First Lecture: 8/18/95

• I. Mechanics of Course:
  • A. There is a text (Posner), optional readings on economics (my Price Theory book), and articles both required and optional. Pay attention to page numbers in the syllabus; in some cases only part of an article is assigned.
  • B. There will be a midterm, counting for less than half the grade.
  • C. The final will cover everything, be mostly or entirely essay.
  • D. These lecture notes will be provided each week, covering the previous week.
• II. What is economics?
  • A. An approach to understanding behavior, based on the assumption that Individuals have objectives and tend to choose the correct way of achieving them. Economists call this assumption "Rationality."
  • B. Some Examples:
    • 1. Why Armies run away.
      • a. Everyone is better if nobody runs, but each person is better if he runs away, whether everyone else is running or everyone else is standing. So the army runs, and dies.
      • b. Modern version: Soldiers rarely aim their rifles, because taking aimed shots makes it easier for the enemy to shoot them. The result is a ratio of rounds fired to enemy killed in modern warfare on the order of 100,000 to one.
    • 2. Why Traffic jams. Consider an intersection, which keeps jamming because people try to get across just before the light changes and get stuck in the intersection, blocking traffic in the other direction. Everyone would be better off if everyone entered the intersection only if he was sure he could get across, but each driver is better off following the current policy, given what everyone else is doing.
    • 3. Note the perverse effect of rationality in both cases.
      • a. Rationality is an assumption about individuals, not about groups.
      • b. Individuals acting rationally may or may not lead to the groups made up of those individuals acting rationally.
      • c. So rules matter. Under some rules, individual rationality produces desirable outcomes for the group, under some it does not.
    • 4. We assume rationality because the assumption is useful, not because it is true. People are not perfectly rational, and it may sometimes be possible to take account of our own irrationality or that of people we know well. But rationality is the predictable element in the behavior of people in general. And in some circumstances, irrational behavior is random, so its effects cancel out when we consider the effect of many people's behavior.
• III. What is the Economic Analysis of Law?
  • A. First Project: The consequences of legal rules.
    • 1. If we impose the maximum possible penalty for armed robbery, the additional penalty for murder is zero, so we have made it in the interest of armed robbers to kill their victims.
    • 2. Plea bargaining: At first glance, it should weaken punishments, but it may strengthen them. Prosecutors have limited resources; if 90% of defendants plea bargain, resources can be concentrated on the remaining 10%, making conviction more likely--and making defendants willing to accept harsher bargains.
    • 3. Requiring CD players in cars. Seems to benefit consumers--until we take account of the effect on the price of cars. The same argument applies to requiring hot water in apartments, safe jobs, ... . Fixing one term of a contract in favor of one party is not in general a transfer .
    • 4. Requiring seat belts. Accidents are the result of rational decisions--how fast to drive etc. Making cars safer makes risky driving cheaper, which increases the amount of it. Sam Peltzman actually observed this result by statistical analysis of accident rates before and after a sharp increase in required safety equipment.
    • 5. Civil vs Criminal law often seem to do the same thing in different ways (Conversion and theft, for example, are civil and criminal versions of essentially the same offense). Why have both, what is the relative advantage of each? One advantage of the civil pattern, where the same person owns the claim against the defendant and controls the case, is that out of court settlements are a way of making the system work, while the criminal equivalent (bribes to the police) are a problem that must be prevented.
    • 6. This project is value-free--the question is "what will happen" not "what should happen." But the conclusions are relevant to what should happen, since in choosing rules you would like to know what their effect will be.
  • B. Second Project: Predicting legal rules.
    • 1. The Posner Conjecture: Common Law tends to be economically efficient.
    • 2. One basis might be a plausible mechanism by which efficient law would be generated; you can decide for yourself if Posner offers one.
    • 3. An alternative basis might be evidence that the observed rules of the common law tend to be the same rules that economic theory tells us are efficient. Posner offers a lot of such evidence. One problem is that the conclusions of economic theory are not always clear cut, so a clever economist who knows what the rule is might be able to construct arguments for why it is efficient.
    • 4. This project is also a positive one--explaining what the law is, not what it should be.
  • C. Third Project: Evaluating Legal Rules--Efficiency as a norm
  • D. One attraction of the economic analysis of law is that it ties together diverse areas of law, providing a common theoretical structure.
  • E. Why is it useful for you? To persuade some judges? To make sense of what you have been learning.

8/21/95

•  
• I. What is economic efficiency?
  • A. The problem--evaluating different systems of rules, outcomes, etc.
    • 1. By whose values?
    • 2. How aggregated?
  • B. The economic solution.
    • 1. Revealed preference:
      • a. Heroin or Insulin, the fact that someone is willing to pay lots of money to get it is evidence that it is valuable to him.
      • b. "Utility" gets used in at least two different senses by economists and philosophers. In the usual economic sense, "A has greater utility to me than B" simply means that, given the choice, I will choose A. In the philosophic sense it means something more like "A will make me happier than B."
    • 2. Aggregate effects across people by using willingness to pay as a common unit. We are using value (utility measured by dollar willingness to pay) rather than utility (units of pleasure, or happiness, or something similar). A dollar might represent more utility to one person (poor--or materialistic) than to another (rich--or ascetic) but it represents, by definition, the same value.
  • C. Defense of B.
    • 1. If we wish to describe behavior, revealed preference, not "mind of God values," is the relevant tool.
    • 2. If we wish to predict outcomes, willingness to pay is more relevant than utility. Whether lobbying, litigating, or simply buying goods on the marketplace, one man's dollar will have about the same effect as another's, independent of how much happiness a dollar represents to each.
    • 3. What about using efficiency as a normative criterion?
      • a. Both elements are then problems, but ...
      • b. It is not clear one can do better. God is not available to run the society. Other people are availabe to make choices for us, but even if they (sometimes) know what is good for me better than I do, they are less certain to seek my good than I am. They may take the opportunity to seek their own good at my expense.
      • c. Many economic choices involve gains and losses to large and diverse groups, in which case differences in utility/dollar may average out.
      • d. Even if efficiency is a good proxy for utility, however, is utility all that matters? If there are utility monsters (people who feel much more intently than the rest of us do) should we devote all of our resources to their pleasure? If you can save the lives of three people about to be lynched by framing one innocent person for the crime, should you do it?
      • e. Utility is probably not all that matters, but it is one big thing that matters, and if we know how to maximize it and don't know how to maximize the rest of what matters (or cannot agree about what it does), then rules that maximize utility (or efficiency as a proxy for utility) may be the best we can do.
  • D. Efficient vs Inefficient outcome: "Efficient" is a sort of outer bound benchmark, relative to the best result we could hope to achieve by any economic system.
    • 1. I define a "bureaucrat god" as someone who knows everything anyone in the society knows, and has unlimited ability to calculate how to coordinate people's actions and to make them do what he tells them to.
    • 2. An outcome is efficient if a bureaucrat god could not improve it ("improve" in the sense we have been discussion--make a change that produces total benefits larger than total costs).
    • 3. If an outcome is efficient, no change in the economic/legal system can improve it, since we have no tools available that the bureaucrat god does not also have.
    • 4. If an outcome is inefficient, we might be able to improve it. But we also might not, since we have no bureaucrat gods available to run our economy.
  • E. Other definitions of efficiency.
    • 1. Pareto:
      • a. An improvement is a change that benefits someone, hurts nobody.
      • b. In practice, few changes in legal rules and the like are pareto improvements.
    • 2. Hicks/Kaldor:
      • a. An improvement is a change that would be a pareto improvement if combined with suitable transfers among those affected.
      • b. This almost always gives the same conclusion as Marshall's definition (what I started out explaining).
    • 3. Both of these make it look as though you are not trading off gains to one person against losses to another, when in fact you are. That is why I prefer Marshall's approach.
  • F. What matters is that you understand these ideas, not that you agree with them.
    • 1. Accept rationality as a working hypothesis for this course.
    • 2. Take Posner conjecture as a conjecture, look at evidence for and against.
    • 3. Feel however you like on the third project.

8/23/95

• 0: [Digression] Revealed preference as a tactic:
  • A. An economist wants to buy a used car. He finds one that fits his requirements, asks the seller if he will provide a guarantee for an additional charge. Answer: no. The economist keeps looking until he finds one willing to offer the guarantee, then buys the car, does not buy the guarantee.
  • B. An island is inhabited by two tribes; members of one always tell the truth, members of the other always lie. You come to a fork in the road; one way leads to the village, one way to a swamp full of poisonous snakes. A native is standing there, but you do not know which tribe he belongs to. How, with one question, do you find the road to the village?
    • 1. Traditional solution: "If I asked you which road leads to the village, what would you answer?" The liar would tell you the wrong road, but he lies about what he would do, which brings you back to the right road.
    • 2. This would not really work, since the native, not being a logician, will assume your question is just a fancy way of asking "which road leads to the village."
    • 3. Economist's solution: "Did you know they were giving away free beer in the village?" Then follow him.
  • C. You want to know if a new professor is planning to stay; you get one question. Solution: "Did you buy or rent the house you are living in?"
•  
• I. Efficiency of competitive equilibrium. Assume perfect competition, full information.
  • A. No firms:
    • 1. Individual consumer buys until the value of the last unit of the good is just down to what it costs: MV=P.
    • 2. Individual worker produces until the cost to him (in work, lost leisure, ...) of the last unit he produces is equal to what he can get for it: MC=P so ...
    • 3. Units are produced and consumed if and only if the value to the consumer is at least as great as the cost to the producer, which is the efficient outcome.
    • 4. Note that this requires perfect competition, since both producer and consumer must take price as given. If the producer believes that additional production will drive down the market price, he will produce less than the optimal quantity, since his "cost" of producing the last unit includes lost revenue on previous units, which is not a social cost (his loss is the buyers' gain).
  • B. With firms:
    • 1. Price of labor represents its cost, as above.
    • 2. Price of other inputs represents their value in alternative uses.
    • 3. So firm gets right signals below and above. The price the firm pays for its inputs and receives for its output represents the real cost to other people of its using those inputs and value to other people of its producing those outputs.
    • 4. So the firm, in trying to maximize its profit, produces optimal quantity in least cost way.
    • 5. Competitive layer cake. Firms may produce goods that are inputs for other firms, but the same argument still goes through, with the firm transmitting the real cost of the inputs used to make its output to the next firm up the ladder in the form of the cost of buying that output.
  • C. If this were a full description of the real world, then the optimal legal rule would be simple: Laissez-Faire. No legal or governmental interference with market outcomes (this is a little too simple, since market outcomes may depend on things such as how property rights are defined). But ...
  • D. The world departs from this picture in a variety of ways, providing arguments for a variety of legal or political interventions (as well as for particular decisions about how to define property rights, ...).
    • 1. Imperfect competition (later)
    • 2. Error (I assumed each party has full information about the facts immediately relevant to him--the quality of the good he buys, prices of alternative goods, wages in alternative jobs, ... .)
    • 3. Conditions for voluntary transaction may not be met. For instance
      • a. Cost of defending and seizing property rights--theft, lobbying, etc. If I can get money by a forced transfer, whether private or political, that is an incentive for me to spend resources doing so that does not correspond to an actual social benefit.
      • b. Producer cannot control consumption (public good, positive externality)
      • c. Inputs are used without permission (negative externality)
      • d. Inputs are not owned--perhaps because defining and enforcing property rights in them is very costly. This is the "commons" problem--common property gets overused (a pasture overgrazed, for example) and underinvested in (nobody fertilizes it).
  • E. This suggests a variety of solutions: Regulation, taxation, changed legal rules, but...
  • F. They are imperfect solutions.
  •  
  • 8/25/95
•  
• III. Traditional Market Failures
  • A. Externality.
    • 1. Negative externality, such as pollution--or playing loud music at 2 A.M..
      • a. What is inefficient is not the fact that there is a cost (worse health or more frequent clothes washing due to pollution, say) but that, because the cost is not born by the person who produces it, he does not take account of it in deciding what to do. So we get pollution (or loud music) even when the benefit of producing it is less than the cost it generates.
      • b. Regulatory solution: Tell steel mills how much they can pollute or how high their smokestacks must be or ...
      • c. Pigouvian solution: Charge polluters the cost generated by their pollution. Possible mechanisms include effluent fees, tort damages, or marketable pollution rights.
      • d. Why c>b, but not necessarily adequate.
    • 2. Positive externality. It may not be unjust but the result is still inefficient.
      • a. Basic research. Subsidize?
      • b. Not so basic research: Patent?
      • c. What about a negative tort system--when I do something that benefits you (repaint my house in your neighborhood thus making it beautiful and your house more valuable) I can sue to make you pay me for it. In a few situations something like this exists, as when I repair the fence between our properties (under CA law, I think). Why is it much less common than tort damages for negative externalities?
    • 3. The law of nuisance is a common law approach to dealing with externalities. Indeed, much of both tort law and criminal law can be viewed that way.
    • 4. Suppose my action imposes a $10 cost on A and a $10 benefit on B, neither of which I have to pay for. Net external costs are zero, so by deciding on my action while ignoring the external costs I make the right decision.This is a "pecuniary externality," one that results in a transfer between two other people.
    • 5. Posner's example in the book is a pecuniary externality, but not for the reason he gives. Suppose I go into business and get your customers by offering them a lower price. Posner says this is pecuniary because it is a tranfer from you to me
      • a. If he were right, it would not be a pecuniary externality, any more than theft it. It would give me an incentive to bear cost in order to go into business (to benefit at your expense) even if there was no corresponding social benefit.
      • b. But he is wrong. It is a pecuniary externality because the gain to your old customers is at least as great as the loss to you. Your cost must be at least as high as the new price, otherwise you would have matched my price cut. You have lost (old price-your cost), your customers have gained (old price-new price)>= (old price-your cost) so I have not imposed a net cost on you+your customers.
  • B. Public Good.
    • 1. A public goods is a good that:
      • a. If produced will be available to all the members of a pre-existing group of people (i.e. the producer cannot control who gets it)
      • b. One individual's consumption does not interfere with another's. (In my view, this is the less important feature)
    • 2. Very much like a positive externality. The difference, insofar as there is one, is that we think of a positive externality as a side effect of activity done for some other purpose, while a public good is something we are producing intentionally.
    • 2. Note that a public good does not mean a produced by government. A radio broadcast is a public good produced privately; mail delivery is a private good produced publicly.
    • 3. One problem with producing a public good is that a potential consumer has little incentive to pay for it, since whether he gets it depends on whether it is produced, not whether he pays.
    • 4. Solutions?
      • a. Unanimous contract--I'll pay if and only if all of you do. Everyone is better off signing than not signing.
      • b. One problem is that whoever draws up the contract must know the value of the good to each consumer, in order to avoid overcharging someone--who will not sign, which means nobody else will pay either.
      • c. One solution is to limit the contract to a small number of consumer who happen to get a lot of the benefit--a so-called "privileged minority" (privileged to pay for what everyone else also gets!). An extreme example is when I paint my house or mow my lawn, benefitting my neighbors. I am a privileged minority of one.
      • d. There are a variety of other solutions, such as tie-in sales.
    • 5. So public goods get underproduced, especially with large publics.
  • C. Problems with all solutions:
    • 1. How does regulator/court/etc. get necessary info, and ...
    • 2. What are his incentives?

8/28/95

•  
• I. Coase: My version of his ideas.
  • A. Nothing works: Pigou refuted.
    • 1. A train throws sparks that start fires in adjacent cornfields. The railroad company could install a spark arrester, at some cost, that would prevent the fires.
    • 2. Pigouvian solution: Charge the train for the cost of the fires.
      • a. If Cost(arrester)<Cost(fires), they install the arrester and there are no fires.
      • b. If Cost(arrester)>Cost(fires), they do not install the arrester and there are fires.
    • 3. But what if the efficient solution is for the farmers to switch to growing clover (or nothing) along the track?
      • a. We will temporarily avoid some problems, involving transaction costs and strategic behavior, by ...
      • b. Assuming that one farmer owns all the land along the track.
    • 4. The problem here is that the "externality" is due to two people's actions. There would be no fires without sparks, but also no fires without inflamable crops in the land where the sparks are falling.
    • 5. Suppose we try to give the farmers an incentive to prevent the fires by changing the legal rule: The train can throw sparks and is not charged for the damage done.
      • a. If cost(clover)<cost(fires), we get clover, otherwise we get fires, but ...
      • b. We do not get a spark arrester, even if that is less costly than either of the other two alternatives (switching to clover or having fires).
    • 6. Result: Pigou's approach works if you impose the cost onthe right person--the one who can avoid the problem at lowest cost. But it does not work in the general case where you do not know in advance which party is the lowest cost avoider.
  • B. Everything works: The Coase Theorem
    • 1. Suppose the train is charged for the damage, there is only one farmer, and switching to clover is the cheapest way of dealing with the problem. The railroad will pay the farmer to switch to clover, making both parties better off.
    • 2. Suppose the train can through sparks with impunity, and a spark arrester is the cheapest way of dealing with the problem. The farmer will pay the railroad to install the spark arrester, making both parties better off.
    • 3. The Coase theorem--first try: As long as property rights are clearly defined and transferrable, how they are defined and who has them will not affect how the property is used.
      • a. Qualification 1: This depends on assuming that there are no transaction costs (see below)
      • b. Qualification 2: Different initial allocations of property rights imply different distributions of income, which imply different patterns of demand and thus differentuses of property. In Coase's examples the potential claimants to the rights were not the consumers of the goods being produced, so that effect could be ignored.
      • c. Second Try: As long as property rights are clearly defined and transferrable and transaction costs are sufficiently low, the property will be used efficiently--although different initial definitions will lead to different distributions of income and thus different efficient outcomes.
  • C. It all depends on transaction costs.
    • 1.We now drop the single farmer assumption: there are lots of farmers along the RR line.
    • 2. Suppose the train has the right to throw sparks, and the spark arrester is the least cost solution. The farmers face a public good problem in trying to raise the money with which to pay the railroad to install the spark arrester.
    • 3. Suppose the railroad is fined for the damage it does and the the spark arrester is the least cost solution, but switching to clover is cheapter than having fires. The railroad might keep throwing sparks and paying the fine, in order to induce the farmers to switch to clover and eliminate the cost and the fine.
  • D. Some alternative legal rules to think about:
    • 1. Absolute right:
      • a. Railroad not liable nor fined, or
      • b. Farmers can enjoin.
    • 2. Right subject to Pigouvian tax
      • a. Railroad has the right to throw sparks, but is fined for the cost that it imposes by exercising that right (i.e. the cost of the resulting fires).
      • b. Farmers have the right to be free from sparks,but are then fined for the cost they impose by exercising that right (the cost of the spark arrester which their injunction forces the RR to install).
    • 3. Right subject to tort liability (pigouvian tax paid to the victim instead of the govt)
      • a. Railroad can run, but gets sued and must pay the farmers the cost of the fires.
      • b. Or farmer can enjoin, but get sued and must pay the RR the cost of the spark arrester.
  • E. Transaction cost story for each:
    • 1. Absolute right:
      • a. Railroad not liable nor fined, or ... Public good problem for farmers bribing RR
      • b. Farmers can enjoin. Holdout problem for RR bribing farmers.
    • 2. Right subject to Pigouvian tax
      • a. Railroad fined for fires. Strategic: RR runs, forcing farmers to switch to clover, since there are no more fires it no longer must pay fines.
      • b. Farmers can enjoin, but are then fined for the cost of the spark arrester.Since any one farmer can enjoin, and will pay for the spark arrester if he does, each has an incentive to let someone else do it. Who will bell the cat?
    • 3. Right subject to tort liability (pigouvian tax paid to the victim)
      • a. Railroad can run, but gets sued. This one works, provided that the court can accurately measure the damage done by the fires.
      • b. Or farmer can enjoin, but get sued! This does not work, for the same reason as 2b above.
    • 4: "Answer." If damage is measurable, and the conflict is between a single party on one side and many on the other, make single party liable for tort damages!
      • a. What we are doing is considering different possible initial rules, different outcomes that might be desirable, and the routes from each rule to each outcome. We are looking for a rule that can get us, reasonably easily, to any of the outcomes (fire/clover/spark arrester) that might be desirable.
      • b. If we actually write the rule as in 4. above, we give actors an incentive not to organize themselves as a single party even if it would be efficient to do so. The RR splits into three firms running trains along the same line so as not to be liable under the rule. Or the farmers don't consolidate their holdings into a single agribusiness corp., even though doing so would be efficient, because they want to keep the RR liable.
      • c. Perhaps we should instead define the rule based on who we think is likely to be the single party--for example, the RR is always liable, because there are usually a lot more farms than RRs in such a conflict.
  •  
  • 8/30/95
  •  
  • F. The approach can be described with a spaghetti diagram.
    • 1. Possible starting rules in a column on the left, possible property uses in a column on the right, a line connecting each rule to each use.
    • 2. Each line is labelled with transactional problems of getting from that rule to that use.
    • 3. To pick a rule, you start with some estimate of how likely each use is to be the optimal one and how difficult each transactional problem is.
    • 4. You choose the rule that minimized the sum of expected transaction costs and expected losses through not getting to the efficient rule.
    • 5. If you knew with certainty what the optimal use was going to be (clover, say), you would pick a rule that got to that use with minimal transaction costs (RR has absolute right to throw sparks)
    • 6. But you are writing general legal rules designed to cover a wide range of cases, so you don't know.
  • G. Bundling property rights.
    • 1. What does ownership of land (for example) mean?
      • a. What rights: how low can someone fly over your land without violating your rights? Can someone transmit radio signals across your land? Can someone take oil from under your land? Can someone take oil from under his land, making the oil under your land flow under his, then take that? Can someone send seismic shocks through your land in the process of learning the geological structure so as to get oil from under his land?
      • b. How can your rights be enforced? Can you enjoin or only sue for damages? (How about shooting trespassers?)
    • 2. Real world issues include:
      • a. The law of nuisance
      • b. Injunction vs damages
      • c. People have a right to be free from all injury (strict liability) or only from negligent injury (negligence)
      • d. A boat ties up to someone else's dock in a storm. Is the owner liable for injury to the dock? Can the dock owner refuse permission or cast off the boat, and if so is he liable for the resulting damage to the boat?
      • e. Domestic and wild animals. Ownership and liability.
    • 3. The answer in principle
      • a. Assign rights to the highest value user (or bundle rights so that rights that are most valuable if held together are in the same bundle)?
      • b. But the court does not know highest value user. Rule a above results in lots of resources being spent by people trying to persuade the court that they are the highest valued user of something and should therefore be assigned ownership of it.
      • c. Define rights in a way which gets them to the highest valued user, either:
      • Directly or
      • Through transactions.

9/1/95

•  
• I. Acquiring Property Rights: The Rent Seeking Problem
  • 1. Litigating: Parties are spending resources trying to get a damage payment (paid by the other side) or avoid paying damages. So one party's gain is another party's loss. So there is no obvious reason to expect an efficient level of expenditure on litigation.
  • 2. Homesteading:
    • a. Individuals got rights to valuable land by being the first to cultivate it for some period of time.
    • b. That gave an incentive to premature cultivation, since if you waited until farming the land actually covered its cost, all the good land would already be taken when you arrived.
    • c. In the simple case of perfect information and identical homesteaders, the result is to dissipate all of the value of the land in the cost of premature homesteading.
    • 3. Patent/Copyright: Incentive may be good--but not in any quantity. By being the first to invent, you get the patent--although inventing something a week earlier provides only a small social benefit. So there is an incentive for inefficient patent races.
•  
• III. Coase from Coase. So far I have been giving my summary of Coase's ideas; it is now time to discuss his version in the article you have read.
  • A. Note the joint cause problem he points out.
    • 1. Cost arises from joint actions of two parties, vanishes if either stops.
    • 2. To get the correct incentive you should put all of the cost on each party!
    • 3. Consider auto accident as continuous case, where the probability of an accident happening is a function of expenditures on precautions taken by both parties.
      • a. Making one party liable for damages to the other gives him the right incentive, since he bears all of the cost of an accident and thus gets all of the benefit of a reduced probability of accident due to his precautions, but it eliminates any incentive for precautions by the other party.
      • b. A fine is a little better, since it gives one party the right incentive and leaves the other with at least a partial incentive (he bears his own accident costs).
      • c. You get the right incentive (in a context without transactions between the two parties) by fining each party an amount equal to the damage to the other party. Now each party bears the full cost.
      • d. But if transactions between the parties are easy, either b or c leads to too much precaution, since the parties combined accident cost is greater than the social cost, giving them an incentive to get together and agree to reduce the accident probability below its efficient level.
      • e. In that context, either rule a or a rule of no liability, no fine, works fine--the Coasian solution. On the margin each party bears the full cost of the accident, in the combination of his own accident cost and the opportunity cost of turning down a bribe from the other party to increase precautions and reduce the other party's accident cost.
  • B. Firm (joint ownership) is another solution to problems of this sort.
  • C. In fact, substantial inefficient externalities are typically nuisances under the common law (or at least the law can be interpreted that way); typically the reason the externality does not make one party liable is a statute eliminating the liability.
  • D. In particular, Pigou's example of sparks and forests is such a case.
  • E. And his theory is wrong, because the farmer, by choosing to grow inflammable crops near the railroad line, is also a cause of the fires.
  • F. Rent Seeking provides an argument for stable bright line rules, so as to hold down the costs of trying to change the rule, or trying to get a court to decide in your favor when the rule is a fuzzy one.
  • G. There is a sense in which this whole argument hinges on implicit assumptions about the limitations of courts.
    • 1. For example, consider a context where the RR is fined for the costs produced by its sparks. The RR keeps throwing sparks, even though the spark arrester is the least cost solution. The farmers switch to clover. A sufficiently clever court would realize that the cost to the farmers of growing clover instead of wheat was being imposed by the sparks, and fine the RR accordingly--in which case the RR would install the spark arrester.
    • 2. But in practice the farmer's lost income due to growing a less profitable crop is much harder to observe, and to prove in court, than the loss due to fires that actually happen.
    • 3. Consider the extreme form of the argument: An omniscient court could simply decree the efficient outcome.

9/6/95

•  
• I. Intellectual Property: The Law, a sketch.
  • A. Copyright Law
    • 1. Applies to expression, not idea.
    • 2. Applies mostly against literal copying
      • a. A bit vague at the edges--Superman (or his copyright owner) won an infringement suit against another superhero that was too similar to him.
      • b. Similarly, a movie derived from a book would violate the book's copyright even if there was very little verbatim copying.
      • c. In computer law, the issue of non-literal copying has become an important one.
      • d. The Mise en Scene exception: Even literal copying cannot be prevented if what is being copied is the only way of expressing a particular idea ( Southern mansions covered with magnolias as a symbol for ...).
    • 3. Copyright protection has very weak requirements of originality. The information in a phone book is not copyrightable, on the grounds that producing it was a mechanical process requiring essentially no human creativity at all--and there is some doubt even about that decision.
    • 4. Copyright provides very long protection.
  • B. Patent Law
    • 1. Applies to the idea, not just the expression.
      • a. Inventor must describe the best implementation he knows, ...
      • b. But better implementations are still covered by his patent, and
      • c. Constructive reduction to practice is now an option, which means that he does not have to actually produce a working model--just a description from which a patent examiner believes that one skilled in the art could produce a working model.
    • 2. Novel and non-obvious.
      • a. The inventor hasn't been doing it for more than a year
      • b. Nobody else has been doing it in public for more than a year
      • c. One skilled in the art could not readily figure out how to do it.
    • 3. Useful.
      • a. In the 19th c. this was interpreted as "not positively undesirable," on the theory that giving a patent on a useless invention did no harm. A famous case stated that an invention to assist debauchery or private assasination would probably not be found patentable.
      • b. One infringer actually won by using this standard to challenge the validity of the patent he infringed. He argued that the invention was positively undesirable, so the patent was invalid, so he should be allowed to practice the undesirable invention. It was a process to mottle tobacco, thus making it look like tobacco that came from places whose product was of high quality--a legal fraud on the consumer.
      • c. More recent courts have given more substance to the requirement of utility, holding, for example, that a process to synthesise a chemical with no known uses is not useful, thus not patentable.
    • 4. Bounds of the invention are set by the claim.
      • a.If too broad, you don't get patent. Either because someone else has already done something that fits your broad claim or because the court thinks you are claiming more than you invented--a very fuzzy idea. Morse's sixth claim (disallowed) was for all ways of using electromagnetism to transmit letters and figures to a distance--and thus covered the fax, EMail, TV, ... as well as the telegraph he had actually invented.
      • b. If the claims are too narrow, the patent is not worth much.
    • 5. First to invent gets the patent in the U.S., first to file elsewhere.
    • 6. Relatively short protection.
•  
• II. The Economics
  • A. Why have protection?
    • 1. Traditional answer: Incentive to produce writings and inventions.
    • 2. To discourage secrecy
      • a. make secrecy unnecessary.
      • b. Giving up secrecy is the price of getting a patent, since you must reveal the best method of practicing the invention that you know, in sufficient detail to allow others to practice it.
    • 3. Kitch homesteading alternative--to propertize.
      • a. Once a range of ideas has been converted into private property by a patent, the owner can develop it, just as a prospector who has filed a claim can develop the mine without worrying about other people digging holes next to his and taking "his" ore out.
      • b. Value of property is also an incentive to find minerals, or invent things, but ...
      • c. Is it the right incentive?
  • B. Why not use Contract instead of intellectual property?
    • 1. The originator of a work or invention transfers it to others on condition that they agree not to make copies or use the idea, and only to transfer it to other people who accept the same agreement. Instead of suing someone for violating your patent or copyright you sue him for violating his contract with you.
    • 2. Copyright. The problem of enforcing it against innocent (?) 3rd party.
      • a. Could be done, by a legal system in which the buyer has only bought part of the bundle of rights corresponding to the work. He does not have the right to make copies, so cannot sell it to others.
      • b. This is the way our legal system handles restrictions on real property, such as easements and restrictive covenants that "run with the land."
      • c. But extending it to other forms of property, without the elaborate registration systems we have for land, could be a problem, and is something our legal system is generally reluctant to do.
    • 3. Patent.
      • a. Using contract instead of patent is done to a considerable extent--Trade Secret law. The rule on innocent 3rd parties who get a trade secret through someone else's violation of his obligation, without knowing the are doing so, is that they can practice the secret only if not doing so would impose serious costs on them (i.e. if they have already built the factory using the secret process).
      • b. But there is a serious problem with this approach in situations where use and sale of the patented good, or the good produced by the patented method, reveal the invention. It is hard to enforce a contract binding every buyer to hide the good he bought from everyone who will not agree to respect the inventor's sole right in the ideas it embodies.
    • 3. The issue of contract as a substitute for intellectual property may become an issue again over computer networks, where new technology may make the enforcement of intellectual property law very difficult.
  • C. Why do we have different patent and copyright rules, and why are they applied to the things they are applied to?
    • 1. Constitution refers to "writings and discoveries" but does not specify the rules for each.
    • 2. Commons problem
      • a. Small for copyright--if I didn't write and copyright the book, it is very unlikely that someone else would have written it.
      • b. Big for ideas. So we have much tighter rules and shorter protection for patents.
    • 3. Costs of fighting over fuzzy boundaries are an argument against protection.
      • a. The domestication of dogs may have made private property in land practical, by greatly reducing the cost of knowing when someone was trespassing.
      • b. Literal copying is easy to spot and prove.
      • c. Copying of ideas is much harder.
      • d. So we have easier and longer protection for copyright.
  • D. Copyright Protection for software.
    • 1. Not a writing (more like a cam--some courts got that right).
    • 2. But has the characteristics that make copyright suitable to writings.
    • 3. As long as protection is limited to literal copying.
    • 4. A lot of problems appear when you push it to cover non-literal copying.
  • E. Patent protection for software.
    • 1. Supreme court opposed it under the "mental steps doctrine," (you could not patent something that was simply a series of mental steps, such as the rule for doing long division) but ...
    • 2. Gradually backed down, under pressure from the CAFC, which was an inferior court but knew more about the subject and had stronger opinions on it.
    • 3. Many believe creating a problem
    • 4. Not because software is not an invention, but because its characteristics may make protection cost more than it is worth.
      • a. A new field, so courts don't understand it very well and give patents for things already in the art.
      • b. Very fast changing.
      • c. Arguably the cost writing programs is lower than the cost of making machines, so the incentive of patent may be unnecessary. Lots of programs were written and lots of progress
  •  
  • 9/8/95

III. General argument: Property rights are more or less desirable depending on issues such as commons cost in creating, enforcement cost on boundaries, transaction costs in exchanging.

• A. Boundaries. Floating islands story: Stack island floated down the Mississippi (erosion at the upstream end, deposition at the downstream end), into the strip of the river where all islands belonged to the owner of the coastal land. Property rights would be hard to work with in a world where that was the norm instead of the exception. Arguably, in intellectual property it is.
  • 1. In patent--what is the boundary of an idea?
    • a. This shows up as the question of what does or does not infringe a patent.
    • b. And in how much you can claim--Morse's 6th claim.
  • 2. In copyright? Not much of a problem defining boundaries if we if only prevent literal copying, since it is easy to see if that has occurred. But as you get farther from that ...
    • a. Advertisements suggesting the framework of a popular cartoon series may infringe its copyright.
    • b. The movie Dr. Strangelove seems to have been based on the novel Red Alert, although with large changes.
• B. Defending. Dogs and property rights.
  • 1. Changes in technology change what rights can be enforced. The widespread availability of copiers means that copyright can no longer be enforced against people who make small numbers of copies for their own use. Similar arguments apply to enforcing copyright in computer programs.
  • 2. One approach to dealing with enforcement issues is to enforce your rights, not against those violating them but against those making the violation possible, under the doctrine of contributory infringement. In one case, a firm had a process patent on a way of using a chemical in growing rice. Other firms sold the (unpatented) chemical, along with instructions on how to use it--the purchasers then violated the patent. The patent holder sued the firms selling the chemical for contributory infringement and won, there being no other substantial uses for the chemical.
• C. Transaction costs
  • 1. problems with contracting over ideas. In order to sell you my idea I have to tell you what I am selling--at which point I no longer have anything to sell. It is possible to get around this sort of problem, but hard.
  • 2. Chasing large animals across private property. It would be costly to bargain with each property owner when you reach his boundary for the right to cross his property--and while you were bargaining the animal would be getting away.
  • 3. Propertising English. Suppose each word belonged to its inventor. Writing a sentence would require a lot of licensing negotiation. One argument against patents for software is that they present a similar problem. A programmer must do a patent search on every programming trick he uses to make sure someone has not patented.
  • 4. Joint ownership v corporation. Suppose a piece of land is owned by 100 people, each of whom has veto power over its use. Getting it used may be hard. One solution is to divide the land up, another is to use the threat of division, perhaps under a "I cut you choose" sort of rule, against those who try to hold out for a large share of the gains. Another alternative is to have it jointly owned, but with the owners stockholders of a corporation.
• D. Creation of Property rights: Rent seeking problems.
  • 1. Homesteading.
  • 2. Patent races.
  • 3. This should not be a problem for copyright. Nor is it a problem that someone who builds a house or an automobile then owns it. What is the difference?
  • 4. Crucial difference--homesteading or a patent race takes something from the commons--that is to say, it eliminates a valuable opportunity (to homestead that piece of land or make that invention) that other previously had. The other examples do not
  • 5. In other words, such an act confers a negative externality on others.
  • 6. But this may be a good thing if there is a positive externality to be balanced.
    • a. Perhaps the homesteading law was a good idea, because settlement that was "premature" in terms of the profit of farming to the farmer was not premature in terms of total costs and benefits. The first settlers might provide a "defense externality" by each making it easier for the others to defend themselves against Indians (or Canadians in the Pacific Northwest or Mexicans in the southwest).
    • b. Similarly, the inventor generates not only knowledge that he owns (how to practice his patent) but also knowledge (how to make other inventions outside of the patent, by using unpatented parts of his idea) of value to others. This is an argument for giving him a benefit in exchange (at other people's expense), but it is not an argument for making the benefit depend so heavily on when he makes the invention, since we get very little extra from his making it a week earlier--which may be what gives him the patent.
    • c. How soon we want something invented depends in part on how rapidly the cost of inventing it is falling with time. If it costs the same amount to invent it this year as next year, we might as well invent it next year; if it costs ten times as much to invent it a year earlier, we might be better off waiting. One advantage of trade secret protection over patent protection is that it gives qualitatively correct incentives in this regard. The faster the cost of inventing something is falling the shorter the period for which you can expect to maintain it as a trade secret, hence the lower the incentive to invent it early.
• E. Supply elasticity.
  • 1. What is the cost of leaving a positive externality external? That depends on how much the reduced incentive reduces output.
  • 2. I get only part of the benefit from not dressing horribly or not ahving a deliberately ugly house. But since it costs me very little (perhaps less than nothing) to do those things, even part of the benefit is enough--so few people have deliberately ugly clothing or houses.
    • a. In such situations, a problem arises only when tastes differ--so that my "deliberately beautiful" (or at least "desirable in some way") is your "deliberately ugly" (punk haircuts, for example).
    • b. Or when one party is malevolent and wants to hurt the other.
    • c. Or when one party is engaging in extortion--imposing costs on others in order to be paid to stop doing so. Most people are strongly committed to a strategy of not giving in and paying off in such situations. That may be why nobody in the class tried to get payoffs in exchange for not blocking a shift to two days a week.
  • 3. Would there be "almost enough" intellectual property even without protection?
    • a. Reputation and other tie-ins provide some incentive. People wrote books, poems, etc. long before the invention of copyright (Homer, Dante, ...). The first firm to come up with a product has a first mover advantage--consumers identify the product with that firm. The first firm may be able to establish standards, and consumers are uncertain whether other firms are successfully imitating them.
    • b. c. 1900 the U.S. did not recognize British copyrights, yet British authors got sizable royalties from their American sales. With large fixed costs and time delays due to typesetting, the first publisher (who got the manuscript from the author) had a sizable advantage over pirates (who had to wait for the first publisher to print his edition before they could start pirating it). Lotus has no patent on the idea of a spreadsheet (which would have gone to Visicalc anyway), yet has a large first mover advantage.
  • 4. A related issue is the supply curve of the copier. A good which is very expensive to copy (paintings, at least until recently, live lectures--although Hal Holbrook's Mark Twain performances may be a counter-example) may not need intellectual property protection.
  • 5. A related issue raised by Kitch is whether it is important to coordinate the production of intellectual property in some area, in order to make sure six people are not working on one part of the problem and none on another. Ownership of the area via a patent is one way of doing this. The owner can hire everyone else, or subcontract, and coordinate their efforts.

IV. Explaining/Justifying the Law?

• A. Why do we have different patent and copyright rules, and for what?
  • 1. The Constitution says "writings and discoveries" but does not specify what the rules are for each, or even that they should be different.
  • 2. Commons problem: The external cost of preventing other people from making your invention or writing your book.
    • a. Small for copyright--nobody else would have written your book.
    • b. Big for ideas. So we have much tighter rules on getting patents, and they provide protection for a much shorter period.
  • 3. Costs of fighting over fuzzy boundaries are an argument against protection.
    • a. Literal copying is usually easy to define.
    • b. Copying ideas is not
    • c. So we have easier and longer protection for copyright.
• B. Copyright Protection for software.
  • 1. A program is not a writing, since it is intended to do something, not to be read.
    • a. John Hersey (author and head of PTO) analogized a program to a complicated cam--some courts agreed.
    • b. Some courts relied on an old case holding that the paper tape controlling a player piano was not a writing, not controlled by copyright.
  • 2. But a program has the characteristics that make copyright suitable to writings.
    • a. You are very unlikely to independently write the same program I have copyrighted
    • b. And if you copy my program, it is fairly obvious, easy to prove.
  • 3. As long as protection is limited to literal copying.
  • 4. A lot of problems have arisen with aprotection against non-literal copying.
• C. Patent protection for software.
  • 1. The Supreme Court opposed it under the mental steps doctrine, but ...
  • 2. Gradually backed down.
  • 3. Many believe creating a problem
  • 4. Not because a program is not an invention, but because software may have characteristics that make patent protection cost more than it is worth.
    • a. It is a new technology, so courts (and patent examiners) don't understand it very well, so peoplle may get patents for things already in the art.
    • b. Very fast changing.
    • c. Invention cost low? I can write a word processor on my own machine using software I own--it would take a substantial shop to do the equivalent for most physical inventions.
    • d. Transaction cost is high if many techniques are owned. A programmer must do a patent search for practically every line--like the problem with owning the English language.

I: Coasian carpool lanes. How do we deal with the externality of congestion? When I decide to drive at rush hour, I slow traffic, imposing costs on other drivesrs.

• A. Pigouvian double cost solution: charge every driver for the congestion cost he imposes on every other driver.
  • 1. "But I am already paying in driving time," since I am one of the people in the traffic jam.
    • a. Wrong. Your decision to drive results both in time costs for you (if you were not driving, you would not be losing time in the traffic jam) and for others. You should pay both in order to have the right incentives.
    • b. This is like the situation where everyone pollutes. Even with perfect symmetry, so that on average everyone bears as much cost as he produces, the result is still inefficient--because on the margin of how much I pollute I bear only a small fraction of the cost.
  • 2. One could vary the charge by where and at what time of day you were driving.
  • 3. Or by how congested it was--leaving it to the driver to predict whether his timing is right.
  • 4. This still does not give the right incentive on all margins--how much congestion you cause may, for example, depend on how fast and how well you drive.
• B. Carpool solution, which is what actually gets used around here, is very imperfect.
  • 1. It provides an incentive (the right to drive in the carpool lane) only on the margin of one person in the car vs more than one. No additional incentive to put four people in one car instead of in two, for example. Nor on whether to drive in rush hour at all.
  • 2. But if transaction costs of full pricing (as in A above) are very high, this might be the least bad practical alternative.
  • 3. But are they high?
    • a. automatic toll collection technology (you pass a radio transmitter which asks your car "who are you," gets back "I am car number 1934791," and bills you accordingly) may make such precise pricing reasonably inexpensive
    • b. A lower technology solution is to forbid cars from the freeway at certain times unless they have paid for a "rush hour commuting sticker." Stickers sold by the year or the day. Singapore has used something like this.
    • c. In some places, such as L.A., when and where you drive also affects the pollution costs you impose, so the same system could be used to internalize those costs.
• C. Internet non-pricing.
  • 1. When you send EMail from here to Chicago, it does not go directly. The SCU machine sends it to a machine that forwards it to a machine that ... . All that is free--the intermediate machines do not bill the originating or receiving machines for their services.
  • 2. Part of being on the Internet is being willing to forward other people's packets in exchange for their forwarding yours.
  • 3. Which seems inefficient--until you consider the costs of billing for each packet, at .02 cents apiece or whatever it really costs.

II. Why have contract law?

• A. Because making contracts enforceable produces net benefits
  • 1. Note that the loss is not the transfer due to opportunism, but
  • 2. the missed opportunities due to opportunism and the threat of opportunism.
• B. But contracts can be enforced in other ways--and are.
  • 1. Within our society:
    • a. Reputation. Why our exterminator kept coming back (after trying, repeatedly and unsuccessfully, to eliminate our fleas).
    • b. Norms: Robert Ellickson's study of Shasta County revealed a society where, for some issues, people ignored the relevant laws and settled their conflicts on the basis of informally enforced norms of neighborly behavior--one of which was not suing each other.
  • 2. Why do countries pay off on their debts?
  • 3. Limitations to such enforcement methods:
    • a. One time killing --making enough by one violation to make up for the reputational costs (countries do occasionally default).
    • b. Some firms are not dependent on reputation (but they don't need long term contracts, since if they did reputation would be important, so the inability to enforce such contracts against them does not matter very much)
    • c. Individuals may not have a reputation outside of local area, so this make work in Ellickson's context of neighbors, but not for forcing me to pay back a loan from a bank in the next state.
  • 4. The substitute for force is information, since reputational penalties only work if it is fairly easy for those dealing with you to find out whether you are a good guy or a bad guy on the basis of your past behavior. This requires ...
    • a. Either a society of neighbors, where people can judge reliability for themselves, or ...
    • b. Specialist courts, producing the information and relying on their own reputation to certify it.
  • 5. What is the Mafia? Perhaps it is mainly such a court system, authorising the use of force against people in the criminal market who have broken their contracts.
• C. Contracts also can be (and are) enforced by the state.
  • 1. Posner jumps from "private solution inefficient" to "public solution superior."
  • 2. But this assumes the public solution will get the law right.
    • a. The private solution has built in market mechanisms for efficiency
    • b. The public solution may not
    • c. We observe people deliberately contracting around courts
    • d. "No one would voluntarily place himself at the mercy of the other party ..." Someone might--if the alternative is placing himself at the mercy of the court.
    • e. Which suggest this is an argument for a default rule only.
  • 3. "Filling in the terms" can be done by arbitration as well--and is.
• D. Arbitration exists in at least three contexts:
  • 1. After the fact to resolve disputes.
  • 2. Before the fact with legal enforceability
  • 3. Before the fact w/o legal enforceability.

III. Filling out missing terms (arbitrator or court).

• A. Some terms are (and should be) missing. There is not enough fine print in the world to cover all contingencies, however unlikely.
• B. If they had considered the contingencies, the parties would have agreed to the efficient terms to cover them, thus increasing the size of the pie that they then divide between themselves.
• C. For that reason, and to maximize the total size of the society's pie, the court should impose the efficient terms.
• D. But ... remember that what terms are efficient depends in part on how competent the court is, and ...
• E. There isn't enough fine print to contract around everything either. So the court may end up imposing inefficient terms if it overestimates its own ability to judge (for example) which party is the best insurer. But what alternative is there if the contract really is ambiguous?
• F. Where the parties do contract around the default terms, the court should respect their contract, except???
  • 1. Apparently inefficient agreement may be evidence of error, fraud, etc.
  • 2. And a contract might be efficient for the contracting parties but impose costs on others--for example a "contract on" someone.

IV. Details (default rules)

• A. Place liability on party who could most easily avoid and/or predict the problem.
• B. In many context, contracting parties face a competitive market before they contract, but are locked into bilateral monopoly once they have signed the contract and born costs associated with fulfilling it. This raises the possibility of large bargaining costs, as parties use the threat of breach to "renegotiate" after the fact.
  • 1. So enforce contracts against opportunistic breach.
  • 2. With some mechanism to deal with breach due to changed circumstances. What?
• C. Note that Posner is mentioning different theories of contract (consideration, meeting of minds, ...) and seeing how far each fits the economic model.
• D. Note the underlying Coasian tone of the analysis.
  • 1. Unlike the tort context, the court does not have to write the contract, but ...
  • 2. For unlikely eventualities, transaction cost may be too high to make it worth specifying terms, even in a low transaction cost environment. Transaction costs are low, but benefits (from providing against unlikely contingencies) are even lower.

IV. Insurance--some fine points.

• A. "risk averse" really describes your taste for income, not for risk; it corresponds to a declining marginal utility of income. Someone could be risk averse in dollars but risk preferring in years of life, for example.
• B. "Best insurer" really has at least two dimensions.
  • 1. Best risk spreader
  • 2. Best risk estimator. Because of adverse selection problem!
    • a. Suppose nobody can control probability of defects, but seller (of a 2nd hand car) knows how high it is, and buyer does not: Market for lemons problem--good second hand cars are driven off the market, since they sell for the same price as lemons.
    • b. Suppose buyer knows and seller does not (you know more about your health, and how risky a life you lead, than your life insurance company does). Adverse selection problem--only the worst risks buy insurance.
    • c. If the person who knows the risk is liable for any resulting costs, he knows what he is selling (a good plus a known probability of having to pay off on the insurance) and the other party knows what he is buying (a good--and he does not care what the probability is of defects, since he is insured against them)--eliminating the adverse selection problem.
  • 3. But this objective may clash with others:
    • a. Risk spreading for life, health insurance.
    • b. Who can best avoid the risk in the second hand car case (the buyer takes care of the car--or doesn't).
• C. Maybe three dimensions--in deciding who is the best insurer we should include the "best preventer" argument in both directions:
  • 1. If the person who would buy the insurance is the best preventer of the risk, that is a reason not to insure: Moral hazard
  • 2. If the person who would sell is the best preventer, that is a reason to insure: by buying insurance on your factory, you are buying expertise on how to avoid fires, with incentive attached in the form of the insurance.

V. Why do the courts construe an insurance contract against insured?

• A. Posner says that courts used to do it the other way because of the moral hazard problem, but stopped doing so because the pool became large enough to let the insurers spread the risk.
• 1. But that is wrong. Moral hazard is not a risk but a cost--the cost of inefficiently low precautions. So increasing the size of the pool does not reduce it.
• 2. Insurance companies were in the business of bearing risk--so why would one want a contract shifting that particular risk to the insured, at the time when the pool was small?
• B. A possible explanation for the present rule is that the risk of losing a dispute on contract interpretation is itself worth insuring against?
• C. Another is that the insurance company is the expert in insurance contracts; this rule gives it an incentive to draw up clear contracts. It fits the general rule that a contract is construed against the party that drew it up.

VI. Information and Incentives: Laidlaw v Organ

• A. Speculation produces a social benefit, by reallocating resources from times when they are plentiful to times when (an expert can predict that) they will be scarce--the successful speculator buys ow and sells high.
• B. The successful speculator produces a benefit and gets a reward, but the latter is not equal, or even closely related to, the former.
• C. Even in a case where elasticities are low, so that the speculator produces only a small reallocation and a small benefit, he might still get a large profit--since his speculation means that resources belong to him instead of to someone else at the instant when their price goes up.
• D. So we might get inefficient speculation--spending $1000 dollars to get information whose private value is $1100 but whose social value is only $100.

VII. Consumer fraud, liability, etc.

• A. Distinguish the argument for default rules
  • 1. Producer should be liable if he can more cheaply inspect to detect defects
  • 2. And control whether the defect exists and does damage
  • 3. Remembering that the damage might depend largely on how the consumer uses the product, which would be an argument against producer liability
• B. From the argument for non-waivable rules.
  • 1. If the consumer knows he is ignorant, he can insist on a guarantee, etc.
  • 2. If consumers do not know that they need a guarantee, how do we get the laws imposing a non-waivable--given that the consumers are also the voters?
• C. Does having the court decide (non-waivable or default) case by case make more sense than a broad rule?
• D. Duress and form contracts ("contracts of adhesion")
  • 1. Innocent explanation: Form contracts reduce drafting costs, eliminate the problem of the firm having to control the employee who negotiates the individual contracts.
  • 2. Freedom of contract argument exists even with monopoly. The more unfavorable the contract is to the consumer, the lower the price the monopolist will be able to charge and still sell his goods.
  • 3. Although the argument is not perfect in the case of a monopolist, since (inefficient) contract terms might be a device for profitable discriminatory pricing--charging a higher (pecuniary plus nonpecuniary) price to the consumers who will still buy at a higher price.
  • 4. Is Posner's "real duress" case (shipwreck) any more real than other cases?
    • a. No--the tug didn't sink the ship
    • b. the right price is the full value of the ship--from the standpoint of incentives to the tug to be in a position to save ships, but ...
    • c. That is too high a price from the standpoint of incentives to the ship to take precautions, since the cost of a wreck is the loss of a ship only if nobody is around to save it.
    • d. So there is no simple price that gives the right incentive to both parties--just like the auto accident problem. The salvor should recieve the full value but the ship owner should pay only the salvor's cost of saving the ship, that being the social cost of a shipwreck when the ship gets salved.
    • e. If we believe that supply elasticity for salving services is low--that it would rarely pay tugs to cruise around during a storm in the hope of saving a ship, even if they could get the full value--the best solution may be a price not much above the actual cost of salving this ship.
    • f. Also, freedom of contract here leads to large transaction costs due to bilateral monopoly and tight time constraints--while you bargain, the ship is sinking.

VII. Damages

• A. What are the margins on which we want to give people the right incentive to avoid breach?
  • 1. To sign or not to sign--since one way of keeping a contract from being breached is not to sign it.
  • 2. To breach or not to breach
  • 3. How much to spend in reliance: Expenditures by both parties whose value depends on whether breach occurs. For example, tooling up to make the custom widgets that you have agreed to buy--which is a waste of money if you decide you do not want them.
• B. Possible rules: Court set.
  • 1. Reliance: Make the victim as well off as if the contract had not been signed.
  • 2. Expectation: Make the victim as well off as if the contract had been fulfilled.
  • 3. Restitution: transfer enough to the victim to make the breaching party no better off than if he did not breach.
  • 4. Specific Performance.
• C. Arguments: Two ways of preventing breach
  • 1. Expectation gives the right incentive to breach, since it transfers the cost imposed by breach (how much worse off the victim is, compared to performance) to the breaching party.
  • 2. Reliance gives the right incentive to sign (when breach might occur), since it means that the victim is as well off with breach as if he had not signed.
    • a. If both parties know the odds of breach this does not matter, but...
    • b. Matters if potential breaching party knows the odds
    • c. Just as in the insurance, adverse selection case.
    • d. Zero damages means that contracts with people who expect to breach look better than they really are for the other party.
    • e. Damages >reliance damages make contracts with people who know they will not breach look better than they really are--you think you are getting a chance of a windfall from breach.
  • 3. Why do expectation and reliance rules lead to different amounts of damages?
    • a. In the standard zero profit, perfect competition world, firms exactly cover their cost, so have no "lost profit" to be included in expectation damages in order to make them larger than reliance damages.
    • b. One answer is uncertainty--zero profit holds ex ante but not ex post.
    • c. Another is monopoly or monopolistic competition
    • d. Another is that cost as measured by courts is not identical to cost as defined by economists.
  • 4. Both expectation and reliance measures induce over-reliance.
    • a. The potential victim of breach knows he will get his reliance expenditures back in case of breach
    • b. So he decides how much to rely as if probability of break were zero.
    • c. But his reliance expenditures are a waste if the contract gets breached--he gets reimbursed for them, but at the cost of the breaching party.
    • d. So the efficient level of reliance would be one that allowed for the probability that breach would make the reliance expenditures worthless.
    • e. Which you get with a fixed damage payment in case of breach, independent of amount of reliance (liquidated damage).
• D. What about having the damages set by the contracting parties?
  • 1. Liquidated damages--the parties specify damages for breach in advance.
  • 2. Generally they are enforceable, unless interpreted by the court as a
  • 3. Penalty clause, meaning that the damages are larger than the damage done.
  • 4. Why not enforce that too? The parties had some reason to make the agreement.

VIII. Self-help remedies: Things you can do without going to court first, such as not delivering when the goods are not paid for.

• 1. In drawing up contracts, avoid contracts that make possible very profitable self-help remedies, since
• 2. There will be an incentive to impose them even when the other party is not guilty, given that he will have to sue you to cancel the remedy--which is costly.
• 3. Robert Ellickson's book on norms describes a good example.
  • a. When your neighbor's cattle trample your crops, and he does nothing about it,
  • b. You eventually drive his cattle somewhere far from you and him, thus imposing a cost on him.
  • c. A more efficient punishment, when you find eight cattle in your field, would be to butcher one, put it in your freezer, then call your neighbor to report seven of his cattle in your field.
  • d. But you would have an incentive to impose that punishment even when your neighbor had not been behaving unreasonably (first trespass, and you had a very low fence around your crop)
  • e. Which would tend to set off expensive feuds, so ...
  • f. The norm Ellickson observed is actually a sensible one.

I. Contracts, a summary.

• A. It is useful to be able to commit yourself to binding agreements.
  • 1. Legally enforceable contracts are one way of doing so
  • 2. Reputational enforcement is an alternative in many contexts.
    • a. In some contexts it does not work
    • b. It is dependent on reliable information about who was in the wrong
    • c. But has the advantage of providing market incentives to judge correctly.
• B. Figuring out what is the efficient contract arises in three different contexts.
  • 1. Drafting contracts. Efficiency improvements increase the size of the pie, giving a gain to be divided between the parties.
  • 2. Filling in blanks in contracts, by court or arbitrator.
    • a. Argument B1 above implies that the efficient rule is what they would have agreed to
    • b. And it is also the rule that makes the world a better place.
  • 3. Modifying contracts contrary to their language
    • a. On the grounds that the modified version is more efficient, which makes the world a better place
    • b. The problem being that B1 above implies that the parties have already agreed to the efficient rules, and since they probably know more about what rules are efficient than you do, you are likely to be making the world a worse place
    • c. Unless you have good reason to think that the argument for efficiency does not apply in this case--fraud, for example, or mistake.
• C. An important issue in figuring out the efficient contract is deciding who should bear some risk.
  • 1. Who can best control whether the risk happens and what costs it produces (moral hazard).
  • 2. Who best knows the size of the risk (adverse selection).
  • 3. Who can best spread the risk.
• D. An important related issue is what happens when the contract is breached.
  • 1. Possible legal rules include:
    • a. Expectation damages: Make the breachee as well off as if the contract had been fulfilled.
    • b. Reliance damages: as well off as if never signed.
    • c. Liquidated damages: Fixed damaged payment, agreed to in advance.
  • 2. Margins on which we would like to get the right incentives include:
    • a. How much to rely (do you bear costs that will pay off only if the contract is not breached)?
    • b. Decision whether to sign a contract that might get breached.
    • c. Decision whether to breach a contract.
  • 3. Reliance and expectation rules both induce inefficiently high levels of reliance, since the breachee gets his reliance expenditures back either way (under expectations damages, they are a cost, and he is entitled to get his costs plus his lost profits covered). Liquidated damages work.
  • 4. Reliance damages make a party as well off signing and being a victim of breach as not signing, so give the right incentive there (eliminate adverse selection type problems)
  • 5. Expectation damages force the breaching party to internalize the costs of breach, so give the right incentive there--only efficient breach.
• E. In many contexts, self help remedies make more sense than going to court. It is important to set things up so that self help remedies will not be too attractive, since the breachee is being a judge in his own case.

II. Divorce: Lloyd Cohen article.

• A. My way of putting it: Women perform early, men late.
  • 1. In a traditional marriage, a major contribution of women is bearing and rearing children; most of the cost of that is done in the first two decades.
  • 2. A major contribution of men is income; their earning power generally rises until retirement.
  • 3. So women are putting more into the marriage than they get out in the early years, and getting paid back in the later years.
• B. His way: Women depreciate faster than men on the marriage market.
  • 1. Nearly equivalent: "depreciate" means "has already performed"
  • 2. Because people have only one lifetime, thus one stream of services to give
  • 3. But putting it that way is less tactful if you wish not to offend feminists.
  • 4. In part because depreciation of women on the marriage market also embodies the facts of male taste
• C. Either way, there is an incentive for the husband to default on the contract.
• D. Making the contract unenforceable means
  • 1. In the short run, husbands default: men gain, women lose.
  • 2. In the long run, people adjust the contract to protect themselves by putting performance more nearly in sync--bearing children later, for example
  • 3. And by investing less in relation specific capital: having a job and hiring somewhat else for a lot of the housekeeping, child care, etc.
• E. What about having the contract be enforceable?
  • 1. Version 1: No divorce ever.
    • a. Locks people into their early mistakes, and ...
    • b. Might be evaded by separation, extramarital affairs, desertion, ...
    • c. Or result in large bargaining costs within marriage.
  • 2. Version 2: Divorce with penalty to breaching party?
    • a. But how do you measure performance?
    • b. Party that wants to breach can degrade performance to get consent.
    • c. Or one party can degrade performance in order to force the other party to breack--and pay the penalty!

III. Why has marriage become a less stable contract over the past century?

• A. Marriage is a long term contract because of firm specific capital in two respects
  • 1. The existence of firm specific capital creates serious bargaining costs otherwise.
    • a. Which a contract can prevent to the extent that it can specify terms
    • b. A contract may be enforceable by an internal bargaining equilibrium, even if outsiders cannot observe performance well enough to enforce it. If either party is clearly not doing his/her job, the other objects, making the marriage an unpleasant one, but ...
    • c. This only works if the duties of marriage are well defined in the society (or parties can clearly define the duties they agree to in advance).
  • 2. Also, long term contracts are less costly when there is a lot of firm specific capital, because that makes it less likely that breach is efficeint.
• B. There is much less firm specific capital now than there used to be because:
  • 1. Drop in infant mortality greatly decreases household production input of wife.
  • 2. Increased division of labor somewhat decreases household production input of wife.
• C. So less long term contracting, more living in sin, more divorce.

IV. Other economics of Marriage

• A. Should you choose a spouse similar to you or different from you?
  • 1. Joint consumption is an argument for like--you will be living in the same house, eating the same meals.
  • 2. Gains from trade are an argument for unlike: It would be very nice of one member of the couple could remember people's names. It is better if one of you likes to cook and one likes to clean up than if both like to cook and neither likes to clean up.
  • 3. The problem of dividing your income (pecuniary and non-pecuniary) between you may be an argument for like. If a very "rich" wife (in income, talents, physical attractiveness--a net measure of desirability as a spouse) marries a very "poor" husband, they will have to divide their "income" very unequally to give her as good a deal as she could have gotten by marrying a husband more like herself. The poor husband washes all the dishes, works, does the child care, ... .
    • a. Very unequal divisions may be costly to implement
    • b. And they may clash with mutual altruism. Do you want to be married to a wife, however desireable, sufficiently hard hearted to enforce a contract in which you do all the work?
• B. Dividing assets at divorce?
  • 1. Note that 50% to the wife may be not generous enough, given both Cohen's point on timing of inputs and the fact that her capital is typically more relation-specific than his, so it loses more value than his does as a result of the divorce.
  • 2. Note also that "not generous enough" may mean "creates incentives for opportunistic breach."

V. Public Schooling: What are the economic arguments for it?

• A. As a solution to the problem of externalities?
  • 1. It is not entirely clear that there are net positive externalities to education. Some possible negative externalities include:
    • a. Much of politics involves one group benefitting at the cost of another, so making my children into more informed voters may mean making them more able to benefit at the cost of your children--a negative externality.
    • b. One of the things people seem to care about is relative status (Robert Frank has a book, Choosing the Right Pond, about this). So even if educating my children, with the result that they are more productive and have higher incomes, does your children no material damage, it might make them less happy-because they feel like failures in comparison.
  • 2. If there are net positive externalities to education, public schooling is a poor way of dealing with the resulting inefficiency.
    • a. The public school system gives parents who would otherwise buy somewhat more education for their children than the public schools provide an incentive to reduce their children's education a little, in exchange for entirely eliminating its cost (i.e. go to a $5000 public school for free instead of a $6000 private school for $6000).
    • b. It makes sense only if the optimal level of education is identical for everyone (within a school district) and equal to the level provided, which seems unlikely.
    • c. All this is true even if the public schools produce as much education per dollar as private schools.
  • 3. A voucher system is only a little better as a solution to this problem.
    • a. It does not give parents an incentive to reduce the level of schooling their children get, but ...
    • b. Marginal cost is zero below the voucher level and 100% above the voucher level, so ...
    • c. Parents who would have spent more than the voucher level spend the same amount with vouchers as with a private system (ignoring income effects from any net income transfer--parents with lots of children are richer with a voucher and spend more, parents with few children are poorer and spend less).
    • d. Parents who would have spent less than the voucher spend the voucher amount--which might be inefficiently high.
  • 4. The right solution would be a subsidized private system. If 25% of the benefit from educating my children is external, then I should pay 75% of the cost and the state pay 25%.
• B. As a solution to the problem of capital market failure?
  • 1. An alternative solution would be to allow parents to borrow money for their children's education that the children would not be able to avoid paying via bankruptcy--perhaps pay back in higher taxes.
  • 2. Or to subsidize education for poor parents--but not for rich ones, who have adequate capital.
  • 3. There is no obvious way of getting the right level of education in this case.

VI. Baby market:

• A. One of the court's arguments is that the rich will be buying and the poor selling.
  • 1. This is surely a serious oversimplification; most buyers will be (most Americans are) neither rich nor poor.
  • 2. In any case, what is wrong with that? Would they ban the markets for housecleaning and child care on the same grounds?
• B. Commodification? A more interesting argument, although not one that convinces me.
  • 1. How we act and observe other people acting affects how we think. If we treat something as a commodity, we and others will think of it as a commodity, which might have bad consequences.
    • a. If babies can be openly bought and sold, perhaps we will think of them more as possessions and less as people.
    • b. If sex can be openly bought and sold (legalized prostitution) perhaps men will think of women more as sex objects and less as people
    • c. So perhaps this is an argument for banning certain acts, not because the acts are bad, but because they teach a bad lesson-- "commodify" things that ought not to be thought of as commodities.
  • 2. But this argument has an odd feature, constitutionally speaking.
    • a. We have an act which is both an act and speech.
    • b. As an act it ought to be permissable (transaction with prostitute or baby seller)
    • c. We ban it because we disapprove of it as speech
    • d. Which seems to run into the first amendment.

VII. It is often claimed that, when I have a child, I impose net costs on others, so that leaving people free to decide how many children they have will result in overpopulation.

• A. But it is not clear what the sign of the net externalities are. Positive externalities include:
  • 1. My child my find the cure for cancer and
  • 2. Will reduce the amount of the national debt your child must bear
  • 3. And the amount your child must pay for national defense, or scientific research, or any other government service whose costs is roughly independent of the population.
• B. How in principle do we define the optimal level of population?
  • 1. If we measure it by per capita income, utility, or something similar, we commit a fallacy of composition.
    • a. Consider one additional person, who will impose neither net costs nor benefits on the rest of us. How can we say that his life (utility 10) is a good thing if the rest of us have an average utility of 9, but the same life is a bad thing of the rest of us have an average utility of 11?
    • b. Mead's example: Consider a world with two communities, A and B. Both are attractive places filled with happy people, but A is a little happier than B. Is the world a better place if B is wiped out by a plague? Average happiness goes up.
  • 2. If we measure it by total utility, we need to define a zero point, so as to know if an individual contributes positive or negative utility to the total.
    • a. The obvious zero point is death, but ...
    • b. That leads to a rule very favorable to large populations.
    • c. Two unhappy people are better than one happy one unless they would be willing to flip a coin: heads they get to be the happy one, tails they die. They will have to be pretty unhappy to agree to that.

VIII. Regulation of Sex. Why do we do it? Adultery laws, fornication laws, ...

• A. Contract enforcement? Like copyright--it makes it easier to enforce the contract against infringement involving partners not party to it.
• B. Overenforce to protect third parties?
  • 1. Children--who may be injured if adultery leads to marital breakup
  • 2. Keep down VD, AIDS
  • 3. Law against prostitution can be viewed as a way in which wives enforcing the marraige contract by making it harder for husbands to break it.
• C. Bigamy error in Posner. Banning polygeny is not a transfer from rich husbands to poor husbands. Its effect is to lower the price of a wife (implicit in the terms of the marriage contract), which is a transfer from wives to husbands.

I. Tort law: My sketch

• A. Optimal supply of accidents: What happens when everyone takes all and only cost-justified precautions.
• B. Strict liability gives you the right answer with unicausal accidents.
• C. Negligence with unicausal accidents, defined by the Hand formula.
  • 1. Gives the right answer if everything is observed by the court, but ...
  • 2. What if the efficiency of some classes of precautions is observable by the actor but not the court?
    • a. Posner's example is "activity level." The court may be able to observe how many trips you take, but not how much it is worth to you o take them.
    • b. Another example would be how much attention I pay to my driving.
    • c. Under a negligence rule, you take the optimal level of the observable precautions, you will therefore not be found negligence, you therefore ignore costs to other parties in choosing the level of the unobservable precautions.
  • 3. It could lead to either more or less litigation cost than strict liability.
    • a. More because there is one more question to be settled (negligence)
    • b. More because there are more accidents, due to the problem of activity level and unobservable precautions
    • c. Less because accidents where the party responsible was obviously not negligent do not need to be litigated, or even settled--the plaintiff has no claim.
• D. Bicausal accidents
  • 1.Need two-sided strict liability, or ...
  • 2. Negligence rule with perfectly informed court.
  • 3. Or strict liability with contributory negligence and perfectly informed court

II. Posner's treatment.

• A. The Hand rule describes how negligence has been decided in real cases since long before Hand-at least qualitatively. Features of a case that increased the cost of precautions or decreased the benefit made it less likely that a party would be held negligent for not taking those precautions.
• B. Custom as a defense. The argument depends on whether the firms in an industry have an incentive to take an efficient level of precaution.
  • 1. Which will not be the case if the injury is to unrelated parties-so custom should be no defense in such cases.
  • 2. Will be the case if the injury is to employees, customers, etc., but.
  • 3. Why do we need a damage rule at all in those cases?
    • a. If someone violated custom, then ...
    • b. He should have--the custom must have been inefficient for him.
  • 4. What happens if we introduc imperfect information and information costs? What if customers and employees judge the firm by the industry average?
    • a. But then an inefficient custom is stable, since.
    • b. Precautions above industry custom cost the firm money but provide a benefit spread over the entire industry-which gets the credit for the lower average accident rate. They do not save on damages, since precautions at the level set by industry custom are enough to avoid liability.
    • c. If the firm lowers its level of precaution below the industry average, its costs increase not only by the cost of the additional accidents but also by the cost of the accidents that would have happened anyway--for which it is now liable.
    • d. So levels of industry custom above or below the optimal will still be stable--it will not pay firms to shift to a level of precaution more efficient than industry custom.
• C. Joint causation problem.
  • 1. Joint care is the more general and plausible case.
  • 2. Alternative care is a corner solution.
  • 3. There might be multiple equilibria
  • 4. And strategic behavior.
    • a. In the case where one player is single
    • b. Not in the many vs many (auto accident) case
    • c. Unless you can observe the (lack of) precaution at the last minute. Drive a dented car and people give you lots of room.
• D. Contributory negligence.
  • 1. The argument: If court knows the optimal level of precaution,
    • a. negligence never happens,
    • b. so tortfeasor is never liable,
    • c. so contributory negligence never happens, so
    • d. You need a theory of mistakes to decide whether contributory negligence is a good rule; in a world without mistakes, the rule never comes into play so has no effect.
  • 3. Suppose the court has an error rate of .01 in determining liability.
    • a. That assumption messes up the analysis of optimal precaution by tortfeasor. Increasing your precautions above the optimal level may be worth doing if it reduces the chance of being (mistakenly) found neligent. Reducing below the optimal level may be worth doing, since you may be mistakenly found non-negligent. We will ignore those problems here.
    • b. Without a rule of contributory negligence, "victim" takes slightly suboptimal precautions, since there is a chance that, even though the other party was not negligent, the court will find him negligent and liable, so the victim will not have to bear his own costs.
    • c. With contributory negligence, the victim takes optimal precautions.
    • d. If for some reason the victim does not take optimal precautions, the accident occurs, and (because of the rule of contributory negligence) the victim does not sue, we save on transaction costs, but ...
    • e. In all other cases, the cost of litigation is made greater by the rule because there is one more issue to be settled (was the victim contributorily negligent?).
• E. Strict liability.
  • 1. Solves the activity level (unobservable precaution) problem.
  • 2. Creates a problem if the probability or cost of the accident depends on precautions by both parties (if A is strictly liable, B has no incentive to take precautions), so ...
  • 3. Appropriate when
    • a. you are sure who is the lowest cost avoider: ultra-hazardous activities.
    • b. and/or activity level is crucial.
  • 4. One could argue, however, that people engaged in new activities (which are particularly likely to be found ultra-hazardous) are generating valuable information for the rest of us, and should therefore have their activity level subsidized--which yields the opposite result.
  • 5. This is an example of a general problem with Posner's approach. It is not clear what arguments he might have come up with to justify the opposite conclusion if that happened to be the law.

III. Products liability:

• A. Caveat Emptor.
  • 1. Since consumers have poor information on unlikely accidents, the manufacturer has an inadequate incentive to avoid them.
  • 2. Unless he believes in a rational expectations model, in which individual consumers over or underestimate the risk, but on average their beliefs are about right.
  • 3. In addition, consumers misestimate the value of the good to them (because they misestimate the risk of accident), thus buy more or less than the efficient quantity.
• B. Negligence liability. Now he has the right incentive to avoid them, but does not include the cost of accidents that still occur in the price, since he will not be negligent and thus not be liable, so consumers who are not aware of the risk buy too much of the good (activity level is too high),
  • 1. But "negligence" in the sense of inadequate precautions to prevent defects is hard to judge, and "negligence" in the sense of poor product design is still harder to judge,
  • 2. And judges and juries are obviously incompetent to judge the latter, and probably the former as well.
• C. Caveat Venditor (strict liability).
  • 1. The seller has good information on product defects, so this gives us the right price, quantity (this is the adverse selection argument applied to liability)
  • 2. But it roughly doubles accident cost, by adding in litigation cost (assuming no effect on accident levels-- the case of "unavoidable" accidents).
  • 3. And it eliminates the incentive for user precautions, unless coupled with contributory negligence.
  • 4. And judge or jury must still decide causality--which they may be incompetent to do in such cases. See books by Peter Huber on our present liability problems.
• D. Freedom of Contract?
  • 1. Posner rejects it becuase parties will ignore disclaimers for low probability.
  • 2. But low expected cost also weakens all of the arguments. Consumer surplus loss goes as the square of the error in price for small errors. So if the consumer's ignorance means that the price of the good (including risk of accident) in cases A and B above is off by one cent, the resulting efficiency cost is tiny
  • 3. And the consumer does not have to decide whether to accept disclaimers for each separate case. He can use a rule (never accept a waiver) if it (like the court's rule) is on average a good one.
  • 4. The refusal of courts to accept freedom of contract is a problem for Posner's general thesis.

IV. Causation complications:

• A. Coincidental causation.
  • 1. I stop my friend for a moment in the street to talk, he then continues on and is killed by a falling safe.
  • 2. Should I be held liable? If I had not stopped him he would not have died.
  • 3. No. My stopping him does not affect the probability of his dying--it might just as easily have resulted in his not being under the safe.
  • 4. A different way of putting this is that if I do not get rewarded when I produce the positive externality (my stopping him happened to save him) I should not get punished when I produce the negative one.
• B. Dual causation: The victim is accidentally shot by two hunters; each bullet would have been sufficient to cause death by itself. Should they be liable?
  • 1. Posner says yes, but is wrong. { Real Case: Summer v Tice}
  • 2. The benefit to my taking a precaution that reduces the chance I will shoot him is not the reduction in probability of shooting him but the reduction in probability of killing him (times the value of his life). Shooting a corpse does no damage.
  • 3. When I change my probability of shooting him, I should benefit only by the resulting change in probability that he will die, so ...
  • 4. I should not be liable in the two bullet case case!
  • 5. This ignores possible problems of proof, etc. It also ignores the possibility of agreements in advance between two hunters; I am assuming both were independently responsible for the accident.
• C. This conclusion is not true of the "one bullet killed him but we don't know which one" case, contrary to what Posner says.
• D. Probabilistic injury.
  • 1. The problem (radiation case). Neither conventional rule works.
    • a. If we must show that it is more likely the death is due to the radiation leakage than that it is not, the plaintiff always wins and the reactor pays nothing for the damage.
    • b. If we accept a much lower standard of proof, the plaintiff always wins and the reactor pays much too much--the cost of all the cancers, including the ones it did not cause.
  • 2. Posner's solution: Make the reactor liable for the increased risk to everyone, using a class action.
    • a. But diffuse costs are hard to litigate--class actions are driven by the interest of the lawyers, not the victims.
    • b. And immediately after the risk has been imposed, evidence on how large it is will not be very good--nobody has actually died, so we cannot start looking for evidence of increased cancer rates.
  • 3. What about giving each one who dies 1/11th damages?
    • a. When they start dying, we have at least some data.
    • b. Fewer cases to try.

V. Why pay tort damages to the victim?

• A. So he will sue.
  • 1. But he could threaten to sue in order to be paid by the offender to drop charges.
  • 2. This may be what actually happened in 18th century (and earlier) English criminal law, where prosecution was private but punishment was by the state.
• B. To avoid too many precautions by victim?
  • 1. That works in the strategic case he describes, with one tortfeasor who, if damages go to the state instead of the victims, can get the many victims to take precautions if he refuses to.
  • 2. But just the opposite is true in the non-strategic case (auto accidents). Paying the damages to the victims reduces their incentive to take precautions below the optimal level.

VI. Loss of earning capacity, death, injury.

• A. Lump sum vs periodic payments
  • 1. A lump sum deduces disincentive effect, but
  • 2. By the same token lowers the cost of fraud. Once the money is paid out you get a ticket to Lourdes and come back without your crutches.
• B. Triple effect of injury
  • 1. On income (readily dealt with)
  • 2. On utility (compensate with cash)
  • 3. On Marginal Utility of Income. This makes compensating for the loss of utility difficult, expensive, inefficient, perhaps impossible.
  • 4. And explains why the price of a life seems infinite if you try to buy one. It is not that the value of life is infinite but that the value of money to a corpse is zero.
• C. Full compensation vs Optimal insurance vs optimal deterrence.
  • 1. Suppose it takes $100 million to make up to you for loss of your sight.
  • 2. You would not insure yourself for that amount.
  • 3. You would not take the precautions, in a case where your actions may risk your sight, that are implied by that price.
  • 4. So full compensation over insures and over deters.
  • 5. But what if you would not insure at all (death for someone with no dependants)? Does it follow that the optimal deterrence price is zero? Obviously not.
  • 6. So these are three different values here ...
• D. Correct solution in principle:
  • 1. Set damages at a level that makes people as well off ex ante with the risk as without, as judged by risk premia for jobs and similar criteria.
  • 2. Allow the sale of inchoate tort claims. Now if my tort claim leaves me "overinsured" I can sell part of it, so as to consume some of the money now when I am not dead/blind/whatever.
• E. My article which discusses this at much greater length is available from me.

VII. Insurance issues:

• A. Insurance reduces deterrence, but ...
• B. Does so efficiently if liability fully compensates the victim.
  • 1. Because my precautions then impose no cost on others
  • 2. And the cost to me (and my insurance company) of my taking fewer precautions must be balanced by the benefit from risk spreading, or I would not buy the insurance at a price at which the insurance company is willing to sell it to me.
• C. The advantage of insurance over tort as a form of insurance
  • 1. Payment depends on relevant, not irrelevant, features. My need for money after an accident does not depend on who was how negligent.
  • 2. Insurance companies paying out money to their own clients have some reputational incentive to be generous; insurance companies settling with people who have claims against their clients have every incentive to be tough. The latter situation raises litigation costs.

VIII. Calabresi and Melamed.

• A. Three kinds of rules.
  • 1. Property: State enforces (with punitives?) but need not estimate the value of what was taken with any precision.
  • 2. Liability: State sets and enforces value of what is taken, but permits market transactions
  • 3. Inalienable: No market transactions are permitted.
• B. Property vs liability.
  • 1. High transaction costs on the market an argument against property rules (but they miss the rentseeking problem with liability rules. Parties have an incentive to spend resources getting courts to misestimate the value of what they take or have had taken).
  • 2. Is liability law a sensible device for redistributing wealth?
• D. Inalienabity
  • 1. Polluter case--but what if the owner is a polluter? Refusing to let people sell something is a poor way of controlling how it is used.
  • 2. Distinguish, as they do not, between "Inalienable" and "cannot be sold to certain sorts of buyers." For example ...
    • a. Countries that used to sell officers' commissions in their army might only permit sale to someone capable of doing the job. or
    • b. Property of strategic value to the enemy cannot be sold to an alien.
    • c. My body can only be sold to me. In this case that is equivalent to a rule "it cannot be sold," since I already own it. But imagine we had a way of switching a mind from one body to another. Then we might want to make the rule "a body can only be sold to someone whose mind will be in it," which is no longer equivalent to "cannot be sold."
  • 3. "Moralisms"
    • a. Because external cost, but
    • b. Why are these costs? Is this an explanation or a surrender--an admission that economics does not help explain these laws?
  • 4. Paternalism.
  • 5. Self interest of others.
  • 6. Are C&M Posnerians? In much of this they seem to think existing law must make sense.
  • 7. Distribution ...
    • a. Banning payments for adoption presumably results in a perverse redistribution, since (on their account) it benefits buyers and hurts sellers, and buyers are richer than sellers.
    • b. They seem to identify "distribution as a reason for laws" with "altruistic views about what distributionis best as a reason for laws." But the distributional effect of laws also provides a selfish reason to support them--because they redistribute to you.
• E. Lots of pollution stuff which we already did under Coase.

I. Criminal Law:

• A. Why have it? Why not do everything with tort law? Some possible answers:
  • 1. Damage to the "society?"
  • 2. Low probability of conviction and judgement-proof offenders mean that there is little incentive to sue (since you won't collect much), so tort law does not work.
  • 3. Criminal law is intended to impose moral stigma.
  • 4. We will return to these questions.
• B. Optimal sanctions:
  • 1. Are criminals rational?
    • a. Who gets mugged--little old ladies not football players.
    • b. Which suggests that muggers are trying to steal money at minimal risk, not prove what he-men they are.
  • 2. The easy case--zero enforcement costs.
    • a. We want to use criminal punishment as a pigouvian tax to produce the optimal level of crime (commit a crime only if the benefit to the criminal is greater than the cost to the victim, as in the case of the lost hunter suggested by Posner)
    • b. So set expected punishment (probability times punishment) equal to damage done.
  • 2. Doing it right: enforcement costs as a function of probability and punishment
    • a. What is apprehension cost?
    • b. What is punishment cost? Fine, Execution, Jail, Stigma!
    • c. Finding the Total Cost (deterrence) function: the cost of producing a given level of deterrence by the least costly combination of probability and punishment.
    • d. Finding the optimal amount of deterrence. Minimize summed cost to victims, criminals, and enforcement system.
  • 3. The optimal expected punishment may be more or less than the damage done, depending on the elasticity of supply of offenses.
  • 4. All of this is worked through in more detail in my Payne article.
• C. Why not hang them all?
  • 1. Argument for efficient punishments.
    • a. If we shift to a lower cost punishment probability combination giving the same deterrence ...
    • b. The expected cost to the criminals is the same
    • c. The crime rate, hence the cost to the victims is the same
    • d. And the enforcement system saves money.
  • 2. What would such an efficient system look like?
    • a. Fine if collectable
    • b. Make it collectable by threat of worse punishment if they can't pay
    • c. Temporary slave labor if they cannot pay a fine.
    • d. Execution if they cannot produce more as slave labor than they cost to feed and guard.
    • e. And after you execute them, use their organs for transplants.
  • 3. English 18th century example.
    • a. No imprisonment for serious crime.
    • b. Hang, transport, or pardon.
    • c. Costs of slave labor too high... history of galley slaves. It looks as though galley slaves (easy to guard and monitor) more than paid their costs, other forms of slavery for violent criminals did not.
  • 4. If such a system is a bad idea, as most people believe, why? We will return to it.
• D. Another look at the optimal punishment question.
  • 1. Two intuitions: "Enough to deter" vs "equal to damage done."
  • 2. Is there such a thing as efficient murder?
    • a. In the sense of "murders we would want to prevent if we could do so costlessly," few or none.
    • b. In the sense of "murders that cost more to prevent than it is worth," probably yes, a substantial number.
  • 3. Why count the criminal's costs at all?
    • a. Because our analysis is supposed to cover everything from murder down to parking violations, and
    • b. Because ignoring costs to criminals require that we know in advance what should be considered a crime--which is one of the things the economic analysis is supposed to be telling us.
  • 4. Rich vs Poor--should they pay the same fines? In some cases yes, but in others no, because.
    • a. For crimes with a payoff in time or utility, the supply curves are different--it takes a higher expected $ punishment to deter the rich offender.
    • b. It is cheaper to punish richer offenders, since they can pay fines, but ...
    • c. On the other hand, they can also hire good lawyers so as to make it costly to convict them.
• E. Marginal deterrence: My paper is available to anyone interested.
  • 1. If armed robbery gets the maximum punishment, then the additional punishment to an armed robber for killing the victim is zero.
  • 2. More generally, in setting optimal punishments we must allow for the possibility that we may deter someone out of one crime and into another.
• F. Why we should not hang them all.
  • 1. The old mistake:
    • a. Economists in the past have frequently answered the question "what would I like the government to do?" instead of the question "what should the legal rules be, given how government will act?"
    • b. In other words, the government was being treated as a philosopher king rather than as a human institution staffed by people with the same sort of limitations and incentives as the rest of us.
    • c. Optimal punishment theory makes the same mistake by ignoring the incentives of the enforcers: police, courts, legislatures.
  • 2. The costs of efficient punishment--other side of the problem.
    • a. An efficient punishment, such as a fine, provides a benefit to someone on the other side.
    • b. That is an incentive to convict or punish someone, whether or not he is actually guilty.
  • 3. Rent seeking: In a world of really efficient punishments, everyone's human and physical capital is at stake.
    • a. If I can properly manipulate the legal system, I get to seize you and your property.
    • b. So we all spend lots of resources defending ourselves and trying to expropriate others.
  • 4. Civil forfeiture and Punitive damages for product liability are modern examples of this problem.
  • 5. Larry Niven offers a fictional example: a society where the organs of those executed forfeit to the state to be used for transplants.
    • a. It looks like an unambiguous improvement--why let organs that could save lives rot?
    • b. But it produces an incentive to increase the number of capital offenses so as to get more organs and save more lives.
    • c. The protagonist of the story has been sentenced to be executed for his third (I think?) dangerous driving conviction.
  • 6. The application of the argument to the question of whether to hang them all is more difficult, since nobody gains--hanging simply eliminates most of the cost of punishment to those other than the criminal.
    • a. If government institutions are driven by a weighted average of citizen values, with the weighting somehow depending on political influence, then a cheap punishment imposed on uninfluential people might be badly overused.
    • b. A cheap punishment might be transmuted into a profitable punishment, if the threat of execution is used to extort a (legal or covert) out of court settlement.
• G. Why have criminal law? The answer must involve incentives to enforcers.
  • 1. "Tort law vs Criminal law" is the wrong question.The general version of the problem is:
    • a. Why bundle rules as we do in the legal system we call "criminal" and "civil."
    • b. Why sort offenses as we do into criminal or civil
    • c. Or ... How should we ... bundle rules and sort offenses ? Our Criminal and Civil are not the only possible alternatives.
  • 2. A few fragmentary answers:
    • a. No probability multiplier in the civil law because it would be an invitation to fraudulent suits, and since there is no probability multiplier the civil law works best for offenses where the probability of apprehension and conviction is high.
    • b. Efficient punishments in the civil law mean that false positives are less socially costly than in the criminal law, so we have a lower standard of proof in civil law.
    • c. Private prosecution is a reason to have the punishment be a fine paid to the prosecutor (as in our civil system), since otherwise you have to worry about preventing out of court settlements--which convert the punishment into a fine paid to the prosecutor.
    • d. If the prosecutor collects the fine there may be a conflict over who prosecutes, so we need some property rule to determine who "owns" the right to prosecute and collect.
    • e. Ownership by the victim, as in our civil law, may make sense because he is the one most likely tohave evidence, and uniting ownership of evidence and claim reduces transactioncosts of prosecution.
    • f. But ownership by the victim reduces his incentive to prevent the crime--if it occurs, he gets a (possibly valuable) claim. In an article on private enforcement, I show that (given some simplifying assumptions) the result is the optimal incentive to prevent.
• H. Organized Crime?
  • 1. A "GM of crime" is unlikely--and the sources we rely on for information about organized crime are mostly unreliable. Police and prosecutors want funding and public support, reporters want good stories.
  • 2. Where do economies of scale exist in criminal enterprises? Perhaps in the "corrupting police and judges" end of the business. There is some evidence for that in accounts of criminal enterprise under prohibition.
  • 3. What is organized crime? Perhaps some combination of Better Business Bureau and private court system.
    • a. People in the crime industry have some common interests, with regard to which they want to communicate and coordinate.
    • b. They can use violence to enforce contracts, but it works a lot better if they can demonstrate to other people in the industry that that is what they are doing--by getting a judgement in their favor from some respected leader or institution.
• I. Economics of drug laws? Does making import harder increase or decrease violence?
  • 1. One possible model: the violence comes from fighting over the territory of local monopolies.
    • a. Think of it as the dissipation of monopoly rents through rent seeking.
    • b. In which case the amount of violence will be larger the larger the rents.
    • c. Raising costs reduces rents, so will reduce violence.
  • 2. An alternative model: people in the business have lots of portable wealth and can't call the police if they are robbed, so there is violence over trying to seize and protect money and drugs.
    • a. The amount of violence should be roughly proportional to the value of money and drugs flowing through the system.
    • b. So violence will decrease with increased enforcement if demand for drugs is elastic (increasing theprice decreases total expenditure on them)
    • c. But increase with increased enforcement if demand is inelastic.
• J. Cannibalism after shipwreck; is this an efficient murder?
  • 1. Cannibalism and the Common Law discusses a real case, in which shipwrecked mariners were rescued, confessed to having killed and eaten one of their number and, much to their surprise, were charged and convicted.
  • 2. Sailors believed the traditional rule was that you drew straws to decide who got killed and eaten in such circumstances. That seems an efficient form of murder--ex ante, everyone is better off than if they simply all starved to death.
  • 3. The case was an attempt by the English legal establishment to establish a legal rule (the defense of necessity does not apply to such situations) inconsistent with customary norms. From the book's discription, they succeeded only by a certain amount of fraud against the jury, which was sympathetic to the norms and the defendants.

I. Antitrust Law.

• A. What is wrong with monopoly?
  • 1. Classical welfare triangle: the inefficiency due to selling above marginal cost, thus failing to produce some units worth more to potential consumers than they cost to produce.
  • 2. Rent seeking argument from Tullock: Monopoly profit will be consumed by competition to become the monopoly--for instance starting the firm early at a loss to get established.
  • 3. But we would not expect inefficiency in the ordinary meaning of the term--fat and lazy monopolies. A dollar more of costs is a dollar less in the owner's pocket, just as for an ordinary firm.
  • 4. We might expect large firms to be inefficient due to the difficulty of controlling people through many layers--but that would be equally true of large competitive firms.
• B. Price discrimination.
  • 1. A monopoly can increase its profit if it can succeed in selling at different prices to customers willing to pay different prices.
  • 2. That explains a lot of observed market behavior.
  • 3. Discriminatory monopoly can decrease the inefficiency of monopoly by increasing output, but it can also increase the inefficiency
    • a. Both because it allocates its output less efficiently, since people are buying at different prices, thus consuming up to different values of MV
    • b. And because it converts consumer surplus into profit, and might then dissipate the profit through rent seeking to become the monopoly.
• C. What can we do about monopoly?
  • 1. Natural monopoly: leave alone, regulate, or government owns it.
    • a. Regulators have an information problem and an incentive problem.
    • b. Owners have the same problems.
    • c. A common fault of both is that they may maintain a monopoly even after conditions make it no longer a natural monopoly. The ICC was founded to control the (arguably monopolistic) rail industry, but then regulated the (naturally competitive) barge and truck industries to protect the railroads from their competition, thus reducing competition in the broader transport industry.
    • d. They might do this because regulators have been captured by the industry the regulate, or because managers of a government industry wish to maintain the welfare of their government monopoly and the political support of its employees (Post Office).
  • 2. Mergers: How to distinguishgood from bad? One proposal, possibly due to John Lott, is that if competitors object to the proposed merger, you should permit it.
    • a. The argument is that if the merger is designed to create monopoly power, restrict output, raise prices, the competitors will gain, won't object, but
    • b. If it is designed to create a more efficient joint firm, they will.
  • 3. Cartels: The simplest solution is not to enforce cartel agreements. A more extreme policy is to punish them-as we do via triple damages anti-trust suits.
  • 4. Artificial monopoly:
    • a. Predatory pricing: the strategy. Big firm cuts prices below cost, drives out little firm.
    • b. But the bigger firm is losing money proportionally faster--indeed more than proportionally, since it is committed to produce enough to keep the price down. So it goes bankrupt first.
    • c. McGee looked at the whole record of the Standard Oil anti-trust hearing, found no evidence Standard had engaged in predatory pricing.
    • d. Successful predatory pricing is not logically impossible. If the big firm can commit itself so strongly that it will obviously keep going till it goes bankrupt, it may not be worth anyone else's coming in. On the other hand, if a new entrant can commit itself, it isn't worth the big firm trying to drive it out. This is an example of the ambiguous results from trying to analyze strategic behavior.
• D. Resale price maintainance--why does it exist?
  • 1. To provide monopoly revenue for the wholesaler? But he can push prices up by pushing up the price he sells at, let the retailers compete down their profit margins. Why should he give monopoly profit to the retailers?
  • 2. To provide an incentive for retailers to provide related sales services such as showrooms, since
  • 3. Otherwise firms that do not provide those will cut prices and free ride on the ones that do.
  • 4. But why are such services bundled with sales of the good, instead of priced separately?
• E. Trade restrictions:
  • 1. Comparative advantage: Gains from trade are due to different relative costs between the two goods exchanged. How good we are at "producing everything" is irrelevant to what we can trade, although relevant to how rich we are.
  • 2. Subsidy by foreigners--so what. If they want to spend their tax money providing us with cheap cars, why should we object?
  • 3. Trade restrictions might benefit one nation at the expense of others if the nation as a whole was a monoposony, but individuals in it were not. The restriction acts like a buying cartel agreement to reduce quantity bought, driving down the price we must pay.
• F. Tie-ins, vertical integration, et. al.
  • 1. Vertical integration: cars and distributors, refineries and gas stations.
    • a. "monopoly profit of both???"
    • b. Why not let the other level compete and get profit at one level?
    • c. But--vertical integration might minimize monopoly inefficiency. If a steel monopoly simply sells steel at a high price, car companies will use an inefficiently low amount of steel in making cars. If the steel firm owns the car companies, it can use its internal cost of steel for deciding how to build cars, but still collect the monopoly profit on the car price. This is a substitute for discriminatory pricing against the car companies.
  • 2. Tie-ins: monopolize computer cards by requiring customers who buy your computers to buy cards from you.
    • a. But that lowers the price you can sell your computers for.
    • b. Why do they do it? Control quality of inputs?
    • c. Price discrimination. High demand customers also use lots of cards.
• G. Disadvantages of antitrust law:
  • 1. May prevent efficient mergers.
  • 2. Or make them much more costly.
  • 3. The threat of predatory pricing damages might keep out new entrants.
  • 4. And any fuzzy law raises litigation costs.

October 30, 1995

II. Regulation by well meaning regulators.

• A. Utility regulation:
  • 1. Rate of return on capital--amoung of capital determined how?
    • a. By amount invested--but what about risk? Inflation?
    • b. Setting a price that gives a reasonable return on replacement cost gives a price closer to actual cost than using initial cost of purchase would, but what if you your investment turns out to be a bad gamble and there is no price at which you can cover your cost-- heads you lose, tails you break even! On unregulated markets, the profit when you guess right balances the loss when you guess wrong.
    • c. By market value of the stocks--circular. The market value of the stock depends on expected profit which depends on how much return the regulators permit.
    • d. How do you measure replacement cost? Past expenditures are observable.
  • 2. How do you measure costs?
    • a. Past year..did they know that year was going to be used to measure costs in order to decide how much they should be allowed to charge in the future?
    • b. Once price is fixed by the regulator, the firm has an incentive to cheat on the quality dimension--so you need more regulation to control that.
  • 3. Price Errors do not cancel--we are concerned with efficiency not fairness. If regulators sometimes set too high a price and sometimes too low, both errors do damage. Ditto for rate of return on equity.
  • 4. Second efficiency condition: How do you decide what projects are worth doing at all? What matters is whether they produce positive total surplus--but consumer surplus is not being observed, just quantity demanded at a single price.
  • 5. Entry control: why?
    • a. To discourage inefficient entry? But ...
    • b. Unnecessary if selling at average cost!
    • c. But useful if you are cross subsidizing (junk mail? rural routes?)
    • d. Or helping the monopolist.
  • 6. Pricing.
    • a. MC vs AC. Deadweight of taxes is larger per dollar the larger the total tax burden. So the right choice between MC+subsidy paid for by taxes and AC might vary with the size of government.
    • b. Second efficiency condition--Posner's bridge vs ferry example.
    • c. Two part pricing--a different price on the marginal unit, not the marginal user.
    • d. Price discrimination to maximize profit (private monopoly) or to cover cost (regulated monopoly with regulators trying to serve the public)?
    • e. Cross subsidy vs price discrimination--is the firm makingn or losing money on the lower priced sales? If losing, and you want to make it keep doing so, you need some sort of exit control.

III. Theory of Regulation: Becker model of politics.

• A. Rational Ignorance problem with civics class democracy.
  • 1. Why it does not pay to be an informed voter
    • a. It costs time and effort to know what politician is doing what and whether it is in your (or the nation's) interest.
    • b. And what you get is one chance in ten million of changing the outcome of the election.
    • c. So it is almost never worth acquiring information for that purpose.
    • d. Unless you are very altruistic, and so give enormous weight to the gains to everyone else from electing the right person.
    • e. And this description fits how people act.
  • 2. Why do people bother to vote?
    • a. Why are sports teams associated with cities and universities?
    • b. Because part of what they sell is the pleasure of partisanship.
    • c. For the cost of a little time voting, you can be part of the biggest and most important game in the world.
    • d. People vote for the same reason they cheer the home team.
• B. Think of a political market with actors selling legislation.
  • 1. Who are the actors?
    • a. Legislators?
    • b. Parties?
  • 2. How are they paid?
    • a. Covert cash
    • b. Legal cash
    • c. Political support, labor, votes, etc.
  • 3. Bids both ways by beneficiaries and victims, high bid on average wins.
• C. What determines how much is offered?
  • 1. Gain to beneficiaries of getting the legislation or to the victims of stopping it.
  • 2. But--public good problem for interest group trying to raise money to lobby.
    • a. How easily the problem can be solved depends in part on the size of the group. A private member's bill, applying to one person, is at one extreme, a law that affects the whole population at the other.
    • b. Other features of a group affect how easily it can solve the problem--how organized it is, how well informed its members are, ...
    • c. Sum up all of these as "concentrated" (good at solving its internal public good problem) vs "dispersed" (bad at ...).
  • 3. Designing bills: The influence of information costs.
    • a. You want the information costs to potential opponents of the bill to be high.
    • b. If the information costs must be the same for everyone, you want them to be high so that only the concentrated interest can pay them.
  • 4. Legislator as entrepreneur.
    • a. If he sells the bill before he designs it, he wants to design it to minimize opposition.
    • b. If he sells it after he designs it, he may want to maximize opposition so as to get the two sides bidding against each other!
• D. Is the result efficient?
  • 1. If all interest groups are equally concentrated, the outcome is efficient, but ...
  • 2. Some fraction of it is competed away in competition for office.
  • 3. With unequal concentration, some tendency towards efficiency but also lots of inefficient transfers.
  • 4. Why not make transfer as efficiently as possible so as to maximize support from beneficiaries, minimize opposition from victims?
    • a. Indirect transfers can raise information costs to victims.
    • b. Auto tariffs are easier to defend than a straight cash payment to the auto firms.
    • c. And efficient transfer is hard--any transfer mechanism gives people an incentive to alter their behavior to fit the criteria for recipients. Even a transfer to the legally blind gives people with very bad but not hopeless vision an incentive not to get a job that would prove they were not sufficiently blind to qualify for the transfer.
• E. Why do we spend so little on campaigns?
  • 1. High information cost constraint prevents transfers directly to politicians,
  • 2. and also prevents transfers directly and efficiently to interest groups.
  • 3. Public good problem by interest group scales down the payment they can make for legislation that benefits them.
  • 4. If each of these costs a factor of ten, we are down to .01.
  • 5. Perhaps competition among politicians to sell legislation drives its price below what the group would pay if necessary.
  • 6. And perhaps "campaign expenditure" is much underestimated because it does not include "payments" of support in exchange for legislation.
  • 7. On the other hand, politicians can make lots of transfers without the money showing up in the budget. The agriculture program is largely a transfer to farmers in the form of higher food prices, for example.

  ---

I. The Economics of Judicial Lawmaking

• A. Precedents as a capital stock:
  • 1. Depreciate, depending on court, generality, legislation.
  • 2. Real empirical work has been done on this, using citations as a measure of how influential a particular precedent still is.
  • 3. Supreme Court precedents depreciate more slowly than Appeals courts precedents.
    • a. One reason is that the appeals court decisions are at the mercy of both the legislature and the Supreme Court.
    • b. The Supreme Court decisions are at the mercy only of the legislature.
    • c. And future Supreme Courts, which are more likely to agree with past Supreme Courts than with past appeals courts.
• B. Why does litigation occur? Why do wars occur?
  • 1. Uncertainty
  • 2. To establish a precedent
  • 3. Breakdown in bilateral monopoly bargaining
  • 4. Making it costly for the winner.
  • 5. If due to 1 or 2, and if important issues at stake, litigation will generate certainty where it is needed.
  • 6. So we get a sort of equilibrium density of precedents. Where the law is uncertain people legislate, making the law more certain.
• C. Why do judges follow precedent?
  • 1. So theirs will be followed? Public good problem--my violation of precedent will impose costs mostly on other judges.
  • 2. Social pressure is used to solve that problem?
  • 3. Apellate review helps solve it. Except for the Supreme Court, which is such a small public that it can solve the problem itself.
• D. Level of generality of Law.
  • 1. Limits of the courts
    • a. Misreading of the Coase Theorem--give goods to whomever values them most highly.
    • b. But courts are incompetent to do that--we use markets instead.
    • c. Ditto for giant Hand formula. "Everyone should act efficiently, and will be punished for not doing so."
    • d. And if they could do those things, how would we know if they were doing them? Giving courts complicated assignments make ithard for the rest of us to monitor their actions.
  • 2. Cost of precision: Any precise rule will sometimes be wrong for complicated activities.
  • 3. And a lot of precise rules mean that ordinary people do not know if what they are doing is illegal.
• E. Efficiency of the common law:
  • 1. If legislating to change precedents, then market/like effect, but ...
  • 2. Different weighting due to effect being mostly external.

II. The Economics of procedure:

• A. Trading off costs of errors of both sorts against costs of avoiding errors.
  • 1. Cost of acquitting the guilty:
    • a. Underinforcement inefficiencies.
    • b. Can you eliminate them by scaling up the punishment?
    • c. Yes--but that is also costly at the margin.
    • d. Could have a system of very high standard of proof combined with severe punishment.
  • 2. Costs of punishing the innocent:
    • a. Unnecessary punishment costs.
    • b. Very small decrease in incentive not to commit the crime
    • c. Reduction in stigma punishments for the guilty.
  • 3. Costs of the potential for error: litigation costs.
    • a. If the criminal court gets the wrong verdict 10% of the time.
    • b. If innocent, I spend money trying to stay out of the 10%,
    • c. If guilty, I spend money trying to get into the 10%
    • d. Assuming, in both cases, that probability of error can be influenced by my actions.
    • e. If court almost never makes mistakes, why pay for an expensive lawyer?
  • 4. Costs of avoiding error--spending more on investigating crimes, keeping police and prosecutors honest, ... .
• B. Trading off two kinds of errors against each other: Standard of proof.
  • 1. The greater the costs due to acquitting the guilty, the lower standard you should use.
  • 2. The greater the costs due to convicting the innocent, the higher standard you should use.
  • 3. Imagine a punishment which imposes small net costs, but prevents future offenses with certainty--not permitting a convicted felon to carry a firearm, in a society where firearms are not very useful for anything other than killing people perhaps.
  • 4. You might be willing to impose that with only weak proof of guilt.
  • 5. "Not Proven" verdict and stigma perhaps?
• C. Incentives re litigation from decision rules.
  • 1. Spend more if result can be influenced.
  • 2. Gather evidence if the rules require you to do so.
  • 3. My argument for adversary system as information revealer.
• D. Posner injunction example:
  • 1. Why irreperable harm?
    • a. Should it be any net social harm (rather than transfer)?
    • b. Or is the point that the other party included his liability for that harm in asking for the injunction?
    • c. Why not count irreperable harm in both directions even against guilty parties?
• E. Settle or litigate:
  • 1. Why not do pretrial discovery by freedom of contract?
  • 2. Might not work. My willingness to agree to the exchange is itself information.
  • 3. But unfavorable information to me! so too much discovery? So why compell it?
• F. Plea bargaining.
  • 1. Why it reduces punishment?
  • 2. Why it does not reduce punishment, and probably increases it.

I. Incentive incompatibility in the criminal law: Becker and Stigler

• A. The problem: Dragnet v Economics
• B. On solution: Monitor. Costly.
• C. Becker/Stigler solution--convert to bounty system.
• D. Commons problem? Overfishing?
  • 1. Need property rights
  • 2. Belong to the victim, like civil law...or ...
  • 3. Belong to the state and auction off? Like patent?

II. The impossibility of efficient private enforcement: Landes and Posner

• A. The optimum has both an optimal probability and punishment.
• B. Their simplification--costless to a max, nothing beyond.
  • 1. Graph, no reason to get the right point.
  • 2. Erroneous "overenforcement" result--finally fixed.
• C. Without simplification, same argument.
  • 1. Close the indifference curves but ...
  • 2. Still no reason to hit the point.
  • 3. Can see because trajectory and optimum depend on different things. Punishment cost, say.
• D. They conclude that it is inefficient, although it might be better than alternative.
  • 1. But works well only with high probability, low detection cost offenses
  • 2. Roughly corresponding to current tort law.

III. Efficient institutions for private enforcement:

• A. Finding the optimal probability/punishment pair.
• B. My institutions.
  • 1. Profit maximizing guarantees trajectory cuts the point
  • 2. Government sets correct expected punishment.
• C. Problem of negative price for offenses.
  • 1. Selling deterrence.
  • 2. Bounty system. Government subsidizes sale of offenses.
• D. Problem of cheating on enforcement.
  • 1. If punishing is profitable on the margin, catch more than you claim, accept payoff to let go.
  • 2. If punishing is unprofitable on the margin, catch fewer--pay them to "turn themselves in."
  • 3. Monitor roughly by deterrence.
• E. Issue of self-protection incentives.
  • 1. Complications: Externalities from self protection.
    • a. I deter you into robbing someone else. Visible protection.
    • b. I deter you from robbing someone else. Invisible protection.
    • c. Assume both away.
  • 2. Without a subsidy, efficient incentive.
    • a. Full argument in article.
    • b. Plausibility argument--if catching and punishing cheap, social benefit of deterrence is low, so is benefit to me of deterring, since I sell the offense for about the damage done.
  • 3. With a subsidy, too low an incentive to self protection.
• F. Could we endogenize the whole thing?

IV. Bottom line: Less clear than Posner thinks, but ...

• A. Judgement proof defendants pose problems for private system.
  • 1. Make them less judgement proof (penal slavery, alternatives of fine or, ...)
  • 2. Use mixed system with govt bounty filling in the cracks of private system.
  • 3. Full public system.
• B. Low probability of apprehension and conviction imposes a problem ...
  • 1. Not, pace Posner, because of the double optimization problem, which is solved by setting <P> instead of P, but ...
  • 2. Because it implies large P thus judgement proof defendants (at least for serious offenses!), and ..
  • 3. Large multiples raise potential fraud problems if prosecution controlled by the plaintiff.
• C. Private system might have a problem with too many resources spent on prosecuting, defending.
  • 1. We need a well thought out analysis of optimal litigation expenditure.
  • 2. Does not come automatically because of externality in litigation.
  • 3. Perhaps including these problems in setting the optimal punishments would solve this one.
  • 4. It really includes the fraudulent offenses categories--that is rent seeking too.
• D. But Public alternative has its own problems:
  • 1. No endogenous mechanism to optimise anything, unlike ...
    • a. Optimal p/P in private system, and ...
    • b. Efficient allocation of resources via usual private incentives.
  • 2. Puts the state in a potentially dangerous special position vis a vis everyone else.
    • a. De facto immunity from criminal prosecution, as in ...
    • b. Ruby Ridge, Black Panther shootout.
    • c. In both cases, civil the victims won (settlement).
  • 2. And that was the 18th century argument against.

V. Why is blackmail illegal?

• A. Bad argument for blackmail--mutually beneficial agreement.
  • 1. But being able to make the agreement may hurt the victim.
  • 2. By giving the blackmailer an incentive to get the information in order to be paid off.
• B. Bad argument against:
  • 1. Prevents law enforcement because evidence is hidden.
  • 2. But imposes a punishment (fine), and ...
  • 3. Creates an incentive to discover an offense
• C. Good argument for: a form of private enforcement.
  • 1. Provided that blackmailing is for things we want to punish.
  • 2. Yes for crimes
  • 3. no for embarassing facts. Eunuch.
  • 4. Sex change operation?
  • 5. Social fraud?

I. Private Law: Ellickson

• A. The study
  • 1. The Coase Puzzle: Is the use of property different under open range and closed range rules?
  • 2. Shasta facts. The county is a patchwork of open and closed range, with which areas are covered by which rules changing over time.
  • 3. Ellickson confirmed Coase's prediction, but concluded that it was true for an entirely different reason; the side payments implied by Coase's argument were not there.
• B. The system of private norms.
  • 1. Straying cattle: apologise, don't do it again, make restitution if significant damage was done.
  • 2. Enforcement: Gossip, if that doesn't work transport the cattle away from their owner, in extreme cases even injure the cattle.
  • 3. But never sue.
  • 4. The norms also produce rules for fence building and repair costs between neighbors.
• C. Why do they care about the legal rules?
  • 1. Cattle owners think the rules determine their rights vis a vis motorists who run into cattle.
  • 2. Such conflicts are usually not with neighbors, so courts matter.
  • 3. Ellickson argues it is a symbolic issue.
  • 4. It is rational to avoid closed range areas, even if the legal difference is small--because the price of grazing rights is the same in open, and there is an excess supply
  • 5. Of government grazing land.
• D. Other norms:
  • a. Whalers on who owns the whale.
  • b. Professors on photocopying articles.
• E. Thesis:
  • 1. Close knit groups develop efficient norms.
  • 2. I offer an argument for evolution of norms within groups.
  • 3. This does not lead to efficient global norms, only to efficient local norms
  • 4. Whaling example. The global norm would have been a restriction on the catch to maintain the number of whales.
• F. Efficiency of inefficient punishments.
  • 1. The punishments used were less efficient than converting a tresspassing cow into hamburger in the victim's freezer, but ...
  • 2. That would have given victims an incentive to overreact, being biased judges in their own case.

II. Iceland

• A. The puzzle: Can civil law replace criminal law? Landes/Posner/Becker /Friedman series of articles.
  • 1. Arguments against
    • a. Judgement-proof defendants
    • b. Impecunious or weak plaintiffs
    • c. Diffuse damage cases
  • 2. Iceland as a test case.
• B. History and institutions
  • 1. Settlement story.
  • 2. Chieftaincy as property
  • 3. Thingmen tie in to the court system through the Godord
  • 4. Which court has jurisdiction determined by which godords the plaintiff and attorney belong to.
  • 5. Logretta: legislature made up of chieftains and their advisors.
  • 6. No executive.
• C. How it dealt with the problem:
  • 1. Judgement proof defendants.
    • a. Coalition loans
    • b. Debt Thralldom
    • c. Outlawry as alternative.
  • 2. Impecunious plaintiffs: transferrable claims.
  • 3. Diffuse damage--anyone can take the claim, if more than one wants it, draw lots.
  • 4. Enforcement without a state. Equilibrium of violence.
• D. How well did it work.
  • 1. Brief sketch of history.
  • 2. Level of violence evidence is imperfect but suggests that it was not very high
  • 3. Produced an impressive literature, including histories and historical novels still in print in English translation (the sagas).
  • 4. Relatively free society.
  • 5. Eventual breakdown? Why?
    • a. Norwegian meddling
    • b. Increasing concentration
    • c. Church--tithes as taxes.

III. 18th century England

• A. The basic puzzles:
  • 1. Selection of punishments.
  • 2. Private enforcement
• B. Detailed story of punishments.
  • 1. Benefit of Clergy story.
  • 2. Pattern of punishments.
    • a. For minor offenses, public whipping, stocks, etc. (In part stigma?)
    • b. Confinement, workhouse, Bridewell for vagrancy etc.
    • c. Confinement until trial in disorganized, cheap jails. Begging, etc. Casanova
    • d. Transportation
    • e. Execution
    • f. Pardoning
  • 3. Transportation story in more detail: Lumpy form of penal slavery
    • a. Early failed attempt
    • b. Successful attempt with subsidy
    • c. American revolution holdup.
    • d. Return from the New World too easy? Nowhere to send the convicts after the American Revolution? Australia.
  • 4. Galley slavery story and explanation.
  • 5. Pardon
    • a. Sold in themiddle ages.
    • b. Still sold? One version. By whom--public v private.
    • c. Or detailed price discrimination scheme? Enough punishmentto deter--determined by the judge after the trial.
• C. Details of private prosecution.
  • 1. By anyone, typically the victim; the prosecutor paid the costs of the prosecution.
  • 2. Problem--why bother to prosecute?
  • 3. To collect an out of court settlement (compound).
    • a. Apparently legal in middle ages, most appeals of felony did not go to trial, ratio of private to public declined steeply c. 1218 after legal change.
    • b. Illegal in the 18th c., majority of cases seem to have gone to trial, but for those that did not the prosecutor was rarely punished.
    • c. Form of compounding mostly discussed was for return of stolen property.
    • d. Like ransom. Reduces cost per crime, increases number of crimes.
  • 4. To deter. Reputation or Society for the Prosecution of Felons.
  • 5. Problem with anonymous victim crimes.
  • 6. Rewards to deal with--especially highway robbery.
  • 7. Problem with rewards.

Summary

I. The economic approach can be applied to virtually all of law; areas we have covered include:

• A. Property, including Intellectual Property
• B. Contract
• C. Tort
• D. Regulation/antitrust
• E. Legal history--in our case Iceland and 18th century England

II. Our treatment of those areas, however, has been relatively shallow

• A. In part because covering all of law in any detail requires three years, whatever perspective you do it from, and we only had a semester.
• B. In part because large parts of law have not yet been analyzed in any detail from the economic perspective--although they could be.
• C. Which suggests a research project adequate for multiple careers--taking the whole body of existing legal scholarship as input
  • 1. Both to provide information of what law has been in all times and places, and ...
  • 2. Thoughts about why.
• D. And redoing it from an economic perspective.

III. The economic approach employs a bunch of concepts, interlinked with each other and each applicable to many different legal issues. For instance:

• A. Rationality.
  • 1. All of the arguments about efficiency etc. hinge on assuming that individual actors are correctly pursuing their own objectives. If contracts were designed by flipping coins to choose the terms, there would be very little reason for freedom of contract.
  • 2. The deterrence analysis of criminal law hinges on the assumption of rational criminals. The case against efficient punishments depends on rational (and self-interested) enforcers.
  • 3. Similarly, the tort liability analysis assumes that, if we give tortfeasors and victims the correct incentives, they will then take the correct actions.
• B. Price
  • 1. The fact that changing one term of a contract results in changes in the others, including the price, is central to our argument that restrictions on freedom of contract do not in general transfer towards those they appear to favor--price adjusts.
  • 2. The analysis of both tort and criminal law views a punishment (or damage payment) in part as a price used to control the amount of some behavior "demanded."
  • 3. Posner's (erroneous) argument for accepting industry practice as non-negligent depended on the (correct) claim that firms would properly take account of costs imposed on customers or employees because those costs would show up in the relevant price (at which goods were sold or labor bought).
  • 4. A standard anti-trust argument--that a monopoly in one area is leveraged into a monopoly in another viatie-in sales, giving profits from both--is due to ignoring the effect of raising the price of (say) punch cards on the price for which the computers that use them can be sold.
• C. Efficiency
  • 1. Is a part of predicting the implications of rational behavior--in those settings (such as low transactions costs or perfect competition) where rational behavior leads to efficient outcomes.
  • 2. May be part of predicting legal rules, if you accept Posner's conjecture.
  • 3. Is arguably an appropriate design objective for legal rules.
• D. Market failure
  • 1. Externality
    • a. Crimes and torts impose negative externalities.
    • b. Invention, especially if there is no patent protection, produces a positive externality and is thus underproduced.
    • c. Moral hazard in insurance is an externality problem--since the car is insured, why should I bother to lock it?
  • 2. Public Good Problem
    • a. Is one of the transaction costs blocking some Coasian solutions in (for example) the railroad/farmer problem.
    • b. Is what keeps criminals from getting together and agreeing not to accept plea bargains, thus straining the prosecutor's resources so badly that he has to drop charges against many of them or else lose many cases through inadequate effort.
  • 3. Information Assymmetry
    • a. Adverse selection in insurance--the market for lemons problem.
    • b. A problem in contracts--when he proposes that he should not be liable for breech, what do you conclude about his plans? So he may not propose it, even if it is efficient.
  • 4. Rent seeking: spending resources trying to transfer in your favor. Appears as ...
    • a. One reason the Coase Theorem does not imply that courts should simply allocate every good to its highest valued user. Buying and selling is cheaper than stealing and litigating. Another reason is that the court does not know enough.
    • b. The argument in favor of bright line rules. Since real world issues are usually complex, a bright line rule sometimes gives the wrong answer. But a more complicated rule gives parties an incentive to spend resources trying to persuade the court that their case is on the right side of the fuzzy line.
    • c. The argument against efficient punishments--they give people an incentive to try to convict other people in order to expropriate them.
• E. Coase theorem/transaction costs
  • 1. Is at the heart of arguments for how property, including intellectual property, should be defined and protected.
  • 2. Appears again in the analysis of tort law, where private transactions may substitute for liability, or be combined with fines to give too much incentive not to impose costs.
  • 3. And in the tort/crime question, where transaction costs for punishing acts that impose diffuse damages may prevent the tort system from working.
  • 4. And the Coasian joint causality point (not tortfeasor/victim but two parties whose actions jointly produce a cost) is at the heart of the problems with liability systems.

  ---

I. Economics:

• What is economics
• Rationality
• economic efficiency
  • Efficiency of competitive equilibrium :
    • Inefficiency due to
    • Market FailurePublic good/Externality
    • Information Assymmetry
    • Rents seeking (aka externality) grabbing property.
    • Always--net cost not transfer
  • Efficiency of 0 transaction cost world. Inefficiency due to
    • Transactions costs, taking the form of
    • public good, holdout, etc.

II. Property.

• A. how to bundle, allocate, enforce.
• B. Ordinary property--transaction/enforcement costs.
  • 1. Dogs
  • 2. Slavery/ransoms
• C. I.P. Copyright, Patent, Copyright for programs.

III. Contract

• A. Benefits from enforceability--tie your hands. Individual not group rationality. Not continual renegotiation.
• B. General argument for freedom of contract, but ...
  • 1. Some exceptions--third party effects. Incompetent signer. Proof of assent.
  • 2. And never enough fine print.
• C. Optimal contract rules arise twice.
  • 1. In designing default rules, and ...
  • 2. In drawing up contracts.
• D. Optimal contract analysis echoes optimal insurance analysis and optimal tort rules!
  • Risk spreading
  • Optimal control of risk
  • Best knowledge of risk.
• E. Optimal damage rules: Reliance, Expectation, Liquidated.
• 1. margin to sign or not to sign
• 2. How much to rely
• 3. Whether to breach

IV. Family law. Marriage as a long term contract.

• A. Cohen on divorce.
• B. Increasing marital instability due to reduced firm specific capital.
• C. Public schooling, as a solution to?
  • 1. Externalities from education? What? Wrong solution.
  • 2. Capital market failure. Why subsidize for everyone, why produce?
• D. Optimal population?
  • 1. Net externalities from children?
  • 2. Defining the optimum.

V. Tort Law: Coase and Pigou again.

• A. Objective: Not zero but optimal accident rate.
• B. Coase: Dual causality
• C. Nothing works.
• 1. Strict liability works for one side.
• 2. negligence works for both if the court knows the right answer, but it doesn't
• 3. Double liability works--but accidents are never reported.

VI. Products liability.

• A. Caveat Emptor.
• B. Negligence liability. Now he has the right incentive to avoid them, but does not include the cost of accidents that still occur in the price, since he will not be negligent and thus not be liable, so consumers who are not aware of the risk buy too much of the good (activity level is too high),
• C. Caveat Venditor (strict liability).
• D. Freedom of Contract?

VII. Criminal Law

• A. Objective like tort law, optimal level of crime, but ...
  • 1. State enforced
  • 2. With costly punishments, some probability of costly apprehension, conviction.
• B. Why not hang them all?
• C. Why count costs to the victim?
• D. Why have criminal law? Enforcers' incentives, presumably.
  • a. No probability multiplier in the civil law because it would be an invitation to fraudulent suits, and since there is no probability multiplier the civil law works best for offenses where the probability of apprehension and conviction is high.
  • b. Efficient punishments in the civil law mean that false positives are less socially costly than in the criminal law, so we have a lower standard of proof in civil law.
  • c. Private prosecution is a reason to have the punishment be a fine paid to the prosecutor (as in our civil system), since otherwise you have to worry about preventing out of court settlements--which convert the punishment into a fine paid to the prosecutor.
  • d. If the prosecutor collects the fine there may be a conflict over who prosecutes, so we need some property rule to determine who "owns" the right to prosecute and collect.
  • e. Ownership by the victim, as in our civil law, may make sense because he is the one most likely tohave evidence, and uniting ownership of evidence and claim reduces transactioncosts of prosecution.
  • f. But ownership by the victim reduces his incentive to prevent the crime--if it occurs, he gets a (possibly valuable) claim. In an article on private enforcement, I show that (given some simplifying assumptions) the result is the optimal incentive to prevent.
• E. Organized Crime implausible.
• F. Economics of drug laws.

VII. Antitrust.

• A. Inefficiency of monopoly x 2.
• B. Problems with doing anything about it.
  • 1. Incentives of the regulators, risk of capture.
  • 2. Problem of regulating, keeping in business, and keeping efficient.
  • 3. Problem of knowing the right decisions to make. Information.
  • 4. Rate of return problems--what rate on what base?
• C. Standard antitrust mistakes.
  • 1. Adding up monopolies--wrong explanation of tie-in sales, retail price maintainance. Price.
  • 2. Predatory pricing mistake.

VIII. Becker model of politics.

IX. Economics of lawmaking.

• A. Precedents as a capital stock:
• B. Why does litigation occur? Why do wars occur?
• C. Why do judges follow precedent?
• D. Level of generality of Law.
• E. Efficiency of the common law:
• F. Trading off costs of errors of both sorts against costs of avoiding errors.

X. Private vs public enforcement.

• A. Civil vs criminal law again, with some civil imperialism. Iceland.
• B. More moderate version 18th c. England.
• C. Can we set up the rules to give private enforcers the right incentives? \
• D. Is this a rerun of the old philosopher king error?

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