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.