Economic Analysis of Law

Spring 2007

1/9/07

v Mechanics

Ø Midterm

Ø Final

Ø Case

§ Any case past or present

§ That wasn’t argued on economic terms

§ And isn’t in my book or Posner’s

§ Oral or written

§ Due in or after the week in which the relevant part of the law is discussed.

Ø Readings

§ My book

· Virtual footnotes

· My problem

§ At least one article, perhaps a few

v What is economics?

Ø A way of understanding behavior

§ Based on the assumption of rationality

§ Meaning that individuals have objectives

§ And tend to choose the best way of achieving them.

§ Not that they are perfect cold blooded calculators.

Ø Examples

§ Rational baby

§ Rational cat

Ø Lessons

§ Rationality doesn’t have to come from calculation

· It might be produced by evolution (babies and cats)

· Or selection (CEO’s).

· Or trial and error (my route home).

§ The assumption doesn’t have to be entirely true to be useful

· People make mistakes, but …

· Unless you have a theory of mistakes

· It makes sense to assume rationality and allow for sometimes being wrong.

· You may know yourself well enough (Posner story). Theory of other people.

· For one theory of mistakes, see the article on economics and evolutionary biology on my web page.

v What does it have to do with law?

Ø Law as incentive

§ If we have this legal rule, how will people behave?

§ Consider expanded discovery in civil litigation

· An incentive not to keep some kinds of records

· Maybe not to ask some questions

· Also a way of raising costs to your opponent

§ Consider legal rules making homeowners civilly or criminally liable for injuring robbers

· It might make them less likely to use deadly force, or …

· More likely

· My Philadelphia story

§ Consider civil forfeiture

· The idea

· Might make innocents more careful about how their property is used, but …

· Might also give law enforcement agents an incentive to target valuable property.

· Benson’s result on the effect of legal changes.

§ So economics provides a way of predicting the consequences of law

· Assuming rationality of potential criminals, but also of …

· Litigators

· Cops, …

§ Forward not backward looking

· The central question is not “how ought the mess to be settled” but …

· How will the way we settle this mess affect the behavior of people in the future

· “Clean up your own mess” as an economically efficient rule.

Ø Predicting and explaining what the law is

§ Posner conjecture:

· Legal rules are designed to maximize the size of the pie

· Which he calls wealth maximization

· And I call economic efficiency.

· And which will be explained and discussed in more detail later.

§ Why would it be true?

· Because it is one of the few good things judges can do, so they do it?

· Because of some invisible hand mechanism? Inefficient rules lead to litigation which leads to a change in the law?

· Neither is very convincing—will come back to them at the end. But …

§ Has created a project that has played a central role in law and econ

· Figure out, in each case, what legal rules would maximize efficiency

· Compare it with the legal rules that exist

§ In the final chapter I try to sum up the evidence on whether the conjecture is true, but …

§ True or false, it has led to a lot of interesting work.

Ø Recommending what the law should be

§ If you think economic efficiency is a reasonable thing for the law to aim it

§ Then you can reverse the argument above

§ Figure out what the law should be and if it isn’t try to change it.

Ø Of these three projects

§ The first is the least disputable—figure out consequences

§ The second is an empirical conjecture

§ The third ultimately a normative project. But easily confused with the second.

§ Note that one could believe that the law is efficient but shouldn’t be, or isn’t but should.

Ø One interesting feature of the project is that it tends to unify the law

§ We see the same economic analysis appearing

§ Across all of the standard categories of the law.

v Law, economics and justice

Ø Many people think law can best be explained and judged in terms of justice

Ø The approach in this book almost entirely ignores such considerations

§ Most strikingly, in giving the same weight to costs and benefits of criminals as to costs and benefits to victims

§ In part because deciding who is a criminal requires a theory of what the law should be

§ Which is one of the things we are trying to produce

§ In part because one interesting result of the project is seeing how much of what we think we favor because it is just in fact is efficient.

§ And in part because I don’t think we have an adequate theory of justice.

v What economists can learn

Ø Abstract theory can make quite serious mistakes

§ Property—I own the land or I don’t own the land

§ Contract—I agree to do X

Ø Looking at the real world application of the theory may highlight those mistakes

§ Just what rights do I own with regard to the land

§ What counts as violation of the contract, what are the penalties?

Ø And sometimes the result is better theory

§ Coase’s “The Problem of Social Cost”

§ Came in part out of Coase looking at law cases and

§ Demonstrated that the approach to externalities generally accepted by economists was fundamentally wrong

§ Making it one of the most cited articles in modern economics

§ Stigler story about U of Chicago.

v Road map to the course

Ø Two approaches—organized by economics or by law. Do both.

Ø First half: by economics

§ Efficiency

§ Externalities

· Two approaches

· Using the theory to design legal rules

· In particular, decide who has what rights and how protected

· Property rule vs liability rule.

§ Economics of risk

§ Ex Post/Ex Ante enforcement

§ Game Theory

§ Value of life

Ø Midterm

Ø Second half: by law

v Property

v Intellectual Property

v Contract

v Family Law

v Tort

v Crime

v Antitrust

Ø Extra stuff

v Some Very Different Systems of Legal Rules

Ø Saga period Iceland—pure tort on steroids

Ø 18^th c. England

Ø Shasta County—norms as a substitute for law

v The Tort/Crime puzzle

v Is the Common Law Efficient?

1/11/07

v Review

Ø Course mechanics

§ Midterm

§ Final

§ Either brief written or oral econ defense of one side of a case.

Ø What is economics?

§ The approach to understanding behavior that starts by assuming

§ Individuals have objectives

§ And tend to choose the acts that best achieve them

Ø What does it have to do with law?

§ Law as incentive

· Suppose

·

Ø One important concept in the field as it has developed is

§ Economic efficiency

§ Aka value maximization

§ As a conjecture about the pattern of the common law

§ Or a proposal for what the law ought to be

v What is efficiency?

Ø The problem:

§ Any change in legal rules (or anything else)

§ Affects lots of people in different ways

§ Making some better off and some worse off

§ Is there any way of summing?

Ø Marshall’s answer

§ Determine, for each person

§ How much he would pay to get the change (+) or prevent (-)

§ Sum those numbers

§ If positive, an improvement

Ø Misunderstandings

§ We don’t determine it by asking but by how people act

· For instance, if I offer you an apple for a dollar and you buy it

· That is evidence that the apple was worth more to you, less to me

· Hence that, if nobody else was effected, that change was an improvement

§ We are talking about changes in value to people, not flows of money

· Apple case, same nbr of dollars before and after, but improvement

· Same improvement if I lost the apple and you found it

· Or if you stole it.

Ø Problems

§ We are judging by actions but people may not know what is good for them

· Insulin to a diabetic is valuable

· And heroin to an addict

· And potato chips and spare ribs to me

· As shown by their actions

§ We are only allowing for values to humans

· Perhaps there are things that matter whether or not they matter to people

· Redwood trees. Live oak in my back yard. Lightning bolt

· Mona Lisa?

§ We are ignoring the different amounts of happiness measured by a dollar.

· Most obviously, rich vs poor

· Less obviously, ascetic vs materialist.

v Answers to problems

Ø People may not always know, but what alternative is there on which we can base legal rules?

§ Someone else not only may not know what is good for me, he may make the decisions in his interest rather than mine.

§ Expertise I can always borrow.

Ø Other values

§ Might be real, but …

§ Except as they are valued by people

§ How are they going to affect human action?

§ The tree can’t sue.

Ø Rich/poor etc. Arguably the strongest.

§ One answer is that courts don’t have much power to redistribute.

· Consider court that routinely favors poor tenants

· The result is to raise the cost of landlords who rent to them

· And ultimately to make housing less available or more expensive to poor people

· Consider Ch1 discussion of nonwaivable warranty of habitability

§ Another version is that redistribution through the tax system makes more sense.

§ Marshall’s was that for most issues it averages out.

§ Final answer is that it is much easier to see how to create institutions to maximize value than to maximize happiness

· Value demonstrated, in comparable form, by market acts

· Every time I buy an apple

· So a market gives us a way of maximizing value. Book—w third party.

· How do you demonstrate utility of an apple.

v Conclusion

Ø Considered as a normative criterion, efficiency is a proxy for utility/happiness

§ Used because it is much easier to implement

§ And the legal rules that maximize it are close to those that would maximize happiness.

Ø Considered as a predictive criterion, efficiency is probably better than happiness

§ What affects legislatures is how much money they are offered to vote for a bill

§ What affects litigation is how much people are willing to spend

§ Only if judges are deliberately trying to do good might happiness make more sense, assuming they could separately maximize it.

v Note for economics students

Ø Two other concepts of efficiency in the textbook

§ Pareto efficiency

§ Hicks/Kaldor efficiency

Ø For reasons I don’t use either, see my webbed price theory chapter on efficiency.

v Alternatives?

Ø Can you offer a better general criterion of goodness?

Ø How would you operationalise it?

Ø [Efficient Murder as a counterexample?]

Ø Note that economic analysis of law doesn’t require efficiency

§ It is an interesting conjecture

§ Perhaps an attractive normative criterion

§ But the same tools could be used for other purposes

v Implications for the law

Ø Not “the court should decide who should win according to which outcome maximizes the efficiency for those people”

§ Most of the time, the court it just shuffling money

§ And in criminal law it is imposing punishments, which are costly.

§ But…

Ø The court should establish those rules that result in people acting in the way that maximizes efficiency.

Ø Punish me for pushing my uncle off the cliff

§ Not because that makes me or my uncle better off

§ But because it saves future uncles from their nephews

v Starting point: Property, trade, laissez-faire

Ø Every object moves to the person who values it most—like apples.

Ø Objects get produced if and only if the summed value to those who most want them is greater than the summed value of the inputs.

Ø Lots of complications in working out this argument to show that the result is efficient

§ Sufficiently interested parties can read my price theory book, or someone else’s

§ But we will let the short argument stand for why it is true

§ And worry instead about why it isn’t.

v Implicit assumptions

Ø Only voluntary transactions.

§ Exceptions include not only crime but also

§ Torts and even …

§ Perfectly legal acts.

Ø Transaction costs

§ We are assuming that if a transaction would benefit both parties, it happens

§ How about the transaction by which I get permission to exhale?

1/16/07

v Review: Economic efficiency

Ø Maximize net benefit summed over everyone

Ø Measured by willingness to pay

Ø Revealed in people's choices.

§ For instance, letting me sell you my apple

§ Which happens only if it increases efficiency

§ Generalize to freedom of exchange

Ø Problems

§ Individuals may not be good judges of their own interest--but who is better?

§ There may be values other than to humans

· but how can they be served?

· End up as arguments used by people for achieving their values

§ A dollar is a poor measure of happiness

· But still the right measure for predicting outcomes

· Legal rules may be a poor mechanism for redistribution

· Efficient legal rules may also be utility maximizing beause of averaging effects

v The Efficiency Theorem—when it does work (defined as max efficiency)

Ø In a perfect competitive market

§ P=MC=MV (explain)

§ So any unit worth producing, and only those, gets produced.

§ And it is produced in the least costly way, because

· Firm wants to minimize cost to maximize profit, and …

· All its costs are prices which are someone else’s MC.

Ø Real world might deviate in lots of ways

§ Monopoly (antitrust chapter)

§ Uncertainty plus information costs (uncertainty chapter)

§ Involuntary transactions

· Externalities

· Crime

· Tort

§ Transaction costs

· Suppose we start with everyone having an injunctive right against CO2 poln

· Unanimous contract before I can breath

§ These are less separate than they might seem, as we will see.

v Externalities: First pass

Ø What they are:

§ Positive or negative cost on someone else which for one reason or another

§ You don’t have to get his permission to impose.

§ Some mix of statement about physical reality and about legal system.

· Radio with enough spies. British?

· Good Samaritan law?

Ø Why the result is inefficient

§ Price of final good doesn’t include the whole cost, so produce inefficiently much.

§ Cost of production doesn’t include external, so produce in the wrong way. Stack scrubbers, high sulfur coal, … .

Ø Regulatory solution

§ Government tells the firm how to produce

§ Note that, done perfectly, this includes the cost of optimal reduction, but not

§ Of the external cost that isn’t eliminated

§ And they may not try to do it right

§ Or not be able to

· Figuring out the optimal control methods requires information on cost of control and damage done by externality

· Which firms might have, or generate, but why should they?

Ø Pigouvian solution

§ Government measures the externality, charges for it

§ In the firm’s interest to take optimal precautions, and …

§ Include both costs in the price

§ Still requires the government to measure damage done, and …

§ To want to do it right.

Ø Mechanisms

§ Effluent fee/transferable quota

· Both impose a marginal cost on pollution

· Effluent fee if you know MC, quota if you know Q

· Quota eliminates TC on industry.

§ Tort damages

§ Important differences?

· With tort, the victim gets compensated.

¨ Is that a good thing? Feels fair, but …

¨ Reduces his incentive to avoid being a victim

· With tort prosecution is by victim and his agents, not regulatory agcy

¨ So one way of looking at the damage payment is as a

¨ Bounty to the private prosecutor

v Pecuniary Externality

Ø I become the 101^st physician; each sees ten patients a day

Ø The price of a visit drops from $50 to $49

Ø Costing the other physicians $1000/day—externality?

Ø But it saves their patients the same amount.

v Policy uses of externality arguments

Ø Form of argument—say for population control or child tax or …

Ø Practical problem

Ø Externalities from my having another child?

§ Negative externalities?

§ Positive externalities?

v Rent seeking

Ø Krueger’s example

§ Exchange controls and exchange permits

§ Permits worth $10,000

§ End up consuming that much

Ø Theft and market equilibrium

§ You steal $100—looks like a pure transfer.

§ Competition wipes it out for the marginal thief

§ Some gain for the inframarginal thief, but…

§ Cost of protection for the victim.

§ Prohibiting theft might make everyone better off.

Ø Difference between rent seeking and pecuniary externality

§ Pecuniary externality, A takes an action that transfers from B to C

§ Rent seeking, A takes an action that transfers from B to A

§ So has an incentive to take the action even if not worth taking allowing for effect on B

§ Indeed, seen one way, the standard externality inefficiency.

Ø Rent seeking and litigation

§ Given a legal procedure to transfer costs, sets off rent seeking

§ Justified only if there is some indirect benefit, such as …

§ Deterrence.

§ Hence “let the cost lie where it falls” makes sense in many cases.

11/18/07

v Review

Ø Why the market is efficient in the simple case

§ Price system transmits human costs in dollar form

§ So the least cost way of producing an automobile is the least human cost way

· Costs being labor forgone, or …

· Alternative uses (really the same)

§ Everything produced if and only if worth producing, in least cost way.

Ø Externalities mess it up twice:

§ External cost not included, so “least private cost” production

§ And price of output no longer accurately measures cost

Ø Can solve the first with regulation

§ Provided the regulator is sufficiently benevolent

§ And sufficiently well informed

§ But still leaves the second

Ø Pigouvian tax solves both

§ But still leaves the cost to be determined by a regulatory agency or

§ Court

§ Helps make sense of tort law.

Ø Pecuniary externalities don’t count, rent seeking does.

§ Because rent seeking the transfer provides an incentive

§ To take actions not worth taking

§ A standard externality problem

§ Litigation—an argument for leaving costs where they fall.

v Coaseian critique of Pigou

Ø Nothing Works

§ Candy factory case

§ Tell the story

§ Pigouvian answer—factory must shut down or pay damages

§ But rearranging the doctor’s house might be less expensive, and …

§ Building the consulting room on the other side to start with surely would be.

§ Why bother if he can shut down the factory or be paid damages?

§ The argument is most persuasive where our intuitions are weak

· Recording studio next to a house with small children

· Seismic station next to a steel mill

· Building houses under the flight path.

· I can see your house from my window, so you can't repaint in a color I don't like.

§ Coase gives lots of real examples, but …

· Applies to any situation where we don’t know in advance who is the least cost avoider, or …

· Where both parties ought to take some precautions.

· You should keep noise of your factory down, but …

· I shouldn’t locate noise sensitive activities near it.

· Tort law: Obligation to minimize injury.

§ Note that this means that even with Pigouvian approach, the court must know enough about avoidance control to know who to make liable.

Ø Everything Works

§ Candy factory pays the doctor off

§ With the opposite legal rule, doctor can pay the candy factory off

§ Think of it as a lot of rights, each moving to its highest valued use.

Ø It’s all Transaction Costs

§ So without tort law I still drive, and drive safely

§ If everyone has the right to enjoin (they have the rights) I buy permission

§ If none of them have any rights against me, they bribe me to drive safely.

§ Coase’s farmer and rancher

§ Something wrong here

· Public good problem where the cost is dispersed

· Monitoring problem where the behavior is not easily observed

· Lots of related problems

§ Coase Theorem: If transaction costs are zero, then …

· Note that this gives an efficient result, but …

· Not always the same one.

· It does in Coase’s example, because both farmer and rancher are producing for the market. My life extension pill.

§ So the conclusion is

· If transaction costs are low for the relevant transactions, efficient outcome

· If not, it is the transaction cost that is the problem.

v Coase+Pigou gives you double counting

Ø Explain the problem

§ Pollution damage $1,000,000, hence $1,000,000 fine

§ Abatement cost $1,500,000

§ Victims offer $600,000 for abatement, get it

§ Inefficient

Ø Does it vanish with zero transaction costs?

Ø Only if the government gets to bargain too.

v Bottom line

Ø Pigouvian solution is a special case

§ Where we know the least cost avoider

§ And can measure damage externally

Ø Coase Theorem is a special case

§ Where transaction costs are sufficiently low

§ In which case we don’t have to measure damage externally

§ It’s all market.

Ø Coaseian analysis gives us the general case

§ With some definition of rights

§ And some transaction costs making some moves costly or blocking them

§ What inefficiency will result?

§ Among possible definitions, which leads to the least bad result?

§ Note that options include property and liability rules. And others.

v Possible Legal approaches

Ø Court/regulator decides who is the lowest cost avoider

§ Tells him what to do (regulatory solution)

§ Makes him liable (Pigouvian solution)

§ Requires that the court at least knows the damage and something about cost of avoidance by the other party. or …

Ø Court makes general rules designed to assign liability to the party who will usually be the lower cost avoider

§ Coming to the nuisance as an example

· Is it the right answer—second mover is the lower cost avoider?

· Perhaps not if later use is predictable.

§ Last clear chance as a similar rule

§ Strict liability for keeping a tiger in your back yard—abnormally hazardous activity.

Ø Bright line rules vs standards.

§ Bright line minimizes uncertainty, litigation costs, but …

§ May give the wrong answer sometimes.

Ø Defining property rights

§ Legal rules determine what bundle of rights go with ownership of land (or other things)

§ First step: Is right A most valuable to the person who has right B? Put them in the same bundle and no transaction is needed. Walking and cultivating

§ If right A might be most valuable to the holder of B or of C—adjacent landowners--which is how likely, and how hard is it to move from one to the other?

§ If we guess wrong, are we better off solving the problem by

· Transaction—property rights or

· Court estimate—liability rights.