An Introduction to Law and
Economics: The Coase
Theorem and Behavioral
Economics
Thomas S. Ulen
University of Illinois College of Law
University of Colorado Law School
June 11, 2008
Introduction
 Why all the fuss?
 A practical and useful innovation or one
that is confined to the academy?
 A stalking horse for a particular political
ideology?
 A (scientific) method of evaluating the
impact of law?
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Assumptions and premises
 “People respond to incentives.”
 Law is a method of ordering society to
further social goals.
 Law creates incentives for people to behave in
certain ways.
 Law can help people by facilitating their
achievement of their legitimate goals.
 Economics provides both theoretical and
empirical techniques for examining law’s
likely and actual effects in the world.
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Assumptions and premises 2
 So, to discourage a particular activity,
law should increase the “price” for
engaging in that activity.
 E.g., 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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Coase Theorem
 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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The Economics of Contract Law
 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.
 Mandatory rules.
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Contract Law 2
 Why do private parties need help in
forming, relying upon, and
completing consensual agreements?
 Time-intensive transactions—i.e., those
that take time to complete.
 Coordination, commitment, and
cooperation.
 Risk allocation.
 Information exchange.
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The Economics of Tort Law
 Minimize the social costs of accidents.
 Precaution costs.
 Accident losses.
 Administrative costs.
 Continue to assume that potential
victims and injurers are rational
decisionmakers.
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Economics of Tort Law II
 Tort law holds out the prospect of
liability for accident losses so as to
 create incentives for parties to choose
levels of precaution and activities in
which to participate in order to minimize
their liability,
 And thereby to minimize the social costs
of accidents.
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Precaution costs
 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—i.e., 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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Precaution costs 2
 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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Additional topics in the economics
of tort liability
 Different tort liability standards.
 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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The Economics of Crime and
Punishment
 Recall the assumption of rational
decisionmakers.
 Gary Becker, Nobel Laureate in
Economics, 1992.
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Crime and Punishment 2
 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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Crime and Punishment 3
 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,
 Do both.
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Recent U.S. Statistics on Crime
 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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Why the Decline in Crime?
 “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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Donohue & Levitt, “The Impact of
Legalized Abortion on Crime”
 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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Donohue & Levitt 2
 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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Donohue & Levitt 3
 (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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Donohue & Levitt 4

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 & Levitt 5

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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Donohue & Levitt 6
 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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New developments in law and
economics
 Empirical research.
 Behavioral law and economics.
 The impact of law and economics on
the legal academy.
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Empirical law and economics 2
 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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Ellickson and social norms
 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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Ellickson 2
 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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Behavioral law and economics
 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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Behavioral law and economics 2
 Consider four examples:




Endowment effect / status quo bias.
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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Endowment effect / status quo
bias
 People seem to place a very high
value on the things they have and the
way things are.
 Systematic difference between the
willingness-to-pay (WTP) price to
acquire something one doesn’t have
and the willingness-to-accept (WTA)
price to give up that same thing if
one already possesses it.
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Status quo bias 2
 WTA ≈ 2 WTP.
 Not experience-related.
 Applies to pens, coffee mugs, and
other trivially valuable items.
 Implication:
 Far more difficult to change the way
things are than one might anticipate.
 Change may not just be a matter of
transaction costs.
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Status quo bias 3
WTA
WTP
Person A
$8
$6
Person B
$10
$4
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The ultimatum bargaining game.
 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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Results of the game
 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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Implications
 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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Loss aversion
 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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Loss aversion 2
 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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Loss aversion 3
 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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Difficulties with probabilistic
reasoning
 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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Probabilistic reasoning 2
 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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Probabilistic reasoning 3
 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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Probabilistic reasoning 4
 You should switch!
 Your chances of winning if you switch
are 2/3.
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Why should you switch?
Your
original
choice
Where the
prize really
is
Monty
opens
You switch
to
Result
1
1
2 or 3
3 or 2
Lose
1
2
3
2
Win
1
3
2
3
Win
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Implications
 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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