Midterm 2000: Answers

I. Economic Efficiency:    (10 points)

A. Explain in your own words what it means to say that one outcome is more efficient than another.

Measure the benefit to someone of getting outcome A instead of outcome B by the largest amount he would pay to do so; measure costs similarly. A is more efficient than B if the summed benefits are larger than the summed costs.

B. Briefly discuss reasons why the more efficient outcome might be, in some plausible sense, the less good outcome.

1. There may be values (justice, ancient redwoods, the will of God) that are not reducible to “individuals getting the outcomes they want.”

2. Individuals may not know what is in their own interest—value heroin even though it is, in some sense, bad for them.

3. The willingness to pay criterion measures benefits in dollars. But a dollar may represent much less happiness to some people than to others. So a change that benefited a rich man by ten dollars and harmed a poor man by nine dollars would be an improvement in efficiency but almost certainly a lowering in total happiness.

II. Externalities:     (15 points)

A. Why does the existence of external costs lead to inefficient outcomes? What about external benefits?

Individuals make decisions based on total costs and benefits to themselves. If my decision also imposes costs on someone else, I may do it because net benefits are positive to me even though net benefits are negative taking into account the external cost. I have then produced an inefficient outcome.

Similarly, if there is a positive externality, I may not take the action (because costs to me are larger than benefits) even though taking it would produce net benefits (including the external benefit), which again results in an inefficient outcome.

B. Briefly describe the Pigouvian solution to the problem and the difficulties in implementing it.

Charge someone who produces an external cost an amount equal to the cost, thus making net cost for him equal net cost to everyone. This requires the agency imposing the Pigouvian tax both to be able to know what the external cost is and to have an incentive to accurately measure it and impose it.

C. Briefly describe Coase’s critique of the Pigouvian solution. (Use the back of the page)
1. External costs are jointly produced by “polluter” and “victim.” If the victim can solve the problem at a lower cost (change the process by which he bleaches mats so that they are no longer turned black by the chemical emitted by a nearby factory, to take one of the cases Coase discusses), you will get the efficient outcome without Pigouvian taxes and an inefficient outcome with them. And the optimal solution may involve actions by both parties.

2. Without Pigouvian taxes but with well defined property rights, if transaction costs are low, the parties will bargain by themselves to the efficient outcome.

3. So the problem is really the transaction costs that sometimes prevent such bargains, and the best solution is an initial definition of rights that minimizes the summed cost of transactions to produce the efficient outcomes and inefficiency due to the failure to produce the efficient outcomes.


III. Designing Legal Rules:     (20 points)

An airport has only one airline flying out of it; the land under the flight path belongs to ten landowners. The airline can either do nothing to reduce noise from planes landing and taking off, or spend a million dollars a year to completely eliminate the noise; for simplicity we assume that those are its only alternatives. The landowners can use their land either for housing or as farmland.

Each landowner’s property is worth $200,000/year as farmland, $400,000/year as housing without airplane noise, $320,000/year as housing with airplane noise.

A. What is the efficient outcome?
Noise and houses.

B. For each of the following legal rules, what is the outcome if there is no bargaining between the parties:

i. The airline is not liable for noise.

Noise and houses.

ii. The airline is liable for noise.

Noise and houses—unless the court overestimates the damage by enough to make it in the airline’s interest to engage in (inefficient) noise reduction. Or unless litigation costs are large enough to produce the same result ($80,000 damages and $40,000 in lawyer’s fees for each case).

iii. Any landowner can enjoin airline noise.

No noise and houses.

C. For each of the rules, what is the outcome if there is bargaining? Briefly explain. In some cases you may want to discuss alternative possible outcomes.   

i. Noise and houses—the landowners, even if they can overcome the public good problem, aren’t willing to offer the airline enough to pay for the noise reduction.

ii. Noise and houses. Airline and landowners may reduce litigation costs by a permanent out of court settlement. Except that …

If courts overestimate the costs and/or litigation costs are high, bargaining costs might force the no noise and houses outcome. This is made less likely by the fact that the airline can settle with some landowners and pay damages to the holdouts—as long as the total is less than the cost of preventing the noise.

iii. Either noise and houses—if the landowners can overcome the holdout problem and accept compensation for permitting noise—or silence and houses if they can’t.

D. Suppose transactions costs are very high, giving the same outcomes as in B above. How large is the inefficiency from each rule, relative to the efficient outcome?
i.  Zero—the efficient outcome.

ii. Zero—except that there may be litigation costs of unknown size (but not more than $200,000 litigation cost to the airline, since otherwise it will stop making noise).

iii. The airline pays $1,000,000 to buy noise reduction that produces a benefit of only $800,000, for a net cost of $200,000.

IV: Answer one of the following two questions:          (10 points)

A. Explain the difference between a property rule and a liability rule, and what determines which is appropriate to some particular legal issue.

Under a property rule, you can only use my property with my permission; if you try to use it without the law imposes costs on you designed to be large enough to keep you from doing so. Under a liability rule, you can use my property without my permission but are then liable to me for the cost that your use imposes on me.

Property rules make sense if the transaction costs of moving goods to their highest valued use via private transactions are low and the costs and errors of doing it through litigation are high. Liability rules make sense in the opposite case—where transaction costs of private transactions are high and courts can accurately and inexpensively measure damages and allocate liability for them.


B. Explain the difference between ex ante and ex post enforcement, and briefly describe the advantages of each.
Ex ante tries to prevent an undesirable outcome, such as a car crash, by penalizing behavior that is believed to lead to that outcome—a speed limit enforced by speeding tickets, for example. Ex post tries to prevent the undesirable outcome by penalizing the outcome, thus giving the party an incentive to prevent it.

The advantage of ex ante is that it can be applied with a higher probability of a lower punishment, thus reducing problems of risk aversion and the need to resort to inefficient punishments such as imprisonment. The advantage of ex post is that it makes it in the party’s interest to apply his private information about what he is doing and what he should be doing to prevent the outcome, while under ex ante it is only the information available to the enforcement system (how fast you are driving but not how much attention you are paying to doing it) that is being used. Ex ante also permits the enforcement system to impose its estimate of the relation between behavior and consequences, while ex post is using the party’s estimate; under some circumstances the former may be superior, under some the latter.

V: Answer one of the following two questions:     (10 points)

A.. What is adverse selection? Why does it lead to inefficient outcomes (give an example). How might one minimize costs due to adverse selection in designing a contract or a legal rule?

Adverse selection occurs when one party has information relevant to the value of what is being sold that the other party does not have and that the first party cannot verifiably transmit. If I know my car is a creampuff, I will price it accordingly, and will probably only be willing to sell it at a creampuff price. But if the buyer does not and cannot know, he will probably be unwilling to pay that price. So the cars that sell are mostly lemons—selling at a lemon price. This is inefficient because a creampuff that is worth more to the potential buyer than to its present owner still remains unsold.

One can minimize such costs by assigning the risk to the party who has the information about that risk. For instance, the seller could guarantee the car. [There are other acceptable answers, but this is probably the most important one for our purposes.]


B. What is the economic argument for the “coming to the nuisance” defense? Against? What facts might be relevant to deciding whether the defense should be allow in some class of cases?
The argument for is that the second mover is often, because he is the second mover, the lower cost avoider of the problem; the developer can choose to locate his development somewhere other than next to the pig farm. It is much harder for the pig farmer to predict that the land where he is going to locate his pig farm is next to where a developer will want to build ten years later, and so avoid the problem by locating elsewhere.

The argument against is that in some cases the victim cannot avoid by building elsewhere, because housing development is the most valuable use of the land around the pig farm, hence the owners are being injured, whether they build or don’t build—and in some of those cases, the pig farmer could have predicted that the city was growing in that direction and located somewhere else.