Midterm

(You may leave any complete question or questions blank for 20% credit.)

(10 points) I. A. Briefly explain in your own words what it means to say that one legal rule is more efficient than an alternative legal rule.

B. What are arguments against economic efficiency? In other words, why might reasonable people sometimes consider the less efficient rule to be, on the whole, better than the more efficient rule?

(10 points) II. A. Why does the existence of an externality lead to an inefficient outcome?

B. Describe the Pigouvian solution ("effluent fees") to the problem of externalities and the argument for why it produces the efficient outcome. How is it superior to direct regulation as a solution to the problem? Use the back of the page if necessary

(10 points) III. What is Coase’s critique of the Pigouvian approach?

(15 points) IV. Airplanes make noise that disturbs residents of homes near the flight path. Suppose that the airline can, at some cost, reduce the noise to an insignificant level. Home owners can get the same reduction by soundproofing their homes. For simplicity ignore the possibility of different levels of noise reduction—there either is or is not a noise problem.

There is one airline; it owns the airport. There are two thousand homes near the flight path. Reducing noise costs the airline a million dollars a year. Sound proofing a house costs $400/year. Airport noise (if there is neither soundproofing nor noise reduction by the airline) reduces the value of the house to its owner by $600/year.

A. What is the efficient solution?

The airline should (reduce/not reduce) noise:

The homeowners should (soundproof/not soundproof):

In answering parts B and C, describe first what happens if there is no bargaining between airline and homeowners and then whether bargaining will change the outcome. Explain briefly.

B. The airline has no legal obligation to reduce noise.

C. If the airline does not reduce noise, it must pay each home owner for any resulting reduction in the value of his house.

(5 points) V. Answer one of the following:

A. Explain the connection between risk aversion and declining marginal utility of income.

B. Insurance transfers the cost of some uncertain event, such as a factory burning down, from the owner to the insurance company. Considering only the issue of moral hazard, under what circumstances is this change an improvement? In other words, when is moral hazard a feature rather than a bug?

C. Briefly describe one of the following games and give an example of its relevance to choosing legal rules.

1. Bilateral Monopoly

2. Prisoner’s Dilemma

Name: _________________________________