Economic Analysis of Law
(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.
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
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
A. Why are external costs a problem? What about external 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.
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.
B. What is the Pigouvian approach to dealing with externalities? What
are its advantages over direct regulation? How would Pigou deal with
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
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
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
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,
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
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.
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
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
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
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
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.
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.