Econ 522Economics of Law

Dan Quint

Fall 2013

Lecture 3

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Logistics

Also lecture notes – try View Notes Page

Efficiency: “all available Kaldor-Hicks improvements made” roughly, maximizing total value, or total surplus, or total payoffs, to

everyone in society… …where everything is translated into dollars, so we’re able to

add/compare across people

Means that… each scarce resource is owned by whoever values it most goods are produced whenever their value is greater than their cost and so on

Monday, we defined efficiency

Externalities People make choices based on private cost and private benefit Efficiency is based on social cost and social benefit When social cost > private cost, negative externality

people will do something more than efficient amount When social benefit > private benefit, positive externality

people will do something less than efficient amount

Barriers to trade, taxes

Monopoly/private information

Also Monday, we discussed some forces that lead to inefficiency

Is efficiency a good goal for the law?

…and then we ran out of time

Finally on Monday, we posed the question:

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Is efficiency a good goal for the law?

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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”

Important distinction: positive versus normative economics

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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, we’d 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

Most of this class will be positive analysis

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“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, Law’s Order, p. 312

Friedman gives a few arguments for studying efficiency

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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…

But…

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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 don’t win anything, you can’t 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, we’d all vote for that rule ex-ante – ex-ante consent

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

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Suppose there are two candidate rules for accident liability One favors pedestrians, one favors drivers The one favoring car drivers is more efficient

Posner’s point: before we know who we’ll be, everyone would unanimously agree to the second rule

Ex-ante consent – simple example

-40-60-20Negligence rule

-500-100Strict liability rule

Expected payoff if you don’t know which one

you’ll be

Expected payoff,

pedestrians

Expected payoff, drivers

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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!

Things are a little more complicated…

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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 They’d 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!

Example: new law requiring landlords to pay for their tenants’ heat

760 – 600= 160

980 – 60 – 760= 160

rent – 600980 – 60 – rentTenant pays for heat

850 – 600 – 100= 150

1000 – 850= 150

rent – 600 – 1001000 – rentLandlord pays for heat

LandlordsTenantsLandlords’

payoffsTenants’ payoffs

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Posner’s 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

Ex-ante consent, ex-ante compensation

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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 you’re broke than when

you already have $900,000, this argument doesn’t 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

Limitations to Posner’s argument

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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 doesn’t 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

This highlights some of the things efficiency is not

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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, it’s 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

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

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1. Taxes can target “rich” and “poor” more precisely than the legal system can

2. Distributional effects of legal changes are harder to predict

3. Lawyers are more expensive than accountants

4. More narrowly-targeted taxes cause greater distortion than broad-based taxes

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

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Two goods: beer (x), pizza (y)

One consumer, with $60 and utility u(x,y) = x0.5 y0.5

a. Given prices p for beer and q for pizza, calculate demand.

(x,y) = (30/p, 30/q)

Beer and pizza are produced at $1 per unit, and perfectly competitive markets

So without any taxes, p = q = $1

b. Calculate demand, and utility, with no tax.

(x,y) = (30, 30) u(x,y) = 300.5 300.5 = 30

c. Calculate demand and utility with $0.50 tax on beer.

(x,y) = (20, 30) u(x,y) = 200.5 300.5 = 6000.5 24.49

d. How much revenue does $0.50 tax on beer raise?

20 X $0.50 = $10

e. Calculate demand and utility with $0.20 tax on both goods.

(x,y) = (25, 25) u(x,y) = 250.5 250.5 = 25

f. How much revenue does $0.20 tax on both goods raise?

25 X $0.20 + 25 X $0.20 = $10

g. Which is the better way to raise revenue?

To make this last point, an example

We’ve seen two arguments in favor Posner: it’s what we all would have agreed on ex-ante C&U: if you want to redistribute, it’s 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, we’ll mostly focus on the positive questions But in the background, I think of efficiency as a “pretty good”, but

definitely imperfect, measure of “goodness”

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

Let’s first dispense with the straw man. I’ve never heard of an economist who believes that every efficient policy is good, and I’ve heard of very few who believe that every inefficient policy is bad.

It’s true that most economists do seem to believe that any good policy analysis should start by considering efficiency. That doesn’t mean it should end there.

I think economists are right to emphasize efficiency, and I think so for (at least) two reasons. First, emphasizing efficiency forces us to concentrate on the most important problems. Second, emphasizing efficiency forces us to be honest about our goals.

– Steven Landsburg

http://www.thebigquestions.com/2010/08/30/efficiency-experts

A nice blog post about why policy evaluation should at least start with efficiency…

Politician: Here’s my program to make the health care system work better by subsidizing health care for the poor.

Economist: Your program costs a billion dollars and delivers half a billion dollars worth of benefits. That’s inefficient.

Politician: So what?

Economist: Well, the “so what” is that maybe you could take that billion dollars and deliver a full billion dollars worth of benefits instead if you spent it a little differently. Why not just hand the cash out to poor people?

Politician: Because I don’t want to help all poor people. I only want to help sick poor people – and this is the only way I can think of to do that.

Economist: Ah. So your goal here is not to make the health care system work better at all. Instead it’s to transfer resources to sick poor people.

Politician: I guess so.

Economist: That’s fine. Now we can have a healthy debate about whether that’s what we want to do.

“Emphasizing efficiency forces us to be honest about our goals”

A quickdigression

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I don’t have many “absolute beliefs” about economics Some people do

I hope that doesn’t make things too confusing

Before we move on, a quick digression…

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I don’t have many “absolute beliefs” about economics Some people do

I hope that doesn’t make things too confusing

Relatedly, if I don’t see economics as a set of rules to memorize, how do I know what I know?

I need to see a model, or an example, that demonstrates it

Before we move on, a quick digression…

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introduce some basic game theory

begin property law (if time allows)

Rest of today:

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Some basicgame theory

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Today, we focus on static games Also known as simultaneous-move games

A static game is completely described by three things: Who the players are What actions are available to each player What payoff each player will get, as a function of

his own action, and the actions of the other players

Any complete description of these three things fully characterizes a static game

A brief introduction to game theory

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(Story)

Players: player 1 and player 2

Two actions available to each player: rat on the other, or keep mum

Payoffs: u1(mum, mum) = -1

u1(rat, mum) = 0

u1(mum, rat) = -10

u1(rat,rat) = -5

Same for player 2

A classic example: the Prisoner’s Dilemma

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In two-player games with finite actions, one way to present game is payoff matrix

-1, -1 -10, 0

0, -10 -5, -5

Mum Rat

Mum

Rat

Player 2’s Action

Player 1’s Action

Player 1’s Payoff Player 2’s Payoff

Always Player 1

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We solve a game by looking for a Nash equilibrium

Nash equilibrium is a strategy profile (an action for each player) such that: No player can improve his payoff by switching to a different action… …given what his opponent/opponents are doing

Nash Equilibrium

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If any player can improvehis payoff by changing hisaction, given his opponents’actions, then it is not a Nashequilibrium

Is (Mum, Mum) an equilibrium? No, if player 2 is playing Mum

player 1 gains by deviating

A strategy profile is a Nash Equilibrium if no player can gain by deviating

-1, -1 -10, 0

0, -10 -5, -5

Mum Rat

Mum

Rat

Player 2’s Action

Pla

yer

1’s

Act

ion

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My best response to a particular play by the other player is whichever action(s) give me the highest payoff

To find Nash Equilibria… Circle payoff from player 1’s

best response to each action by his opponent

Circle payoff from player 2’sbest response to each action

Any box with both payoffscircled is an equilibrium

Because each player is playinga best-response to his opponent’s action…

…so neither one can improve by changing his strategy

In two-player games, we find Nash equilibria by highlighting best responses

-1, -1 -10, 0

0, -10 -5, -5

Mum Rat

Mum

Rat

Player 2’s Action

Pla

yer

1’s

Act

ion

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Another classic: Battle of the Sexes

(Story)

Circle player 1’sbest responses

Circle player 2’sbest responses

We find two equilibria: (ballgame, ballgame) and (opera, opera) Game theory usually doesn’t have that much to say about which

equilibrium will get played when there are more than one

Some games will have more than one equilibrium

6, 3 0, 0

0, 0 3, 6

Baseball Game Opera

BaseballGame

Opera

Player 2’s Action

Pla

yer

1’s

Act

ion

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Growth model

(Story)

Circle player 1’sbest responses

Circle player 2’sbest responses

Two equilibria: (invest, invest)and (consume, consume) Some papers explain differences in growth across countries by

saying some are in “good” equilibrium and some are in “bad” one

Sometimes, there will be a “good” and a “bad” equilibrium

2, 2 0, 1

1, 0 1, 1

Invest Consume

Invest

Consume

Player 2’s Action

Pla

yer

1’s

Act

ion

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Scissors, Paper, Rock for $1 Look for Nash

Equilibria by circling best responses

No square with both payoffs circled

No equilibrium where each player plays a single action

In this class, we’ll focus on games with a pure-strategyNash equilibrium

Some games don’t have any equilibrium where players only play one action

0, 0 1, -1

-1, 1 0, 0

Scissors Paper

Scissors

Paper

Player 2’s Action

Pla

yer

1’s

Act

ion -1, 1

1, -1

Rock

1, -1 -1, 1Rock 0, 0

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Now on to…

That’s a very quick introduction to static games

Skip

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Property Law

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To begin, a story

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We already saw one reason Tragedy of Commons – overuse of land is held in common

For another example, imagine two neighboring farmers

Each has two choices: farm his own land, or steal crops from his neighbor Stealing is less efficient than planting my own crops

Have to carry the crops from your land to mine Might drop some along the way Have to steal at night move slower

If I steal your crops, I avoid the effort of planting and watering

Why do we need property law in the first place?

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Suppose that planting and watering costs 5, the crops either farmer could grow are worth 15, and stealing costs 3

With no legal system,the game has the following payoffs:

We look for equilibrium

Like Prisoner’s Dilemma both farmers stealing is the only equilibrium but that outcome is Pareto-dominated by both farmers farming

Why do we need property law in the first place?

10, 10 -5, 12

12, -5 0, 0

Farm Steal

Farm

Steal

Player 2

Pla

yer

1

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Suppose there were lots of farmers facing this same problem

They come up with an idea: Institute some property rights And some type of government that would punish people who steal

Setting up the system would cost something Suppose it imposes a cost c on everyone who plays by the rules

So how do we fix the problem?

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So how do we fix the problem?

10 – c, 10 – c -5 – c, 12 – P

12 – P, -5 – c -P, -P

Farm Steal

Farm

Steal

Player 2

Pla

yer

110, 10 -5, 12

12, -5 0, 0

Farm Steal

Farm

Steal

Player 2

Pla

yer

1

MODIFIED GAMEORIGINAL GAME

If P is big, and c is not too big, then 12 – P < 10 – c In that case, (Farm, Farm) is an equilibrium

Payoffs are (10 – c, 10 – c), instead of (0, 0) from before

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Anarchy is inefficient I spend time and effort stealing from you You spend time and effort defending your property from thieves Instead of doing productive work

Establishing property rights, and a legal process for when they’re violated, is one way around the problem

So the idea here…

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Cooter and Ulen: property is

“A bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others”

Property rights are not absolute Appendix to ch. 4 discusses different conceptions of property rights

Any system has to answer four fundamental questions: What things can be privately owned? What can (and can’t) an owner do with his property? How are property rights established? What remedies are given when property rights are violated?

Overview of Property Law

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BUT…

Answers to many of these seem obvious

source: http://www.msnbc.msn.com/id/21088150/

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Take a look at Coase, “The Problem of Social Cost”

Have a good weekend – see you Monday

Monday: Coase