertical integration
-
Occurs when a firm absorbs certain or all elements of the distribution chain
-
This process generally increases output and reduces price (internalization of costs). In certain settings, though, a
firm may vertically integrate to obtain exclusive control over an upstream input that its downstream competitors need
to compete.
-
The law scrutinizes such situations for anti-competitive “price squeezes”, though under current US law, liability is
unlikely where no duty to deal is present.
Anticompetitive mergers: unilateral and coordinated effects
-
It would make little sense to condemn exclusionary conduct and cartel agreements if competitors were free to merge
to monopoly. For that reason, the law scrutinizes mergers and acquisitions to determine whether they will produce
“unilateral effects” (i.e. significant market power) or “coordinated effects” (a sufficiently concentrated industry bearing
characteristics making tacit collusion likely)
-
Although economics shows that mergers enhancing market power may be desirable on account of achieving
productive efficiencies – “Williamson mergers” – the law does not presently permit them. The reasons are focus on
consumer, rather than aggregate, welfare and the difficulty of verifying the attainment of merger specific efficiencies.
Economics of Natural Monopoly
-
Natural monopolies are industries in which one firm can satisfy market demand more cheaply than two or more
companies
-
Competition in such industries creates allocative efficiency, but also generates productive inefficiency due to
needless network duplication
-
Where scale economies (big companies have big costs and big gains, small companies have small costs and small
gains) are sufficiently powerful, competition may cause insolvency because firms cannot recoup their capital
investments in network or infrastructure when forced to price at marginal cost.
Containing monopoly power: regulation of price and entry
19
-
To promote social welfare in natural monopolies, governments should try to spur productive efficiency by eliminating
needless replication. They should also minimise allocative inefficiency by limiting supra-competitive pricing to the
point necessary to cover a common carrier’s or utility’s average costs in efficiently investing in the network.
o
The traditional US solution was to grant one company a lawful monopoly and then to regulate its pricing and
service
-
o
In Europe, the conventional measure was to nationalize the industry
o
Neither solution is ideal because neither can replicate the incentives of Darwinian competition
As marginal cost-pricing leads to insolvency, no optimal pricing regimen exists. Nonetheless, regulators tools with
which to limit the harm caused by allowing regulated utilities to cover their average costs.
-
“Ramsey”, or inverse-elasticity pricing, is a form of price discrimination in which price increases with the inelasticity
of each consumer’s demand. By increasing price more for price-inelastic customers, utilities and common carries
can reduce deadweight loss. Such pricing can create equitable issues, though by forcing people with limited choice
to subsidise others.
-
Two-part tariffs consist of an upfront access fee, and subsequent per-use charges. If a utility sets the latter fee equal
to marginal cost, and uses upfront fees to cover its fixed costs, it facilitates efficient use of its network for those
whose demand exceeds the initial access price.
-
Peak-load pricing adjusts price to smooth consumption between high-and-low demand periods. By charging less
for electricity consumed during the night vis-à-vis the morning, for instance, a utility incentivizes its customer to shift
their usage away from the times of greatest demand, thus reducing congestion. Such pricing facilitates more efficient
usage of the network and can increase social welfare.
-
The leading forms of profit regulation are
o
(1) rate-of-return regulation and
o
(2) price-cap regulation.
o
The goal is to limit supra-competitive pricing while both facilitating a sufficient return to attract capital for
ongoing investment and incentivizing productive efficiency.
-
Rate-of-return regulation: calculates the utility’s revenue needs, and then sets the price that over the anticipated
volume of sales will generate the targeted sum.
o
The revenue requirement equals the rate base (the capital that the utility devotes to providing its product or
service) by a reasonable rate of return (calibrated to allow the utility to attract sufficient capital) plus the cost of
service, which is the sum of operating and depreciation expenses.
o
The problem with rate of regulation is that it links costs and price, thus suppressing the utility’s incentive to cut
costs and achieve productive efficiency. If the regulator allows an excessive rate of return, it may induce the
Averch-Johnson effect, leading the utility to overcapitalize (in order to boost its rate and hence its authorized
revenue)
-
Price-cap regulation: identifies an authorised revenue target for a utility, sets a price-cap designed to facilitate that
level of revenue, and then adjusts that cap upward based on inflation and downward based on the utility’s perceived
ability to achieve productive-efficiency gains.
o
By committing to reduce the cap regardless of whether the utility achieves cost-savings, the regulator mimics
market incentives to cut costs. Similarly, by delaying the price-cap decrease for a time, the regulator
encourages cost-cutting so that the utility can increase profit.
o
In practice, however, a regulator’s threat to reduce the cap is non-credible if doing so would threaten the utility’s
solvency. By adjusting the cap to keep it a going concern, a regulator would re-establish the link between costs
and price, thus transforming incentive regulation back into rate-of-return regulation.
20
Restoring competition: the deregulatory movement
-
Since the 1970s, deregulation has taken place in the aviation, natural gas, telecommunications and electricity
industries (and elsewhere). Economists realized that natural monopoly conditions were not as pervasive as once
thought, and some argued that regulatory capture had led the state to champion the interests of regulated utilities
and common carriers rather than those of consumers.
-
Liberalization produced overriding consumer benefits in many industries, though the US experience in partially
deregulating the telecommunications and electricity was successful only in part.
The limits of competition: the case of the financial services industry
-
Deregulation had calamitous results in one important field: financial services. It reflects the instability of financial
service markets, as well as the crucial economic role that financial institutions play as intermediaries in the economy,
facilitating business transactions through the provision of credit.
-
The global banking crisis of 2008 and 2009 revealed that preceding deregulatory measures had been misplaced.
SEMINAR 4 – MODEL ANALYSIS - FUKUSHIMA CASE
Intro:
-
Tohoku earthquake and Fukushima accident – 11th of March 2011  Nuclear disaster
-
Legislation on and around the exploitation of nuclear energy before and after the accident
-
Economic analysis: economic rationality, incentive analysis, risks, liability, uncertainty, costs and benefits
-
Keeping as a goal the reduction of impact of the disaster of the competitiveness of the Japanese economy, can the
efficiency of the measures help to predict a fast recovery?
-
Announce of the plan:
o
Historical overview – facts (the accident – causes – effects – impact)
o
Economic consequences
o
Legal consequences
o
Economic analysis
Historical overview
Facts
-
On March 11, 2001  earthquake with magnitude of 9Mw hits Japan  consequently triggered tsunami that had
hit the Fukushima Daiichi Nuclear Power Plant (“FDNPP”)
-
Minutes later a nuclear emergency announced by Japanese gov. – announcement instructed people living in area
of 20km zone around FDNPP to leave as soon as possible, otherwise they would be exposed to deadly radiation
that was leaking from FDNPP.
-
Officials reaffirmed it is not really a nuclear explosion  It’s a chemical one
-
Human tragedy – killed more than 20,000 people and left a huge part of Japan devastated
-
Due to the damage some of the reactors exploded and released huge amounts of radiation into air above Japan
Natural cause:
21
-
Earthquake in Japan on 11 March 2011 – Tohoku earthquake
-
Magnitude of 9.0 in region of Pacific Coast of Japan – earthquake is known as the Great East Japan Earthquake
-
Huge tidal wave (tsunami)  added to the deadly effect of the disaster
Infrastructural reasons:
-
One of the biggest power plants of Japan (Fukushima) was situated along the coast and was severely damaged by
the tsunami
-
Left region without electricity
-
Not very strong standards  no record of meetings on security of nuclear power plant between Tepco and the
Ministry before crisis in 2011
-
Components made in the US pressure containers not designed according Japanese Industrial Standards (“JIS”) but
according to American Electricity Law
Legal cause:
-
A very old legislation for Atomic Energy – Atomic Energy Basic Law of 1955  outlines basics for use of nuclear
power in country  it is not updated for new technologies.
-
Objective of law  to generate wealth and to contribute to the national living standard = incentive analysis by the
economists, it creates predictable ways in the costs and benefits, prices and laws.
-
Population knows the costs of using such energy (determined by the government) and what kind of benefits they
may receive
-
Benefits to the government – the government collects taxes from the usage of this energy + regulator of the energy
market as a regulator + manage the marketable pollution rights. This responds to the “efficiency criterion”: support
their capability of supplying incentives for the maximization of the society’s benefits.
= not adapted to the new context of the exploitation of nuclear energy as the role of the regulator should have started
with an update of the standards in order to internalize the risk of accident, through regular controls. There was a
need for the management of risks (no separated legislation on this). Liability was not regulated which decreased
the economic efficiency in case of externalities.
Effects
On population
-
The tsunami and the accident killed more than 25,000 people until now and left a huge part of Japan devastated
-
Living area between 20km and 30km from the site were regulated as “indoor areas” – later urged as “evacuation
areas”
-
Resulted in mass displacement of people living near the place of the accident (40km or nearer)
On infrastructure and the sector
-
Region without electricity during several months
-
1/5th of Japan’s nuclear capacity  was stopped. Resulted in shortage of electricity in many regions of the country
-
Huge areas  devastated or partly damaged  Roads, buildings, homes and even companies went in the ground
22
Impact
-
Damages have been estimated to range within $122 and $235 billion amounting to 2.5-4% of Japan’s GDP
-
Effects to trade, industries, insurance markets and in overall Japan’s economic activities
-
Economists claim that Japans economy was struggling even before the events, however, it has increased the
difficulties
Economic consequences
-
New economic challenges  starting with shortage of electricity
-
Shortages in electricity and nuclear power are the starting point for a discussion of the economic implications Japan
has to face
-
As a result of the power shortage, production in many industrial areas has been terminated
-
Damages the reputation of the quality or organic products produced there
-
Radioactive influence  damaged the competitive abilities of Japanese products, which guaranteed their place on
the international market
-
The Eastern region of Japan affected by environmental disaster suspended production of parts, metals, chemicals
and many others
-
As a domino effect, production in other areas was affected and quickly spread to multiple sectors and levels of
production
-
Transportation costs  risen and businesses have incurred high unexpected losses. Supply to capabilities have
decreased substantially (no roads) or became very expensive for suppliers to operate in the damaged regions
(national trade level). At international trade level, it suffered a lot more, because gap between supply and demand
has increased significantly.
-
Mitigation by several actors
Legal consequences
General Measures
-
Japanese gov. abandoned its policy of promoting atomic power until the current gov. is discussing the decision
again.
-
Energy White Paper (2011) – approved by the Cabinet – for reduction in the nation’s reliance on atomic power (was
the 3rd biggest user of fuel before the March 11 earthquake and tsunami)
-
Authorities particularly pay attention to the development of energy-saving and environment friendly technology
-
Combining executive supervision and policy laws and regulations. Government encourages the production with less
energy and high efficiency; the local businesses were asked to adjust industrial structure; limit the development of
high-energy consuming industries and encourage the transfer of such industry to foreign countries; make energysaving plan and set energy-saving target; set strict standard to those high-energy consuming products etc.
Financial measures by the Bank of Japan
-
Bankruptcies occurred in the region affected by the disaster
-
The bank decided to reduce or even to compound the debts of businesses which were affected.
-
Ensure a fast return to business for firms and corporations without being heavily burdened by loans
-
The Bank of Japan also poured $183 billion in the economy in order to stabilize the market. For the sake of the
global financial markets.
23
Measures taken by the government
-
On 12th of March the gov. announced start of programs for facilitating the release of huge monetary support. It began
issuing bonds in order to support the recovery of the region and of Japan’s economy as a whole
-
No raise in taxes (to limit the negative impact)
-
Emergency measures were implemented immediately to support the country in the first month after the disaster,
and the shortage of power has been overcome
-
Only four working nuclear reactors left  50 reactors stopped running
-
Strict 40 years limit on the life of reactives  construction of new reactors is forbidden
-
Projects on “green power” (solar batteries, wind power generators) replacement by these before 2030
-
Risk management  In high development
Recovery plan
-
Create incentives for businesses and individuals that will boost participation, development and cooperation
-
Switching to fossil-fuel power is not an alternative for Japan given their obligations to reduce greenhouse gas
emission
-
The first mechanism adopted as an emergency measure, that proved to be ineffective, was the allocation of quotas.
For the long-term, a sustainable solution was necessary.
-
Increase subsidy in supporting environmentally friendly industries or the introduction of high-efficiency water heaters
etc. Coming from the taxation of petroleum and coal and provides low-interests loan and less taxation to energysaving industries.
-
New subsidy items also cover individuals and families, for instance, one third of the cost spent on the installation of
solar energy will be subsidized by the gov. for each family.
-
“Rewarding system” also has been introduced and established for outstanding local businesses in energy saving
achievements. These policy instruments have given the incentives to local businesses to run their business in an
energy-saving and environmental friendly way.
Legal Consequences
-
New Energy Innovation Bill (6/09/2012) Japan aims at ending “nuclear energy dependence” increasing “ecological
resources” and “energy supply”
-
2 phases: cut down the nuclear energy 15% by 2030 and realizing the “nuclear-free” target
-
Problem: Japan is a resource-poor country and depends on the import of energy and oil. If Japan successfully
reaches the nuclear-free target and annul the nuclear power plants, the residents will have to pay the electricity fee
two times more than the current amount. It might accelerate by the scarcity of the resources
-
Government amended the Atomic law: the new version of the Bill provides for environmental legal instruments such
as liability rules, command and control mechanisms as well as provides economics instruments as collecting taxes
and marketable pollution rights
Measure by TEPCO
-
Payment of a huge amount of compensation to the victims. The company was ordered to pay compensation to every
person evacuated. Total amount that the company has to pay till 2013 is more than $59 trillion
Economic analysis
24
-
Posner’s wealth-maximization principle: the implementation of an effective framework will allow internal forces to
adjust supply and demand of power. One of the basic economic principles a, ‘efficiency criterion’ provides that law
must focus on efficiency and its primary objective must be creating incentives for the maximization of benefit and
improving efficiency.
-
The mechanisms in place must give individuals the freedom to choose when to use electricity and at the same time
it must meet the demand: introduction of a price mechanism. Consumers apply a cost-benefit analysis and decide
whether the cost of power can be weighted to the benefits they gain from using that power. Introduction of a higher
rate for peak periods balances the demand during different period of time and allows for alternatives. In this way,
demand meets the supplier’s capacity
-
Surplus benefits return to the public, through local business, helped by the national incentives. Consumers face
additional burden by paying more. However, users must realize that this burden provides them with incentive to use
less power and its aim is to balance supply capacity of power companies and demand from individual users
-
Sharing quality information regarding the new set of Energy law and policy might restore the good reputation of
Japanese products. Keeping consumers informed and decreasing unnecessary avoidance of Japanese products is
the only economic mean to approach this aspect of the disaster
-
Problem: even if production capacity in the region is restored, it would be extremely difficult to attract the customers
back. There is a new need to restore work and production for local businesses and consistent distribution of
information on the recovery plan
Continued…
-
Operations on the market: the role of the labels. Various products are labeled differently according to their
different levels of energy consumption. The “label mechanism” has been applied to cars, air conditioners,
refrigerators, heaters and more than 20 other different kinds of products so that the market can turn to an energysaving-oriented market.
-
The new law includes liability : capacity to provide ex ante incentives to avoid environmental damages and
capacity to guarantee ex post the proper compensation of victims.
-
The newly amended law has secured the two forms of environmental protection policies which are “command and
control” meaning direct regulation of activities that discharge polluters and “economic incentive” (tax benefits,
liability facilitation funds).
-
Economic rationality in the new legislation: Encouragement of creations of alternative methods of generating
energy (substitutability and marginality): building gas, oil, fuel, coal and hydro plants
-
Incentives: provides predictability in the costs and benefits, prices and laws in order to adjust the demand and
supply.
-
The amended law reduces risk and uncertainty in regards the decisions that are being taken, in announcing in the
policy, the expected value or expected utility until 2030
Conclusion
-
For economists, reconstruction and recovery should go beyond the level of the Japanese economy before the
earthquake. This cannot be done only by the government, but with all the actors of the Japanese economy.
-
The financial support which is directed to the problematic areas such as adjustment to the new system of energy
for the coming 20 years without making the population supporting it financially. This support is used to rebuild the
destroyed roads, houses, etc. in order to facilitate transportation and return the trade back to its normal pace.
25
-
It is clear that with the new amended law the government has included the both considerations of the legal side of
the environmental law and the side of the economists. The new law provides transparency in the energy market
where the consumers and producers know the types of benefits, costs and the possible risks.
-
As a conclusion, it should be noted that before the earthquake the law governing the generation of energy by
atomic nuclear power plants was lacking some environmental economics instruments. With the amendment of the
law, the government secured the victims with compensation, provided alternative methods of producing energy by
providing more benefits, costs and risks (liabilities) - and thus securing that the amended law is economically
efficient
LECTURE 5
Legal vs economic reasoning:
26
-
Lawyers and economists have 2 different ways to think (which creates resistances when crossing the studies).
Lawyers look at the past (jurisprudence) and economists look at the future (models and theories).
-
Lawyers: there is a dispute and a loss to fix => find a solution to bring the charge of the loss on the shoulders of
one of the parties => restrictive use of law, expected effects are not exploited by the lawyer
 a good law
prevents a crime, an illegal act, an accident… if good laws, less work for lawyers…
-
Economists: past is a “sunk” cost. Law must set a system of incentives and constraints affecting future actions

more effects of law, same effects for every case in the same circumstances
-
Common Law: analyzing law with economics reveal actually a lot of politics (interventions) but also effects, costs,
advantages of laws and their alternatives.
The economic approach – choice and scarcity:
John Meynards Keynes: “Economics offers an approach” (a way of thinking about a problem). No need of any scarcity
in a world of abundance. Rationalizing the law or the allocation of resources, involved choices  study choices of
individuals as judges, lawyers and litigants.
Economic rationality:
Need for a basis when selection between alternatives (based on several assumptions to maximize net profits):
-
Substitutability: goods are assumed substitutable for another one at the margin.
-
Marginality: equalizing marginal values and diminishing marginal returns  compare marginal costs and
benefits.
-
Fixed tastes and preferences: for an individual, tastes and preferences are stable and given.
Economic assumption of rationality  a way of identifying the predictable response of a group of individuals (markets)
to changes in the factors which affect the choice.
Incentive analysis:
Groups react in a predictable way in the costs and benefits they face.
 prices and laws are viewed as creating incentives  Laws of demand and supply (when a price goes up, less is
purchased)  market, economics formalizes conditions of a market.
Example: law restricting speed limits  penalty exists to make sure that it is taken into account by drivers 
prevent accidents – if you pay more, your demand of overspeed drive will decrease – but not always the case,
only when applied to a large number of people.
Incentive effect is used to deter large number of individuals (not extreme punctual behaviors or mentally ill people).
27
A quantitative measure of the incentive effects of a change in price, cost or legal sanction is known as its elasticity.
A higher elasticity indicates greater responsiveness.
Example: inelastic demand on cigarettes, alcohol, petrol, because users are addicted or dependent.
 good taxation then for the government because it’s difficult to substitute these products.
Benefits and costs:
-
Benefits = the willingness to pay:
Utilitarian notion of happiness, WTP, consumer surplus.
Individuals with an intense preference for the good, receive a surplus benefit for their purchase = consumer’s
surplus.
-
Valuing intangibles:
Many aspects in life cannot be reduced to a monetary value: freedom, life, love, environment.
But some must be assessed with economic impacts: choice of a job (with the entire package of benefits), tort
law (for the good of a good insurance – notion of optimal safety)
-
Cost as lost opportunities:
Opportunity costs – current value for having and maybe fixing a good (also cost of production).
-
Cost vs transfers:

Real loss: net loss of consumers’ and producers’ surplus

Wealth transfer: a loss to one entity has been affected by an equivalent gain (example tax on goods:
each time ought, transfer of wealth to the government)
-
-
Time value of money: discounting and interests:

Benefits and costs are often spread over time  interest rate and discount rate.

Reason: humans have limited life and prefer present consumption to future consumption

Interest rate: rate of exchange between present and future consumption

Discount rate: present value of the early receipt of future income.
Risk and uncertainty:
More decisions when the outcome is far from certain, when there are expectations (probabilities to maximize
benefits), ex ante choices:

Expected value or expected utility approach

Individuals have different attitudes to risk: indifferent, averse, or enjoy

A trade-off between risk and wealth  critical aspect in law (tort, criminal, contract)
Options are evaluated ex ante in the face of imperfect information
Risk averse individuals. They will pay to avoid risk.
Individuals will trade money for risk reduction.
In order for laws to be ex ante efficient and convey incentive effects, they must lower litigation rate, so that discounted,
they equal the actual losses.
28
Markets and market failures:
 Place or space where individuals and firms trade goods, services and other legal claims for mutual gain 
coordinate actions, sellers, buyers. There is freedom, prices well balanced
 Provides information to individuals in the economy
 Competition = “Invisible hand”
Market failures:
-
Monopoly: too much powers in few hands, creating artificial scarcity
-
Externality: technological coming from production, pecuniary like taxes
-
Public goods: consumption by one individual does not destroy that of any other individuals (ex: defense)
-
Asymmetric information (party better than the other one, choices are distorted)
Coase Theorem:
Explication of the Theorem:
-
Externalities = pollution
-
Pollution is an external cost to society because it has negative effects that affects third parties when a product
is produced or consumed. External costs are not paid by the producer of the costumer = market failure.
 taxes on producers and polluting goods.
-
Government (police, tax authorities…) must intervene
-
Coase says: if property rights are well specified and transaction costs are equal to zero, the outcome is pareto
efficient and there is no externality problem.
 In the other sense: if there are externalities, either the property rights have not been well defined or there
are transactions costs or both.
-
Solution: who got the property rights? (these ones must pay, not others). Better to find an agreement with
everybody (than going to the court). This way everybody gets the benefits.
Endowment effects (the law affects the distribution of wealth between the parties).
Transaction costs: law operates in a world of positive transaction costs.
10 Coasen tenets:
29
-
Law as a factor of production
-
Principle of reciprocity
-
Causation is irrelevant
-
Joint cost
-
Coase Theorem itself
-
Cheapest cost avoider need not be the cost bearer
-
Laws do not have distributive effects in exchange relationship
-
Transaction costs are critical
-
Efficient law requires consideration of the cost of transaction
-
Institutions and laws arise to economize on transaction costs.
One view on the Common law:
Calabresi and Melamed who used the concept of economic efficiency with distributive justice and corrective justice.
Basic legal rights, claims obligations
Decisions based on economic considerations:
30
-
Property rule
-
Liability rule
-
Inalienability rule
LECTURE 6 – Intellectual Property Law & Economics
Innovation Policy:
 Determinant of long-term welfare, priority for public policy.
-
Scientific progress lifts constraints that had previously restricted a community’s wealth potential. A society’s
technological ability to transform scarce inputs into valuable consumables and services limits the potential
value of the economy.
-
Technological advancement may make entirely new products and services possible, thus creating value for
consumers where none existed before.
 Greater productive efficiency and new sources of utility.
Important: some people also have devoted their visionary and technical talents to nefarious goals: creative techniques
of torture and ever-more-lethal weapons are obvious examples.
-
Economics provides the policy recommendations upon which to build an innovation platform.
-
Law is the mechanism by which governments can enact rules that inculpate incentives to invent.
-
Distinct roles and actors in enhancing the innovation policy.
Platform for technological progress:
-
Inventors strive for pecuniary gains, crave social recognition and esteem of their peers. Others again do not
expect any reward.
-
Some sources of inventions are more important to modern innovation policy than others, such that one can
fruitfully inquire what conditions are most conducive to R&D in the former context. A government would
responsibly direct a disproportionate share of its efforts to foster such conditions.
-
Certain inducements are likely to spur innovation in many contexts and are unlikely to impede it in others.
Fostering those catalysts is likely to enhance the aggregate value of innovation in the economy.
Source of modern innovation:
-
Central role of private companies:

Private companies are the principal drivers of technological progress nowadays.
IT: Google (internet search algorithm), Facebook, Apple (game-changing device market), blackberry,
YouTube.
Hardware: Intel, Microsoft, Apple with applications.
Car manufacturers with safer and ever-more-efficient vehicles.
Biopharmaceutical companies with life-saving drugs and biologics.

 Pursuit of profits which has important public policy ramifications.
Appropriate mechanisms are therefore indispensable to high rates of private sector research (R&D).
These benefits are ancillary to positive expected returns on investing in innovation.
31

Prospect of great financial awards for companies that successfully introduce technologically superior
products.
-

Fierce competition among companies to achieve that goal.

A broad pool of talents combined to drive creativity.

Coordinated and sophisticated efforts between the private sector, universities and the public sector.
Universities:

Funding for conducting basic research.

Universities do much of the early legwork, identifying subsets of promising technologies, developing
them to a stage where they have credible potential for commercial application, and then selling them
to private companies.

Universities are key incubators of modern-day industrial innovation.

Tenure, promotion, and reputation are more important than pecuniary awards. Financial rewards
though represent a portion of the social value of successful research endeavors, to spur ever-greater
efforts.

-
External funding is crucial.
Government:

The Government has the role of identifying goals of interest to the larger community. The government
can devote public funding to worthy projects free of the risk that may hinder private investment and
with more concern for potential long-term payoffs.

The government can conduct its own innovation, which has historically been significant and has had
many desirable spillovers into public life.
Example: Government research in military and space technologies: internet, jet engines, radar, GPS,
etc.

Whether the government should conduct research that the private sector eschews depends on the
reason why the project does not possess positive expected value at the private level.

The government should enact policies permitting more effective appropriation by private enterprise or
undertake the research itself.

R&D process requires spending scarce resources.

Optimal rate of industrial invention = point where marginal increase in inputs to the innovation process
yields an expected gain in social welfare equal to the cost of that incremental input.
-
Individual Inventors:

Individual inventors have a romantic image in the public eye, the image of Thomas Edison. In reality,
it’s that lion’s share of innovation today results from institutional R&D.

The capital funding needed for effective research in many technologies precludes garage-based
efforts at the individual level. This does not apply to computer programming and software. In such
settings the contributions of individual innovators remain significant.
32
Conditions conducive to private-sector innovation:
-
There is a complex interplay between private enterprise, public sector, institutions of higher learning.
Industry should be the foremost focus of a responsible innovation policy. Governments should foster the
environment.
-
Public sector, university-based should focus on research that companies pursue at sub-optimal rates.
-
The quality and rate of innovation depends on the inputs that are available to feed the R&D process. That
system operates as a post innovation appropriation mechanism, which can infuse desirable ex ante incentives
to invent, as well as ex post incentive to commercialize.
8 conditions:
-
Political stability:

Unstable governmental systems frequently undermine both the rule of law and macroeconomic
conditions – two effects that do much violence to innovation. Uncertainty freezes industrial capital
investment in the R&D process.

Business can rationally invest in risky environments because, by diversifying their portfolios, they can
achieve risk neutrality and devote capital to projects bearing positive expected values.

Faced with political instability, private entities will typically turn to safer investment opportunities
because those prospects are more susceptible to net-present. value analysis.
-
Education:

Human capital is an obvious input into the knowledge economy. Innovation advances the state of the
art beyond its pre-existing level, which obviously requires a threshold level of training in the applicable
field on the part of the relevant innovator. At the level of a national economy, private enterprise cannot
engage in fruitful R&D without having access to a pool of knowledgeable workers. An educated
workforce is therefore a critical prerequisite of technological innovation.

While eradicating a country’s education system would have catastrophic effects on technological
innovation, it does not necessarily follow that reduced funding for education would suppress a
country’s long-term economic growths founded on R&D.

Education boost productivity by instilling otherwise absent skills in prospective workers.

Education is a sorting mechanism that sends credible signals to prospective employers concerning
the traits of the relevant students.

University-level in sciences and in engineering is more likely than most disciplines to instill productivity
enhancing abilities. Sciences, technology, engineering, mathematics are likely to be more conducive
of high rates of technological innovation in an economy than studies focused on the humanities and
social sciences.
-
33
The legal system:

Private sector innovation depends on the rule of law.

Corruption disorts market processes, which would otherwise direct resources to higher-value uses.
Extortion may be a problem, as will unchecked expropriation of proprietary interests in technology.
The latter effect may be particularly harmful. Collectively, a compromised legal system is a serious
barrier to entrepreneurship, foreign direct investment, and private enterprise’s devotion of capital to
the research and commercialization of promising technologies.

Consistent with these factors, economists have consistently found a positive relationship between the
strength of the rule of law and economic growth.
-
Capital-Market efficiency:

Much industrial innovation is investment heavy, and thus depends on inventors’ access to capital. The
funding required to innovate is heavily context dependent.

The most capital-intensive research industry is biopharmaceuticals, then semi-conductor industry. In
the pharmaceutical industry, the average time to develop a promising chemical compound into a
marketable drug is 12 years.

The availability of capital funding (be it in the form of equity, credit or grants) serves a critical function
in bridging the gap between expense and return.

Thriving venture capital activity, for instance, played a role in the rise of Silicon Valley as the world’s
innovation center.
-
Competition Policy:

Are competitive or concentrated industries superior incubators of innovation?

Joseph Schumpeter: monopoly is the best driver of invention because the large profits associated
with supra-competitive pricing produce surplus funds for research and development. Dominant
companies have incentives to invest private capital because their installed client base and scale
efficiencies lessen the chance that fringe rivals can appropriate the value of any successful
inventions. Competitive markets with low profits margins will not drive innovation. Monopoly may
provide a “more stable platform” for R&D investment.
 Laissez faire approach to antitrust policy with respect to dominant-firm behavior.

Kenneth Arrow: Competition best spurs innovation. Dominant firms have relatively weak incentives to
research ground-breaking technologies because they face a high opportunity cost in doing so.
Specifically, because monopolists earn monopoly profits on the basis of then-existing technology,
their spending those profits to realize a new marketable technology may simply displace one profit
base for another = “replacement effect”.
-
Regulation and bureaucratic red tape:

Governments can adopt policies promotive of education, political and macroeconomic stability and
law. Yet, the state can inadvertently stymie the process. Ex: from bureaucracy a regulatory system
enacted in order to “protect” consumers. Compliance costs, regulatory delays, etc. It is a negative
input into the innovation process.
34

Symmetric and complete access to information is a requisite of economic models that predict Pareto
efficiency. Information is vital to the efficacy of market process and its absence is a major reason why
real-world markets depart significantly from the hypothesized predictions of neoclassical models
premised on perfect competition.

By requiring disclosure of pertinent data concerning one’s product or service, the government can
allow consumers to make more-informed choices.

This effect will lead in turn to market prices that better reflect the value of the commodity in question,
thus sending superior signals to the market. There is thus a tension between the compliance costs of
regulation and the benefits of consumer protection.
-
Bankruptcy laws:

Debtor protection: Laws governing the relationship between borrowers and creditors can significantly
affect R&D investment. To understand why, one must first discern bankruptcy laws’ basic economic
effects.

In absence of a bankruptcy code, borrowers would remain liable for the full amount of debt that they
incur. This may be draconian, environment for imprudent or unfortunate debtors, but would not be
bereft of any economic benefit. Holding a borrower liable for the full amount of her debt would be an
instance of strict liability because of the legal obligation to repay would invariant to fault. Such liability,
causes actors to internalize the negative externalities that would otherwise accompany their conduct.
Applied to borrowers, the absence of bankruptcy protection would incentivize debtors to borrow
responsibly and to take every cost-justified step to ensure solvency. The benefit would be lower
interest rates and lower costs of capital for entrepreneurs and other innovators. Notice to lenders’
unqualified right to depend repayment would benefit not just creditors, but would also confer a
collective benefit on debtors, who would enjoy cheaper access for financing.

Many of the most valuable R&D prospects fact a high rate of failure (start-up) out of the few Google,
Apple, Amazon and Hewlett-Packard.
-
Immigration rules and employment law:

Human capital is the sine qua non of industrial innovation  education

Immigration law: countries should embrace liberal immigration policies directed at skilled workers. By
making visas easily and cheaply available for foreigners with advanced training, governments can
provide technology companies with access to the employees whom they need to engage in cuttingedge research. As the best minds are never going to be unique to a single country, fluid cross-border
movement of skilled human capital is conducive to innovation and efficiency (companies likes
Microsoft, Apple, Google, Intel are prominent advocates of more-liberal immigration laws for
foreigners with advanced training in science, engineering, and mathematics)

Employment law plays a related role in enriching, or limiting, human capital as an input to the
innovation process. Few issues are more politically contested than the degree to which government
should promote economic efficiency in labor markets. Economic theory suggests that fluid labor
markets are conducive to innovation because they permit employers readily to hire the most skilled
35
employees and to part company with those who fail to perform at the expected levels.
-
Public investment:

Finally, the state can spur innovation through public subsidies. Government funding can stimulate
valuable research on projects that are not sufficiently conducive to monetization to entice private
investors. By funding shortfalls that stymie worthy research efforts, the state can spur a more
comprehensive and socially valuable innovation platform.

There is a real danger, however, which arises when governments try to identify and pick victors in the
market. Misdirected government subsidies may also crowd out private investment. If that were indeed
to occur, it would be problematic because the private sector, which is subject to keener incentives, is
better than the bureaucratic state at identifying promising technological research.
Patent system:
Public Goods theory and the economics of innovation:
 Create an environment conducive to effective research and development (R&D). Consumers prefer products
entailing superior technologies and will pay to get them.
 Should innovate to avail of consumer demand. Incentives may be even more pronounced in competitive markets,
where Darwinian survival requires innovating enterprises not to fall behind their rivals.
 applies to inventions but many discoveries as well.
-
Pursuit of profit should spur firms, even dominant ones to develop novel, cost-reducing production and
delivery methods. Such innovations diminish companies’ efficiency, saving scarce resources, increasing
demand and thus profit for the innovating companies.
-
In the presence of competition, such process-based innovation may be indispensable to long term survival.
-
Ultimately, when exposed to competition, companies that lack productive efficiency will become insolvent and
will be forced to exit market.
A primer on patent law and economics:
-
The economic problem is that innovation spawns positive externalities, meaning that free markets will engage
in too little R&D.
-
One can thus think of the law’s role as being to create a Pigouvian subsidy.
Incentives to invent independent of the Patent system:
The patent system imposes costs, as well as benefits…
36
-
First, it confers economic monopoly power on inventors of valuable technologies for which no substitutes
exist. Monopoly pricing distorts market outcomes by generating lower output than would exist under
competition. Economists refer to the ensuing welfare costs as “deadweight loss”.
-
Second, because transaction costs are pervasive, proprietary interests in technology fetter the universe of
cutting-edge knowledge available for follow-on innovation.
Industry-specific innovation profiles:
-
In industries that must combine discrete technologies to create a single product, patenting can create anticommons and thicket problems.
-
The former arises when many different entities own the patents needed to create an end product, such that a
firm must secure licensing permission from numerous licensors.
-
Cournot-complement effects cause those patentees to charge more than they would in the presence of
vertical integration. Thicket effects arise when patents’ claims are vague, allowing multiple patentees to claim
the same technology.
Both of these problems magnify transaction costs and suppress commercialization of technology…
-
The law holds that rules of nature, abstract discoveries, and stand-alone computer software are not
patentable. That prohibition makes economic sense because each such discovery, if patentable, would lie
upstream and bear myriad applications. Due to real-world transaction costs, upstream monopolies would
stymie the downstream application of technology. The law, however, permits patenting of useful downstream
applications of such principles.
-
To be patentable, an invention must be novel, useful, and non-obvious. The economic explanation for those
requirements are as follows:

Novelty: anticipated inventions are not inventions at all. Generally, allowing one to claim a monopoly
over what others already knew would impose a tax without a corresponding gain. Nevertheless,
economics suggests that the law should provide patents or alternative incentive awards when bringing
a known technology to market is expensive and vulnerable to free-riding. An example is certain
unpatentable drugs.

Utility: patenting useless inventions would add to an already large universe of IPRs, increasing
transaction costs for firms wishing to secure clearing positions.

Non-obviousness: if an invention is obvious, it was likely inevitable. In that case, granting a patent
imposes a social cost but this is not a “but for” cause of innovation. Simultaneous invention on a wide
scale may suggest inevitability, and thus evidence obviousness.
-
Several factors affect the need for patent protection over an invention. These are: susceptibility to reverse
engineering; the quantum of necessary capital investment; the risk of failure and the sunk nature of the
associated R&D; first-mover advantage, including network effects; and speed of obsolescence. As different
industries bear dissimilar characteristics along these lines, the need for the patent system varies markedly
between them.
37
-
Patents are not the only means by which to solve under investment in easily appropriated technology. Prizes
calibrated to exceed inventors’ reservation returns can accomplish the same goal.
Alternatives to patents: prizes buy-outs and regulatory exclusivity:
-
Prizes offer advantages: In particular, they do not confer economic market power on inventors, and thus
facilitate competitive markets for the acquisition and use of technology; and
-
Prizes are subject to disadvantages: Two are especially noteworthy: First, government funding of prizes
created distortions elsewhere in the economy and require those not using the ensuing technology to crosssubsidize those who do. Second, prizes can only spur the discovery of solutions to known problems.
-
Patent buy-outs (companies selling to state) and regulatory exclusivity are also available to governments as
alternatives or complements to traditional patent systems.
Copyright law:
Copyright’s economic role is to spur artistic expression by limiting third-party appropriation. Exclusive rights allow
artists to capture more of their works’ social value, thus inducing them to create in circumstances where otherwise
they would not.
Proprietary control of expression, however, carries costs.
-
Artistic endeavors are cumulative, improving prior work and drawing on it for inspiration. Since the universe of
literature, music, and art is the principal input in future expression, granting authors vetoes over the use of
their work stymies future creation. In short, in a static setting, copyright shrinks the public domain.
-
Copyright can also bestow authors and artists with economic market power, enabling them to charge supracompetitive prices, which create deadweight loss. The static inefficiency may be severe for digital goods
susceptible of flawless and costless recreation.
Copyright law and the incentive to create expressive works:
-
Many incentives other than copyright drive artistic expression. The innate urge to self-expression, competition,
social norms, pursuit of status, altruism, and many other factors can spur the creation of expressive works.
Where copyright is unnecessary to create incentives to create, its enforcement can reduce social welfare.
-
Open systems free of proprietary rights may be the best incubators of creation in certain settings. For
instance, innovation flourished in the early days of the Internet based on TCP/IP protocols that no one owned.
-
The public-goods theory justifying copyright is greatest with respect to investment-heavy creation that third
parties can easily appropriate, such as the commercial film and video-game industries.
The optimal scope of copyright protection:
38
Copyright scope has expanded over time, simultaneously enhancing incentives to create, the social costs of
monopoly, and the portion of existing works that do not lie in the public domain.
-
The economic goal is to adjust copyright scope to achieve the optimal balance between these factors.
-
Particularly valuable adjustments expand the public domain without materially reducing incentives to create.
For instance, registration and notice requirements induce the portion of artists/authors for whom copyright is
important to self-select into protection. Creators who express themselves for non-pecuniary reasons may not
go to the trouble, thus making their expressive material free for the world to enjoy.
Fair use and fair dealing are doctrines that limit copyright scope. Their economic function is to facilitate socially
valuable third-party use of expression in high transaction-cost settings.
-
Fair use is likely superior to fair dealing as a public-policy tool because its flexibility allows courts to permit
copying expression in new circumstances that the legislature could not have envisioned.
The efficient copyright term:
Present copyright terms of the life of the author plus 70 years are economically excessive, absent congestion
externalities.
Discount rates mean that the increment in protection, say, 50 to 70 years is negligible to a present-day author
contemplating an expressive work.
39
LECTURE 7 – Aviation Emissions Trading System (ETS)
Aviation Environmental Protection:
Selected aspects include:
-
Environmental law (Rio Declaration, customary international law…)
-
ICAO policy regarding environment
-
ICAO Mandate (see Kyoto Protocol)
-
ICAO & aviation noise pollution (engines standards etc.) and aviation emissions
-
IATA global approach to reducing aviation emissions
-
Open Skies Agreement (selected provisions, including discrimination)
-
Sovereignty of states over their airspace
-
Claims over the high seas
-
Right to fly
The Chicago Convention:
-
Art 1 is fundamental:
States sovereignty over their airspace.
-
Art 15 on airport and similar charges):
No fees, dues or other charges shall be imposed by any contracting state in respect solely of the right over or
entry into or exit from its territory of any aircraft of a contracting State or persons or property thereon.
-
Art 24 on custom duty:
Fuel on arrival in the territory of another contracting State and retained on board on leaving the territory of that
state shall be exempt from customs duty, inspection fees or similar national or local duties and charges.
Aviation Emissions Trading System:
CJEU Case C-366/10:
-
Validity of the EU ETS Scheme
-
Aviation and ETS scheme
-
Chicago Convention applicability
-
Customary international law
-
Extraterritoriality of EU law
-
Charges, fees and taxes
Consequences: until COP21:
40
-
EU aviation ETS: a real climate difference or rather a political stand?
-
Have possible economic retaliations from operators from outside of the EU influenced the latest agreements?
-
Are the effects of EU ETS limited?
-
Air Transport Association of America, AA, Continental, UA: challenged in Court, so must abide?
-
WTO dispute settlement system; next step (in case)?
-
Crisis and carbon market  consequences
Background of the EU ETS:
-
Aviation emissions represent 2% of the global Co2 emissions.
-
Including aviation in the EU ETS is forecast to save around 176 million tons of Co2 emissions by 2015.
-
EU Emissions Trading System (ETS): application to air transport
-
Scope: ALL operators of flights to or from EU airports
-
Emissions from international aviation are part of the EU ETS as of 1st January 2012
-
Applied to flights within and between EU countries.
-
See Directives 2003/87/EC and 2008/101/EC; Commission Regulations (EC) No 748/2009 and (EU) No
82/2010 (operators regulated by Member States), etc.
-
Proposed regulation in drafting relative to the determination of ETS international credit entitlements.
-
Extra-territorial application of taxes?
-
Goals COP21 Paris
-
MBM (Market-based measures) + 2016 Bratislava Declaration
-
International Carbon Market (ICAP): EU is a founding member
-
Temporarily suspended by the EC for flights operated 2010-2012 from or to non-European countries (see US,
China, India, etc.) in view of the Fall 2013 ICAO Assembly and the 2016 ICAO Assembly
-
Goals 2020: Global agreement at the ICAO level (+ interim measures)
-
Proposed amendments of the ETS Directive by the EC (Decision No 377/2013/EU) with a proposed regulation
in drafting relative to the determination of ETS international credit entitlements.
-
CORSIA (Carbon Offset and Reduction Scheme for International Aviation) adopted at ICAO, agreement
signed by 191 states with 2020 aims
-
CORSIA: phased introduction with a pilot phase (2021-2023) and mandatory from 2027.
Current status:
-
Provisional agreement reached restricting the scheme to intra-European flights (rest was suspended), until
2017.
41
-
2015 COP21 where inter alia a global deal on airline emissions was reached on MBM (considered to be the
most cost-efficient approach)
-
2016 ICAO Assembly agreement adopted by 191 States + basket of accompanying measures adopted:
CORSIA system implemented with a phased introduction
42
-
CORSIA – EU: EU ETS (Aviation) extended until 2021
-
COP24 Katowice, Poland
-
Latest US announcement (see inter alia coal production)