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An Introduction to Law and Economics: The Coase Theorem and Behavioral Economics

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Title: An Introduction to Law and Economics: The Coase Theorem and Behavioral Economics


1
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

2
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?

3
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 laws likely and actual
    effects in the world.

4
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.

5
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).

6
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.

7
Contract Law 2
  • Why do private parties need help in forming,
    relying upon, and completing consensual
    agreements?
  • Time-intensive transactionsi.e., those that take
    time to complete.
  • Coordination, commitment, and cooperation.
  • Risk allocation.
  • Information exchange.

8
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.

9
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.

10
Precaution costs
  • How does a rational potential injurer decide how
    much precaution to purchase?
  • Assume provisionally that the injurer will be
    liable for the victims losses if there is an
    accident.
  • But recognize that most parties are acting
    behind a veil of ignorancethey do not know if
    they will be a victim or an injurer.
  • A rational potential injurer takes all
    cost-justified precautioni.e., precaution for
    which the cost of the last unit of precaution
    taken is just equal to the benefit provided by
    that precaution.

11
Precaution costs 2
  • The expected benefit of a unit of precaution
    equals the probability of an accidents occurring
    times the anticipated accident losses.
  • Suppose that one more unit of care will reduce
    the probability of an accidents 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.

12
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 youre 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.

13
The Economics of Crime and Punishment
  • Recall the assumption of rational decisionmakers.
  • Gary Becker, Nobel Laureate in Economics, 1992.

14
Crime and Punishment 2
  • Beckers 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.

15
Crime and Punishment 3
  • A rational potential criminal commits the crime
    if EB gt EC and refrains if EB lt 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.

16
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.

17
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?

18
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.

19
Donohue Levitt 2
  • Whats the evidence for legalized abortions
    effect on crime?
  • (1) Broad consistency with the prevailing
    patternnamely, 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 thats 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.

20
Donohue Levitt 3
  • (3) Higher 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 there is little change in crime
    among older cohorts over the last 30 years.

21
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. Its 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.

22
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 teensthe prime
    years for committing crimes, there are fewer of
    them and, therefore, less crime.
  • The cohort quality effect.
  • Children born after abortion legalization may
    on average have lower subsequent rates of
    criminality.
  • (1) Women 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) Women 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.

23
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.

24
New developments in law and economics
  • Empirical research.
  • Behavioral law and economics.
  • The impact of law and economics on the legal
    academy.

25
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.

26
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?

27
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.

28
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.

29
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 Ill seek to seek to show how these
    empirical findings necessitate our amending some
    settled conclusions of traditional law and
    economics.

30
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 doesnt have and the
    willingness-to-accept (WTA) price to give up that
    same thing if one already possesses it.

31
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.

32
Status quo bias 3
33
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.

34
Results of the game
  • The game has been played in over 100 countries
    with thousands of players of all ages and
    socio-economic 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 1s receiving more of the surplus
    than if Player 1 is selected randomly.

35
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.

36
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, risk-preferring, and
    risk-aversion.

37
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.

38
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.

39
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.

40
Probabilistic reasoning 2
  • The Monty Hall (or Three Door) Problem
  • You are a guest on Lets Make a Deal and are
    invited to play the final prize game.
  • There are three doors on stage, each marked with
    a number1, 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.

41
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, Youve 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?

42
Probabilistic reasoning 4
  • You should switch!
  • Your chances of winning if you switch are 2/3.

43
Why should you switch?
44
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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