Economics 320F – An Economic Analysis of Law
Midterm Exam
Suggested Answers
Fall 2003
University of Toronto
Joanne Roberts
Please answer all parts of the exam in the exam booklet provided.
Calculators are permitted.
This test will be marked out of 50.
The marks for each question are noted throughout the exam.
Part 1: [20 marks -- 10 each]
Comment on two of the following:
1. Should society take as its objective the eradication of all crime? Of all pollution? Of
all accidents? On what basis should society allocate its scarce resources toward
reduction of crime, pollution, accidents, and other bad things?
A Efficiency suggests that resources should be allocated toward the reduction
of these bad things to the extent that it is efficient to do so. The efficient
allocation of resources to the reduction of one of these bad things is the level
at which the marginal benefit of allocating the last unit of a resource to the
reduction in question equals the marginal cost of allocating that last unit. If
fewer resources are allocated to the reduction of the bad thing such that the
marginal benefit of adding an additional unit of resource is greater than the
marginal cost that would be incurred, it would clearly be efficiency
enhancing to allocate that additional unit. On the other hand, if more
resources than this level were allocated such that the MC of adding the last
unit is greater than the MB of doing so, it would be efficiency enhancing to
reduce the level of resources so allocated. Therefore, in general, it is not
desirable from an efficiency point of view to allocate resources so as to
eradicate all crime, all pollution and/or all accidents. Instead, resources
should be allocated such that no more (and no less) than an efficient level of
each of these things occurs.
2. Recently, steps have been taken in the United States to ban the commercial market in
human blood. The principal argument given was that commercially-provided blood is
more likely to be infected with hepatitis, the AIDS virus, and other harmful elements than
is volunteered blood. Can this ban be justified on efficiency, or any other, grounds?
What would be your prediction about the effect of such a ban?
A Volunteers donate blood because they gain some satisfaction from making a
contribution to a public good (the supply of blood). Paying people for their
blood may induce some people who are at high risk of having infected blood
(e.g., drug users) to contribute their blood in order to receive such a
payment. This, in turn, may increase the need for costly screening
procedures. Banning such the commercial-provision of blood would
potentially reduce these costs, but would also clearly reduce the amount of
blood that is donated (perhaps causing shortages of blood as is common in
Canada where there is no commercial provision of blood). Whether this
would be efficient depends on the MC of the extra screening that would be
saved by the implementation of such a ban in relation to the MB of the
additional volume of blood that would no longer be collected. If the cost
savings outweigh the benefits forgone, then the ban would be efficient. Even
if the ban were not efficient, there may be other moral or ethical
justifications for banning people from selling their blood.
3. The Coase theorem says that, in a world of zero transaction cost, it would make no
difference at all how property rights (or the legal liabilities that define those rights) are
assigned. True or False.
A False. The Coase theorem says that in a world of zero transaction costs the
assignment of rights (or liabilities) to one party or another will not affect the
final allocation of those rights since parties will be able to negotiate market
transactions which will ensure an efficient outcome (at least in the long-run).
However, the theorem does not suggest that there is no difference – the
distribution of wealth is clearly affected by the assignment of the rights since
the party to whom they are assigned can (potentially) extract a payment from
the other party in exchange for the right (or some of the rights).
Part 2: [30 marks -- 15 each]
Answer both of the following questions.
1. Criminal Law and Drugs
a) Discuss, using supply and demand diagrams, why increasing the severity of
punishment for selling drugs may actually increase the amount of drug-related
crime (Hint: you need only consider an addict’s demand for drugs). In your
discussion, note carefully the assumptions that you must make in your analysis
(about the shape of the demand curve, the story told about why drug use and
crime are connected, etc.).
A [See the discussion at page 507-9 of the textbook.] The popular explanation
for the link between increased drug use and increased crime is threefold: 1.
some drug addicts need to commit crime to generate income since they are
unable to earn enough working at legitimate jobs, due to the debilitating
effects of their habit, to support the purchase of drugs; 2. drugs reduce
people’s inhibitions which can lead them to commit more crimes; and 3. drug
dealing can be a lucrative business worth protecting through, in part, the
commission of violent crimes against their competitors. Thus reducing the
use of addictive drugs is one way to reduce the social cost of crime.
Increasing the severity of punishment for selling drugs may tend to cause
some people to stop selling them; however, because an addict’s demand for
drugs is very inelastic the reduction in supply due to increased severity of
punishment for selling drugs could actually cause an increase in crime. This
is because the reduction in supply combined with highly inelastic demand
will cause the market price to rise significantly (rather than reduce the
quantity of drugs demanded by an addict) which in turn could cause addicts
to commit more crime to produce greater revenue to support the greater
expenditure required to maintain their drug habit. See page 508, Figure 12.1
for (left panel) for the diagram.
b) Now consider the punishment for buying drugs. This crime can be punished in
two ways – by using fines, or imprisonment. Based on the assumptions that you
make in part a), is it likely that we will be able to punish drug use as cheaply as
we would like to be able to? Explain your answer using a diagram that shows a
“deterrence isoquant” across the severity of fines and the severity of
imprisonment.
A For each level of deterrence of drug use which can, in theory at least, be
achieved either through imprisonment or fines we can draw an isoquant in
fines/imprisonment space. Each point on the curve represents a combination
of fine and imprisonment which will achieve the same level, D0, of deterrence.
Since the social costs of operating a prison are high, the fine is likely the
cheaper method. However, the problem is that given our assumptions about
drug addicts’ liquidity constraints (i.e., their drug use reduces their ability to
earn an income which combined with the addictiveness causes them to
commit crimes to earn the cash need to support the habit), it will be
impossible to impose anything above a certain level of fine on most drug
addicts. Thus, even though fines would be the cheaper method for deterring
drug use, (i.e., y* would be the lowest cost option for achieving deterrence
level D0) it seems likely that some use of imprisonment will be necessary (i.e.,
x*).
Fine
y*
Offender’s
Solvency Constraint
Higher cost
D0
Low cost
x*
Imprisonment
2. Fred lives next door to Amy. Amy has a habit of singing every morning at 8:30 as loudly as
she can. Fred values his residence at $5,000. If he is unable to sleep peacefully whenever he
wants to, his value falls by $2,000 (leaving him with a value of $3,000). Amy gets $1,000 worth
of utility from her singing.
Discuss whether efficiency will be achieved under the following legal rules (1 through 3)
1) Amy has the right to sing.
2) Fred is entitled to compensatory damages from Amy if she sings.
3) Fred is entitled to an injunction against Amy.
when
a) transaction costs are high enough to preclude bargaining. In so doing, identify the
payoffs to each player, and the joint payoffs earned by the players under each
rule.
A Under rule 1 (Amy has the right) Amy gets a payoff of $1000, and Fred gets a
payoff of $3000 for a joint payoff of $4000. Under rule 2 Amy will choose not
to sing since her benefit is only $1000, but she would have to pay Fred $2000
(assuming damages fully compensate Fred). Therefore, Amy will get a payoff
of $0 and Fred will receive a payoff of $5000 for a total joint payoff of $5000.
Under rule 3, Amy will not be allowed to sing and thus the payoffs are the
same as under rule 2.
b) transaction costs are not high enough to preclude bargaining. In this case, specify
the threat values for each player, the surplus that can be gained through
bargaining, what the bargain will be, and the payoffs gained by each player after
the bargain.
A Under rule 1, Amy’s threat point (threat point = payoff from non-cooperative
solution) is $1000 and Fred’s is $3000. The surplus that can be gained
through bargaining is the difference between Fred’s MB of no singing
($2000) and Amy’s MC of no singing ($1000) = $1000. Fred will negotiate
with Amy to convince her not to sing. Amy will accept anything over $1000 to
give up singing (her MB forgone) and Fred would be willing to pay up to
$2000 (his MC from the singing). Nash bargaining solution is $1000 +
½*($2000-$1000)= $1500. Fred’s payoff will be $5000-$1500=$3500. Amy’s
payoff would be $1500. Total joint payoff is therefore $5000. Under rules 2
and 3 Amy’s threat point is 0 and Fred’s is $5000; there is no surplus from
bargaining, and therefore no bargaining will occur. Total joint payoff in both
cases is $5000.
At the end of your solution, summarize your results in a table like this one:
Payoffs if no bargaining:
Payoffs if bargaining
Legal
Fred
Amy
total
Surplus
Fred
Amy
total
rule:
available
1)
3000
1000
4000
1000
3500
1500
5000
2)
5000
0
5000
5000
0
5000
3)
5000
0
5000
5000
0
5000
c) State the two conclusions of the Coase Theorem, and explain how this problem
relates to those conclusions.
A If transaction costs are low (zero), the legal rule will not affect the final
allocation of rights since the efficient allocation will arise through bargaining.
On the other hand, the legal rule does affect the distribution of wealth since
the person to whom a right is assigned will be able to extract payment from
the other party (if that would be the efficient outcome). If transaction costs
are positive, this analysis does not necessarily hold since bargaining may not
take place even where it may otherwise be efficient. Here, in part 2 where
transaction costs were low, the final allocation was the efficient result that
Amy would not sing. However, under rule 1, Amy is able to extract a
payment from Fred which she is not able to do under either of rule 2 or rule
3.
bargain
1500
-