Econ 522Economics of Law

Dan Quint

Spring 2014

Lecture 2

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TA sections and office hours begin this week

“Fake homework” for Wednesday on website

First real homework also up, due next Thursday (Feb 6)

If you want to read ahead: Richard Posner, “The Ethical and Political Basis of Efficiency

Norm in Common Law Adjudication” For a counterpoint to Posner: Peter Hammond, “Review: The

Economics of Justice and the Criterion of Wealth Maximization” Both have links on syllabus, and both are on Learn@UW

Logistics

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defined law and economics

saw some brief history of the common law

and the civil law

and discussed ownership of dead whales

Last week, we…

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quick review of rational choice

what is efficiency?

is efficiency a good goal for the law?

Today: efficiency

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Rationality, optimization,revealed preference

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People have preferences… They understand their options, and how much they like each one

…and they optimize They choose the option they like the best

This is what economists mean when we talk about rationality or rational behavior Behavior that is consistent with someone having well-defined,

consistent preferences

And this is what we’ll be assuming throughout the semester

Most microeconomics is based on the premise of rational choice

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If I see you choosing something…

…I infer you like it more than your other alternatives

We assume people succeeded in doing what they like, rather than screwing up and doing the wrong thing

And this allows us to learn peoples’ preferences from their choices (to some degree)

This leads to the idea of revealed preference

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If we assume that people have coherent preferences…

…and that we might be able to learn those preferences…

…then we can try to use those preferences to judge when one societal outcome is “better” than another

All this is useful if we want to judge what are “good” outcomes

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a Pareto improvement is any change to the economy which leaves… everyone at least as well off, and someone strictly better off

example you prefer $3,500 to your car I prefer your car to $3,500 I buy it for $3,500 – Pareto improvement

an outcome is Pareto superior to another, or Pareto dominates it, if the second is a Pareto improvement over the first

One way to do this: Pareto criterion

Vilfredo Pareto(1848-1923)

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Pareto improvements are “win-win” but most new laws create some winners and some losers so the Pareto criterion usually can’t 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

Pareto superiority is not that useful a measure for evaluating a legal system

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Kaldor-Hicksand Efficiency

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Given any two options, I can figure out which one I like more (or else I truly don’t care)

Given two options – say, $4,000, or a 2002 Grand Am… Maybe I prefer the money Maybe I prefer the car Maybe I’m truly indifferent between the two But one of these must be the case

We generally assume preferences are complete

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If you don’t like it, you can always burn it…

…but we generally assume everyone prefers more money to less money

“Everybody needs money. That’swhy they call it money.” -Danny DeVito, in Heist

We also assume more money is better…

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If I prefer your car to $3,000…

…but I prefer $5,000 to your car…

…then there must be some amount in between that makes me indifferent

We can say that’s my value for the car If I’m exactly indifferent between $4,000 and your car… …we can say I value your car at $4,000

And finally, we assume preferences are continuous

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Informally: a K-H improvement is any change to the economy which increases the total value achieved by everyone in society…

…where the “value” some gets from something is measured by their willingness to pay for it

Going back to the car example suppose your car is worth $3,000 to you and $4,000 to me government seizes your car and gives it to me

I’m better off, you’re worse off But since I value the car more than you… …this is a Kaldor-Hicks improvement

Next, we define Kaldor-Hicks improvement

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Unlike a Pareto improvement, a Kaldor-Hicks improvement can create some winners and some losers…

…as long as the winners gain more than the losers lose If I get your car for free… I end up better off by $4,000 (my value for the car) You end up $3,000 worse off (your value for the car) $4,000 > $3,000, so this is a K-H improvement

Another way to think about Kaldor-Hicks improvements

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a change to the economy is a Kaldor-Hicks improvement if it could be turned into a Pareto improvement with monetary transfers K-H improvements also called potential Pareto improvements

I get your car for free If we combined this change with me giving you $3,500… …then it would be a Pareto improvement So even without the transfer, it’s a K-H improvement

Formal definition of a Kaldor-Hicks improvement

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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 – can’t be, because it makes me worse off

Is the party a Kaldor-Hicks improvement? Yes – it increases total value: $50 + $150 – $100 = $100 > 0 (Or: you could throw the party, plus you give me $40 and each of

your guests gives me $3 – that would be a Pareto improvement, so just having the party is a K-H improvement)

Another example

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we will call a change to the economy efficient if it is a Kaldor-Hicks improvement

we’ll say law A is more efficient than law B if moving from B to A is a Kaldor-Hicks improvement

and we’ll say a situation is efficient if there are no available Kaldor-Hicks improvements an efficient situation is when there’s no way to make some people

better off, without making some others worse off by more we’re already getting maximal value out of all available resources

Efficiency

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Pareto vs Kaldor-Hicks improvements

“good for society as a whole”

may make some people worse off, but increases total surplus/value

“good for everyone”

makes some people strictly better off, doesn’t make anybody worse off

Kaldor-Hicks improvementPareto improvement

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Pareto vs Kaldor-Hicks efficiency

no available K-H improvements

impossible to help someone without hurting someone else more

(impossible to increase total payoffs realized by everyone)

no available Pareto improvements

impossible to help someone without hurting someone else

efficiencyPareto efficiency

kind of useless for comparing different

policies

what we’ll be focusing on this semester

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Is it efficient for you to have the party?

Makes you $50 better off

Makes 30 guests $5 better off

Makes me $100 worse off

$50 + $150 – $100 = 100 – party “creates $100 of value”

So it’s efficient for you to have the party True whether you compensate me or not Even if “my slice of the pie” is smaller, overall pie is bigger… …which is all that efficiency is concerned with

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What we’ve really done here

In a sense, what we’ve done here is created a way to add up different peoples’ utility functions…

…by equating utility 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, I’d be just as well off as before

Once we’ve done that, what’s efficient is whatever configuration of the economy “creates the most value”

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Another 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: there’s 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

It’s efficient for me to drive to work if the benefit I get is more than $11 If the benefit is less than $11, it’s inefficient for me to drive

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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’”

Some other, similar measures

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What forces lead to inefficiency

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To see whether something’s 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 benefit I gain by driving to work So we just said: it’s efficient for me to drive to campus whenever

the value I get from driving is more than $11

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How do we expect people to actually behave?

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 I’ll 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 that’s inefficient

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So externalities cause inefficiency

I’ll do something whenever private benefit > private cost

Efficiency depends on whether social benefit > social cost

If I was the only one affected by my choices, then social benefit = private benefit and social cost = private cost when I’m deciding which movie to watch on Netflix, nobody else is

affected by my choice, so my choice will be efficient

But when my choices affect other peoples’ payoffs… social benefit private benefit, or social cost 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 fewer

fish are left in the lake… …and the harder it is for everyone

else in the village to catch fish So my fishing imposes a cost

(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

(a) 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

(b) 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

Hours fishing, per day, per fisherman

Total fish caught

0 1263 9

“Maximum Sustainable Yield”

Efficient Level of Fishing

“Equilibrium” Level of Fishing

H (260 – H)

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What’s 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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Without some sort of regulation/intervention… Activities which impose a negative externality will tend to happen

more than the efficient amount… …and activities which impose a positive externality will tend to

happen less than the efficient amount

One recurring theme we’ll see in this class:

if we want the law to lead to efficient outcomes,

we can try to design the law to eliminate externalities! “Internalization”

So externalities can lead to inefficiency

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Other forces which lead to inefficiency

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Cuban cigars Suppose I’d pay $15 each for Cohibas They cost $2 each to make, and another

$3 each to transport from Cuba to Madison Clearly, it’s 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 we’re not allowed to sell…)

Another thing that leads to inefficiency:barriers to trade

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I value my free time at $40/hour

Working in a factory, I can build things worth $50/hour

Clearly, it’s efficient for me to work Each hour I work creates $10 of new value Doesn’t matter who gets it – it’s efficient for me to work

But if income tax is 25%, then it won’t happen Factory owner can’t pay me more than $50/hour But $50/hour pre-tax is only $37.50 after-tax… …and I’d rather stay home than earn $37.50 an hour So I don’t get hired, which is inefficient

Another thing that leads to inefficiency: taxes

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This is a new BMW that’s been cut in half

Taxes distort behavior away from efficiency

Another example of taxes leading to inefficiency

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CS

Profit

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

Another thing that leads to inefficiency: monopoly

P* = 70P = 100 – Q

Q* = 30

MC = 40DWL

(or private information)

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For example we just said taxes lead to inefficiency… …but without taxes, there’s be far too few public goods, which is

also inefficient we just said monopoly leads to inefficiency… …but we’ll study patents, which are legal monopolies used to get

companies to innovate

But also, we’ve defined “efficient”, but we haven’t claimed that “efficient = good”

Which brings us to…

But, saying these things lead to inefficiency doesn’t automatically mean they’re bad

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Is efficiency a good goal for the law?

Jump

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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…

Jump

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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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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?

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One argument from C&U for why law should focus on efficiency, redistribution should be done through taxes:

“narrow taxes cause more distortion than broad taxes” Wednesday, we’ll 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 won’t get to Coase till next week)

See you Wednesday!

For Wednesday…

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If you want to read ahead: Richard Posner, “The Ethical and Political Basis of Efficiency Norm in Common Law Adjudication”

If you want a counterpoint to Posner:Peter Hammond, “Review: The Economics of Justice and the Criterion of Wealth Maximization”

If you want to see a problem we’ll do on Wednesday:I’ll be showing an example of how “narrow taxes distort more than broad-based taxes”The example is online as a “fake homework”

See you Wednesday!

For Wednesday