Econ 522Economics of Law

Dan Quint

Spring 2013

Lecture 25

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Models inEconomics

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Imagine you’re a physicist

(Not drawn to scale)

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The world is too complicated to study “as is”

So we make a simple model

Try to leave in the “important parts” for studying a particular question

Realize that our results follow from the assumptions that we made, and may or may not be relevant to the real world

Economists (at least theorists) work the same way

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The way I think about it

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“All models are wrong, but some are useful.”– George Box (Statistician)

Another way to think about this:

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What does it take to do economic theory?

Solvethe

model

Reduce asituation toa tractable

model

Interpretthe

model

Technical ability Judgment

(Which assumptions to make)

Judgment

(How much to “trust” results, given the model/ assumptions behind them)

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“Are people risk averse?” Ask a sociologist, you get an answer Ask an economist, he’ll say, “It depends on what type of problem you’re

studying”

For some questions, risk aversion is important How people choose investment portfolios How people save for retirement if they don’t know how long they’ll live

For other questions, risk aversion plays no role Including risk aversion complicates model, without adding insight So we assume agents are risk neutral – not because they are, but

because we’re focusing on something else

Many assumptions get made differently in different situations

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So, some assumptions get made differently in different settings

Other assumptions get made so consistently that they become a part of the “standard way” that economists look at the world… …almost become a part of conventional wisdom

And then we start to forget that they were assumptions in the first place

The idea of a “standard” model

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People have preferences Allowed to like whatever they like… …but assumed to understand all their options, and how they rank

them

And people optimize People pick whichever option they like most… …subject to what they can afford

To put it another way, people are rational

Basically all mainstream microeconomics is based on two premises

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“People respond to incentives according to what they correctly perceive to be their own rational best interest”

Property/nuisance law each knows own threat point, can bargain with each other to transfer

ownership of entitlements to whoever values them most

Contract law can negotiate efficient contracts, courts can enforce them correctly

Tort law people know effects of their actions, react rationally to incentives courts can assign liability and assess damages correctly

Criminal law even criminals react rationally to incentives, commit crimes when benefit

outweighs expected cost

We’ve been assuming this throughout the semester

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Very useful assumption Led to lots of predictions about how laws affect behavior… …and therefore what types of laws would lead to efficient outcomes

But conclusions are only as valid as the assumptions

Today: How these assumptions sometimes fail in real life… …and therefore why we may be skeptical about some of the

semester’s conclusions But, you’re still being tested on those conclusions! Think of today as a digression

Rationality is a strong assumption

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Behavioral Lawand Economics

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How peoples’ actual behavior differs from predictions of “standard model”

Started out ad-hoc Take a prediction of the standard model, e.g., expected utility

maximization Do an experiment – put a bunch of undergrads in a room and make

them play a game Or look for instances in real world where prediction was violated

Over time, generated some fairly robust conclusions Systematic ways behavior differs from perfect rationality in a number of

different situations

Behavioral economics

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What’s important is that deviations from standard predictions of economics are not random Not random errors But consistent, systematic biases

At its best, behavioral economics holds itself to a “higher standard” than traditional economics Traditional economics: makes assumptions (rationality and

optimization), derives predictions Asks whether predictions seem right, but doesn’t spend much time

questioning the assumptions Behavioral economics looks to justify the assumptions as well

Behavioral economics

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Two recent “pop economics” books that are supposed to be pretty good:

Behavioral economics – sources

Effect of behavioral economics on law and econ:

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Positive “Increase in expected punishment will lead to decrease in crime” Or, an explanation for the laws that do exist, as outcomes of some

process (evolutionary, legislative, etc.)

Prescriptive “To achieve efficiency, the law should specify injunctive relief when

transaction costs are low, and damages when TC are high”

Normative What should be the goal of the legal system? (For this class, we’ve assumed it’s efficiency)

Jolls/Sunstein/Thaler discuss three different “uses” for economics

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Positive Goal of any positive model is to mirror actual behavior

Prescriptive If people respond differently than standard model predicts… …then the law should be designed differently to account for this

Normative If people seem to make “incorrect” choices, should we force them to

choose “correctly”? If people do not optimize based on stable preferences, even the definition

of efficiency becomes unclear

Behavioral economics has implications for all three of these

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To give a more accurate model of how people actually behave…

…and use that model to reconsider the positive, prescriptive, and normative conclusions of law and economics

The goal of behavioral law and economics

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Bounded rationality We make mistakes… …and use simple heuristics or “rules of thumb” to make choices

Bounded willpower Even when we know what we “should” do, don’t always do it Means commitment devices can have value

Bounded self-interest We aren’t totally selfish, even in anonymous situations with strangers

So, how does behavior typically differ from the standard model?

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Behavioral biases in how we evaluate alternatives

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Similar to the first experiment we did in this class 44 students in an advanced undergrad Law and Econ class Half were given tokens Each was given a number – how much they could exchange a token for

at the end of the experiment Given an opportunity to trade As you’d expect, people with high token values bought them from

people with low token values This was with tokens – which had objective, artificial value

Reran experiment with coffee mugs Half the students were given Cornell mugs Then they were given opportunity to trade

Trading experiment from Cornell

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Since the mugs were given out randomly… If each person knew exactly what a mug was worth to them… …we’d expect half the mugs to change hands Since half the mug owners would have above-average values, and

half would have below-average values

Instead, only 15% of the mugs were traded On average, people who got a mug asked more than twice as

much money for them as people who didn’t get a mug were willing to pay

And the effect remained if the experiment was repeated

Trading experiment from Cornell

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Conclusion from the Cornell experiment: having something makes you value it more If you have a mug, you value mugs more than if you don’t

“Endowment effect”

Existence of this bias seems robust One of the chapters in Sunstein book shows 12 studies where

Willingness To Pay for something is compared to Willingness To Accept an offer for something people already have

Every time, people who have something value it more than people who don’t – typically by 3X or more!

Endowment effect

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Contradicts Coase Theorem Coase: without transaction costs, initial allocation shouldn’t affect

final allocation, since whoever starts with something, it will get traded to whoever values it most

But endowment effects mean initial allocation does matter in predicting final allocation

Plus, if preferences depend on who starts with the object, it’s not even clear how to define efficiency!

Endowment effect – so what?

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Using injunctive relief for private nuisances When TC small, clarify threat points and let parties bargain Endowment effect: initial allocation effects preferences, outcome

Calculating damages Suppose someone with two arms thinks losing one would be a

catastrophe, like a $10,000,000 loss Someone with one arm realizes he’s OK that way, thinks damage

done was $500,000 What should construction company owe a worker who lost an arm? Should they take precautions that cost $3MM per lost arm saved?

Endowment effect – so what?

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“Second-cheapest wine” effect

Context dependence

Price

Quality/features

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Behavioral biases in how we perceive probabilities

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Once something happens, people overestimate what its likelihood was One year before 2008 election, what was chance

Obama would win? In November 2007, Intrade had Obama at 7%

Famous study (Baruch Fischhoff) Nixon’s historic 1972 visits to China/USSR Students asked to assign probabilities to outcomes After visit, asked to recall the probabilities they reported For the things that happened, 78 of 103 students gave

higher probability estimates after than they gave before (For things that didn’t happen, only 58 of 102)

Hindsight bias

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Determining negligence (Hand Rule) requires figuring out the probability something would happen, after it happens Example: risk of factory fire is 1 in 1,000, harm is $1,000,000,

company chooses not to install $10,000 sprinkler system Fire occurs, jury thinks risk was 1 in 50, finds company negligent Publicly-owned companies must disclose “material risks” to investors

Judges/juries will find negligence more often than “should”

Jolls/Sunstein/Thaler suggestions for dealing with this Keep jury in the dark about what happened Raise standard of proof for finding negligence

Hindsight bias – so what?

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People overestimate probability of a certain type of accident if they’ve recently observed a similar accident “Availability” – memory of a recent accident is available in your

mind, colors your judgment “Salience” – how vivid the memory is

Explains environmental/safety regulations covering “hot topic” without regard for cost-benefit

Made worse because some people may deliberately keep the accident available for private gain “Availability entrepreneurs” – think of U.S. politicians after 9/11/01

Similar bias – perception of probability skewed by availability and salience

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Relative optimism when both sides have same information

Example Loewenstein, Issacharoff, Camerer and Babcock (1993), “Self-Serving

Assessments of Fairness and Pretrial Bargaining”, Journal of Legal Studies 80 students asked to negotiate settlement for tort case Some chosen at random to represent plaintiff, others defendant Given facts of actual case from Texas – car hit motorcyclist, who was suing

for $100,000 Actual (retired) judge examined case and gave ruling (secret) Students would negotiate a settlement (or fail to reach an agreement and

accept judge’s ruling minus costs) Before negotiations started, students asked to predict how judge had ruled,

and what they thought was “fair” settlement

“Self-serving bias”

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What happened?

So what? Pre-trial settlements may be hard to reach… …and sharing information may not be solve the problem

(all students had exactly same information)

“Self-serving bias”

$30,560Actual judge’s ruling

$24,426$38,953How do you think judge ruled?

$19,318$37,028What do you think is a fair settlement?

Students representing

defendant

Students representing

plaintiff

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Boundedwillpower

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People discount future events…

…but not in the way standard model predicts Standard model: if discount factor is 11%, $100 today = $90 in a year = $81 in two years = $73 in three = …

Drop in value between “now” and “later” is more severe than between two future times Example: $100 today versus $150 in six months… …or $100 in six months versus $150 in a year

So what? Longer prison sentence may have weak deterrence effect (Also, people may not save enough for retirement)

How people discount the future

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Boundedself-interest

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Player 1 proposes a way to divide up $10 Player 2 says yes or no

Yes: they each get the proposed share No: they both get nothing

Backward induction: only equilibrium is for 1 to keep almost everything, 2 to say yes

Experiments: offers less than $3-4 are often rejected, many people offer fairly even split

Shocking to economists, obvious to everyone else: People sacrifice their own well-being to help those who are being

kind to them And sacrifice their own well-being to punish those who are unkind

“Ultimatum game”

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People care not only about their own payoff, but also about “fairness” But fairness is not objective – not all offers < $5 rejected

Preference for fairness could explain lots of rules we see: Rules against scalping tickets Rules against predatory pricing during emergencies Rules against usury (very high interest rates) Any voluntary transaction should be a Pareto-improvement… …but prices which are too “unfair” are sometimes illegal

One interpretation of bounded self-interest

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Jolls/Sunstein/Thaler prescriptive and normative

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Lots of interesting stuff on positive aspects

Less on prescriptive and normative

Jolls/Sunstein/Thaler

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How people respond to information depends on how it’s presented Example: choosing between safe and risky retirement investments

So if government is putting out information, should think about how “framing” changes its effect Safe driving ads used to be, “Drive carefully, or you’ll kill someone” But everyone believes they’re a good driver Ads became more effective when message changed to,

“Drive carefully, there are other BAD DRIVERS out there you have to watch out for!”

One prescriptive suggestion

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Antipaternalism Government shouldn’t tell people what to do

J/S/T stop short of advocating paternalism If behavioral bias leads individuals to make mistakes, could also

lead government bureaucrats to make mistakes in telling people what to do!

“Anti-antipaternalism” We shouldn’t automatically reject paternalism, since it may have a

role sometimes

Jolls/Sunstein/Thaler’s conclusion: the case for “anti-antipaternalism”

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Unenforcedlaws

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Optimal criminal system will not detect/punish every crime, for two reasons Some crimes may be efficient (rare) When cost of deterrence is positive, it’s not worth paying enough to

deter every crime

But we still assumed most crimes are inefficient, and main reason not to punish them all is cost

We saw last week…

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There are a lot of old laws in many states that seem inefficient Massachusetts: can’t buy alcohol on Sundays Many states still have laws passed a long time ago

In some cases, law is enforced

Tim Wu, “American Lawbreaking” – many laws that we, as a society, have basically decided not to enforce at all

However…

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(Example I found online a year ago)

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Begins with New York prosecutors sitting around office, choosing celebrities (John Lennon, Mother Theresa) and coming up with obscure crimes they could be charged with “obstructing the mails,” “false pretenses on the high seas”

“Full enforcement of every last law on the books would put all of us in prison for crimes such as “injuring a mail bag.” No enforcement of our laws, on the other hand, would mean anarchy. Somehow, officials must choose what laws really matter.”

“Tolerated lawbreaking is almost always a response to a political failure – the inability of our political institutions to adapt to social change or reach a rational compromise that reflects the interests of the nation and all concerned parties. That’s why the American statutes are full of laws that no one wants to see fully enforced – or even enforced at all.”

Tim Wu, “American Lawbreaking” (Slate)http://www.slate.com/id/2175730/entry/2175733/

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“Over the last two decades, the pharmaceutical industry has developed a full set of substitutes for just about every illegal narcotic we have.” Rather than legalizing street drugs… …society has developed Ritalin, vicodin, oxycontin, clonazepam, etc… …which may serve legitimate medical purposes in some instances, but

also mimic highs of cocaine and other drugs

Marijuana: several cities where police chiefs or DAs have announced they won’t prosecute possession Philadelphia law will treat possession as a ticketable offense Medical marijuana in California and elsewhere

First example doesn’t perfectly fit premise, but interesting

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Apparently, there’s porn online

And it’s basically all illegal

Federal law prohibits using a “computer service” to transport over state lines “any obscene, lewd, lascivious, or filthy book, pamphlet, picture, motion-picture film, paper, letter, writing, print, or other matter or indecent character.”

Wu’s second example: pornography

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In 1968, Congress set up a commission to investigate Commission recommended we repeal all obscenity laws, replace them

with laws to protect children and control public display Nixon and other politicians condemned report as “morally bankrupt”,

insisted they would continue war on pornography

A few well-publicized prosecutions in 70s and 80s, halted in 90s

2005: Attorney General Alberto Gonzalez tried to pressure local prosecutors to crack down, but nothing happened One Miami attorney: “compared to terrorism, public corruption, and

narcotics, [pornography] is no worse than dropping gum on the sidewalk.”

Wu’s second example: pornography

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So pornography is technically illegal, rarely prosecuted

What’s developed is unofficial zoning system – rather than prohibiting behavior, it’s regulated Prosecuted when it crosses certain lines Ignored otherwise Super Bowl wardrobe malfunction – when something gets on prime-time

network TV, people freak out Child pornography still prosecuted But “mainstream” porn left alone, so functionally legal

So as a society, we’ve functionally legalized porn… Not through legislation or courts… …but through general consensus among prosecutors, FCC, FBI, local

police, etc., to do nothing about it

Wu’s second example: pornography

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Amish refuse to pay Social Security taxes, do not accept benefits, do not educate children past eighth grade

Mormons to some degree still practice polygamy

Wu discusses history of legal treatment

Again, what’s emerged is de facto zoning Mormon polygamist went on Sally Jessy and Springer to discuss his

lifestyle, he was tried and convicted But when it’s done quietly, in scattered communities outside of big

cities, polygamy still goes on and is basically tolerated Amish are open about how they live, but keep to themselves, and

nobody worries about it

Wu’s other examples: copyright law, illegal immigration, Amish and Mormons

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You’d think crimes are crimes because society wants them to be crimes

But in some cases, society doesn’t care whether something is a crime, but doesn’t care enough to make it legal either

Or, political system is “broken” enough that some things can’t be fixed, we adapt by ignoring certain laws

More obvious example: speeding

This all doesn’t really fit into our framework of criminal law

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Throughout the semester, we’ve been assuming rationality Of individuals, of businesses, etc.

This has led to a number of conclusions

Today: like with all economics, our conclusions are only as strong as our faith in our assumptions When we apply these conclusions to the real world, need to be

aware of how they depend on assumptions, how robust they are when assumptions are violated

So what’s my point for today?