Thomas S. Ulen
University of Illinois College of Law
Universidad de San Andrés
Buenos Aires, Argentina
September 16, 2009

 “People respond to incentives.”
 Law is a method of creating incentives so as to order society to further social goals.
 Economics provides both theoretical and empirical techniques for examining law’s likely and actual effects in the world.
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 So, to discourage a particular activity, law should increase the “price” for engaging in that activity.
 For example, by increasing the sanction for engaging in undesirable behavior.
 Or by increasing monitoring and enforcement of the undesirable activity.
 If legal sanctions increase or become more likely, people will “consume” less of the sanction-triggering activity.
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 One of law’s functions is to encourage the efficient use of society’s scarce resource.
 There are other functions for law
(such as doing justice and redistributing income and wealth), and sometimes efficiency must give way to those other functions.
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 Ronald A. Coase, “The Problem of Social
Cost,” 3 J.L. & Econ. 1 (1960).
 If transaction costs are zero, bargaining will lead to an efficient allocation of resources, regardless of the law.
 Law is only necessary to induce efficient behavior when transaction costs are positive.
 An implication: assign legal entitlements to the party who would have ended up with the entitlement (that is, to the person who values it the most).
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 Legal versus equitable remedies.
 Use legal remedies when transaction costs are high.
 Court acts to clear a hypothetical market.
 Use equitable remedies when transaction costs are low.
 Let the parties themselves use bargaining to assign legal entitlements.
 More recent work suggests that liability rules are efficient in a very broad range of circumstances, including those of low transaction costs.
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 Law’s attempts to assign and enforce property interests should seek to encourage the efficient use of society’s scarce resources.
 Resources will be more efficiently used if property rights to them are clear and easily transferred.
 Intellectual property
 Limited duration of patents.
 Expanding duration of copyrights.
 Relatively unlimited duration of trademarks.
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 Law should seek to reduce the costs of concluding and enforcing consensual agreements.
 Law does so by providing a set of default and mandatory rules that contracting parties can use as a template for concluding an agreement.
 Default rules (majoritarian and penalty).
 Mandatory rules.
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 Why do private parties need help in forming, relying upon, and completing consensual agreements?
 Time-intensive transactions—those that take time to complete.
 Coordination, commitment, and cooperation.
 Risk allocation.
 Information exchange.
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 Remedies for breach of contract
 Efficient breach of contract.
 Liquidated or stipulated damages.
 Limited to a reasonable approximation of actual losses from failure to perform?
 Or available in any amount to which the parties agree, subject to the usual formation defenses?
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 Expectation damages as a means of protecting the “benefit of the bargain.”
 Moral hazard?
 Specific performance as a default remedy for breach.
 Personal services contracts.
 Peevyhouse v. Garland Coal & Mining Co.,
382 P.2d 109 (Okla. 1962), cert. den., 375
U.S. 906 (1963).
 Jacob & Youngs v. Kent, 230 N.Y. 239, 129
N.E. 889 (1921).
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 Why do we need a separate law for accidents between strangers?
 No opportunity to bargain ex ante an accident about precaution and responsibility for accident losses.
 To minimize the social costs of accidents.
 Guido Calabresi, The Costs of Accidents (1970).
 Social costs of accidents:
 Precaution costs
 Accident losses
 Administrative costs
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 How does a rational potential injurer decide how much precaution to purchase?
 Assume provisionally that the injurer will be liable for the victim’s losses if there is an accident.
 But recognize that most parties are acting
“behind a veil of ignorance”—they do not know if they will be a victim or an injurer.
 A rational potential injurer takes all cost-justified
precaution—precaution for which the cost of the last unit of precaution taken is just equal to the benefit provided by that precaution.
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 The expected benefit of a unit of precaution equals the probability of an accident’s occurring times the anticipated accident losses.
 Suppose that one more unit of care will reduce the probability of an accident’s occurring by 0.005 and that if an accident occurs, given that amount of precaution, the losses are likely to be $100,000.
 The expected benefit of that unit of precaution is
(0.005) x $100,000 = $500.
 So, if that unit of precaution costs less than $500, society would like a potential injurer to purchase the precaution because the cost is less than the expected benefit.
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 Articulated by Judge Learned Hand in U.S.
v. Carroll Towing Co., 159 F.2d 169 (2d
Cir., 1947).
 Society induces potential injurers to take care by threatening them with liability for the injuries that their failure to take care causes.
 The rational potential injurer, faced with the possibility of liability, will continue to purchase precaution up to the point at which the cost of the last unit of precaution exactly equals the expected benefit.
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 Judge Hand formulated the rule as holding a defendant to have been negligent if B <
PL (where B = the burden or cost of precaution; P = the probability of an accident’s occurring; and L = the accident losses).
 Law and economics holds that if a court determines liability according to the Hand
Rule, then the social costs of accidents (the sum of precaution, accident, and administrative costs) will be minimized.
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 We haven’t talked about different tort liability standards.
 We haven’t yet considered that victims can take care.
 We haven’t considered other social policies besides tort law for minimizing the social costs of accidents.
 We have continued to assume that potential injurers (and everyone else, too) are rational.
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 Let x = the amount of care taken by the injurer, and
 Let x* = the social-cost minimizing level of care (the legal duty).
 We may define negligence as follows:
 Defendant is negligent if x < x*.
 Defendant is not negligent if x ≥ x*.
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 The key economic question is, “Why should there be an exonerating level of care?”
 We’ve already seen that a rational potential injurer will recognize that she can minimize her expected liability costs by complying with the legal duty of care—by selecting precaution that is at least as great as that demanded by the legal duty.
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 But there is an additional reason for holding out the possibility of exonerating the injurer: it induces a socially optimal amount of care by potential victims.
 A rational potential victim will reason as follows:
 If I am injured, it will be by a rational injurer. He knows that he will be exonerated from liability for my losses if he takes at least as much precaution as required by the legal duty.
 So, being rational, the person who injures me will comply with the legal duty and, therefore, will not be liable, under a negligence standard, for my losses.
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 So, I will be responsible for my own accident losses.
 Therefore, I had better take care, too, so as to minimize the likelihood of an accident and my accident losses, if an accident should occur.
 Conclusion: negligence induces both potential victim and potential injurer to take care.
 Bilateral precaution.
 Frequently, one has no idea whether one will be an injurer or a victim in one’s next accident.
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 Suppose that there is no level of care that will exonerate the defendant. If there is an accident and the injurer caused it, he will be liable for the victims’ losses.
 How will a rational potential injurer behave when faced with this tort liability standard?
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 Any rational injurer will seek to minimize his expected liability costs.
 Therefore, he will take all cost-justified precaution, regardless of which particular tort liability standard he faces.
 This leads the strictly liable injurer to take exactly the same amount of precaution as would a negligent injurer.
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 So, what’s the difference between negligence and strict liability?
 In strict liability the victim is relieved of any duty to take care.
 Unilateral precaution.
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 The relationship between administrative agency safety regulation and tort liability.
 Should regulatory compliance be a defense in a private tort action?
 “Who are these rational people you’re talking about?”
 If injurers and victims are not fully rational, then a situation that might seem to be one of bilateral precaution may be, instead, one of unilateral precaution.
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 Recall the assumption of rational decisionmakers.
 Great debate about the decision to commit crime and the possibility of deterrence:
 Hypothesis I: Crime is the result of socioeconomic factors. Deterrence is unlikely to be an effective means of reducing crime. Better to improve the socio-economic conditions that induce crime.
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 Hypothesis II: People respond to incentives. Crime occurs because criminals believe that the benefits of crime exceed the costs. They can be deterred by raising the costs of committing a crime.
 Gary Becker, Nobel Laureate in
Economics, 1992.
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 Becker’s rational-choice theory of the decision to commit a crime:
 Criminal compares the expected costs and expected benefits of a crime.
 Expected costs include the probability of detection, arrest, and conviction times the value of the sanction imposed.
 Expected benefits include the monetary value of the crime plus any non-monetary satisfaction the criminal receives.
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 A rational potential criminal
 commits the crime if EB > EC and
 refrains if EB < EC.
 Society can reduce crime by raising the expected costs of crime.
 Raise the probability of detection, arrest, and conviction or
 Increase the criminal sanction or
 Increase the “opportunity cost” of crime or
 Do all of the above .
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 Generally cheaper to increase the expected costs of crime by raising the sanction than by incurring real resource costs of raising the probabilities of detection, arrest, and conviction.
 Ultimately the test of the theory is its explanatory and predictive power.
How well does the Becker theory do?
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 Empirical work in the mid- and late
1970s suggested that for a wide variety of crimes, “deterrence works.”
 Professor Isaac Ehrlich’s famous finding that one execution deters between seven and eight subsequent murders.
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 This academic literature had a profound effect on criminal justice system policy:
 Creation of the U.S. Sentencing Commission
 General decline of discretionary sentencing.
 Remarkable increase in the sentencing of criminals to confinement:
 A four-fold increase in prison population between
1980 and 2000,
 From 500,000 to over 2 million.
 Highest percentage of population incarcerated of all but one nation in the world.
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 Since the mid- and late 1980s a decline in non-violent crime. There is now less auto theft in the U.S. than in much of Western
Europe.
 Property crimes down 30 percent in the 1990s.
 Since 1991 a precipitous decline in violent crime, with homicide at the lowest level since the 1930s.
 Homicide rates down 40 percent in the 1990s.
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 “Deterrence works.”
 Increasing incarceration rates.
 More police and improved policing strategies.
 Decline in crack cocaine.
 A robust economy.
 Increased victim precaution.
 Alarms and security procedures.
 Faster and more effective trauma treatment.
 The legalization of abortion?
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 116 Q. J. Econ. 379 (2001).
 Donohue and Levitt attribute half of the decline in crime since 1991 to the legalization of abortion in 1973.
 Roe v. Wade led to a significant increase in the number of abortions. (1.6 million per year by
1980; 1 abortion per 2 live births.) Therefore, relatively fewer 18 year-olds in the population beginning in 1991.
 All the other factors together account for the other half of the decline.
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 What’s the evidence for legalized abortion’s effect on crime?
 (1) Broad consistency with the prevailing pattern—namely, most crime is committed by
18-24 year-old males; because of legalized abortion, there are fewer 18 year-olds exactly
18 years after Roe, and that’s when the downturn in crime began.
 (2) Five states legalized abortion in 1970
(before Roe v. Wade), and they experienced a decline in crime before the rest of the country did.
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 (3) “[H]igher rates of abortion in a state in the late 1970s and early 1980s are strongly linked to lower crime [in that state] for the period from
1985 to 1997.”
 (4) “There is no relationship between abortion rates in the mid-1970s and crime changes between 1972 and 1985.”
 (5) Almost all of the decline in crime in the
1990s can be “attributed to reduction in crime among the cohorts born after abortion legislation[;] [t]here is little change in crime among older cohorts [over the last 30 years].”
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 The other hypotheses are unlikely to explain the drop in crime in the 1990s.
 The greater use of imprisonment, more police, and changes in police strategies have been going on for a long time. It’s unlikely that they could cause a sudden and sharp drop in crime just in the 1990s. And the drop occurred in places, such as Los Angeles, where there was no particular improvement in the police force.
 Similarly for the decline in the crack cocaine trade. That was largely a phenomenon of major urban areas. But the crime drop occurred not just in major urban areas but everywhere.
 The robust economy has been with us since the early 1980s, not just in the 1990s. And, moreover, there is a relatively weak correlation between macroeconomic activity and crime levels. Indeed, there is some evidence that much crime is anti-cyclical, increasing when the economy is doing well and declining when it is doing poorly.
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 Donohue and Levitt identify two components that make up the total effect that legalized abortion had on crime:
 The “cohort size” effect.
 When the cohort reaches the late teens—the prime years for committing crimes, there are fewer of them and, therefore, less crime.
 The “cohort quality” effect.
 “[C]hildren born after abortion legalization may on average have lower subsequent rates of criminality.”
 (1) “[W]omen who have abortions are those most at risk to give birth to children who would engage in criminal activity.”
Teenagers, unmarried women, and the economically disadvantaged.
 (2) “[W]omen may use abortion to optimize the timing of childbearing.” Through abortion women may delay childbearing till later if their current conditions are suboptimal. Children tend to be born into better environments.
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 Of the half of the drop in crime in the
1990s that Donohue & Levitt attribute to the legalization of abortion,
 about half of that total effect is attributable to the “cohort size” effect and
 about half to the “cohort quality” effect.
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 Empirical research.
 Behavioral law and economics.
 The impact of law and economics on the legal academy.
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 Robert Ellickson, “Of Coase and Cattle,” 38
Stan. L. Rev. 623 (1986), and Order
Without Law (1991).
 Natural experiment: damage done to property by unsupervised cattle in Shasta
County, California.
 In part of the county the owners of cattle were responsible for damage done by their unsupervised cattle.
 In the other half of the county, owners were not responsible.
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 Should there be a difference between the two halves of the county in terms of the number of cattle and other indicators of efficiency?
 Not necessarily, if the Coase Theorem is true.
 There was no difference in behavior between the two halves, even though the liability rules were different.
Why?
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 Not because neighbors were bargaining to the most efficient result, regardless of the law.
 Rather, because neighbors were not paying attention to the law.
 They sought to conform their behavior to the prevailing social norms, not to the law.
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 Recall the close connection between rational choice theory and traditional law and economics.
 Social and cognitive psychologists have found some systematic deviations from the predictions of RCT.
 Taking these deviations into account in analyzing law leads to changes in the economic analysis of that flowed from RCT.
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 Consider three examples:
 The ultimatum bargaining game experiments.
 Loss aversion.
 Difficulties with probabilistic reasoning.
 In each case I’ll seek to seek to show how these empirical findings necessitate our amending some settled conclusions of
“traditional” law and economics.
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 Two parties are to split $20.
 This is a pure cooperative surplus.
 The players are not allowed to talk or meet.
 Player 1 makes an offer for division of the
$20.
 Player 2 can accept the offer, in which case they each get the proposed division, or reject the offer, in which case neither player receives anything.
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 The game has been played in over 100 countries with thousands of players of all ages and socioeconomic circumstances.
 The modal result is a 50-50 split.
 An unexpected finding (although not necessarily inconsistent with rational choice theory) is that if
Player 1 proposes a split that give him or her more than 70 percent of the surplus, Player 2 almost always rejects the offer.
 People have a strong sense of what is fair.
 Interestingly, if Player 1 is selected on some seemingly meritorious criterion, Player 2 will tolerate Player 1’s receiving more of the surplus than if Player 1 is selected randomly.
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 Perhaps we need not worry overly about how parties divide up cooperative surpluses. They seem to do it equitably.
 But we need, perhaps, to pay attention to the fact that overreaching can cause otherwise mutually beneficial transactions to fail.
 The Normative Hobbes Theorem.
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 The standard social science theory of decisionmaking under uncertainty is that of subjective expected utility
(SEU).
 Individuals are thought to maximize expected utility rather than expected value.
 The difference arises from attitudes toward risk: risk-neutrality, riskpreferring, and risk-aversion.
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 Kahneman and Tversky found that most people are risk-averse with respect to gains but risk-seeking with respect to losses.
 Option A: $50 with certainty
 Option B: $100 with probability 0.5 or
$0 with probability 0.5
 Same expected value.
 Most people prefer Option A.
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 Option C: -$50 with certainty
 Option D: -$100 with probability 0.5 or
$0 with probability 0.5
 Same expected value.
 Most people prefer Option D.
 Implication: In civil actions, defendants may be less likely to settle than plaintiffs.
 The standard law-and-economics theory of litigation versus settlement is that trial almost always results from mistaken and inconsistent estimates of the likelihood of prevailing at trial.
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 Many legal situations imply that decisionmakers make probabilistic calculations.
 Rational criminals are thought to compare expected costs and expected benefits of crime.
 Tortfeasors and victims are imagined to compare precaution costs with expected liability.
 Jurors engage in Bayesian updating in determining liability in civil trials and guilt in criminal trials.
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 The Monty Hall (or Three Door)
Problem
 You are a guest on “Let’s Make a Deal” and are invited to play the final prize game.
 There are three doors on stage, each marked with a number—1, 2, or 3.
 Behind one door is $60,000 in cash.
Behind the other two doors are goats.
 Monty invites you to choose a door.
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 Suppose that you choose Door 1.
 Monty turns to his assistant and asks her to open Door 3, revealing a goat. Doors 1 and 2 remain closed.
 Now Monty says to you, “You’ve chosen
Door 1. That door and Door 2 remain closed. Would you like to remain with Door
1 or would you like to switch to Door 2?”
 What should you do?
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 You should switch!
 Your chances of winning if you switch are 2/3.
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Your original choice
1
Where the prize really is
1
Monty opens
2 or 3
You switch to
3 or 2
Result
Lose
1
1
2
3
3
2
2
3
Win
Win
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 Decisionmakers may not do as able a job in estimating probabilities as RCT assumes.
 For example, they may overestimate their abilities to avoid an accident. Therefore, there may be too many accidents.
 A possible corrective is to take safety decisions away from individuals and place them on manufacturers. Auto safety.
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 Law and Economics has provided a universal theory for talking about law, regardless of specialty or jurisdiction.
 Jurisprudence and Roman law provided that unifying theory for some continental legal systems.
 Law and Economics even provides a language, a theory, of talking about the differences among legal systems.
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 Law and Economics also brought in, perhaps unintendedly, a commitment to empirical work as a means of validating assertions about the law.
 And a commitment to the belief that that empirical work matters – in the sense that it can and ought to change one’s beliefs. For example, Ellickson’s article.
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 Law and Economics has become the default method of scholarship at the elite United States law schools.
 More inter-disciplinarity in U.S. legal scholarship.
 Illinois: changes in faculty. 13 of 36 faculty with a degree in another discipline than law.
 Adoption of the customs and mores of other university disciplines.
 Sharing work in progress.
 Tighter standards for tenure and promotion.
 “What are you working on?”
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
 Judge Harry Edwards.
 How to counteract that “growing disjunction”?
 Three new courses.
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 Law and economics has become the default method of doing legal scholarship.
 Recognition that people respond to incentives.
 But there are some interesting new developments taking place in law and economics:
 Empirical legal research.
 Behavioral law and economics.
 Some fundamental changes in the nature of legal education and legal scholarship.
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