Econ 522 Economics of Law

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Econ 522Economics of Law
Dan Quint Spring 2012 Lecture 2
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Logistics

• If youre still trying to get into the class, get
  your name on the yellow pad
• TA sections begin this Friday
• Fake homework for Wednesday on website

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Monday, we

• defined law and economics
• saw some brief history of the common law
• and the civil law
• and discussed ownership of dead whales

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Today efficiency

• what is efficiency?
• is efficiency a good goal for the law?

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What isefficiency?
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First concept Pareto improvement

• a Pareto improvement is any change to the economy
  which leaves
• everyone at least as well off, and
• someone strictly better off
• example of a Pareto improvement
• your car is worth 3,000 to you, 4,000 to me
• I buy it for 3,500
• an outcome is Pareto superior to another, or
  Pareto dominates it, if the second is a Pareto
  improvement over the first

Vilfredo Pareto(1848-1923)
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Pareto superiority is not that useful a measure
for evaluating a legal system

• Pareto improvements are win-win
• but most new laws create some winners and some
  losers
• so the Pareto criterion usually cant tell us
  whether one policy is better than another
• even the car example might not be a true
  Pareto-improvement
• so we need another way to compare outcomes

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Next concept Kaldor-Hicks improvement

• a Kaldor-Hicks improvement is any change to the
  economy which could be turned into a Pareto
  improvement with monetary transfers
• also called potential Pareto improvement
• car example again
• your car is worth 3,000 to you and 4,000 to me
• government seizes your car and gives it to me
• Im better off, youre worse off
• combined with me giving you 3,500, its a Pareto
  improvement
• so me getting your car is a Kaldor-Hicks
  improvement
• a Kaldor-Hicks improvement may create winners and
  losers, but gains outweigh the losses
• Im 4,000 better off, youre 3,000 worse off,
  4,000 gt 3,000

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Example

• You and I are neighbors, you want to throw a
  party
• The party would make me 100 worse off
• and make you 50 better off
• and make each of your 30 guests 5 better off
• Is the party a Pareto improvement?
• No it makes you and your guests better off,
  makes me worse off
• Is the party a Kaldor-Hicks improvement?
• Yes because the party, combined with the
  appropriate money transfers, would be a Pareto
  improvement
• (Example you throw the party, you give me 40,
  each of your guests gives me 3 thats a Pareto
  improvement)

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To check if something is a Kaldor-Hicks
improvement, we can

• look for transfers that turn it into a
  Pareto-improvement
• or, just count up the gains of the winners and
  the losses of the losers, and see which is bigger
• a change in the economy is a Kaldor-Hicks
  improvement if the winners gains outweigh the
  losers losses
• if you have the party
• Im 100 worse off
• Youre 50 better off
• 30 guests are each 5 better off
• 100 50 30 X 5 100 gt 0
• Gains outweigh losses, so party is a Kaldor-Hicks
  improvement

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So

• A Kaldor-Hicks improvement is any change
  thatcreates value
• where value is equated with willingness to pay
• We said the party made me 100 worse off
• We equated my disutility from you making noise
  with the amount of money that would replace the
  inconvenience if you threw the party and gave
  me 100, Id be just as well off as before
• By equating utility with money, we create a way
  to compare utility across individuals

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Efficiency

• we will call a change to the economy efficient if
  it is a Kaldor-Hicks improvement
• well say law A is more efficient than law B if
  moving from B to A is a Kaldor-Hicks improvement
• and well say a situation is efficient if there
  are no available Kaldor-Hicks improvements
• an efficient situation is when theres no way to
  make some people better off, without making some
  others worse off by more
• were already getting maximal value out of all
  available resources

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Example is it efficient for me to drive to work
instead of taking the bus?

• Bus to campus from where I live is free
• Driving is more convenient, but costs me 1 (gas)
• Driving also imposes costs on other people
  theres more traffic, less parking, more
  pollution
• Suppose when I drive to work, it makes 1,000
  other people worse off by 0.01 each
• By driving to work, I create 11 of total costs
• Its efficient for me to drive to work if the
  benefit I get is more than 11
• If the benefit is less than 11, its inefficient
  for me to drive

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Some other, similar measures

• our definition of efficiency actions are taken
  when total benefits outweigh total costs
• goal is to achieve all Kaldor-Hicks
  improvements
• Ellickson efficiency is minimizing the
  objective sum of
• (1) transaction costs, and
• (2) deadweight losses arising from failures to
  exploit potential gains from trade
• Posner wealth maximization
• Polinsky Efficiency corresponds to the size of
  the pie

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What forces lead to inefficiency
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To see whether somethings efficient

• Compare gains to everyone in society (total
  social benefit)
• to costs to everyone (total social costs)
• Example we already saw (me driving to work)
• Total social cost 1 (gas) 1,000 X 0.01
  11
• Total social benefit whatever I gain by driving
  to work
• So we just said its efficient for me to drive
  to campus whenever the value I get from driving
  is more than 11

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But what do people actually do?

• When people decide how to act
• they consider the cost and benefit to
  themselves, not to everyone
• private benefit and private cost
• Driving only costs me 1
• so Ill drive whenever benefit to me is more than
  1
• On days when value I get from driving is more
  than 1 but less than 11, I drive to work even
  though thats inefficient

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So externalities cause inefficiency

• Ill do something whenever private benefit gt
  private cost
• Efficiency depends on whether social benefit gt
  social cost
• If I was the only one affected by my choices,
  then social benefit private benefit and social
  cost private cost
• when Im deciding which movie to watch on
  Netflix, nobody else is effected by my choice, so
  my choice will be efficient
• But when my choices affect other peoples
  payoffs
• social benefit ¹ private benefit, or social cost
  ¹ private cost
• so actions I choose to take may not be efficient

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A classic example of this the Tragedy of the
Commons

• Hardin (1968), The Tragedy of the Commons
• Picture a small fishing village on a lake
• The more fish I catch, the fewerfish are left in
  the lake
• and the harder it is for everyone else in the
  village to catch fish
• So my fishing imposes an externality on everyone
  else
• So everyone ends up fishing more than the
  efficient amount

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Tragedy of the Commons example

• 20 fishermen
• Cost of fishing is 8 fish per hour
• Notation
• h how many hours I fish
• H combined hours everyone fishes
• H hours everyone but me fishes
• Fishermen catch 260 H fish per hour
• What is the efficient level of fishing? How much
  utility does that give to each fisherman?
• 6.3 hours per day per fisherman 793.8 fish/day
• Left to their own devices, how much will each
  person fish? How much utility will each person
  get?
• 12 hours per day per fisherman 144 fish/day

Total fish caught
Maximum Sustainable Yield
H (260 H)
Efficient Level of Fishing
Equilibrium Level of Fishing
0
12
6
3
9
Hours fishing, per day, per fisherman
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Whats going on here?

• Fishing imposes a negative externality on other
  fishermen
• Each one ignores this externality when deciding
  how much to fish
• so they all end up fishing more than the
  efficient amount
• Same thing happens with other communal resources
• Cattle grazing, whaling, overhunting, oyster beds
• Aristotle That which is common to the greatest
  number has the least care bestowed upon it
• Elinor Ostrom, who shared the 2009 Nobel Prize in
  Economics, studies how different societies solve
  this problem
• Positive externalities work the opposite way
• Activities which create positive externalities
  are naturally done less than the efficient amount

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So externalities can lead to inefficiency

• Without some sort of regulation/intervention
• Activities which impose a negative externality
  will be done more than the efficient amount
• and activities which impose a positive
  externality will be done less than the efficient
  amount
• One idea well see several times in this class
• if we want the law to lead to efficient
  outcomes,
• we can try to design the law to eliminate
  externalities!
• Internalization

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Other forces which lead to inefficiency
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Another thing that leads to inefficiencybarriers
to trade

• Cuban cigars
• Suppose Id pay 15 each for Cohibas
• They cost 2 each to make, and another3 each to
  transport from Cuba to Madison
• Clearly, its efficient for me to smoke Cohibas
• But trade embargo on Cuba makes it illegal for me
  to buy them
• Anything that prevents me from buying something I
  want can be a source of inefficiency
• One approach to property law make it as easy as
  possible for people to trade among themselves
• (This may seem like an obvious point but then,
  there are lots of things were not allowed to
  sell)

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Another thing that leads to inefficiency taxes

• I value my free time at 40/hour
• Working in a factory, I can build things worth
  50/hour
• Clearly, its efficient for me to work
• Each hour I work creates 10 of new value
• Doesnt matter who gets it its efficient for
  me to work
• But if income tax is 25, then it wont happen
• Factory owner cant pay me more than 50/hour
• But 50/hour pre-tax is only 37.50 after-tax
• and Id rather stay home than earn 37.50 an
  hour
• So I dont get hired, which is inefficient

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Another example of taxes leading to inefficiency

• This is a new BMW thats been cut in half
• Taxes distort behavior away from efficiency

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Another thing that leads to inefficiency monopoly
(or private information)

• Example
• Demand for some good given by P 100 Q
• Monopolist can produce good for 40/unit
• Monopoly price is 70, demand is 30
• Deadweight loss is inefficiency
• Customers willing to pay more than marginal cost
  but unable to trade

CS
P 100 Q
P 70
Profit
DWL
MC 40
Q 30
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But, saying these things lead to inefficiency
doesnt automatically mean theyre bad

• For example
• we just said taxes lead to inefficiency
• but without taxes, theres be far too few public
  goods, which is also inefficient
• we just said monopoly leads to inefficiency
• but well study patents, which are legal
  monopolies used to get companies to innovate
• But also, weve defined efficient, but we
  havent claimed that efficient good
• Which brings us to

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Is efficiency a good goal for the law?
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Important distinction positive versus normative
economics

• positive statements are statements of fact
• can be descriptive in 2007, U.S. GDP was 13.8
  trillion
• can be theoretical predictions if prices rise,
  demand will fall
• economics of what is
• normative statements contain value judgments
• for example, less inequality is better
• or, government should encourage innovation
• economics of what ought to be

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Most of this class will be positive analysis

• Predicting behavior, and outcomes, that follow
  from a law or legal system is positive economics
• Law X will lead to more car accidents than law
  Y
• Law X will lead to more efficient outcomes than
  law Y
• But in the background, wed like some sense of
  what is the normative goal of the legal system
• Law X is better than law Y
• One candidate for that normative goal is
  efficiency

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Friedman gives a few arguments for studying
efficiency
The central question in this book is a
simple one what set of rules and institutions
maximize the size of the pie? What legal rules
are economically efficient? There are at least
three reasons why that is the question we
ask. The first is that while economic
efficiency is not the only thing that matters to
human beings, it is something that matters quite
a lot to most human beings. The second reason is
that there is evidence that considerable parts of
the legal system we live in can be explained as
tools to generate efficient outcomes It is a
lot easier to make sense out of a tool if you
know what it is designed to do. A final reason
is that figuring out what rules lead to
efficient outcomes is one of the things
economists know how to do and when you have a
hammer, everything looks like a nail. -
Friedman, Laws Order, p. 312
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But

• This answers the question, Why is it interesting
  to study efficiency?
• Not the question, Should the law be designed
  with the goal of achieving efficiency?
• To answer this latter question

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Posner gives us one argument why the law should
aim to be efficient

• Richard Posner (1980), The Ethical and Political
  Basis of Efficiency Norm in Common Law
  Adjudication
• Starts with the observation if you buy a lottery
  ticket and dont win anything, you cant complain
• Imagine before we all started driving, everyone
  in the world got together and negotiated a
  liability rule for traffic accidents
• If one rule is more efficient than another, wed
  all vote for that rule ex-ante ex-ante consent

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Ex-ante consent simple example

• Suppose there are two candidate rules for
  accident liability
• One favors pedestrians, one favors drivers
• The one favoring car drivers is more efficient
• Posners point before we know who well be,
  everyone would unanimously agree to the second
  rule

Expected payoff if you dont know which one
youll be
Expected payoff, pedestrians
Expected payoff, drivers
-50
0
-100
Strict liability rule
-40
-60
-20
Negligence rule
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Things are a little more complicated

• People without cars would prefer a less efficient
  system if it meant drivers were responsible
• Posner deals with heterogeneity with a different
  example
• Landlord-friendly versus tenant-friendly laws
• Might think tenants would prefer pro-tenant laws
• But rents are determined competitively
• If laws become more tenant-friendly, rents might
  go up to compensate
• And if tenant-friendly law is less efficient, it
  could make both sides worse off!

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Example new law requiring landlords to pay for
their tenants heat

• Suppose tenants get 1000 value from apartment,
  minus rent
• Landlords pay 100 for heat, 600 in other costs
• Without this law, tenants would pay for their own
  heat
• Theyd heat apartment less, get 980 value and
  pay 60 for heat
• Might think tenants would prefer inefficient
  tenant-friendly law
• But rents are set competitively, would go up to
  compensate
• So both landlords and tenants do better under the
  old law!

Landlords
Tenants
Landlords payoffs
Tenants payoffs
850 600 100 150
1000 850 150
rent 600 100
1000 rent
Landlord pays for heat
760 600 160
980 60 760 160
rent 600
980 60 rent
Tenant pays for heat
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Ex-ante consent, ex-ante compensation

• Posners basic argument if we choose the most
  efficient legal system, everyone is compensated
  ex-ante for the choice, and should willingly
  accept the outcome they get
• Of course, all this consent is hypothetical
• and it does have certain limitations

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Limitations to Posners argument

• The lottery ticket analogy requires risk
  neutrality
• 50 chance at 1,000,000 is just as good as 50
  chance at 900,000 and 50 chance at 100,000
• If 100,000 is worth more to you when youre
  broke than when you already have 900,000, this
  argument doesnt work
• Counterpoint to Posner Hammond (1982)
• Efficiency is really a special case of
  utilitarianism, and subject to the same
  limitations
• Value willingness to pay
• 1 worth the same to everyone

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This highlights some of the things efficiency is
not

• efficiency is not equity
• efficiency is not fairness
• efficiency is not maximizing happiness
• Suppose that pituitary extract is in very short
  supply and is therefore very expensive. A poor
  family has a child who will be a dwarf if he
  doesnt get some of the extract, but the family
  cannot afford the price or borrow the money.
• A rich family has a child who will grow to
  normal height, but the extract will add a few
  inches more, and his parents decide to buy it for
  him.
• In the sense of value used in this book, the
  pituitary extract is more valuable to the rich
  family because value is measured by willingness
  to pay, but the extract would confer greater
  happiness in the hands of the poor family.
• - Posner, Economic Analysis of Law

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A more pragmatic defense of efficiency as a goal
for the law

• Cooter and Ulen (textbook ch. 1)
• Efficiency should not necessarily be the goal of
  society
• But efficiency should be the goal of the legal
  system
• If redistribution is desirable, its better to
  make the legal system efficient, and address
  distribution through taxes
• Cooter and Ulen offer four reasons why the tax
  system is a better way to redistribute wealth
  than the legal system

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Four reasons the tax system is a better way to
redistribute wealth than the legal system

• 1. Taxes can target rich and poor more
  precisely than the legal system can
• Distributional effects of legal changes are
  harder to predict
• Lawyers are more expensive than accountants
• More narrowly-targeted taxes cause greater
  distortion than broad-based taxes

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So, summing up is efficiency a good goal for the
law?

• Weve seen two arguments in favor
• Posner its what we all would have agreed on
  ex-ante
• CU if you want to redistribute, its better to
  do it through taxes
• But there are definitely some problems with
  efficiency
• Distribution matters not everything is
  monetizable people might care about procedural
  fairness
• My take
• In this class, well mostly focus on the positive
  questions
• But in the background, I think of efficiency as a
  pretty good, but definitely imperfect, measure
  of goodness

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For Monday

• One argument from CU for why law should focus on
  efficiency, redistribution should be done through
  taxes
• narrow taxes cause more distortion than broad
  taxes
• Wednesday, well work through an example of this
• Optional homework problem
• If you want to read ahead, look atRonald Coase,
  The Problem of Social Cost(although we
  probably wont get to Coase till Wednesday)
• See me if youre not yet registered

Thats it for today see you next week