Economic Analysis of Law
Spring
2009
Midterm
(you may omit any complete
question
or questions for 20% credit)
I. Explain in your own words
what it means to describe one outcome as more efficient than
another.
(5 pts)
Outcome A is more efficient than outcome B
if the sum of the amount
that people who prefer B would be willing to pay, if
necessary, to get
A instead of B is larger than the sum that people who prefer B
would be
willing to pay, if necessary, to get B instead of A
II. Externalities
(15 pts)
A. Why are external costs a problem? What about external
benefits?
External costs are a
problem
because the actor decides what to do on the basis of his private
costs
and benefits. If private benefit is larger than private cost but
smaller than private cost plus external cost, the actor takes
the
action even though it result in a net loss if we count all costs
and
all benefits.
External benefits are a
problem
because an actor may fail to take an action even though total
benefits,
external included, are larger than total costs, if his benefit
is
smaller than his cost.
B. What is the Pigouvian approach to dealing with externalities?
What
are its advantages over direct regulation? How would Pigou deal
with
external benefits?
The Pigouvian approach is
to
charge the person producing the external cost the amount of the
cost.
Its advantages over direct regulation are that it makes it in
the
interest of the actor to produce in the optimal way, counting
all
costs, which he is likely to know much more about how to do than
the
regulator knows, and that it rersults in external costs being
incorporated in prices, and so sending the right signal to those
who
buy what the person in question sells.
Pigou would deal with
external
benefits by a negative tax, a subsidy to the person producing
the
external benefit equal to the amount of the benefit.
C. Explain, in your own words, Coase's critique of Pigou. Give
an
example of a situation where applying the Pigouvian approach
makes the
outcome less efficient than doing nothing. (Use the back of the
page if
necessary)
Coase pointed out that an
external
costs is normally the result of choices by both parties--my
choice to
play my music late, your choice to try to sleep when I
am playing
my music. In general we do not know which party can eliminate
the
problem at lower cost, so imposing the cost on one of the
parties might
result in the higher cost solution.
An example is given in
problem
III. The Pigouvian solution is to fine the factory $1.2
million, with
the result that it stops polluting, the resorts stay as
resorts. That
is less efficient then doing nothing and having the resorts
switch to
being hunting lodges.
III. A factory pollutes a
lake
which is also used by twenty vacation resorts. It would cost the
factory $1,000,000 a year to prevent the pollution. Each resort
faces
the following alternatives (remember that there are twenty
resorts):
a: Operate as a resort on an unpolluted lake, making
$100,000/year
profit.
b: Operate as a resort on a polluted lake, making $40,000/year
profit.
c: Operate as a hunting lodge, making $60,000/year profit,
whether or
not the lake is polluted
A. What is the efficient solution? Circle the correct
answer. (5 points)
The factory should (pollute/not
pollute)
The resorts should be operated as (resorts/hunting lodges)
In answering parts B and C, describe first what happens if there
is no
bargaining between factory and resort owners, and then whether
bargaining will change the outcome. Explain briefly.
B. The factory has the right to pollute if it wants to and is
not
liable. (5 points)
No Bargaining, factory
pollutes,
resorts switch.
Bargaining, the same
result, since
the value to the resorts of preventing pollution is less than
the cost,
so they will be unable, even if they can solve the public good
problem,
to offer a high enough price to get the factory to stop
polluting.
C. Any resort can enjoin the pollution, so the factory can only
pollute
if it has permission from all the resorts. (5
points)
No Bargaining, factory
stops
polluting, resorts stay as resorts.
With bargaining the factory
might
be able to buy permission from the resorts, giving the
efficient
outcome--but in doing so it will face a holdout problem.
IV. Pick one of the following
pairs of alternatives. explain what they mean and the advantages
of
each, and give a real world example of each. Use the back of the
page
if necessary. (10 points)
A. Ex post vs Ex ante enforcement
Ex
post enforcement means preventing bad outcomes, such
as auto
accidents, by imposing costs on the person responsible when
and if the
outcome occurs. Ex ante enforcement
imposes
costs on a person for acts believed to increase the
probability
that the outcome will occur. Ex post has the advantage of
making it in
the interest of the actor to use his private information about
what he
is doing and about what he should be doing to try to prevent
the
outcome, information much of which is not available to those
who would
be enforcing an ex ante rule.
Ex
ante enforcement has the advantage that, if the
outcome itself
is unlikely, the punishment required is much lower than with
ex post
enforcement--a thousand $100 speeding tickets replacing one
$100,000
fine for causing an accident. Lower punishments can more often
be
imposed in the form of fines, which are less costly per amount
of
punishment than imprisonment or execution, so ex ante may, in the case
of
unlikely events imposing large costs, permit more efficient
punishment.
It also permits the enforcing authority to impose its view of
what
actions cause the outcome on the actor, instead of his view,
which
might be an advantage or a disadvantage.
Speeding tickets provide
one
example of ex ante
enforcement, required attendence in class another. The
corresponding ex post
examples are liability,
civil and/or criminal, when an accident occurs, and final
grades.
B. Rules vs Standards
A rule, such as "you must
be 35 to
run for President" or "you may not drive over 65 mph" provides
a bright
line--almost all cases clearly do or don't satisfy it. A
standard, such
as "you must be of good character to be admitted to the bar"
or "you
may not drive in an unsafe manner" provides a much less clear
criterion.
The advantage of a rule is
that it
is easy to tell if it is violated, so not much effort must be
spent
either on deciding if you are violating or on litigating over
whether
you have violated. The disadvantage of a rule is that the
underlying
objective is usually not simple enough so that the rule
accurately
achieves it. A standard can use more elaborate criteria, and
so has the
potential to do a better job of punishing what we actually
want to
punish.
C. Property rules vs liability rules
A property rule, such as
"if you
use this car without the owner's permission you go to jail,"
attempts
to make use without permission costly enough so it almost
never occurs.
A liability rule, such as "if you dent my car through your
careless
driving you must pay the cost of fixing it" attempts to make
inefficient use, use that does more damage than it is worth to
the
user, unprofitable, hence discourage inefficient use while
permitting
efficient use.
Property rules work well if
the
transaction costs of market transactions are low, since the
property
ends up being used by whomever values the use most. Liability
rules
work well if transaction costs of market transactions are high
but the
costs and errors of litigation to determine who is liable and
for how
much are low.
V. Pick one of the following
and
explain it: (10 points)
1. Hawk/Dove equilibrium: What determines the percentage of
hawks
(bullies) in equilibrium? What does this have to do with the
question
of whether crimes of passion, such as killing someone in a blind
rage,
can be deterred?
In equilibrium, the payoff
to the
two strategies is the same, at least for the marginal
individual--the
dove best qualified to be a hawk, or the hawk least qualified
to be a
hawk (or the same for everyone if everyone is identical). The
cost of
being a hawk comes from the risk of a hawk/hawk
confrontation--that
balances the gain from winning when a dove backs down in a
hawk/dove
confrontation. Punishing crimes of passion makes a hawk/hawk
interaction more costly, and so shifts individuals to the dove
strategy
until the decrease in the number of hawks reduces the risk of
hawk/hawk
enough to compensate, thus it reduces the number of crimes
coming from
hawk/hawk interactions.
2. Prisoner's Dilemma: Explain the argument for why the
existence of
plea bargaining might make criminals worse off. Would the
argument
still hold if transaction costs among defendants were zero?
Explain.
A. (What I intended) If
many
defendants cop a plea, that frees up resources for the
prosecutor to
use on those who don't, increasing his conviction rate and so
letting
him offer worse terms than he otherwise could to those who do
plea
bargain. If transaction costs among defendants were zero, the
defendants could all agree not to cop a plea, thus making all
of them
better off.
B. (Alternative correct
answer) In
the traditional prisoner's dilemma game, the fact that the
prosecutor
can "bribe" a defendant to confess by offering him a lower
punishment,
in effect making a plea bargain, results in both defendants
being worse
off than if punishment depended only on conviction.
VI. Briefly explain two of
the
following ideas, in each case giving one example of its
relevance
either to designing an insurance contract or to choosing a legal
rule.
(10 points)
1. Risk aversion
Because an additional
dollar is
worth less to him the more dollars he has, a risk averse
individual
prefers a certain payout to a less certain payout with the
same
expected value. That is one reason to prefer ex ante punishment, since it employs a
higher
probability of a lower fine.
2. Moral Hazard
If you insure your factory
against
fire for 90% of its value, it's only worth taking precautions
to
prevent fire if the savings in reduced risk is at least ten
times the
cost of the precaution, since you only get a tenth of the
saving. So
you may fail to take precautions that are worth taking, just
not that
much worth taking. One way in which an insurance contract can
deal with
this is by specifying some required precautions, another is by
not
insuring too large a fraction of the loss.
3. Adverse Selection
If a seller has information
on
quality that he cannot credibly transmit to the other, high
quality
goods may not get sold because the buyer is only willing to
offer a
price appropriate for goods that might be high or low quality,
while
the seller will only accept a price appropriate for high
quality. The
fact that sellers of high quality goods are unlikely to accept
the
offer means that accepting will signal lower than average
quality,
which is a reason for even lower offers. The same problem can
arise in
other cases of assymetric information.
This provides an argument
against
a legal rule that forbids insurance companies from obtaining
information about the risk that they are insuring which the
buyer of
the insurance has, since such a rule creates assymetric
information and
so may prevent buyers for which the information is favorable,
such as
people with a low risk of a heart attack, from buying
insurance.