ECO 320 Final Exam
Property Law
Imagine a train running through a wheat field and dispersing sparks which tend to set fire to the wheat. Suppose
that the value of the lost wheat is $50. Moreover, suppose that the Railroad Company could prevent the loss by
installing a spark arrestor at a cost of $100. Will the outcome be the same regardless of which party is endowed
with the relevant property rights? What is the socially optimal outcome?
If the farmer is endowed with the property right to be free of sparks, the railroad company will purchase the rights from
the farmer for, say $75, with the result that the train will continue to run through the wheat fields. The farmer has been
compensated for his lost wheat ($50) and still some ($25).
If the railroad company is endowed with the property right to emit sparks, there is little the farmer can do. The farmer
would bribe the Railroad Company no more than $50 to install a spark arrestor. The Railroad Company wouldn’t accept
anything lower than $100. Thus the train will continue to run through the wheat field as before.
Regardless of which party is endowed with the relevant property rights, the socially optimal outcome is the same: the train
will continue to run through the wheat field.
Although the socially optimal outcome may be efficient, alternative property rights will affect income distribution.
Consider again the train and wheat problem. Assume that $50 worth of wheat is lost due to the sparks from a
passing train. Also assume that it costs $100 to install a spark arrestor. Now, let us assume that it costs the Railroad
Company $60 in lawyers’ fees to make any contract with the farmer. Will the outcome still be the same regardless
of which party is endowed with the relevant property rights? Explain.
If the railroad company is endowed with a property right to emit sparks, there is little the farmer can do. The farmer would
bribe the railroad company no more than $50 to install a spark arrestor. The company wouldn’t accept anything less than
$100.
If the farmer is endowed with the property right, the railroad company would have to pay compensation for damages
($50) and incur negotiation costs ($60). The railroad company stands to lose more if it pays off the farmer than if it
installs a spark arrestor.
The outcome will depend on the allocation of property rights. When negotiation costs are non-trivial the assignment of
property rights will influence the outcome.
Prior to 2000, in Ontario, governments limited non-smoking prohibitions to public places. However, municipalities,
then the province, extended the prohibition to private businesses such as restaurants and bars. Using
microeconomics, compare and contrast this regulation with the willingness of some businesses to voluntarily
segregate customers and staff into smoking and non-smoking areas without regulation as some businesses did prior
to the municipal and provincial rules.
The key point is externalities and who should regulate them. There is a potential double externality. There is second hand
smoking affecting non-smokers. There are inconveniences to smokers.
The message of the Coase Theorem is that the more localized the bargaining, the more efficient the outcome. So initially,
railroads designed smoking cars, airlines and restaurants had smoking sections, and employers smoking areas.
As greater knowledge about negative side of effects of second-hand smoking increases, the smoking bans become wider
and private choice may not be adequate in initializing the broader harms. So municipal bans and provincial bans become
more popular.
State the Normative Coase Theorem and give one example. Explain why this Theorem supports economic
efficiency
“structure the law so as to minimize the transaction costs to encourage bargaining by so doing”. Allowing an environment
friendly to contracts will increase social surplus among contracting parties. Examples: landlord-tenant- residential leasescan be verbal-contracts that do not need lawyers. Legal aid, mediation services.
Toronto has a form of rent controls. Studies detail how tenants in 2-bedroom apartments have enjoyed rent
controls longer than those in bachelor or 1-bedroom apts. Using microeconomic analysis including diagrams,
explain how this could happen.
In the late 1900s the rent control laws in Ontario were amended to permit landlords to set a new rent at market rates upon
the departure of a tenant. When similar apartments change hands more frequently, those landlords can charge market rents
more frequently, thus increasing the SS of such apartments relative to the larger or more luxurious apartments. When
larger apartments change hands less frequently, those landlords can charge market rents less frequently, thus decreasing
the SS of such apartments relative to the smaller or cheaper luxurious apartments. Over time, families that might have
been housed in larger apartments, squeeze themselves into smaller ones, while singles, who might have downsized in an
unregulated market, can afford to stay on in rent controlled larger apartments
If everyone has free access to a public beach, who, if anyone, has the power to control the use of this resource?
The beach is a public good. Allowing one individual to access the beach does not diminish the amount of access that a
second individual might have to the beach. If one were to attempt to exclude others from the beach, it could be costlier
than the case of private property. Thus, efficiency requires that the beach be publicly owned and maintained by the
government.
Another test: Do the TC that arise from private enforcement > (use public ownership) or fall below (use private
ownership) the TC of public enforcement.
The student should first identify what elements of a public beach make it a public good and a private good. Although a
public beach – like other land – could be privatized – the cost of making a beach rivalrous and exclusive could be so high
as to preserve its public good aspect. These costs involve high transaction costs. This suggests that only a very large
organization – such as a government agency has the power to control the use of the beach
Text pg 102-105. Question 4.15
Public ownership of the beach imposes transaction costs in terms of public administration and collective decision making.
The private property approach is to grant each property owner the right to control access to their part of the beach,
protected by the remedy of compensatory damages.Alternatively, the public property approach would declare that access
to the beach as a public good and assign the task of maintaining the beach to a government agency. The choice between
private and public ownership should depend on whether the costs of private enforcement and exchange are more or less
than the costs of public administration.
In the diagram it would depend on where the positions of the PMC (marginal cost of private ownership) lies in
relationship to the SMC (marginal cost of public ownership)
Explain why the following 3 assumptions 1) parties are rational, 2) parties have perfect information, 3) TC are 0
ensure that the Coase Theorem predicts these parties will reach an efficient agreement with respect to their
property rights.
Parties who are rational, will act in their own self-interest. So if their utility, profits or welfare increases by entering an
agreement, a rational party will do this.
If any relevant economic information is missing or wrong, the parties will more likely make mistakes by entering the
wrong agreement or no agreement at all. According to the theorem of Coase, if transaction costs are low or zero, parties
will bargain to a point that is socially optimal.
In the “invariance” version of the Theorem of Coase, the initial assignment of property rights will only have an impact on
the distribution of payments between the parties, but not on the economic outcome of the parties’ activities.
By use of a diagram of cost functions for a fishing firm, operating in a perfectly competitive market for the fish it
catches, compare, contrast and explain the optimal level of production the firm should choose with the actual level
of production it does choose. Explain how a rule could be designed to make these firms choose the optimal level of
production.
The diagrams below represent the representative fishing firm (on the left), competing in a price competitive market (on
the right) . The key point is that unlike the typical price competitive market model, the fish firm does not have to pay a
“prior owner”, for example, an owner of the “property” where the fish are harvested for the “property right” to take the
fish. There are other costs, but the absence of “property rights” in this market leads to the following outcome. Each firm,
believing their rivals will take more fish than they need to maximize profits, will themselves over fish. This leads to an
equilibrium where market price = average cost (not marginal cost). This equilibrium (red) is stable (Nash equilibrium)
but it is not efficient for the market nor optimal (profit-maximizing) for the fish firms. A rule that assigns property rights
that can be bought or sold will motivate firms to fish at the more optimal equilibrium (blue) where market price =
marginal cost.
This could be accomplished by a government or an international agency issuing licences to each fish firm or tradeable
permits where the supply of the licences or permits reflect the optimal level of fishing.
State the Normative Coase Theorem. What does the theorem do if transaction costs are too high for parties to
voluntarily make efficient agreements? Give two (2) examples of measures that a government applies in order to
illustrate this Theorem.
The Normative Coase Theorem - “Structure the law so as to remove the impediments to private agreements.” This
Theorem recognizes that transaction costs incurred by parties (firms or individuals) may be too high to motivate the
formation of contracts. For example, transaction costs exceed the amount of surplus (profits or utility) that could be
gained by forming a contract. This means transaction costs form an impediment to contracts.A government could remove
this barrier by a number of methods:
(1) Pay an outright subsidy to the parties for legal fees and court costs. This would enable the generating of
surplus for contracts
(2) Allow parties to deduct legal fees from taxes amounting to an “indirect” subsidy – Canadian Income Tax
regulation permits firms to do this.
(3) Simplify the law so that individuals can make contracts without the aid of lawyers. This could reduce
transaction costs and increase surplus
(4) Encourage the development of clear contractual “gap-filling” rules that reduce the work of lawyers and
thereby reduces transaction costs.
Explain why two adjoining slum landlords will not improve their apartments even if they are permitted to charge
tenants whatever rents they choose to recover improvement costs? Why will an “improvement” contract between
the two landlords fail? If a government authority intervenes to force improvements, what Theorem is involved and
why?
Both landlords know (have perfect information) that improvements to their respective buildings will permit them to
charge higher profit-maximizing rents to tenants. (Assume no rent controls that might prevent higher rents) Both landlords
further know that they could contract with each other so that each landlord undertakes to do the necessary improvements
to their respective apartment buildings to permit the higher rents being charge. In the absence of some strong remedy for
breach of contract or in the presence of some other impediment to the enforcement of this contract, such as high
transaction costs, each landlord will ignore the “improvement” contract and proceed to “free-ride” on the other landlord’s
improvement. Knowing the presence of this “contract failure”, neither landlord will make any improvement. A
government such as the municipality in which these apartment buildings are located, could enact property standards
bylaws, for example, with strong non- compliance penalties to force improvements. In doing so, such a government is
involving the Normative Hobbes Theorem. Normative Hobbes Theorem “Structure the law so as to minimize the harm
caused by failures in private agreements.”. By allocating property rights to the party who values them the most (the
tenants), the courts or the legislators make exchange of rights unnecessary and thus save the costs of transactions.
Explain when injunctions and damages are efficient. Use diagrams and examples in your explanation.
Injunctions are efficient in two (2) cases:
(i) When transaction costs are low – injunctions can motivate parties to bargaining. Then the Theorem of Coase
applies. It allows parties to bargain to a point that is socially efficient. This would be on point B of the diagram
below. The Electric Company and Laundry is an important example.
(ii) When transaction costs are high – injunctions can achieve the best efficient outcome when the court takes into
account the relative value parties assign to their rights. For example, in the absence of any possibility of
bargaining, such as an out-of-court settlement, if it is not possible for a court to establish compensation due to
missing information, the Normative Hobbes Theorem directs the court to grant an injunction to the party who
values the injunction more than the party who values no injunction being granted. See point A of the diagram
below.
Damages (compensation) is efficient when transaction costs are high – since this can achieve the best efficient outcome
when the court takes into account the absolute value parties assign to their rights. For example, in the absence of any
possibility of bargaining, such as an out-of-court settlement, if it is possible for a court to calculate compensation, the
Normative Hobbes Theorem directs the court to grant compensation to the party who values it more absolutely than the
party paying it would value not paying compensation. See point C of the diagram below.
What is meant by “invariance” in relation to the Theorem of Coase? Explain when resource allocation under the
Theorem of Coase would be efficient but not necessarily invariant. Use diagrams and examples in your
explanation.
According to the theorem of Coase, if transaction costs are low, parties will bargain to a point that is socially optimal. In
the “invariance” version of the Theorem of Coase, the initial assignment of property rights will only have an impact on the
distribution of payments between the parties, but not on the economic outcome of the parties’ activities. For example, in
the Rancher Farmer problem, whether or not the farmer was assigned the right to sue the rancher, the economic outcome –
12 head of cattle – was the outcome. See Point B in the diagram below.
If one allows for income effects that result from the different distributive results, then the invariance result disappears. For
example, in the Rancher-Farmer example, the Farmer keeps more income under the strict liability rule because he or she
does not have to pay anything to the Rancher. This changes the consumption behaviour of both parties which will result in
different economic outcomes. See Point C in the diagram below.
Many students set out in some detail the farmer-rancher example, which is good, it time permits.
State the Normative Hobbes Theorem. What does the theorem do if transaction costs are too high?
“Structure the law so as to minimize the harm caused by failures in private agreements.” Here the student may refer to
other parts of the test, such as question 1, to explain this answer. Besides encouraging bargaining, courts or the legislators
try to minimize disagreements and failures to cooperate, which are costly to society. The law should be designed to
prevent coercive threats and to eliminate the destructiveness of disagreement. By allocating property rights to the party
who values them the most, the courts or the legislators make exchange of rights unnecessary and thus save the costs of
transactions.
Use the Normative Hobbes Theorem to predict whether the injunction or damages (compensation) would be the
more efficient remedy whenever each of the following rights are breached. Briefly explain why the remedy you
predict is more efficient:
(a) A landowner’s right to exclude from his property a neighbor’s gas line.
An injunction to meet the obstacle in calculating compensation because of the land owner’s uncertainty about what the gas
line might do to the property.
(b) A new car owner’s right to have her car’s defective transmission replaced by the seller.
Damages – due to the ease of finding the cost of installing a new transmission.
(c) A homeowner’s right to be free from air pollution by a nearby factory.
Damages – due to the ease of finding a valuation of a comparable house in a neighborhood not affected by the factory.
(d) A spouse’s right to half the house on divorce. (25 marks)
Damages – due to the ease of finding a valuation of the house and the calculating one half of this value.
2.8
Distinguish between private marginal cost and social marginal cost for property

When we impose on firms some law, that changes the cost curve of the firm to shift to the left/or rotation to
the left. We call this the Social Marginal Cost curve (SMC). Draw diagram, show original cost curve (MC),
and shifted SMC curve.

The second source of market failure is the presence of what economists call externalities. Exchange inside a
market is voluntary and mutually beneficial. Typically, the parties to the exchange capture all the benefits and
bear all the costs, thus having the best information about the desirability of the exchange. But sometimes the
benefits of an exchange may spill over onto other parties than those explicitly engaged in the exchange.

The reason the market fails in the presence of external costs is that the generator of the externality does not
have to pay for harming others, and so exercises too little self-restraint.

In a technical sense, the externality generator produces too much output and too much harm because there is a
difference between private marginal cost and social marginal cost.

Private marginal cost, in our example, is the marginal cost of production for the factory. Social marginal cost
is the sum of private marginal cost and the additional marginal costs involuntarily imposed on third parties by
each unit of production.

Social marginal cost is greater than private marginal cost at every level of output. The vertical difference
between the two curves equals the amount of the external marginal cost at any level of output. Note that if
production is zero, there is no externality, but that as production increases, the amount of external cost per
unit of output increases.

The profit-maximizing firm operates along its private marginal cost curve and maximizes profits by choosing
that output level for which Pc = PMC—namely, qp. But from society’s point of view, this output is too large.
Society’s resources will be most efficiently used if the firm chooses its output level by equating P c and SMC
at qs. At that level the firm has taken into account not only its own costs of production but also any costs it
imposes on others involuntarily.

The key to achieving the social optimum where there are externalities is to induce private profit-maximizers
to restrict their output to the socially optimal, not privately optimal, point. This is done by policies that cause
the firm to operate along the social marginal cost curve rather than along the private marginal cost curve.
When this is accomplished, the externality is said to have been internalized in the sense that the private firm
now takes it into consideration.
Firms are assumed to maximize profits, which are defined as the difference between total costs (including
opportunity costs) and total revenues. A firm maximizes profits by choosing that output level for which the
marginal cost (the addition to total cost of the last unit of output produced) equals the marginal revenue (the
addition to total revenue of the last unit of output produced). (Note that if we call marginal revenue “marginal
benefit,” then the rule to maximize profits by choosing the output level for which marginal cost equals marginal
revenue is exactly equivalent to our general maximization rule of equating marginal cost and marginal benefit.) If
the firm finds itself producing an output level for which it is the case that marginal revenue exceeds marginal cost,
then by producing more output it can add more to total revenue than to total cost and thereby increase its profits.
Alternatively, if marginal cost exceeds marginal revenue, the firm should cut back on production: the revenue lost
from lower output will be less than the cost savings.
4.3
Suppose a railroad runs beside a field in which commercial crops are grown. The railroad is powered by a steam
locomotive that spews hot cinders out of its smokestack. From time to time those cinders land on the crops
nearest to the track and burn them to the ground. Assume each year, the farmer whose crops are burned loses
$3000 in profits, and that the annual cost to the railroad of installing and maintaining a spark-arrester that would
prevent any damage to the crops is $1750. Does it matter to the efficient use of the farmer’s land or to the
efficient operation of the railroad whether the law protects the farmer from invasion by sparks or allows
the railroad to emit sparks without liability? Why or why not?
Railroad Example (Coase Theorem - invariance – outcomes are same) diff versions exist

Farmer will pay the $1750 to the railroad to get the installation done, as it is cheaper than the loss of $3000.
The Social cost is the same, whether or not you impose liability on railroad or the farmer.
If transaction costs are zero, then the initial distribution of property rights over land will not bar the efficient
outcome. The efficient solution will be reached whether the law protects the farmer or allows the railroad to emit
sparks. However, if the costs of bargaining are high, then the efficient solution may not necessarily be reached.
One scenario under which high bargaining costs may exist is when there are a multitude of actors on either side of
the conflict.
4.5
Invariance. With zero transaction costs, the farmer fences the cornfield rather than the rancher fencing the ranch
—regardless of the rule of law. Notice that in this example, the use of the fields for cattle-ranching and corngrowing is the same, regardless of the initial assignment of property rights. This version of the Coase Theorem is
called the invariance version (because the use of resources is invariant to the assignment of property rights). This
version turns out to be a special case. The more general case is one in which the resource allocation will be
efficient (but not necessarily identical), regardless of the assignment of property rights. There will be a Paretoefficient allocation of goods and services, but it may be different from the Pareto-efficient allocation that would
have resulted from assigning that same entitlement to someone else.
To illustrate, assume that farmers like to eat more corn and less beef, whereas ranchers like to eat more beef and less corn.
Assume that farmers and ranchers own their own land, that transaction costs are zero, and that fence is costly
relative to their incomes. The change from “ranchers’ rights” to “farmers’ rights” will increase the income of
farmers and decrease the income of ranchers. Consequently, the demand for corn will increase, and the demand
for beef will decrease. Greater demand for corn requires the planting and fencing of more cornfields. Thus, the
change in law causes the building of more fences. Remember the distinction between “price effects” and “income
effects” in demand theory? Can you use these concepts to explain this example?
Explains why identical resource use is special case of efficient resource use

If you bring in the operation of outside markets (meat, corn), then the results are NOT identical. Benefitting
the farmer is a benefit for vegetarians. The rancher is benefitting as well, slight decrease in cost. You have
efficient use of resources, but not identical. Because if farmer did not build a fence, cost of both resources
will go up. Coase Theorem will still apply in an unbalanced market. Key to study how it connects to 4.3
The invariance principle is a strong version of the Coase theorem and states that not only does any initial endowment lead
to an efficient outcome, but that the same outcome will be reached no matter what the initial endowment. The” income
effect” is the change in the quantity demanded for a good whose price has fallen attributable to a rise in real income due to
the price change. The “price effect” is the increase in quantity demanded directly attributable to the fall in price.
4.6
Endowment effects. Surveys and experiments reveal that people sometimes demand much more to give up
something that they have than they would be willing to pay to acquire it. To illustrate, contrast a situation in
which people have an opportunity to “sell” the clean air that they currently enjoy to a polluter to the situation in
which people currently not enjoying clean air have an opportunity to “buy” clean air from a polluter. Evidence
suggests that people may demand a higher price to “sell” a right to clean air than they would pay to “buy” the
same right. An endowment is an initial assignment of ownership rights. The divergence between buying and
selling price is called an endowment effect because the price varies depending on the initial assignment of
ownership.
Why might farmers place a different value on the right to be free from straying cattle depending on whether they
were selling or buying that right? Is it rational to place different values on those rights? How do these flip-flops in
the relative valuation complicate an efficiency analysis of the assignment of property rights?
Endowment Effects are ignored in the Coase Theorem, but these effects are important in the emerging area of
economics called Behavioral Economics




Theorem of Coase does not apply when transaction costs are (either zero or something)
What people think might apply? Lawyer transaction costs may not be actually high, but is always thought of
as high.
“You’re richer than you think” – Endowment Effect
o Banks won’t tell you that you are poor, as it costs them money
Endowment effect in Law
o 4.3 suppose you are farmer, didn’t pay 1750, clearly better off, law is on your side (not endowment
effect because you are actually better off)
 Endowment effect, because you’ve been assigned this legal right, in addition to 1750, you
believe to be richer because you have your legal right
 Difference between income and substitution effect
 Endowment effect is never assumed unless it is specified in the question
One way to approach this problem is to consider the increase in wealth associated with an increase in the initial
endowment. For instance, suppose the farmers were granted the right to be free from cattle and all the ranchers’ land. The
farmers may decide to build a house on the rancher’s land rather than allowing cattle to graze. While this is the efficient
outcome, it is a very different result from a situation where land is split evenly.
4.9
Rank the following six transactions from lowest to highest transaction costs. Explain your ranking by
reference to the costs of search, bargaining, and enforcement. (There is no uniquely correct answer.)
Transaction Costs (search/bargaining/importing)
1. Getting married
High, Finding Mr. Right, Marriage Costs, Pre-nup
2. Buying an artichoke
Low, (sales tax – not a transaction cost)
3. Gas line across neighbor
High, negotiation with neighbor
4. Selling a Burger King
High, Finding a buyer, lawyer
5. Going to college
Finding college, time spent picking courses (time = cost)
6. Purchase car warranty
Maybe not a transaction cost, form of insurance?
In terms of the transaction costs of search, bargaining and enforcement, buying an artichoke would seem to be the easiest,
and perhaps getting married the most difficult. But the level of transaction costs involved in the other situations would
vary greatly depending on the situation. For instance, selling a Burger King franchise may have very low costs if standard
forms and a clear legal framework exist. However, if a unique contract is written for each franchise and if there is
uncertainty in the legal system as to how franchising law operates, then the transaction costs could be very high. [p. 90]
4.10
Consider the right to smoke or to be free from smoke in the following situations. In which situations do you
think that transaction costs are so high that they preclude private bargains, and in which cases do you
think that transaction costs are low enough for private bargains to occur? Explain your answer.
a)
b)
c)
d)
Smoking in a private residence
Smoking in a public area
Smoking in hotel rooms
Smoking on commercial airline flights
Low, familiar parties, room for private deal
High, many parties, public space
High, hotel management, fees,
High, enclosed in fire-prone space
Place each contract along the spectrum of transaction costs. In which situations are the costs of contracting a market-based
solution “too high”? Here’s one suggested ranking of these various circumstances, ranking from lowest to highest
transaction costs:
1. smoking in a private residence.
2. smoking in hotel rooms.
3. smoking on commercial airline flights.
4. smoking in a public area.
The factors that seem to differentiate these situations are the number of parties involved in a particular transaction and
whether there might be a competitive market that would compel a profit-maximizing private provider to take the desires
of consumers into account. Why would we rank “smoking in hotel rooms” as having lower transaction costs than
“smoking on commercial airline flights”? Perhaps because hotel owners are generally subject only to local or state
regulation in the United States, and the regulation is relatively light-handed. So, hotel proprietors can be relatively quick
and flexible in their responses to changing consumer tastes. Airlines, in contrast, are relatively heavily regulated and, more
importantly, their normal business has them crossing state lines so that the ability of local regulators to reach them is
attenuated. Realistically speaking, only federal regulators or the national legislature could have caused the airlines to
make their flights smoke-free (unless, that is, the airlines decided on their own to make that decision).
Another difference between hotel rooms and airplane flights is that the external cost of smoking is more immediate
and less avoidable on an airplane flight than in a hotel room. Presumably, those who are occupying the hotel room can
decide among themselves whether to smoke. And, very importantly, the hotel can accommodate both smokers and
nonsmokers by simply designating some rooms or floors as nonsmoking. It’s difficult to do that in an airplane (although
airlines used to do just that years ago: some rows were for smokers, and all others were for nonsmokers).
But these arguments may be thin. Maybe “smoking in hotel rooms” and “smoking on commercial airline flights” are
really pretty closely related.
4.11
a) When transaction costs are low enough, efficient resource allocation will follow regardless of the
particular assignment of property rights. When transaction costs are high enough, efficient resource
allocation requires assigning property rights to the party who values them the most. Give an example of
each case.
When transaction costs are minimal, the allocation of rights does not matter. Because people start at any point,
people will trade until efficiency is achieved. Coase Theorem explains this. But if transaction costs are high, the
initial allocation of property rights is important to whoever values the property most. Example: A farmer growing
corn on his land might find it more productive to put that land in someone else’s care. If the farmer tries to
maximize value, he might be convinced to transfer the property to someone who can put it to more productive
use. An example of a low-transaction cost setting might be one in which the issue is the assignment of a legal
entitlement to place a poster on a wall in a rental apartment. Should the landlord or the tenant have the entitlement
to decide whether and how to place a poster on an interior wall? In some senses it doesn’t matter: the cost of
negotiating between the parties are so small that whoever values the entitlement more is likely to possess it. An
example of a high-transaction cost situation might be the entitlement to hold a parade on public streets.
b) Can you use the Normative Hobbes Theorem to justify legislation regulating the collective bargaining
process between employers and employee unions?

The theorem suggests that both parties due to their self-interest will not easily come to a mutual
agreement through the negotiation process. By pursuing litigation, a 3 rd party (courts) can determine who
benefits most from the outcome.
Should the bargaining process between employers and employees be regulated or left entirely to the parties to resolve?
Recall that the Normative Hobbes Theorem says, “Structure the law so as to minimize the harm caused by failures in
private agreements.” It is certainly possible that employers and employees can bargain to a mutually satisfactory
conclusion in their collective bargaining agreement, but there is a significant chance that they may not. And if they do not,
the costs to the parties and to society can be substantial. There used to be significant labor disputes in which strikers
would be without pay and other benefits for months and employers were unable to hire replacement workers (because of
menacing action by the current striking employees) and, therefore, to produce anything for months at a time. Those costs
can be significantly high and can ripple through the community. Law might limit the damages that failures to reach an
agreement might cause by giving the government to power to order strikers back to work or imposing a “cooling off”
period. Additionally, competent mediators can help to bring deadlocked negotiators together. And skilled personnel
management can seek to head off these disputes.
Such crippling industrial disputes between employers and employees have become far less common than they used to
be, as can be seen by looking at the number of work days lost to labor disputes at the Department of Labor website.
c) When people strongly disagree, they may try to harm each other, or they may walk away from a
potentially profitable exchange. What does the Normative Hobbes Theorem suggest the response of the law
should be to these two possibilities?

Due to high transaction costs, as the parties are hostile, law will require litigation between both parties to
determine who values the outcome most
What should the law do about the possibility that parties might (physically) harm each other because of their inability
to agree on a private bargain? What should it do about the fact that parties may walk away in disgust from what would
have been a potentially profitable exchange? Clearly, the law ought to take significant steps to prevent violence from any
source. There are direct and indirect methods of doing so. Directly, the government might announce (as it does) that it will
punish violence severely. Indirectly, the government can seek to educate citizens about techniques of bargaining and
communication so that they can be more effective bargainers. As to walking away from otherwise profitable bargains, this
is an example of the Hobbes Theorem. Since Cooter’s original insight in “The Cost of Coase” that there were significant
social costs to bargains not completed that would have been mutually beneficial, we have known that parties sometimes
“overreach” – they bargain so hard for a large portion of the cooperative surplus or so misjudge the amount that the other
party was willing to pay or accept that the bargain does not take place.
One might say that this is rare—that the parties can always resume their bargain later if they have misjudged things in
the prior bargaining sessions. Perhaps. But there are often hard feelings and misunderstandings that prevent a return to the
bargaining table.
Collective bargaining used to provide pointed examples of intransigence in bargaining. A large employer and the
union representing the large work force of employees would sometimes bargain to no avail. Then the union would go on
strike, sometimes for weeks and months at a time, to the distress and discomfort of the workers and the employers, their
families, the viability of the employer, and, in some instances, the peace of the community. The series of collective
bargaining statutes – the National Labor Relations Act of 1935 (known familiarly as the “Wagner Act” after its sponsor)
and the Labor-Management Relations Act of 1947 (familiarly known as the “Taft-Hartley Act” after its Senate and House
sponsors)—were meant to create constraints within which these potentially devastating failures to bargain would be kept
to a minimum.
One of the heartening developments of the last 50 years is the general improvement in the labor-management climate:
the number of days lost to labor strikes has been declining almost continuously for this period. How have labor unions and
management avoided the costs of failing to bargain? How have they managed to take account of the Hobbes Theorem?
This would be a terrific question to investigate with your class.
4.13
Use the theory of transaction costs to justify protecting the following rights by injunction or damages:
a. A landowner’s right to exclude from his property a neighbor’s gas line.
Injunction. Two parties involved, so the costs between them to negotiate an easement for the neighbor’s
gas line should be small.
b. A car owner’s right to have her car’s defective transmission replaced by the seller.
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Could be either injunction or damages, depending on if the seller might misbehave that might require
supervision resulting in potentially more costs
This is actually a subtle question. Normally, one would say that the car owner ought to have the right to
have his defective transmission replaced—that is, he or she ought to have the equivalent of a property rule
running in his favor. If, then, the seller wanted to try to bargain ought of this obligation, that would be fine
because the seller would have to offer the car owner enough compensation to make him or her indifferent
between having the transmission replaced or not. But it is possible that the seller, if required to replace the
transmission, might misbehave in some way that would require someone – perhaps a court – to supervise
what he or she was doing to the car. If those supervisory costs are sufficiently high, then it might be better
to have the seller pay the buyer compensatory money damages.
c. A homeowner’s right to be free from air pollution by a nearby factory.
Damages, as since there will be many homeowner’s affected by the nearby plant, making the external
costs too high
 The transaction costs between a single homeowner and the factory might be low, but there may be lots of
homeowners who are affected by the pollution. If so, then the total transaction costs of internalizing the
external costs that the pollution imposes may be so high as to argue in favor of compensatory money
damages instead of an injunction. You might also talk about the possibility that a regulatory solution—
having an administrative agency set pollution limits on the factory and then monitor compliance—might
be superior to a private law solution (in which the homeowners bring a nuisance action against the
factory.).
d. A spouse’s right to half the house on divorce.
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4.14
Unless both parties can agree on a means to dividing the house, they each will get nothing
This situation illustrates a situation first articulated in Ian Ayres & Eric Talley, “Solomonic Bargaining:
Dividing an Entitlement to Facilitate Coasean Bargaining,” 104 Yale L.J. 1027 (1995). The title comes, of
course, from the famous story in the Bible of King Solomon’s sitting in judgment of two prostitutes, who
came before him to ask him to determine which of them was the mother of a baby. The evidence was
ambiguous as to which of the women was the true mother. Solomon, renowned for his wisdom, suggested
taking his sword and dividing the baby in half. That suggestion induced the true mother to give up her
claim to the lying mother so as to assure her baby’s survival. The true mother so revealed, Solomon
awarded the baby to her.
The proposal to divide the house in two should induce the spouses to negotiate about its value. Half a
house is, typically, a useless commodity and, therefore, has no particular value, while the whole house
may have a significant market value. Unless the two parties can agree on a means of dividing up the
asset’s value, they will each get nothing (or close to it). This illustrates Ayres’ and Talley’s proposition
that sometimes the best way to induce bargaining is to compel the parties to do so by making the
ownership of the entitlement unclear or divided between them.
Suppose that two people choose to litigate a dispute. Should the law presume that if two parties are
prepared to litigate, transaction costs must be high, and therefore the court should choose damages as the
remedy, not an injunction?
If transaction costs are high, two parties will choose to litigate because it doesn’t make sense to attempt to
communicate and collectively bargain. It makes sense to award damages when there is high transaction costs and
injunction when there is a low transaction cost so they can bargain in the future to come up with the most efficient
outcome.
If two parties choose to litigate rather than settle, should the law presume that the transaction costs between them are high
and, therefore, award legal relief (compensatory money damages)?
This is a question that Ulen has used on his final examination several times. It is a very difficult issue. There are
several issues to think about here. If the transaction costs between the parties were low, then they would have settled their
dispute. And, as we shall see in Chapter 10, the vast majority of disputes do settle. The best estimate is that less than 5
percent of all disputes result in a trial. So, it does seem to be the case that if they are willing to litigate, then perhaps the
bargaining costs are high. But are there other reasons that people litigate—that is, other reasons besides the level of
bargaining costs? Sure. They might litigate because they are not communicating very well—an example of the Hobbes
Theorem. They each might be overoptimistic about their chances of prevailing at trial. The underlying legal issue at the
heart of their dispute might be a new issue about which the law is unclear, and so it is unclear what will happen. Also, one
of the parties may have a strong interest in having this matter of law cleared up or changed in his favor because he has an
on-going interest in this type of litigation.
Article: McKie vs KVP (Know all 4 Theorems)
1. For the five (5) plaintiffs (claimants) suing the upstream pulp mill, why was their access to unpolluted water from
the Spanish River considered a property right?
a. Not black and white. The courts recognize is your property includes a stream, you have a right to enjoy
that river.
2. Chief Justice McRuer cited the following quotation from an earlier English case – “I think that in cases of this
nature much more weight is due to the facts which are proved than to conclusions drawn from scientific
investigations.” What bias against science in general and particularly economics might be revealed here?
a. At this time, economists weren’t allowed in court. Is the judge being biased to be anti-science. No black
and white answer.
3. In establishing the remedies (compensation and injunction) that the Chief Justice assigns to the claimants, he
relies on precedents (rulings from prior court decisions). Which of the four (4) “theorems”, if any, that we
discussed in class support his approach?
a. Two major remedies (injunctions and compensation). The theorem that applies the Normative Hobbes
Theorem, he didn’t believe the company was taking the clients seriously.
4. In granting the injunction is it fair to say that the Chief Justice was ignoring the economic survival of the plant
and the welfare of the employees and their families? (Contrast this with Boomer vs. Atlantic Cement at pp. 170 –
171 of the text.
a. Firms causing damage. Courts stopped filing injunctions because of..
4.15
If everyone has free access to a public beach, who, if anyone, has the power to control the use of this
resource?
Beach is a public good. Therefore, it is best owned and controlled by the state due to efficiency considerations.
Public goods are hard to privatize because of the “free rider” problem. Costs to privately monitor the beach are
too high.
If everyone has free access to a beach, there is a real danger that there will be very little discretion in the use of this
resource. The result may be that there are too many people, too many cars, and too many conflicting activities
(such as fishing and swimming or free access and the building of beach homes). A rationing device is called for to
minimize these and other problems. One such rationing device is assigning private property rights to the beach;
another is governmental ownership of the beach but establishing rules of use of the beach and charging a user fee
to those who make use of the beach.
5.21
Suppose the statute of limitations for adverse possession is 10 years. After 9.9 years of trespass owners
retain full rights, but after 10 years of trespass owners lose all of their rights. Instead of owners losing their
rights abruptly at the end of 10 years, the statute could be written so that the rights depreciate gradually
over time. For example, the trespasser could be granted a 10 percent interest in the property for each year
of adverse possession, so that after one year the trespasser would own 10 per cent of it and after 10 years
the trespasser would own all of it. Compare the efficiency of the “discontinuous rule” and the “continuous
rule.”
One consequence of this rule is that the original owner would have to spend more time monitoring her property under the
gradual depreciation rule than under the sudden-dispossession-after-10-years rule. That might be a more efficient
practice than that of swooping in in the last week of the 10-year period, asserting one’s claim, thereby
disappointing the adverse possessor.
5.22
If the value of a lost object is low enough, the estray statutes do not apply. Consequently, the finder has no
legal obligation to advertise. Discuss the costs that need to be balanced to the most efficient lower bound in the
value of a lost object for purposes of the estray statutes.
Compare the costs of searching for the owner and bargaining with her with the value of the lost object. Will the efficient
lower bound be the same in all circumstances?
5.29
Classify the items in the following list as markets, private externalities, or public externalities.
a. A lighthouse warns ships about rocks.
Public externality
b. My building blocks your sunlight.
Private externality
c. You outbid me at the auction.
Markets
d. Bees pollinate your apple trees.
Private externality
e. Noise lowers the sale value of my house.
Markets
5.31 Is the externality in Boomer private or public?
There are a large number of actors involved on the plaintiffs’ side. This can create high transaction costs. On the other
hand, the people who are adversely affected by the cement plant are a limited group, seeming to make this a private
nuisance or bad. Even though the bad may be private, there may still be high transaction costs among the limited number
of victims involved.
5.33 Suppose the households had a right to enjoin the cement company to stop polluting. What obstacles would the
cem ent company face if it tried to purchase the right to pollute from the households?
If the cement company tried to bargain with its neighbors, one possible problem might be a hold-out problem. One
neighbor or a group of neighbors may try to extract a large payment in order to get their approval.
Another issue with which the cement company must deal is subsequent owners of the neighboring properties. The
company certainly does not want each successive owner to complain of the dirt, smoke, noise, and vibration. So, if the
company settles with the current owners, it would also insist that this settlement be binding on all subsequent propertyowners. In the words of the law, this settlement would “run with the land” and not be specific just to the current owners.
As a result of such an agreement running with the land, the externality of the cement company’s production has been
internalized to the prices of housing in the neighborhood. That is, the prices of the homes near the cement company will
be lower to reflect the disamenity of their situation. Potential owners who are not so sensitive to their surroundings will
find these now lower-priced homes more attractive. Homes that are further away from the cement company will
presumably be higher-priced to reflect their relative amenity.
Consider Question 5.35 in light of this discussion.
5.34 Explain the remedy given by the court. Suppose that at some time in the future the cement company doubles
its rate of output, thus increasing the noise, smoke, dust, and vibration inflicted on the neighbors. Do the
homeowners have a remedy?
The court granted the plaintiffs a “once and for all” settlement by awarding permanent damages. This is accompanied by a
servitude on the land, which transfers the court’s decision onto all subsequent owners of the property.
5.35 Contrast the difference between temporary and permanent damages on the incentives of people to build new
houses near the cement factory
Notice that temporary damages create no efficiency problem: if money damages are compensation for a fixed amount of
harm inflicted in a past time period, then if, in the future, the amount of harm increases, then so will the subsequent
amount of damages. Are permanent damages amenable to this adjustment? Certainly. They may be considered as the
present discounted value of the amount necessary to compensate the neighbors for a given level of harm for a specified
number of future time periods. If the level of harm rises or if the number of future periods during which harm is inflicted
rises, the permanent damages previously awarded become under-compensatory. The neighbors should have a new cause of
action to have the level of permanent damages increased.
5.36 To what extent can the private law of property solve the problem of pollution?
If all property rights (rights to air, water, etc.) were explicitly assigned and the transaction costs of bargaining were zero,
then an efficient outcome would en-sue. For instance, if the cement company owned the right to pollute, then the plaintiffs
could approach them with a contract to reduce emissions. However, because all rights are not assigned, and transaction
costs are high, considerable effort is spent on litigating these decisions.
5.39
What if the government needs to purchase a single, large piece of property in order to provide a public
good, say, a satellite-tracking station? There is only one private owner with whom to deal. And his property
is the only one that is suitable for the station. Should the government be allowed to compel this individual, a
monopolist for the contemplated public use, to sell at fair market value?
Asking whether or not they should be allowed is a trivial question as it has already been determined through
eminent domain/expropriation that the government can legally take your land if it is in the ultimate betterment of
the public. Instead of fighting the government over taking over your land, you should save your energy for
fighting for what you think is a reasonable amount in exchange for your land.
The question has been phrased so that there is no doubt of the legitimacy of the government’s taking: it is truly for a
public purpose—the provision of a public good. What is at issue here is the computation of “just compensation.”
The situation in which a monopolist (one seller) faces a monopsonist (one buyer) is known as a “bilateral
monopoly.” In the absence of governmental intervention, the price and quantity at which an exchange takes place
in a bilateral monopoly are indeterminate. In our example of the governmental purchase of a parcel of land for use
as a satellite tracking station, there is no controversy about the quantity of land to be purchased. The dispute is
about the price. The monopolist landowner hopes to maximize his profits by charging a price that is consistent
with marginal cost being equal to marginal revenue. The monopsonist (the government) wishes to pay as little for
this parcel as possible. If there were bargaining between the government and the parcel owner, the price would be
somewhere between the monopoly and monopsony price depending on the relative bargaining skills of the parties.
If there were no constraint on the government, then it is likely that the price paid for the parcel would be close to
the monopsony price. But the existence of the just compensation requirement for compulsory sales to the
government should compel the government to take the parcel at a price closer to the perfectly competitive price.
5.41
Compare the efficiency of the following two methods of amending the just-compensation constraint:
a) Define just compensation to be fair market value (including relocation costs) plus, say, 20 percent.
I would consider this to be more efficient as it allows the market to determine the appropriate price of the land,
and even adds an additional 20% to the owner including relocating costs. It is very accommodating. Suppose that
the law defined “just compensation” to be “fair market value” of the property taken plus 20 percent. How might
that influence both the government in its decisions to take land and private property owners in their decisions to
plan for or resist taking? As to the government, the 20 percent add-on clearly raises the cost of taking and might,
therefore, make the government less likely to take private property (as opposed, say, to regulating property). But
because the 20 percent applies to all property taken, then the add-on would not bias the government in its
decisions as to which property to take. So, the only effect would be the possible one to discourage taking. But our
intuition is that this discouragement would be minimal.
As to private property owners, the 20 percent add-on might make them less likely to resist taking than they
would be if they could only expect to receive fair market value.
b) Allow private property owners to make their own assessments of the value of their property. Property
owners agree to pay property taxes on that self- assessed value. If the government ever takes the
property, it agrees to pay the self-assessed property value as just compensation.
I believe this to be less efficient as individual owners may have a conflict of interest in reporting to what they
think is the value of their land. Assuming owners cheat, the government would pay more than what is expected of
the value of the land. This alternative method – having the property owner declare a value of the property, pay
property (and other) taxes on that declared value, and then have the government compensate the owner at that
level in the event of taking – has much to be said for it. The principal argument in its favor is that it presents a
tractable way for property owners to declare any subjective value they attach to their property. But because they
will be obliged to pay property taxes on that declared (subjective) value, it is costly to declare a value in excess of
the fair market value. Of course, some people may declare a higher value on speculative or strategic grounds—
they may anticipate their property’s being taken and see this as a way to get more for the property (even though
they may not truly attach any subjective value above the fair market value to continued ownership of the
property).
The only clear argument against the plan might be its administrability. How often, for example, might
someone be allowed to alter the declared value? Clearly they cannot do so in the months or weeks before their
property tax bill is due. But with that exception can they do so once per year? Once every five years? And what
about absentee owners? Will they be allowed to participate in this scheme or must one actually inhabit the
property? What if you do inhabit the property but you also rent out some of it? Can you still participate? And is
commercial property excluded? Why should it be? Can’t one have a subjective attachment to commercial
property, such as a family farm? Or does this procedure apply only to single-family residential property?
5.44
The Federal Government provides disaster insurance that helps people to build vacation homes in places
subject to flooding, such as sand dunes. Assume the government wants to protect the environment by
preventing construction of homes on a specific sand dune near the ocean. If the government takes private
property on the sand dune, either by condemning it or by imposing regulations that forbid any
construction, should compensation include or exclude the increase in the value of the land caused by
government flood insurance?
If the government includes the insurance value of the land, it will motivate people to build beach homes as they
know they will be compensated for the value added with the insurance. However, if government does not give
full value, it will incentivize people to not build beach homes.
Suppose that the government wants to protect the environment and takes property, such as vacation homes, on sand dunes.
Because that property is subject to damage through flooding and other natural disasters, homeowners have typically been
offered disaster insurance by the federal government to compensate them when their homes are damaged by those
occurrences. In taking the private property thus protected by disaster insurance, should the government include in its
compensation amounts, the increase in the value of the property owing to its being insured? This is a difficult question.
The availability of the federally subsidized insurance induced the people to stay on the dunes and to rebuild when there
had been disasters before. If the owners had not had the insurance, then the value of their property would have been less
and they might have been induced not to rebuild. Or they might have bought vacation homes in different locales. The
insurance may have been, from a social point of view, a mistake. It may have encouraged people to locate there when
social values would have been enhanced by their not being there. If you believe that the government insurance unfairly
induced families to remain on the dunes in their homes, then you may argue that the families are entitled to the full value
of their homes (that is, including the increase in value due to the availability of federal insurance) if they are taken.
On the other hand, you may believe that the homeowners should never have had that insurance in the first place. And
if you believe this strongly enough, you may be in favor of compensating them, if their homes are taken, only up to the
extent of the homes’ values if there had been no insurance.
Article: Boomer vs Atlantic Cement
a) Is the externality in Boomer private or public?
a. Public, as the dirt/smoke affected neighbors
b) Are the transaction costs of bargaining among the parties low or high?
a. High, otherwise a private deal would have been made, but it went to litigation
c) Suppose the households had a right to order the cement company to stop polluting. What obstacles would
the cement company face if it tried to purchase the right to produce from the households?
a. The cost of that right, will be significant as well as varied. The company would have to occur additional
transaction costs to negotiate with each affected household. Time will also be spent to convince ALL
households to agree to a price at which a certain level of pollution is acceptable. Money invested into
improved techniques could be quite slow as well.
d) Explain the remedy given by the court. Suppose that at some time in the future the cement company
doubles its rate of output, thus increasing the noise, smoke, dust, and vibration inflicted on the neighbors.
Do the homeowners have a remedy?
a. Injunction was denied, and damages awarded totaling $185,000 to all plaintiffs. If the pollution doubled
its rate, surely sufficient evidence will display this doubled rate of pollution and the plaintiffs could file
for an injunction.
e) Contrast the difference between temporary and permanent damages on the incentives of people to build
new houses near the cement factory.
a. Temporary damages require victims to return to court if harm continues. Permanent damages are a onetime permanent fix. The latter would dissuade people to build new houses near the factory, whereas the
former creates an incentive to reduce harm in the future, therefore more might be willing to build.
f) To what extent can the private law of property solve the problem of pollution?
a. Through a normative view on law, it can be stated that your private property should not be subjected to
dangerous contaminants. However, after the positives and negatives are weighed, either damages or an
injunction can typically be recommended to help solve the problem of pollution
Contract Law
ECO320 – Tutorial 4
Electric Company E emits smoke, dirtying the wash at Laundry L. E earns $1000 if it does not install scrubbers. L
loses $200 if E does not install scrubbers. L earns $300 if E does install scrubbers. E can abate its pollution by
installing scrubbers that would cost E $500. L can eliminate E’s externality by installing filters that would cost L
$100.
a) Set up the social contract game showing the four possible outcomes of this problem.
b) Which outcome is socially optimal? How is this determined?
No scrubber for E and filter for L is socially optimal, as the total sum if $1200.
c) If no liability is imposed on E or L, how will bargaining proceed? Which outcome will result?
By the Theroem of Coase, the “no scrubber” for E and filter for L is the most optimal level of social surplus
amounting to $1200.
d) If damages liability is imposed on E for L, how will bargaining proceed if there are no TC? Which
outcome will result?
By the Theorem of Coase, the no scrubber for E and filter for L is still the most optimal bargaining result, so
through bargaining E will transfer $100 to L to compensate for the filter. And $50 representing an equal share
of the co-operative surplus, leaving E with $850 and L with $350, reaching the most optimal level of social
surplus of $1200.
e) How will your answer ∆ in d) if TC become too high to make a contract feasible?
By the Normative Hobbes Theorem, the damages would force E to pay L damages of $200. Laundry earns
profit of $1000-$200. Social surplus is sub-optimal at $1100.
f) If an injunction is imposed on E for L, how will bargaining proceed if there are no TC? Which outcome
will result?
By the theorem of Coase, the no scrubber for E and filter for L is still the most optimal bargaining result, so
through bargaining E will transfer $100 to L to compensate for the filter, and $200 representing an equal share
of the co-operative surplus, leaving E with $700 and L with $500, reaching the most optimal level of social
surplus of $1200.
g) How will your answer in f) ∆ if TC become too high to make a contract feasible?
By the Normative Hobbes Theorem, the injunction would force E to operate scrubbers for a profit of$500.
Laundry earns profit of $300. Social surplus is suboptimal at $800.
h) What does your answer in e) and g) tell one about the effect of the Theorem of Coase on the choice of
efficient technology?
If TC are too high, the parties cannot bargain for the most efficient technology and the Theorem of Coase will
not apply.
How does the Theorem of Coase relate to the theory of expectation damages for breach of contract?
In one major respect, the Theorem of Coase predicts parties to a contract are motivated to bargain in order to optimize
their joint social surplus if TC are low and the parties are rational. Expectation damages supports this optimization
process. As the most efficient court-designed remedy, expectation damages minimizes the TC by act as a “default rule”
requiring less input from lawyers. The Theorem of Coase implies that remedies such as expectation damages and specific
performance differ from each other with respect to efficiency when TC are high. So when TC are low, expectation
damages and specific performance remedies are equally optimal, but differ in distributional results.
A rich uncle promises his niece a gift of 10k if she quits gambling. Discuss the economics of enforcing this promise.
Include an appropriate diagram in your analysis.
When the promise is made, the niece’s expected income increases and she will substitute away from gambling. The
problem arises, at point A when the unmet promise is sub-optimal. Enforcement will restore the niece’s utility.
At A the niece does no gambling, but enjoys less than what she was promised. At her optimal point, A could relapse into
some gambling, but at a lower level.
For the nice if the uncle keeps his promise, or is forced to keep it, it is optimal.
Discuss the relationship of deductibles in insurance contracts to the problems of private information and
expectation damages.
In the insurance contract, a deductible means part of the loss suffered by the insured(gent) is borne by the insured. From
the vantage point of the insurer (principal) the insured has private information such as hidden actions (moral hazard) from
the insurer. So an insured buying theft insurance without deductibles would be more inclined to leaving his car unlocked,
parking it in unsafe areas, or even leave the keys in the ignition. Deductibles motivate insured to reduce these hidden
actions.
Discuss the rule of capture. Is it efficient? Explain how in the LR, using examples, how a rule of capture may lead
to an inefficient outcome
The TC involved in a rule of capture, like the rule of first possession, are typically low. Children can understand a rile like
“fineders keepers”. It works best when there is low competition for a scarce resource so that a first finder more optimally
makes the investment in something they know they will own. Where a rule like this becomes less optimal or efficient is in
heavy competition for a resource when some may resort to pre-emptive strategies that block others from accessing the
resource. Historic examples of this led to the regulation of oil fields and depletion of fisheries.
Explain why compensation the victim of breach for expectation damages causes efficient performance and breach,
whereas compensating the victim of breach for excessive reliance may cause inefficient performance and breach.
Expectation damages measures what leaves a principal indifferent between a performed contract and a breach of contract.
Reliance damages measure what leaves a principal indifferent between no contract and breach of contract.
When both expectation damages and reliance damages are optimal given situation, then the efficiency condition under
both measures of damages allows the principal to rely on the contract at the socially optimal level. When over reliance
occurs, the principal may simply do the agent’s job-moral hazard, shirking are some of the problems making reliance
damages inefficient.
Discuss the remedy of specific performance in contracts. How might this remedy relate to the Theorem of Coase?
Performance of the conract is ordered, instead of damages. This usually involves a service or a good where there are no
close substitutes- so that damages would not be adequate compensation.
Should homeowners be required to disclose to buyers whether or not their house had marijuana grow-ops?
The default rule is buyer beware. The parties are free to contract out of this rule, or the buyer might consider taking steps
to research the property, do police checks, etc. Cooter discusses the duty to disclose based on safety information. This
would be a welfare increasing measure where the parties agree to it (Theorem of Coase) or if imposed by law (normative
Hobbes Theorem).
Temporary rentals in Toronto have become a real problem for tenants. A landlord will evict long term tenants with
a view to making the apartment available to short term tenants. These tenants typically pay rents closer to the
market rate because of the turn over provisions currently allowed under rent controls. While current eviction rules
do not allow eviction for market reasons, many tenants do not know their rights and leave. Carefully analyze this
problem by using appropriate diagrams and arguments. Your answer should include how rent controls contribute
to this problem, the role of property rights in determining the strategies landlords and tenants apply, and the
possible application of any of the “four (4) theorems” – Coase Theorem, Converse of Coase Theorem, Normative
Coase Theorem and the Normative Hobbes Theorem in resolving this problem in the interests of landlords, tenants
and society.
It is most helpful to include a discussion of the Normative Hobbes Theorem in your answer. For example, the imposition
of rent controls may be described as a case where the legislator thought to “re-assign” property rights from the landlord of
residential apartments to the tenants. But was this done efficiently? The result of an earlier amendment was to create two
(2) rental markets for residential apartments. The diagram below illustrates the effect of rent controls on the supply of long
term rentals. Equilibrium of supply is at Point L. However, the supply of short term rentals is at S, the market equilibrium.
This suggests landlords might attempt to move to the short term rental market by removing long term tenants, since they
would get higher rents. Although this increases the available supply of apartments for tenants – tenants pay a higher (per
area) rent, leading to the crowding effect of more tenants in smaller apartments.
One approach applies the idea that the rent controls pose regulatory obstacles to bargaining for which the Normative
Hobbes Theorem might offer a remedy. Applying this theorem properly involves who would value deregulation (removal
of rent controls) the most? Tenants or Landlords?
The Inverse of the Theorem of Coase would apply since the costs of not being able to bargain are very high and pose
additional obstacles to the regulatory ones.
The Theorem of Coase would only apply post-controls where bargaining is allowed between tenant and landlord to
achieve the most optimal matching of apartments.
The Normative Coase Theorem-“Structure the law so as to remove the impediments to private agreements.” For example,
keep as many landlord and tenant disputes out of court as possible.
Comments:
Emphasizing the inelasticity of supply of apartments was quite properly raised in some answers. This is relevant because
it gives landlords both strategic and legal leverage over tenants. Some students gave actual illustrations of property right
transfers between landlord and tenant, such as a right to stay or a right to evict. Others looked at the unintended
consequences of rent controls causing shortages that accentuate other problems like discrimination, slum landlords, and
health concerns that can in turn harm neighbourhoods.
List and explain 4 purposes of contract law
The city of Toronto wants to expand its network of parks and walkways along Lake Ontario. To carry out its plan,
Toronto will need to expropriate houses for FMV as determined by independent real estate agents. The average
house has been appraised at 1 mil. The park space that results from each expropriation is estimated to generate 2
mil in enjoyment by the public.
a) determine whether this plan would be efficient. What role do productive efficiency and allocative efficiency
play here?
Productive and allocative efficiency might happen? More people enjoy the public space when it is converted from
private space. However, theriage is an issue with respect to FMV being less than the subjective value or expected
value an individual might have in their private home. So coast theorem is not followed when FMV is imposed,
instead of bargaining. This means the social welfare of this expropriation is sub-optimal.
b) Is this pareto imporoving or kaldor-hicks improving? Explain
The result is pareto improving if at least one home owner finds that the FMV offered falls below what he/she
believes (subjective value) they could have gotten through private bargaining.
c) What theorem applies?
Normative Hobbes Theorem- structure the law as to minimize the harm caused by failures in private agreements.
State the Theorem of Coase
When TC are 0, an efficient (socially optimal) use of resources results from private bargaining, regardless of the legal
assignment of property rights
Apply the Theorem of Coase to explanin the difference between injunction and damages (compensation).
Where TC are low, the injunction is the most efficient remedy. The right to an injunction gives the parties a clearer
position from which to bargain, although the parties may eventually agree to a settlement based on compensation. When
TC are high as to prevent bargaining, switching from the injunction to damages makes the injurer better off (Electric)
without making the victim worse off (Laundry)
Explain and analyze the Expectation Damages rule in contracts
The damages measure under the bargaining theory of contract is (perfect) expectation damages. Actual amount the Agents
has to pay the Principal in compensation to put the Principal in the same economic position it would have been had the
contract been performed. Theorem of Coase does not apply. Without this rule, fewer contracts would be negotiated, so as
the rule is imposed and enforced by the courts, it may be regarded as an example of the Normative Hobbes Theorem.
Why is Expectation damages rule efficient?
The rule awards “expectation damages” as compensation for breach. Awarding perfect expectation damages restores the
Principal (promise) to the position that he or she would have enjoyed if the Agent (promisor) had performed.
Explain why the Expectation Damages rule can be considered a default rule
Perfect expectation damages is an example of the rule courts follow to impute the terms to the contract that the parties
would have agreed to if the parties had bargained over the relevant risk. The rule of expectation damages is a default rule
because it automatically applies to all contracts (unless the parties expressly exclude it or substitute their own
measurement of damages in their contract.)
What theorem applies to default rules?
Default rules fill gaps in contracts in order to reduce TC. This is in application of the Normative Coase Theorem
8.1
People often change the form of a promise in an attempt to increase their certainty that courts will enforce it
according to its terms. For example, suppose the rich uncle in Example 1 wanted to assure his nephew of the
enforceability of the promise of a trip around the world. He might do this by changing the form of the promise
from a gift to a bargain. According to tradition, the uncle would solemnly offer to give his nephew a trip around
the world in exchange for a peppercorn from the dinner table, and the nephew would solemnly give the uncle a
peppercorn. Will this charade make the uncle’s promise enforceable under the bargain theory? Answer this
question by using the doctrine that courts inquire into the presence of consideration but not its adequacy.
Also answer this question using the doctrine that courts should refuse to enforce extremely unfair bargains.
A promise is enforceable if the courts offer a remedy to the victim of the broken promise. Traditionally, courts
have been cautious about enforcing promises that are not given in exchange for something. In this example, the
promise of a trip around the world is a gift to the nephew. The rich uncle does not receive anything in exchange,
so, according to tradition, the courts should not enforce the uncle’s promise.
When the nephew gives the uncle the peppercorn, he seeks to make the promise enforceable by the presence of
consideration. If courts only require that there be consideration in order for a promise to be enforceable (and do not
inquire into the adequacy of the consideration), then the bargain is likely to be enforceable. But modern courts are not so
formalistic that they would not see this subterfuge. Rather, modern courts will see to determine if the consideration was
roughly adequate (and we really mean “roughly”) if they think that this was a genuine bargain. Or if they believe that this
was a gift promise, then under modern understanding they will inquire whether the promise (regardless of the handing
over of a peppercorn) would have induced reasonable reliance by the promisee (the nephew) on the enforceability of the
promisor’s intention to convey the gift.
8.3
Explain why the numbers in the Figure 8.2 indicate that the second player is liable for expectation damages
in the event of breach.
If the Agent performs the promised task, he will invest 1 to make 2, resulting in a positive utility of 5. If the
Agent breaches the contract, he will return the initial investment of 1 and pay damagers of .5, resulting in a
negative utility of -5.
If the second player performs the contract, the first player can expect to receive a profit of 0.5. Therefore, the second
player must compensate the first player for the value of the investment and the services she would have provided.
8.4
In the Figure 8.2, both parties desire enforceability of the second player’s promise when the promise is
made, but when the time comes to perform, the promisor may not want enforceability. What do these facts
say about the Pareto efficiency of enforcing the second player’s promise? (Hint: Distinguish between the
Pareto efficiency of enforceability when the promise is made, which can be called ex ante Pareto efficiency,
and the Pareto efficiency of actually enforcing the promise when the time comes to perform, which can be
called ex post Pareto efficiency.)
Consider again the car dealer promising to hold the new Chevrolet for a period of time. At the time the bargain was made,
the car dealer calculated the probability of selling the car to the current party—that is, of this buyer’s not going through
with the deal at the later date—and the probability of somebody else’s walking in and offering to buy the car before that
first buyer returns. (A related point is whether, if the first buyer does not return, there will be a lost sale. That would
certainly be the case if the seller had customized the car to the buyer’s specifications.) Given this information, the seller
may choose to hold the car for the first buyer. If someone else in fact does show an interest in buying the car, the dealer
may regret promising to hold it. If he were to incur no penalties for failing to keep the offer open for the first buyer, then
he would be better off to breach the offer to the first buyer and sell to the second. But recall that part of the purpose of
making promises enforceable is to allow the first player to rely upon the commitment made by the second player. Part of
this commitment is the willingness to forego alternatives that may arise between the time that the contract is formed and it
is performed.
8.5
As an exercise in legal vocabulary, let us modify the facts about the contract in Figure 8.2 and describe it
differently. Assume that the first player offers to invest in exchange for the second player’s promise to cooperate, and the second player accepts by promising to cooperate. What is the “consideration” in this
contract?
This is like being in law school. Consideration is something of value that the promisee gives to the promisor. What did the
second player give to the first player in exchange for his promise to invest? In most instances, the simple promise
to cooperate is not enough to serve as consideration. The law typically requires something tangible—and,
therefore, verifiable by the court—to count as consideration. Actions (a nod of the head, a shake of the hand) and
mere words (“I promise to cooperate”; “You can count on me”) are not enough. The sense is that consideration,
being something of independent value to both parties, signals seriousness and eases evidentiary problems.
8.6
Figure 8.2 describes a game based upon a bargain. Construct a similar figure to describe a game based
upon a firm offer.
Recall that a “firm offer” is an offer to keep an offer open and that under the traditional bargain theory this was not an
enforceable promise. Under the economic theory the firm offer might be enforceable. In your answer to this question, bear
in mind that you must show what difference the enforceability of the firm offer would make.
8.9
Explain why compensating the victim of breach for expectation damages causes efficient performance and
breach, whereas compensating the victim of breach for excessive reliance may cause inefficient
performance and breach.
Expectation damages causes efficient performance as the promisor has incentives to perform and invest in
precaution of breach, while over-reliance causes inefficiency because the promise increases her benefit from
performance but also the promisor’s cost of breach.
There are many facets to the answer. Consider one: if the breachee receives compensation for excessive reliance, then
breachees have an incentive to overrely, which is inefficient. From the point of view of the breacher, the liability for
excessive reliance by the breachee may induce performance when breach is more efficient.
We have already explained that if the breachee receives the “benefit of the bargain” – expectation damages, then he is
indifferent between performance and breach. And so the breach is Pareto efficient.
8.10
“Default rules save transaction costs in direct proportion to their efficiency.” Explain this proposition.
Default rules minimize transaction costs because it is inefficient when the TC for negotiating a remote risk that is
unlikely to occur. If a remote risk is likely to happen or costly, it is more efficient to negotiate the contract prior
to executing the contract.
That is, the more efficient a default rule is, the greater the savings in transaction costs. By supplying routine contract
terms, default rules allow parties to save on the costs of crafting their own contract terms. One of the principal ways to
choose default rules is to choose those rules that the vast majority of contracting parties would have chosen, if they had
thought of those terms. This is called the “majoritarian” basis of default rules. (See the Ayres and Gertner piece mentioned
in n. 16 for an alternative method for choosing a default rule – “punitive” default rules.) The more uniform the preferences
of the majority are, then the greater are the savings from adopting a default rule on the “majoritarian” ground.
8.12
Doctors who form a partnership may say nothing in the partnership agreement concerning its future
dissolution. The parties may deliberately avoid discussing dissolution for fear of breeding distrust. Provide
some other examples of gaps left in contracts for strategic reasons.
Cost of allocating the risk is higher than the cost of it happening. Marriage, signing pre-nup, possible divorce
strategies during your honeymoon.
Consider a situation where the cost of allocating risk is less than the benefit of allocating the risk. The benefit – or
“expected” benefit – of allocating the risk is the costs of the risk if it materializes time the probability of the risk
materializing. So, suppose that if the risk materializes, it will impose losses of $1,000 and the probability of the risk’s
materializing is 0.05. The expected benefit is, therefore, $1,000 x 0.05 = $50. So, if the cost of allocating this particular
risk is less than $50, then the parties out to allocate it.
In the case of marriage, to take another example, the costs of allocating risk for losses if there is a divorce may be
(depending on at what point in the marriage this negotiation takes place) may be extremely high. For instance, imagine
two people on their way to the courthouse to get a marriage license. Suppose that one of them says, “You know, there is a
probability of 0.45 that this marriage is not going to work out and if it does not, things could get messy. Maybe we ought
to take a few moments to allocate the risk of loss if this marriage contract doesn’t work out.” Wouldn’t your first reaction
be to call the whole thing off? Why marry someone who’s thinking about the worst that could happen instead of the best
that could happen?
Would business mergers have the same problems?
8.13
What sorts of things can corporations give as hostages in long-run contractual relations? Does hostage
giving in long-run relationships serve the same or a different function as consideration in a short-run
contract?
Corporations might promise to transfer valuable assets, such as plants, marketing territories, or patents. to a partner as a
method of inducing reliance on the long-term relationship.
The short-term and long-term relationships might be different in several important ways. Short-term relationships
usually have as their goal the accomplishment of a single or relatively simple task. But in the long-term the principal goal
is the establishing of a relationship, rather than the accomplishing of a specific goal or set of tasks. One way to look at this
is to suggest that in the short-term one partner doesn’t necessarily need to trust the other – just to have some assurance
that they will do what they said they will do. In the long-term, however, a significant aspect is to establish trust, a belief
that one can rely on the other person.
These differences are not hard and fast. For example, there may be a relatively simple one-off, short-term deal that is so
valuable to one of the parties that he wants a hostage to guarantee performance. And in some long-term
relationships (such as marriage) one of the keys to success may be the engendering of trust without a hostage’s
being involved. Consider the fact that in some relationships one wants to know the partner’s character so that it is
important to believe that the person complied with the implicit terms of the relationship because his character led
him to do so, not because he contemplated the loss of a hostage if he failed to comply
9.2
The actual choice of a damage measure often depends on practical problems, not theory. Give some
examples of breached contracts in which opportunity-cost damages are easier to implement than
expectation damages. Give some examples of breached contracts in which reliance dam- ages are easier to
implement than opportunity-cost damages.
For the first question, consider situations where the payoff from a certain action is unknown, but the payoff from the nextbest-alternative is known. This might be a nonmarket traded good or service. For the second question, consider situations
where the amount invested in reliance of a contract is easily observed, but the opportunity cost is difficult to measure
(perhaps, again, because there is no market for the traded good or service).
9.3
Perfectly competitive markets contain many buyers and sellers of the same contract; so, the best alternative
contract is identical to the actual contract signed. What does this fact imply about the relationship between
perfect expectation damages and perfect opportunity-cost damages for breach in perfectly competitive
contract markets?
The cost of all contracts will be the same since they are identical in a perfectly competitive market. If the OC is
the same as the expected payoff, then the expectation damages should = OC damages. This will be true ONLY in
a perfectly competitive market. If you breach one contract, you breach all contracts in this industry. If the
opportunity cost is the same as the expected payoff, then the expectation damages should equal the opportunitycost damages. This is likely to be true only in a perfectly competitive market.
9.4
Airlines routinely sell more tickets for flights than the number of seats on the plane. “Overbooking” seldom
causes problems because a statistically predictable number of ticketholders fail to show up for flights. In
contrast, each retailer of hearing aids typically has the capacity to sell many more hearing aids per week than it
actually sells. “Excess capacity” is routine for retailers of hearing aids. Contrast the effects of overbooking and
excess capacity on profits lost by the seller when the buyer breaches a contract to buy.
When a plane overbooks, they have statistical data claiming that ticket holders will breach their contracts by
failing to show up for their flights. Since flights typically overbook the airline loses no money and makes a profit
because at the end of the day they still filled up an entire plane. Excessive capacity is a different story because the
store carries more hearing aids than it sells, so if a buyer breaches a contract to buy the hearing aid, the store
doesn’t record that sale making no profit for that particular buyer.
One simple way to think about this issue is to imagine yourself canceling an airline ticket versus canceling a purchase of a
hearing aid. Who is hurt more by your decisions? Has the seller lost a profitable sale in one case and not lost a
profitable sale in the other? Which is which? The airline typically has other customers willing to take the seat you
did not occupy. But can the hearing aid manufacturer easily find someone to purchase the aid that you did not
buy?
9.6
Earlier we explained that specific performance is the usual remedy for breach of a contract to deliver goods
for which no close substitutes exist, whereas damages are the usual remedy when close substitutes exist. Use
the “closeness of substitutes” to explain why the death of an artist releases his estate from any contracts
that he signed to paint portraits, whereas the death of a house painter does not release her estate from
contracts that she signed to paint houses.
The contract with the portrait painter is a contract for specific services, as would be the case with a specific actor to
perform a specific role. Courts are reluctant to enforce these contracts through specific performance because they
fear high enforcement costs. But with the housepainter, there are plenty of substitute performers, and there are no
particular monitoring or enforcement costs (none, that is, above and beyond the normal such costs).
9.7
Restitution is usually inadequate to compensate the victim. What practical reasons do courts have for using
restitution as a remedy?
Courts like using restitution (rather than expectations) as it is very cheap and easy to measure the amounts for restitution.
Court orders breacher to return any benefits that the innocent party gave to him. Expectations is harder to measure as it
includes intangibles. Restitution is very easy to measure. The court simply orders the breacher to return any benefits that
the innocent party conferred on him or her. [p. 323]
9.8
Assume that a swindler must expel her profits if she gets caught. In order to make swindling unprofitable
(expected value of swindling equals zero), how high must the probability of getting caught be?
The probability must be high enough that when multiplied by the amount gained from swindling is less than or equal to
the amount that is to be expelled. As long as there is a positive probability of not getting caught, the swindler’s profits are
positive. That is, the probability of getting caught must be 1. If that probability is 0.5, then the amount that the swindler
should return is twice the actual loss. (We are going to meet this principle again when we discuss crimes in Chapter 12.)
9.9
Can you describe conditions when specific performance is an impossible remedy? Can you describe
conditions when specific performance is an unfair remedy to a third party? (Hint: Suppose the dealer in New York
breached his contract and sold Faulkner’s manuscript to someone else.)
Specific performance may simply be impossible: the travel agency promised you no rain on your trip to Cancun, but there
was rain. The agency cannot specifically perform something that has already been performed. Or consider the example
discussed above in which the portrait painter died. He simply cannot specifically perform. Under what legal rule would
specific performance be “unfair” in the example given in the hint? Would paying the third party her cost of the
manuscript compensate her for her loss?
9.10
Construction company C and landlord L negotiate to build an office building for occupancy on September
1. Landlord L wants to sign up commercial renters to occupy the building on September 1. Unforeseeable causes
often delay construction projects. C is willing to take this risk. C pro- poses a price of $10 million and a liquidation
clause requiring C to pay L $1,500 per day for completing the building late. You are a lawyer hired by L to help on
the contract. L tells you in private that he will actually lose $1,000 per day of delay, not $1,500 per day. How would
you explain to L that he might benefit from proposing to reduce liquidated damages from $1,500 to $1,000 per day?
In order to increase the probability of the court to enforce the contract it would be better to decrease the amount of the
penalty to 1000 which is how much each day of delay is valued by the Landlord. Because L can, contractually, receive
$1500 for each day of the breach of contract but will only suffer $1000 in losses, there is $500 in a cooperative surplus
that the parties can split through renegotiation. So, you, as the lawyer, might propose reducing the contract price by
something between $1 and $499 (depending on how confident you are in your bargaining skills) in exchange for accepting
only $1000 per day that the contractor is late (rather than insisting on the $1500 to which you are, contractually, entitled).
9.11
Assume that A values his house at $90,000. B is willing to pay $110,000 for A’s house in order to relocate
closer to work. (Forget about person C for purposes of this question). After signing a contract, B’s employer
announces that the company will move to another city. In view of this fact, the value of the house to B is reduced to
$75,000. From an efficiency viewpoint, who should own the house, A or B? How will the parties achieve efficiency
in allocating the house if the court enforces the contract?
After the employer announces the move, the house is more valuable to A than to B. It therefore should never be the case
that B moves into the house. Should B (who knew his own employment situation better than A did) be responsible for
taking the hit—that is, the loss from having to complete the contract and resell the house? Probably so. Alternatively, B
could try to renegotiate the contract, paying A to release him from the contract and paying for the costs of re-advertising
the house for sale?
9.12
Give examples of unfortunate and fortunate contingencies that could make breach of contract more
efficient than performance. Give reasons why the parties might not insert explicit terms in the contract to deal with
these contingencies, such as a term excusing breach when performance is very costly.
One situation might be a contract to ship goods overseas. What fortunate or unfortunate contingencies might appear? A
war might begin, making the usual shipping routes impossible and thus necessitating a longer and more expensive
delivery route. Or a war that was in progress might end, making a more direct and cheaper shipping route possible. Think
of some other contracting situations. Would parties insert clauses to cover these contingencies if to do so would reveal a
special subjective value on performance? What if the costs of identifying and then allocating the risk of some losses was
higher than the expected benefit? What then?
9.13
State the Coase Theorem as applied to remedies for breach of contract.
The most efficient outcome will always be in the contract if there were no TC and therefore would have an efficient
outcome. Regardless of what contract says, if TC =0, private bargaining would result in the most efficient outcome. In
contracts, when TC =0, parties will always bargain to an efficient agreement, including performance and breach,
regardless of what law says. The Coase Theorem states that given zero transaction costs, private bargaining always
succeeds in allocating resources efficiently, no matter what the initial endowments. In the contract setting, when
transaction costs are zero, the parties will always bargain to an efficient agreement, including efficient performance and
efficient breach, regardless of what the law says.
9.14
Assume that a fortunate contingency makes breach efficient for a sales contract, and assume that the
parties cannot renegotiate the contract. Explain why the remedy of damages can save transaction costs by reducing
the number of sales required to move the good to the person who values it most. Explain why the remedy of specific
performance enables the court to avoid the problem of subjective valuations of the good.
The remedy of damages allows the promisor to breach and sell to the party who values the good more and pay damages to
the party to the original contract. Specific performance would require the good to be sold to the original contracting party
who would then (presumably) sell to the third party who values it the most (this would be two transactions instead of one).
The damages remedy however, requires the court to determine how much the contracting party actually values the good
which is a costly if not impossible investigation – specific performance allows the court to avoid this determination by
allowing market transactions to sort out who values the good the most. So long as renegotiation costs (or transaction costs
generally) are low (zero), the choice of specific performance will not effect the efficiency of the outcome, but will affect
the distribution of wealth (Coase). For the first question, consider the example given in the text. For the second question,
think about the court’s problem of measuring subjective valuation. If the court awards specific performance, who or what
process determines the subjective value that the breachee attaches to performance? Renegotiation between the parties
9.15
Explain the difference between foreseeable events and foreseen events.
Foreseeable events are events that are directly related as a consequence of an action. Forseen events are events that are
predicted, as they are probable. This is fairly straightforward. A “foreseeable event” is one that a person possessed could
foresee at reasonable cost. A “foreseen event” is a subset of the group of foreseeable events: those foreseeable events that
a person actually foresaw.
Tort Law
What are 5 things a victim must show to prove “simple negligence”?
1)
2)
3)
4)
5)
Identify the victim and defendant(s)
Proves the link of causation between the defendant and victim
Proves that there was a monetary loss flowing from the action of defendant
There is a standard of care
The standard was breached
Draw and explain the “contributory negligence rule” curve.
When court finds the plaintiff contributed to the negligence (so he didn’t take enough precautions to avoid the accident)
then he could be barred from any recovery
Draw and explain the “comparative negligence rule” curve.
The plaintiff is found to be negligent but can only recover damages that the defendant contributed. So there’s a limit as to
how much the defendant is negligent
How might the availability of liability insurance effect the amount of compensation for a victim if there is more
than one defendant found liable under the negligence rule?
When two or more defendants with limited wealth are subject to the joint and several liability rule, the defendants’
insurance decisions are the outcome of a game of bilateral positive externalities.
The deep pockets effect: As Defendant 1 buys more insurance, it confers a positive externality on Defendant 2. Defendant
2 believes a claimant-victim will go after Defendant 1 first because there is a “deeper pocket”
The cascade effect: But Defendant 1 sees what Defendant 2 is doing and decides it will reduce its exposure as well.
Defendant 1 doesn’t want to be the deep pockets. Defendant 1 instead wishes to receive a positive externality from
Defendant 2 being the deep pocket
What are the economic motivations for the common law rule of joint and several liability- allowing a plaintiff to
sure multiple defendants either individually or together?
It was the courts that initially established the idea of contributory negligence in order to apportion damages among more
than one defendant while disqualifying plaintiffs (claimants) even if marginally negligent.
When legislators passed comparative negligence laws that allowed apportionment of damages among plaintiffs and
defendants, some defendants would free ride on the insurance of others or free-ride on the perceived liquidity of codefendants, resulting in an exhaustion of available moneys for victims.
Courts attempted to curb these losses by imposing “joint and several liability”. This enabled courts to award 100%
judgments against co-defendants, who would normally pay only a portion of damages, but for the lack of funds from
uninsured or bankrupt co-defendants. It assisted plaintiffs to assert their claims against several defendants, in effect,
shifting the burden of evidentiary costs to the defendants, to sort out their liabilities.
If anything, these measures worsened the “deep pockets effect”. Those potential defendants fearing this effect may retreat
from the insurance market outright or adopt strategies- bankruptcy or limited liability measures- to further reduce their
liability. This reduces available compensation overall.
Text pg 383-385
The directors of a corporation are often the first people to know about facts that affect its stock price. The law
forbids directors and other insiders from using “inside” info to speculate on the value of the company stocks. Use
the theory of first appropriation and the economics of info to make arguments for and against the efficiency of this
prohibition.
This part of the economics of info problem where lack of some reward or return in having info may lead to
underinvestment in the company by insider investors (Text p126). The analogy may be made between the insider investor
and an investor be rewarded for innovation.
The contrary argument emphasized the perils of overinvestment. An insider finds our relevant information sooner than
outsider shareholders. This causes a lopsided redistribution of wealth from outside shareholders to inside shareholders that
may encourage a different type of underinvestment by outside shareholders. This was the motivation for insider trading
laws that mandate regular reporting by insiders. (Text pg 126).
A first appropriation rule argument (like first come, first serve) may emerge to reward insiders for the initiative to work in
a risky business.
The directors of a corporation are often the first people to know about facts that affect its stock price. Ontario law
does not prohibit directors and other “insiders” from using “inside information” to trade on the value of the
company’s stocks – but it requires disclosure if the company is publicly traded. Is the law optimal? Please explain
using contract arguments for insiders, the strict liability model for non disclosure and Becker’s model concerning
criminal deterrence and policing.
The key point outlined in the question is that insiders should disclose their trades in conformity with the legislation. What
happens if the trades are not disclosed?
The strict liability approach would identify the victims (ex. outside shareholders), causation – identifying the link between
inside information and the harm caused and damages – the monetary loss.
The student might consider the negligence model – but this is sub-optimal since the statute gives specific directions and
rules for disclosure eliminating a need for a precautionary standard of care.
The strict liability model becomes sub-optimal as soon as one allows for a public bad as well as a private bad result to lack
of disclosure. The Becker model establishes the link between punishment and policing levels that would attempt to
internalize the social costs that are not captured by strict liability – damage to the reputation of capital markets – a
discount on the value of stocks, etc.
The student should include in their discussion a contrast between perfect disgorgement of profits and imperfect
disgorgement of profits – a diagram and the analysis set forth on p. 466 would be useful.
What are the economic arguments for and against the extension of copyright protection to copyright owners
against internet downloaders who do not intent to resell the downloaded material?
One argument against the extension of copyright protection turns on the extent to which high TC would make it too costly
to extend infringement or prosecutorial remedies beyond commercial uses or public websites to include the private
computers of private users.
Instead, technology such as encryption or some form of cyber-barrier might be the best and cheapest defence against this
kind of infringement in many cases.
An argument for extension of copyright protection would argue that the market includes both types of users so it means
the problem applies and must be rectified by a form of control that is all inclusive.
Why is it efficient to limit the duration of patents and copyrights?
A diagram revealing the difference between monopoly profit – obtained under copyright or patent - with the zero long run
profit condition for no IP – is useful here. (See p. 31 – Text for an illustration.) This way, the student can identify the
social dead-weight loss and lower production that justifies putting limits on IP protection.
A further argument emphasizes the finite duration of monopoly profit as a payoff for innovation.
Question 5.11 pg 153
Explain how the strict liability rule requires a seller to provide the customer with a joint product – soda and
insurance. What inefficiencies arise?
QUESTION 6:24 p. 226
A diagram illustrating strict liability as a cost curve should emphasize that a seller subject to this rule would want to be at
the lowest point on the curve. This cost minimization process will include the cost of liability. In a perfectly competitive
markets it is not likely that a seller could sell insurance – or even be able to add a premium of insurance to the cost of
producing the soda – the consumer will opt for buying the cheaper soda – without the extra insurance cost.
Even a monopoly seller, charging the insurance premium – would be generating inefficiencies through lower production
and higher dead weight loss to social surplus – see QUESTION 3.
How might rules of tort liability apply to encourage the use of seat belts? Fully explain your answer including the
identification of moral hazards that might arise from seat belts
Suppose that the faulty driving of B causes an accident that injures driver A. Driver A was not at fault in her
driving, but she was not wearing her seat belt, and this fact aggravated her personal injury. Using diagrams,
discuss liability under the rules of simple negligence, negligence with a defense of contributory negligence and
comparative negligence.
A critical issue hidden in this question – should liability be limited to causation (in which case the seat belt aspect is a red
herring) or should liability embrace all aspects of injury prevention?So the student should focus on the economics of this
issue – economics would tend to support the more all-encompassing definition of liability – by evaluating the liability of A
and B under simple negligence, negligence with a defence of contributory negligence and comparative negligence.
Diagrams should be used – you could accept both liability interpretations – provided the arguments are law and economics
based.
Question 6.11 pg 210-211
Offer an economic explanation for why the owner of a dog is liable for the harm it causes due to his/her negligence,
whereas the owner of a tiger is strictly liable for any harm that it causes.
As a domestic pet, dogs are a function of the care and control and training that their human owners give them, suggesting
a more appropriate connection with the precautionary components of a negligence model. For the opposite reasons, most
tigers are not domestic pets. The more traditional rule of strict liability would appear to be more optimal for wild animals.
a) In a simple negligence trial involving medical malpractice, a judge may make mistakes due to misleading
evidence on certain issues. For example, if claimants exaggerate their pain and suffering due to a doctor’s
negligence, explain how this might impact the behaviour of future doctors in preventing operating room
accidents.
A doctor will want to satisfy the legal standard and escape liability even if the court makes errors in measuring damages.
So no change in doctor’s behaviour. In general injurer’s precaution does not respond to modest court errors in setting
damages under the negligence rule (Pg 218). To change the injurer’s cost-minimizing precaution, the error made by the
court in awarding damages must be very large (pg 219).
b) If experts testifying at such trials were general practitioners instead of specialists, explain how this might
impact the behaviour of future doctors in preventing operating room accidents
Most doctors would minimize their costs by conforming exactly to the legal standard, regardless of whether it > or < of
efficient precaution. Consequently, an excessive legal standard (specialists) causes excessive precaution, and lower legal
standard (general practitioners) causes lower precaution. So general practitioners as experts would change doctors’
behaviour to a level of lower precaution. In general, injurer’s precaution responds exactly to court errors in setting the
legal standard under negligence rule (pg219-220)
c) How does your answer change for a and b under strict liability?
In general, consistent court errors in setting damages or liability under strict liability rule causes the injurer’s precaution to
respond in the same direction as the error (Pg 218). So a) changes to greater precaution by doctors even when patients
exaggerate their damages. And b) still applies here.
In the manufacturing of a product involving several firms at each stage of production, compare and contrast how
the application of the following legal systems – comparative negligence, strict liability and no fault impact on the
efficiency of production.
Negligence: If liability requires the victim to prove negligence, as with a negligence rule, then many manufacturers will
avoid liability, and they will take little precaution. (p. 217) Here the students may discuss the deep pockets and cascade
effects between firms under joint and several liability as each firm attempts to avoid liability and focus on production.
(See slides 23 to 31 – Lecture 7) Since harm to consumers is not internalized, then production will not be reduced.
Strict Liability: Manufacturers are held liable for the harms caused by their defective products, regardless of whether the
manufacturer was at fault. (p. 198) The emergence of strict products liability in tort law effectively causes manufacturers
to insure consumers, and manufacturers may buy liability insurance for themselves. (p. 238) Since harm to consumers is
internalized, then production will be reduced.
No fault: This is the same answer as strict liability except the costs are born by insurers, not firms, so production and
possibly harms to consumers increase
What is vicarious liability? Is it efficient?
When one party is held liable for the torts committed by another. Examples include parents being held liable for the acts
of their children and employers being held liable for the acts of an employee. Arguably efficient when employers and
parents are ina better position than their employees and children to make precautionary decisions. Question 7.5-7.7 pg
244-245
In what ways are rent ceilings and limits on compensation similar?
Insurance companies who pay such claims can reduce their premiums, ultimately reflected in lower costs to manufacturers
(so Supply increases) this is the opposite of rent controls. On the victim side, ceilings on compensation may induce some
victims to take greater precautions and thereby reduce their accident rates.
Carefully read the excerpts from the Butterfield v. Forrester (pp. 64 – 65) and Davies v. Mann cases. (pp. 66 – 68)
Focus on the economic issues.
1. (a) What would be the main economic reason for denying Butterfield his claim?
2. (b) Is the Expectation Damages model relevant here? Why or why not?
3. (c) What was different in the Davies v. Mann case?
4. (d) Which of the “Four (4) Theorems” discussed earlier apply to using precedents to solve “novel” cases?
5. (e) Look at Question 6.4 p. 196
QUESTION 6.1: According to the conclusion to Chapter 4, “. . . property rights are part of the law that makes owners
internalize the social costs and benefits of alternative uses of the goods that they own.” Torts are also an essential part of
that law. Explain why.
(p. 190) Regulations typically correct for market failures, while efficient default rules reduce the transaction costs of
bargaining. How do the concepts of “transaction cost reduction” and “market failure” apply to tort law? Bargaining is not
really possible between the vast majority of people who will meet in an accident. So, the transaction costs that are to be
reduced certainly are not those that are involved in pre-accident bargaining. The market failure in most accidents is an
externality. By taking precaution someone can confer a benefit on another – an external benefit – by making accidental
injury less likely and less severe.
QUESTION 6.2: Suppose that a person who is burned in an accident suffers intense pain for 1 week and then fully
recovers. What does “perfect compensation” mean in principle as applied to the burn? Why do you expect actual
compensation to be imperfect?
(p. 192) The court would need to decide what amount of money would perfectly compensate the burn victim for her one
week of pain. This is extremely difficult to calculate, thus illustrating the problem. Do you have any idea how much
money you would accept in exchange for suffering one week of intense pain? We doubt it.
QUESTION 6.5: Adapt Figure 6.2 to represent the rule that motor vehicles must stay within a designated speed limit (say
90 kilometers per hour).
pg 198
QUESTION 6.6: Offer an economic explanation for why the owner of a dog is liable for the harm it causes due to his
negligence, whereas the owner of a tiger is strictly liable for any harm that it causes.
(p. 198) Part of the answer has to do with the commonness of dogs as pets and the unusualness of keeping a pet tiger, and
the domestication of dogs and the basically wild nature of tigers. An old legal adage says that every dog is allowed one
bite. What does that mean?
QUESTION 6.8: Assume that you park your car in a legal parking space on a corner, and a driver who comes around the
corner too fast rams the bumper of his truck into your car, damaging your car but not his truck. A rule of no liability gives
the driver of the truck the same incentives to avoid such accidents as the incentives given to you to park your car in a safe
place under a rule of strict liability with perfect compensation. Explain why.
(p. 205) The rule of strict liability with perfectly compensatory damages gives the victim no incentive to avoid the harm.
On the other hand, the rule of no liability gives the injurer no incentive to avoid the harm.
QUESTION 6.9: Explain why the incentive problem in the previous question cannot be solved by a rule of strict liability
with imperfect compensation (say, actual compensation equal to 50 percent of perfect compensation).
(p. 205) The injurer has no incentive to take all accident-avoiding precautions because he is liable for only half of the
damages. And the victim has no incentive to take care to avoid all harm because he is liable for only half of his own
injuries.
QUESTION 6.10: A game is in equilibrium when no player can increase his or her payoff by changing strategy, so long
17
as the other players do not change their strategies. Prove that the simple liability game is in equilibrium when the
injurer and the victim take efficient care.
(p. 208) Once each party is taking efficient care, there is no incentive for either party to change the amount of care he is
taking.
QUESTION 6.19: “In general, the injurer’s precaution responds to court errors in setting the legal standard under a
negligence rule.” Is this statement true for all forms of the negligence rule, or only for the simple negligence rule?
(p. 220) This is an extremely complicated question. Under all forms of negligence, the rational potential victim should
presume that the rational person who injures him was complying with the legal duty of care and will not, therefore, be
liable for his accident losses. So, the potential victim should always take all cost-justified precaution. What complicates this
scenario is two things. First, people do not know whether they will be victim or injurer in their next accident. Second, if the legal duty of
care is set at a level different from the social-cost-minimizing level of care, then there could be problems. It still makes sense for the
potential victim (if he knows he’ll have that role) to assume that the other party will comply with the legal duty of care and, therefore, not
be held liable. But suppose that that level is below the social-cost-minimizing level of care so that accidents are more frequent and severe
than they should be. Would that change the way in which the potential victim should behave? Should he or she take more precaution
than he otherwise would? Perhaps so. But all this presumes a great deal of knowledge about where the legal duty of care lies, where the
social-cost-minimizing level of care is, what role one is going to have, and so on. The simplest thing to do is simply to take all costjustified precaution, regardless of whatever else is going on.
QUESTION 6.20: “Excessive damages increase expected liability under a negligence rule, which results in excess
precaution.” Explain the mistake in this proposition.
(p. 222) Excessive damages awarded by the court will increase the expected liability of the injurer, but will not influence
her level of precaution. The excess damages will simply shift the expected accident cost curve up. But that will not shift
the level of due care to which the injurer is to be held.
QUESTION 6.21: “If the legal standard of care in a negligence rule is necessarily vague, the court should set it below the
level of efficient precaution.” Explain the economic argument in favor of this proposition.
(p. 222) This is related to the fact that small random errors in the legal standard will probably cause the injurer to increase
precaution. The simple reason is that when faced with uncertainty about liability, it is cheaper to take extra precaution than
to chance an accident’s occurring, a trial’s taking place, and being held liable.
QUESTION 6.13: Who is the ultimate bearer of the costs of harm under a rule of comparative negligence? Explain your
answer.
(p. 213) Both parties are the bearers of residual liability.
QUESTION 6.17: Courts have to decide whether to defer to community norms when setting a standard of negligence or
to set a legal standard independently from the community norm. A community of homeowners has norms for maintaining
the safety of steps leading to the front porch of a house. Similarly, hospitals and private companies that collect blood have
norms for storing it safely. Make arguments for why a court might appropriately show more deference to community
standards for porch steps than to a community standard for storing blood.
(p. 217) Apply the logic of Figure 6.6 to this question. Will “too few” or “too many” accidents occur?
QUESTION 6.24: In effect, a rule of strict liability requires the seller to provide the consumer with a joint product: soda
and insurance. What inefficiencies arise from such a compulsory purchase?
(p. 226) One inefficiency might result if the seller is an inefficient producer of one of the joint products. Or the purchaser
might be able to produce or to buy one of the tied products more cheaply elsewhere.
QUESTION 7.1: Wearing seat belts and shoulder harnesses is an efficient means of minimizing the costs of automobile
accidents. Assuming that the benefits of these passive restraints exceed their costs, but that not all drivers and passengers
use seat belts, how might the rules of tort liability be changed so as to induce a greater number of people to wear seat belts
and shoulder harnesses?
(pp. 234-35) Three hypotheses might explain the limited use of seat belts. First, the decision to wear a seat belt is a utilitymaximizing decisions made by fully informed, rationally self-interested economic actors. They wear seat belts up to the
point at which the benefits exceed the costs but not beyond. So, whatever they do is optimal (assuming there are no
external effects from the decision about whether to wear seat belts).
A second hypothesis is that people fail to wear belts because they have made an inaccurate estimate of the benefits of
doing so. If so, then the public policy corrective is to get them the correct information. That might be done through public
service ads on TV or in newspapers and magazines.
A third hypothesis holds that people misestimate the benefits from wearing seat belts because of an inability to make
the relevant calculations, not because of a lack of information. People might be over-optimistic about their driving
abilities and believe, as a result, that they do not need protection from automobile accident injuries. If so, then the solution
might be mandatory safety measures, such as mandatory air bags. The alternative of allowing people to purchase seat belts
or airbags only if their own private calculations indicate that they are cost-justified is not to be trusted to minimize the
social costs of accidents.
QUESTION 7.2: Are subrogation clauses efficient? Be sure to review your answer in light of the section below about
litigation costs and their effect on the efficiency of the tort liability system.
(p. 240) Subrogation clauses are almost certainly efficient. We have just explored, in this section, the possibility that
costly litigation might deter victims from bringing an action for compensation against the person who injured them and
the further possibility that this might muddy the signal about the appropriate amount of precaution that a potential injurer
should take. But the fact that the victim’s insurer may have, through the subrogation clause, an interest in proceeding
against the injurer or the injurer’s insurer for indemnification of the amount that the insurer paid to the victim diminishes
the adverse effect of the victim’s not bringing an action against the injurer. [p. 240]
QUESTION 7.3: Use the economic theory of bargaining to characterize the torts in which the transaction costs of settling
disputes are likely to be large. (Hint: Recall the distinction between public bads and private bads.)
(p. 243) Recall our discussion in Chapter 4 of the distinction between a private bad (an external cost imposed only on one
person or a very few people) and a public bad (an external cost imposed on many parties). We argued there that the
appropriate remedy for a private bad was an injunction because that remedy clearly delineates rights and induces the
parties to solve their disagreement through negotiation. For a public bad the costs of achieving a bargaining solution are
too high so that the court must undertake a hypothetical market transaction and determine, through the levying of
compensatory damages, the appropriate price to impose on the wrongdoer. The same factors apply to the issue of settling
disputes when litigation is costly. If only a few parties are involved, bargaining costs are low and a settlement is likely. If
many parties are involved, bargaining costs are high. It is possible that if the bargaining costs exceed litigation costs, a
trial will result. We will return to the important issue of litigation versus settlement in the next chapter.
QUESTION 7.5: What if an accident has occurred because an employee was performing a job for which he was not
qualified after the employee had falsely told the employer that he was qualified? Should the employer still be liable for the
victim’s losses under respondeat superior?
(p. 245) Clearly, the employer has a duty to do a reasonable check on the qualifications of an employee and to continue to
monitor the employee’s performance to make sure that the employee does, in fact, have the qualifications necessary to do
the job. If the employer fails to perform due diligence before hiring the employee or fails to monitor that employee’s
performance, then the employer ought to be liable for the employee’s torts done in pursuance of that employee’s regular
assignments. This possibility of liability will create a strong incentive for the employer to take due care.
But if the employer has done all that it might reasonably do to check the employee’s qualifications and performance,
then it is the employee who ought to be held liable (even if he or she does not have the resources to compensate the
victim). To relieve the employee of all liability would create an unfortunate incentive for prospective employees to lie
about their abilities.
QUESTION 7.6: The common law did not hold parents liable for their children’s unintentional torts unless the parents’
negligent supervision led directly to the tort. But the common law did hold husbands vicariously liable for their wives’
torts (a rule since abrogated by statute). Can you provide an efficiency explanation for these common law rules?
(p. 245) The justification for the distinction was apparently that although parents could not, at reasonable cost. control
their children’s actions, husbands could at reasonable cost control their adult wives. We wonder whether that is still true.
QUESTION 7.7: In many states, a bartender (under so-called “dram shop laws”), friend, party host, or other person who
serves liquor to an already- intoxicated person may be held vicariously liable for any damages that person subsequently
inflicts on other people or their property. Does this form of vicarious liability make economic sense?
(p. 245) We will see in Chapter 8 that contract law treats a person who is drunk as incapacitated, so that a promise that a
drunk makes is unenforceable. Similarly, tort law recognizes that a drunk is no longer capable of making reasonable
decisions about precaution although his condition creates a high probability of causing harm. One way to reduce this
probability or to make accidents involving drunks less severe is to make sober people responsible for the drunk’s actions.
As between the drunk and the bartender or social host, there is now a situation of what we have called “unilateral
precaution”: only the sober bartender can guide the drunk into taking adequate precaution. It is worth thinking about
whether the bartender or social host should bear complete or only partial liability for the drunk’s action. Are social hosts
more likely to help if liability is shared with the drunk? Will helpers avoid drunks if they realize they become fully
responsible for the drunks’ actions? If so, can this effect be reduced by applying comparative fault principles to the
helper?
QUESTION 7.11: Analyze caps and limitations on litigation awards using the analysis of rent control in Chapter 2.
(p. 268) Remember that in the rent control example in Chapter 2, a cap was placed on the amount of rent that landlords
could charge, on the assumption that that maximum price was below the market-clearing price. The result was a shortage
of housing—that is, the demand at that price exceeded the supply. More people wanted apartments at the capped price
than were being supplied by the market. This created a housing shortage and problems such as fewer improvements in
existing structures and black markets for apartments.
Suppose that states place a monetary cap on damages in tort. What are the predictable effects? Presumably, there will
be no effect on those accidents that have relatively minor injuries because the compensable amount will be below the cap.
But for major incidents that have losses above the cap, there may be adverse consequences. First, potential injurers may
not take adequate precaution against these major incidents. As a result, those incidents may be more frequent or more
severe. Second, if potential victims figure out that they are not going to be fully compensated for major injuries, they may
respond in various ways, most of which involve inefficiencies. For example, they may take out more insurance; they may
take much more precaution than they otherwise would, including avoiding activities, routes of travel, and places where
there might be high-loss accidents.
QUESTION 7.12: Use the graphical analysis of liability of the previous chapter to show the effect on the precautionary
decisions of a potential injurer when the amount of compensatory damages that a victim may receive is capped.
(p. 268) Be sure that you understand why your answer will differ if the legal standard is negligence or strict liability.
QUESTION 7.15: Imagine a system of contractual or elective no-fault with respect to product-related injuries.
Manufacturers would offer with their products schedules of benefits that they would pay if consumers should be injured
while using the products. In the event of an injury, there would be no inquiry into the product’s defect or the user’s fault;
benefits would simply be paid to the injured consumer according to the contractual schedule. Pain and suffering would not
be compensable; collateral benefits would be deducted; and a few other restrictions would apply. Those manufacturers
who chose not to offer elective no-fault would still be strictly liable for product-related injuries under the current system.
Explore the efficiency of this elective no-fault system. (See J. O’CONNELL, ENDING INSULT TO INJURY (1975).)
(p. 273) In the first contracts chapter, Chapter 8, we will consider what are called “standard form” contracts. Those are
The elective no-fault proposal, like the UTC, imports contract principles into tort law where (contrary to our general
assumption about tortious situations) the costs of bargaining between injurer and victim are low. And presumably this
contract-like solution will allow the parties to allocate risk more efficiently.
Crime and Punishment
Define and explain a plea bargain
A plea bargain is the outcome of a bargaining game, a contract, between a defendant, their lawyer, and the crown attorney.
It is an important application of the Coase Theorem, since a plea bargain divides the surplus between the accused and the
Crown attorney that arises through cost savings of not having a proceeding.
Would a plea bargain that confers damages on a third party victim be optimal or sub-optimal?
To be fully optimal, a criminal remedy must confer full compensation for both the private damages and public loss of the
crime. Since the focus of the plea bargain is on the Crown and the accused, and not necessarily on the victim, then
generally the plea bargain falls short of full compensation. But in actual cases the civil remedies may be so deficient (all
defendants have no wealth) as to allow a third party benefit conferred by a plea bargain to be Pareto improving
How does the Crown office and defendant each benefit?
The defendant gains from having his sentence reduced and from foregoing the trial. The Crown receives a lower expected
sentence, but saves the cost of a criminal trial.
Explain how increasing the severity of punishment might increase the frequency of plea bargains?
When the severity of punishment is increased, the costs of trial increase. This places additional pressure on the Crown
attorney’s resource constraint. Crown attorneys find themselves required to make frequent and sometimes more generous
plea bargains. This may result in decreasing expected sentences for any given potential criminal.
If the government simultaneously increased mandatory sentencing while cutting back on police services, will this
increase or decrease the frequency of plea bargains?
When punishments are increased, the costs of trial increase. This places additional pressure on the prosecutor’s resource
constraint. Crown attorneys find themselves required to make more frequent and sometime more generous plea bargains.
This may result in decreasing expected sentences for any given potential criminal.
Explain why “armed robbery” is a crime. Who is the victim? How would Becker apply his model to this issue?
There is a private bad and a public bad component to the crime. The private bad might appear to be minor. It might be no
more than the actual amount of the money stolen.
Armed robbery has led to additional social costs such as increasing the TC of money itself, in the form of costs created by
increased security like security guards, alarm systems, and greater policing.
Becker’s approach would focus on the elements of punishment and policing. Risk adverse criminals would be concerned
with both factors, but be certain the punishment was more probable and is therefore motivated not to take the risk due to
the seriousness of the punishment. Risk neutral offenders are indifferent to the risk of punishment and arrest. Risk
preferring types would place more emphasis on policing, so would tend to target stores or banks that they feel are least
likely to have security or protection.
Text pg 458 question 12:2
Explain how outright prohibition of marijuana might amount to an increase in profits to criminals who supply
drugs. Use digrams. Explain the difference between hard core addicts and occasional users.
Text pg 518-522
Before the campaign, the price of drugs is p1, which results in drug use by addicts
and nonaddicts denoted x1 and , respectively. After the campaign against drugs, the
price rises to p2. The price includes the purchase price and also the monetary equivalent
of the risk of punishment caused by purchasing illegal drugs. At price p2, addicts use
drugs in the amount x2. The fact that x2 is not much less than x1 indicates that demand by
addicts is inelastic. At price p2, nonaddicts use drugs in the amount . The fact that is
much less than indicates that demand by addicts is elastic. Raising the price of drugs
from p1 to p2 has little effect on drug use by addicts and a large effect on nonaddicts.
Now consider the effects of the increase in price on expenditures on drugs. Addicts
purchase x1 drugs at the low price p1, which results in total expenditures of p1 " x1, as indicated by areas B & C in Figure
13.1. After the campaign against drugs, addicts purchase x2 drugs at the higher price p2, which results in total
expenditures of p2 " x2 as indicated by the areas A & B in Figure 13.1. The campaign thus causes a large increase in
expenditures on drugs by addicts, specifically an increase of A ( C. Total expenditures go up because addicts continue
buying almost the same quantity of drugs and paying a much higher price. Consequently, addicts will need a lot more
money to buy drugs, and much of that money may come from property crimes. Thus, public policies that raise the cost of
drugs to addicts may cause more crime rather than less. (The campaign against drugs, which raises prices, also causes
total expenditures by nonaddicts to go down by A' ( C'.)
This analysis exposes a dilemma: Public policies that raise the price of drugs have
the good effect of reducing their use by nonaddicts. Less use by nonaddicts presumably
implies fewer crimes committed by them, and also fewer nonaddicts becoming addicts.
However, public policies that raise the price of drugs have the bad effect of substantially
increasing expenditures on drugs by addicts. More expenditure on drugs by addicts
implies more crimes committed by them in order to get more money for drugs.
The obvious response to these facts is to try to get the best of both worlds by raising
the price to nonaddicts and not raising the price to addicts. In other words, the obvious
response is a drug policy that discriminates in drug prices between addicts and
nonaddicts. Successful price discrimination causes the addicts in Figure 13.1 to face
the low price p1 and the nonaddicts to face the high price p2. As implemented in the
United Kingdom and elsewhere, addicts can submit to medical examination and register
their addictions. After registration, they can buy cheap drugs legally by prescription,
much as people obtain medicinal drugs by prescription from a doctor.
Consequently, addicts obtain a safe supply of drugs sufficient to maintain their habits.
However, nonaddicts (or unregistered addicts) cannot obtain drugs legally from pharmacies;
instead they must purchase drugs illegally at much higher prices.
We have discussed a system of prescription sales for addictive drugs that creates
price discrimination between addicts and nonaddicts. Note that price discrimination in
this system goes in the opposite direction from price discrimination practiced by profit maximizing companies. The
prescriptions system aims to lower the price of addictive
drugs to consumers with inelastic demand (addicts), whereas profit-maximizing companies
aim to raise the price of their products to consumers with inelastic demand.
Does the Canadian Corporations Arrangement Act (CCAA) have valid economic purpose? What is it? Is the
Normative Coase Theorem involved? Why or why not?
Going back to contracts, expectation damages approach commitment to payment and performance terms, but courts
applied strict rules that limited renegotiation when a change in material circumstances occurred. This forced otherwise
viable companies to go bankrupt even if only one creditor or debt not being met was an issue. In the Great Depression,
this had devastating impact on key companies, especially railways, vital to the economic infrastructure of the company.
In an effort to reduce bankruptcy, court costs and TC, Canada enacted the CCAA to facilitate restructuring otherwise
viable firms. A clear case of the Normative Coase Theorem applied. On the other hand, since it is difficult to identify any
advantage or disadvantage immediate to either the creditor ot debtor, the normative Hobbes Theorem likely does not
apply.
Give three (3) reasons for having criminal punishments instead of tort liability, giving a concrete example
illustrating each reason. Explain the economic analysis that lies behind each reason you give.
1. To deter harms caused by the public cost part of a crime – separate from the compensation for the private cost of the
private harm. For example, thieves cannot be deterred by the requirement that they return what they have stolen whenever
they happen to get caught. In order to deter thieves, the law must impose enough punishment so that the expected net
benefit of crime to the criminal is negative. (pp. 461 - 462)
2. The law should aim for deterrence when perfect compensation is impossible in principle or in practice, when people
want law to protect their rights instead of their interests, or when enforcement errors systematically undermine liability.
(p. 462)
3. Even if perfect compensation were possible, the law may seek to protect the rights of potential victims in priority to
their interests. (p. 462)
4. Punishments in criminal law should, in part, be set so as to protect and encourage voluntary exchange through markets.
(p. 462)
If Canada’s Criminal Code prescribes the exact punishment for each crime, instead of allowing judges a range of
punishments, predict what may happen to the level of crime in Canada, the level of arrests, the level of convictions
and the amount of plea bargaining?
Mandatory minimums are examples. Any rigidity that hampers plea bargains will result in fewer plea bargains, more
expensive trials, more acquitals and fewer trials due to costs, where Crown attorneys are forced to consider the outright
withdrawal or dropping of charges, because they cannot negotiate sentencing. Even where punishments appear to be
clearer and more severe, risk averse criminals might reduce their crime levels, but this will likely be offset by the
perception that convictions or jail is less likely – so risk neutral and risk preferring criminals (repeat offenders) are
inspired to commit more crime. So Canada sees more arrests and more crime by repeat offenders, fewer convictions and
less plea bargainng. (Pg 489-491)
Using a carefully detailed diagram, compare and contrast how private cost and social cost form the basis for crime
prevention remedies
What is the role of policing in crime prevention? Who is most likely deterred from crime when police budgets are
increased?
For the risk preferring, punishment effect < enforcement effect, meaning they are the group most deterred.
What is the role of incarceration (jails and prisons) in crime prevention? Who is most likely deterred from crime
when more jails and prisons are built?
For the risk averse, punishment effect > enforcement effect, meaning they are the group most deterred.
Explain the prisoners’ dilemma when 2 accused are charged with the same crime where both were involved.
Explain why counterfeiting money is a crime. Who is the victim? How would Becker apply his model to this issue?
QUESTION 12:2 p. 458
Like the insider trading question – Question 1 – there is a private bad and a public bad component to the crime. The
private bad might appear to be minor. It might be no more than the actual amount of the money counterfeited.
Counterfeiting has led to additional social costs such as increasing the transaction costs of money itself – in the form of
costs created by increased security and printing precautions as well as non-cash alternatives and credit checks.
Becker`s approach would focus on the elements of punishment and policing. Risk adverse criminals would be concerned
with both factors, but be confident the punishment was more probable and is so motivated not to take the risk as the
seriousness of the punishment. Risk neutral offenders are indifferent to the risk of punishment and arrest. Risk preferring
types would place more emphasis on policing, so would tend to target areas or victims that they feel are least likely to
have security or protection.
Using a diagram such as the ones on p. 465 or p. 466 is encouraged.
For burglary, the loss of the victim usually exceeds the gain of the burglar. Why? For breach of contract, the loss of
the victim is less than the gain of the person breaking the contract. Why? What are the implications for relative
dollar values of compensation and punishment?
Using a diagram such as the ones on p. 465 or p. 466 is encouraged. The explanation contrasting civil and criminal
compensation is on p. 460.
Question 12.6 pg 460
QUESTION 10.2: Why is a trial economically inferior to a settlement on the same terms as the expected trial
judgment?
Because the costs of litigation are generally much greater than the costs of settlement. Indeed, the cost of settlement have
typically been incurred before a trial begins.
QUESTION 10.3: The tree in Figure 10.4b is identical to that in Figure 10.4a, except that a trial costs the plaintiff
$40 instead of $20, and settlement is for $51 instead of $50. Solve recursively for the expected values of the legal
claim by filling in the blanks at each stage in the following tree. What is the plaintiff’s expected net profit from
filing a legal complaint?
Work your way backwards as in the example in the text. The only difference is that the expected value of the trial (EVT)
is now $10 instead of $30.
QUESTION 10.5: Example 4 at the beginning of this chapter concerns whether a judge should order a divorcing
couple to attempt mediation before beginning a trial. Assume that false optimism causes trials and predict whether
compulsory mediation would cause more disputes to be settled without trial.
These assumptions may result in the policy prescription that the courts should set lower administrative fees for business
decisions than for divorces. Why? Generally speaking, at least for economic analysis, it is more important to encourage
litigation where there are efficiency consequences than were there are distributional consequences.
QUESTION 10.6: Assume that discovery increases the optimism of plain- tiffs and thus increases the value of their
legal claims. Explain the conse- quences for the number of claims filed.
In economic jargon, this is called a “price floor.” This is the opposite of the rent control example of Chapter 2, which was
a “price ceiling.” The quantity demanded is q1 while the quantity supplied is q3. How does this excess supply influence
the market for lawyers? The price per unit of legal services cannot, by assumption, go down, as it would in an unregulated
market. As a result, people may economize on legal services, using whatever substitutes they can, such as more
precaution.
QUESTION 10.7: Trial procedures are formal and involve a lot of people, whereas discovery procedures are
relatively informal and involve relatively few people. Consequently, discovering a fact before trial is cheaper than
finding it during trial. Most trials, however, are averted through an out-of- court settlement. As a result, if the
parties postpone finding a fact until trial, they may avoid the cost completely. To appreciate this trade-off between
cost and certainty, consider a numerical problem. Let x denote the ratio of the cost of finding a fact during the trial
and the cost of discovering the fact before trial. Assume that the probability of a settlement out of court equals .9.
How large must x be in order for the expected cost of finding the fact at trial to exceed the cost of discovering it
before trial?
Consider the question in this way. There is only a 10 percent probability that the dispute will go to trial, and a 90 percent
chance that it will settle. Suppose that the cost of obtaining the information before trial is $100. We know that the cost of
obtaining that same information at trial is 100x, where x is some number greater than 1. Presumably, we will be indifferent
between trail and settlement when the expected value (or cost) of this information is the same before and at trial. So, we
need to solve the equation: .1(100 x) .9(100). And that gives x = 9. So, the implication is that if the expected cost of the
trial information is less than 9 times that of the expected cost of the discovery information, go to trial. Otherwise, settle.
QUESTION 10.11: Bribing or intimidating the court is a persistent worry in trials. The use of juries is often
justified on the ground that corrupting the jury is more difficult than corrupting a judge. Why might this be true?
10.11. (p. 408) Clearly, it is far easier to bribe one person (a judge) than to bribe a majority of the jury. Put in the
vernacular of this book, the transaction costs of bribing one person are much less than those of bribing seven.
QUESTION 10.4: In Europe, the party who loses at trial pays the litigation costs of the winner. Assume that the
plaintiff in the preceding figure pays liti- gation costs of $40 if she loses at trial, and the plaintiff pays litigation
costs of $0 if she wins. Recompute the expected values of the legal claim under this assumption.
This will change the EVT. Instead of subtracting the trial costs as a lump sum, you must include them in the probability.
That is EVT = -.5($100) + 0.5(-$40) = $30.
QUESTION 10.12: Assume that the plaintiff demands $1000 to settle, the defendant rejects the offer, and the jury
awards $900 at trial. Who “won” for purposes of the rule “loser pays all”?
Here’s what Rule 68 of the FEDERAL RULES OF CIVIL PROCEDURE (the “Offer of Judgment” rule) says: “An offer not
accepted shall be deemed withdrawn and evidence thereof is not admissible except in a proceeding to determine costs. If
the judgment finally obtained by the offeree is not more favorable than the offer, the offeree must pay the costs incurred
after the making of the offer.” So, if the court follows this Rule, then the plaintiff will pay most of the defendant’s legal
fees. (Presumably, the pre-offer legal fees of the defendant will not be covered by this rule.)
QUESTION 10.15: The parties to a suit may dispute the fact and extent of liability. Disputes over whether the
defendant was liable often have no scope for compromise, whereas disputes over the magnitude of damages have
scope for compromise. Explain why the rule of “loser pays all” may cause parties to resolve most disputes over the
extent of liability but not the fact of liability.
The issue of liability is not amenable to compromise: one is either liable or not. So, there is not much scope for bargaining
on that matter. But once liability is established, the matter of damages is amenable to compromise. The matter of legal
fees could be traded off against the value of a monetary judgment.
QUESTION 10.24: In Chapter 6 we explained the Hand rule for determin- ing whether an injurer was negligent.
Does the Hand rule require that “injur- ers show equal concern for the harms suffered by others as for
themselves”?
Remember that under the Hand Rule, the injurer is negligent when the marginal cost of her precaution is less than the
marginal benefit resulting from her precaution. So, yes, the injurer has got to give due regard to the health of those whom
his or her failure to take care might injure.
**********Question 10.9- Assume that the litigation will cost the plaintiff $100 and the defendant $100. Assume
that settling out of court is free (SC = $0). What is the largest value of relative optimism (∆EJ) at which the parties
can still settle out of court?
-
As long as there is a settlement (doesn’t have to be a perfect one) there will be a social surplus generated
To get optimal settlement, need rational plaintiff and defendant
As soon as you introduce bias, still get a settlement, but wont be optimal.
In a bargaining situation, the parties can cooperate, or each party can act on its own with- out the other party’s
cooperation. The joint payoff from cooperating exceeds the sum of individual payoffs from not cooperating. In order to
induce someone to cooperate, the party must receive at least as much as can be obtained by not cooperating, which is
called a threat value by economists. The sum of the threat values equals the noncooperative value of the game. The
difference between the joint payoff from cooperating and the noncooperative value of the game equals the cooperative
surplus. In a civil dispute, an agreement to settle out of court can replicate any judg- ment that the court would have
reached after a trial.
Thus, a settlement could achieve the same outcome as a trial, and the parties would save the cost of litigation. The savings
in the cost of a trial could have been divided between the parties, making both of them better off. For any trial, a
settlement usually exists that makes both parties better off; so, trials are usually inefficient.
A settlement out of court is a cooperative solution, and a trial is the noncoopera- tive solution. The difference between the
joint payoffs from a settlement and the sum of the individual payoffs from a trial equals the cooperative surplus. A
reasonable set- tlement divides the cooperative surplus equally.
Now we relate the reasonable settlement to the expected judgment. The expected judgment from a trial equals the actual
judgment multiplied by its probability. Recall our simple measure of social costs as the sum of administrative costs and
error costs. When the settlement replicates the expected judgment, a settlement uses lower transaction costs to achieve the
result as expected at trial. Thus, the administra- tive costs are lower, and the error costs are the same. Therefore, a
settlement that repli- cates the expected judgment at trial usually reduces social costs. Given this fact, the law should
encourage settlements that replicate the expected judgment. By doing so, the law can achieve the same results as trials
while lowering social costs.
In general, the reasonable set- tlement equals the expected judgment at trial when (1) the plaintiff and defendant have the
same expectations about the trial, and (2) the plaintiff and defendant bear the same transaction costs to resolve the
dispute.
Earlier we explained that relative optimism causes trials. In bargaining together, the parties may agree to disagree on these
probabilities, and to compute resulting gain from cooperation. The computation of the surplus from cooperation as
perceived by the parties can be called the “putative cooperative surplus”— that is the surplus that they impute to
cooperating, given that they do not agree about their prospects at trial. If relative optimism reduces the putative cooperative surplus below zero, then settlement cannot occur.
Because cooperation produces a negative putative surplus, both parties prefer a trial. Settlement cannot occur because
each party expects to gain more from a trial than he could gain by a settlement acceptable to the other side. This example
illustrates that relative optimism about trial can overwhelm the sav- ings in the cost of litigating. We can state the
relationship precisely. Relative optimism is measured by the difference in the expected judgment of the two parties, which
we write ¢EJ. By settling, the parties save the difference in costs between litigating and settling, which we write LC - SC.
The expected surplus from settling becomes nega- tive, making trial inevitable, when relative optimism exceeds the
difference in costs be- tween litigating and settling:
****QUESTION 10.13: Assume that the plaintiff demands $1000 to settle, the defendant offers $600, and the jury
awards $900 at trial. Extend the defini- tion of “winner” and “loser” to this case for purposes of applying the rule
“loser pays all.”
-
in economic sense they lost b/c were awarded less than settlement would have given
-
claimant won, b/c last offer was $600. Need to look at last offer to determine winner. So original demand is no
longer relevant.
-
Why optimal? Look at 10.9. Goes back to Coase Theorem
QUESTION 10.15: The parties to a suit may dispute the fact and extent of liability. Disputes over whether the
defendant was liable often have no scope for compromise, whereas disputes over the magnitude of damages have
scope for compromise. Explain why the rule of “loser pays all” may cause parties to resolve most disputes over the
extent of liability but not the fact of liability.
-
if risk-averse, have that bias, so loser pays all works as a deterrant.
-
Where no bias, neither rule makes a difference
The issue of liability is not amenable to compromise: one is either liable or not. So, there is not much scope for bargaining
on that matter. But once liability is established, the matter of damages is amenable to compromise. The matter of legal
fees could be traded off against the value of a monetary judgment.
QUESTION 10.16: Assume that both parties to a legal dispute are averse to the risk of losing at trial. Would riskaverse parties be more inclined to settle out of court under a rule of “each pays his own” or “loser pays all”?
-
Risk-averse more inclined to settle out of court under rule of loser pays all (bias=risk-averse)
Risk-neutral don’t have this bias
There’s a great deal of controversy about this matter. Our intuition is that if both parties are risk-averse and if the case is
closely contested (that is, both parties have a roughly even chance of winning), then they are more likely to settle under
the English rule than under the American rule. The total amount that each party has at stake is larger under the English
rule.
QUESTION 10.17: Suppose “loser pays all” is more efficient than “each pays his own.” In a jurisdiction that
follows “each pays his own,” the Coase Theorem would predict that the two parties would sign a contract requiring
the loser to reimburse the winner, thus adopting the more efficient rule by private agreement. Give some economic
reasons why this does not occur in fact.
The transaction costs for the parties of bargaining around the default rule might inhibit this deal from occurring.
Recognize that for most parties litigation is not so common that they can develop boilerplate to deal with this situation.
For most parties, litigation is uncommon. (The average American consults a lawyer only three times during a lifetime.)
And many people may well be overly optimistic about their abilities to prevail at trial, thus inclining them not to want to
bargain away from the default of “loser pays.”
QUESTION 10.18: By setting fees for appealing, the state can discourage appeals with low probability of success.
Construct a numerical example to il- lustrate this fact.
-
If low chance of winning an appeal, then put less weight, so most claimants don’t even consider
So put more weight on trial
Why so little weight? Error the judge makes
How can judge make error> 1) ignoring evidence that shouldn’t be ignored. 2) awarding the damages
Many examples are possible where appeals with high probability of success are pursued, but appeals with low probability
of success are not. As you will learn later in the chapter, appeals are not that expensive but are not that common either.
QUESTION 10.20: Assume that delay is more costly to the plaintiff than the defendant. How does the possibility of
appealing an adverse court decision, which delays resolution of the case, affect bargaining between the parties to
settle the dispute out of court?
-
Another type of bias- need to settle as fast as possible
Expected value of trial
The speed might not ∆, but amount got from settlement might shrink, so sub-optimal
If the cost of delay is higher to the plaintiff than to the defendant, then presumably that creates an incentive for settling
sooner rather than later and on terms that may favor the defendant.
QUESTION 10.21: The plaintiff who brings a suit to establish a more effi- cient precedent enjoys only a fraction of
its social value. Does this fact show that the government should subsidize lawsuits by paying part of the cost of
litigation?
-
Very optimistic claimants and very optimal defendants, surplus will be 0 b/c no settlement and will go to trial
Yes. If there is a potential social benefit to an appeal (which can make law), then society has an interest in having the
appeal go forward. To encourage the appellant to bring that appeal, the government should subsidize the costs of appeal.
But not fully. The appellant needs to bear some of the costs, too.
QUESTION 12.2: Explain why counterfeiting money is a crime. Who is the victim? Is there a private victim as well as
public victims?
(p. 458) We have suggested that the term “victimless crime” implies that society or the social fabric, rather than a single
individual, is the victim. Counterfeiting is a crime in two senses: it imposes extraordinary costs on individuals and on
society. For example, counterfeiting causes losses to the individuals who accept the counterfeit currency. And that may
make them suspicious of accepting paper money. If that suspicion becomes widespread and if substitute methods of
payment are not easily available, then commerce generally could be adversely affected. The costs to everyone of engaging
in mutually beneficial exchange are raised. Other aspects of counterfeiting that are important in explaining why it is a
crime are that it is an intentional wrong and that it is frequently difficult to apprehend and convict counterfeiters. Why
these are elements of a crime will become evident shortly.
QUESTION 12.6: For burglary, the victim’s loss usually exceeds the in- jurer’s gain, but the opposite is true for breach of
contract. Why? What are the implications for relative dollar values of compensation and punishment?
(p. 460) There are two important differences between burglary and breach of contract for the purposes of computing
damages. First, burglary is intentionally wrong and unavoidably harms the victim; breach of contract may be intentional
but it is not (if remedies are appropriate) done with the intention of harming the breachee. Second, we are only probably
likely to detect and identify the burglar (and the probability of doing so may be well below 50 percent); we are almost
certain to identify the breacher. These two factors argue for a different measure of damages for the two activities. Indeed,
the concept of “damages” isn’t really appropriate for burglary; we do not want that activity priced correctly. We want it
stopped. With respect to breach, we do not want breach stopped; we want it priced correctly.
QUESTION 12.7: We gave three reasons for having criminal punishments instead of tort liability. Give a concrete
example illustrating each reason.
(p. 463) The three reasons for having criminal instead of tort punishments are: limitations on compensation, protecting
rights rather than interests, and deterrence. It is difficult to find an adequate amount of money to compensate for an
intentional or reckless loss of life. The previous answer’s discussion of discouraging burglary, rather than simply pricing it
correctly, is an example of “protecting rights rather than interests.” And the need for supracompensatory damages (or
punishment) in crime so as to discourage (strongly) the activity – rather than merely compensating the victim – is an
example of deterrence.
QUESTION 12.15: What are some ways to measure the social costs of the harm caused by murder? (Recall our
discussion in Chapter 7 of how to assign value to a life lost in an accident.)
(p. 475) Remember that the social cost of a crime is the sum of the cost of crime prevention and the harm it causes, not
just to the particular victim but to others, too. And you should be certain to include direct and opportunity costs in your
computation. The crime of murder clearly has direct costs to the victim and his or her immediate family, friends,
acquaintances, and co-workers. (There are also direct costs to the family, friends, and co-workers of the perpetrator.) But
there are also indirect costs to others who are frightened by the murder and take steps to avoid being victims themselves.
For instance, some people may spend resources arming themselves so as to fight back. Others may avoid certain areas or
commercial entities where they anticipate being victimized.
QUESTION 12.10: How do Figures 12.3 and 12.4 change if the police be- come more efficient and catch a larger
proportion of criminals? What does the change in the figures indicate about a change in criminal behavior?
(p. 467) This will shift the expected punishment curve closer to the certain punishment curve. That could indicate that
either fewer crimes are being committed or that they are less severe or both.
QUESTION 12.13: Why should the law punish a person more severely for committing the same crime deliberately rather
than spontaneously?
(p. 470) We defined a lapse as an episode where an actor temporarily discounts the future consequences of her actions at a
very high level. This leads the actor to care less than she normally would about the penalties associated with her crime.
Therefore, deterrence is much more difficult when the actor experiences a lapse. Lapses are difficult for the potential
offender to anticipate. By contrast, a deliberate crime was not spontaneous or the result of a momentary lapse. All of us
sense that deliberately doing wrong is far worse than doing so spontaneously. There is an old expression in the law: “Even
a dog knows the difference between being stumbled over and kicked.” That captures, imperfectly, the difference between
spontaneously committing a crime and deliberately doing so.
QUESTION 13.3: How would economics try to answer the question, “Does crime increase or decrease as a society
becomes more wealthy?”
(p. 491) Let’s think about this both theoretically and empirically. First, theoretically. If a society grows wealthier, then
three things of relevance to crime happen. First, because everyone is wealthier, then there is more valuable stuff to steal.
Crime can be more lucrative. So, the expected benefit of crime is greater, all other things equal. Is this true however if
both the average wealth and the variance of wealth increases? Second, the fact that the society is wealthier may well
mean that it spends an increasing amount of money (perhaps an increasing fraction of its GDP) on law enforcement and
other public services. As a result, deterrence may be greater. And third, because the society is wealthier, the opportunity
cost of crime may be greater in that legitimate job opportunities are more plentiful. One of the crime-deterring qualities of
legitimate employment is that it gives the worker a reputation that might be sacrificed if he or she were to commit and be
convicted of a crime.
How do these three factors play out – is there more, less, or about the same amount of crime as a country grows
richer? As we can see, there is no compelling theoretical argument to answer that question. So, we have to do some careful
empirical work. One of the first things to recognize is that when we do that, we typically measure crime on a per capita
basis, not simply in absolute numbers. To our knowledge, there is no empirical learning on this matter.
QUESTION 13.4: When statutes prescribe the exact punishment for each crime, the judge’s discretionary power
decreases and the prosecutor’s increases. Predict how this change might affect the charges made against arrested persons.
(p. 491) The fact that judges have less discretion in sentencing, means that the prosecutor is more likely to charge criminal
suspects with the highest-sentence crime that he or she can plausibly establish. Because the defendant knows that if
convicted, there is no discretion for the judge to mitigate sentencing, he is certain to serve the specified time. So, his
thinking focuses on the strength of the prosecutor’s case. All other things equal and assuming risk-averse defendants, this
may induce prosecutors to plea bargain more harshly than when judges had discretion in sentencing. And not only is there
likely to be more plea bargaining, it is also likely that the deals agreed to are more pro-prosecutor and less defendantfriendly than was previously the case. These are, of course, empirically testable propositions.
QUESTION 13.9: Competition among sellers improves the quality of goods for consumers. Could this mechanism work
for the private supply of prisons?
(p. 509) The incentive to earn profit in a competitive environment spurs cost-cutting, technological innovation, and a
superior quality output. Could competition among private prisons accomplish the same goals? Critics of private prisons are
concerned that cost-cutting may lead to a sacrifice in the quality of prisoner care such as low quality food, shelter and
other material conditions for the prison population. We might try to control those forms of competition by regulating the
minimum terms and conditions that private prisons must maintain. But will there be adequate monitoring and enforcement
of those regulations? Perhaps not. And, in addition, many states may be unwilling to have competitive prison systems
within their state. They probably would prefer to have one provider whom they can, at least in theory, closely monitor.
QUESTION 13.13: Opponents and proponents of capital punishment deny that their beliefs depend on the presence or
73
absence of deterrence effects, yet Ehrlich’s study provoked intense debate and outrage. What do these facts say about
the contribution of econometrics to criminal law?
(p. 517) Statistical analysis is a very powerful tool as it often appears to provide hard answers to difficult questions.
Hypothesis tests however are rarely if ever perfectly formulated. Questions will always arise concerning the choice of
variables, the construction of the test, and what the chosen variables actually measure. Still, econometric analysis is a
useful tool for analyzing criminal behavior. But notice that very few people will formulate their final views about the
death penalty on the basis of empirical evidence. That is, few of those who are opposed would change their minds if they
were shown compelling empirical evidence on the deterrent effect of capital punishment. And few proponents would drop
their endorsement of capital punishment if shown compelling empirical evidence that it does not have a statistically
significant deterrent effect. To quote an old joke, most people use statistical evidence in the same way that a drunk uses
lampposts, “more for support than illumination.”
QUESTION 13.15: During the “war on drugs” in the United States, the street price of most illegal drugs has remained
stable or has fallen. What does this fact indicate about who is winning the “war”?
(p. 522) Remember that the equilibrium price is determined by the intersection of the supply and demand schedules. If the
price of drugs is falling, then the supply must be increasing faster than the demand is decreasing. The principal reason that
has happened is that the attempts to interdict supply or to induce people to get out of the criminal business of supplying
drugs has failed.
QUESTION 13.16: Use economics to compare three ways to reduce the demand for heroin: (i) the substitution of
another, less dangerous, and less debilitating drug, such as methadone for heroin, to registered addicts; (ii) the free
availability of the illegal substance to registered addicts; and (iii) a legal proscription on use, which is the current policy.
(p. 522) We already know about the ineffectuality of the current system of proscription, policy (iii). Policy (ii) would
certainly reduce the price of drugs and thereby cut some of the connection between drug use and crime. Policy (i) of
asking addicts to register and, having done so, giving them daily access to methadone has been tried with mixed success.
Methadone, developed in Germany in 1937, operates on the same opiate receptors as do heroin and opium and is
frequently used in treating chronic pain. One of methadone’s advantages over other powerful pain relievers is its low cost
—typically, $20 per month.
So-called “methadone maintenance treatment” is a common way of dealing with heroin addicts. Daily doses of
methadone reduce the craving for heroin. But the treatment must be supplemented with other treatments, such as
counseling, in order to be effective.