Table of Contents

I. Mechanics of Course

II. Sketch of course

III. What is economics

IV. What is the Economic Analysis of Law

V. What is economic analysis of law good for? Why should people study it?

VI. What is the relation between economics broadly defined and economics more conventionally defined?

VII. What is economic efficiency?

VII. Law

I. Externalities: The conventional Analysis

II. Externalities in the law

III. Coasian critique of externality theory: An argument in three acts.

IV. Some further implications:

V. Damages vs fines:

VI. Fines vs Damage Payments in summary:

VII. Other Coasian stories:

VIII. Coase vs Pigou--a summary:

IX. Property rules vs liability rules:

X. Another take: Its all a matter of information

I. Insurance: why it is interesting:

II. Why insure?

III. The economics of risk aversion:

IV. Von Neumann and Morgenstern formalized this argument as Von Neumann utility

V. One problem with insurance: Moral Hazard.

VI. The other problem with insurance: Adverse Selection.

VII. Application to product liability. Who is liable for damage done by exploding Coke bottles?

VIII. Why doesn't the law make these calculations for ordinary insurance, deciding for you whether you are insured or not?

IX. Why not apply the same analysis to tort liability?

I. Review: Marginal vs average.

II. Ex Ante, ex Post:

III. "Impossible attempts": Should there be a penalty for attempting to kill someone by a method that cannot work?

IV. Strategic behavior:

V: What is property?

VI: Determining property rules really involves a set of questions:

VII. Property rules--including Intellectual Property (I.P.), primitive societies, et multae caetera:

VIII. Intellectual Property Law: What the law is.

IX. The Economics

I. Contract Law:

II. But contracts can be enforced in other ways than by law--and are.

III. Damages

IV. Consumer fraud, liability, etc. [I will be covering this material Monday 11/4]

V. Duress

VI. Information and Incentives: Laidlaw v Organ [I will be covering this material Monday 11/4]

VII. Contracts, a summary.

I. Divorce: Lloyd Cohen article.

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

III. The economics of wedding rings-argument from an article by Margaret Brinig (not in the packet):

IV. Adoption market:

V. 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.

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

I. Tort Law:

II. "Wrongful"

III. Causation complications

IV. Liability

V. Complications in tort damage analysis

VI. Liability alternatives

VII. Summary of implications

VIII. Amount of damage payment awarded

IX. My Explanation 1: Punitive damages are for very deterrable torts

X. My explanation 2: Punitive damages are for strategic torts

XI. Why pay tort damages to the victim?

XII. Three steps to an efficient world

XIII. Damages for loss of earning capacity, death, injury

I. The nature of the criminal law:

II. Economist's view of what should be a crime and why.

III. If this is how we set our punishments, then the reason we do not make them higher is that we are afraid of deterring efficient crimes. Can that be right? Is the reason we do not increase the punishment for murder that we are worried that we would then have too few murders? [This set of issues is discussed in more detail in my "Payne v Tennessee" and "Punitive Damages" articles]

IV. The cost of crime control.

V. If punishment were costless, the optimum level would be expected punishment equal to damage done, deterring all and only inefficient offenses. How do we calculate the optimal punishment taking account of the cost of imposing it?

VI. Why count the criminal's costs at all?

VII. Rich vs Poor--should they pay the same fines? In some cases yes, but in others no, because:

VIII. Marginal deterrence: My article (with William Sjostrom) is accessible from the web page.

IX. The Paradox of Efficient Punishment:

X. Some more points involving crime:

XI. Criminal law summary:

I. The Issue of Monopoly

II. The Efficiency and Inefficiency of Discriminatory Pricing: A XMas Tale

III. Solving the efficiency problem of natural monopoly by regulation:

IV. What about legal rules to discourage monopoly?

V. As these examples show, imprecise verbal arguments about monopoly behavior, or economic behavior in general, often produces the wrong answer. There is something to be said for precision--and for formal mathematical models.

VI. The English vs the American Rule

I. Looking at how other societies did it.

II. Iceland. History. Harald's unification of Iceland. [This is given in much greater detail in my article "Private Production and Enforcement of Law: A Historical Case" which you have, and which is also on the web]

III. 18th century England. [This is given in much greater detail in my article on 18th century England]

IV. Twentieth Century California. [This is discussed in more detail in my review "Less Law Than Meets the Eye," and in much more detail in Ellickson's book]

V. Summary:

VI. Efficiency and the common law:

I. What is economics?

II. What is economic analysis of law?

III. Allocational vs distributional issues: At the heart of many political arguments, including the preception of economic analysis of law as conservative.

IV. Economic efficiency

V: What is Law?

VI. Essential economic concepts

VII. Property

VIII. Contract Law

IX. Family law

X. Tort law

XI. Criminal Law

XII. Monopoly

XIII. The English vs the American rule

XIV. Some interesting historical cases

XV. Summary of Summary

---

Class Outline: Economic Analysis of Law

This outline contains what I said, what I think I said, and what I ought to have said, so discrepencies between what it contains and what you remember are not necessarily due to your poor memory.

• I. Mechanics of Course:
  • A. Written material will consist of:
    • 1. A short book by Polinsky
    • 2. Lots of articles which will be handed out in class; note that in some cases only part of the article is assigned.
    • 3. An outline of the lecture, which will be handed out each week for the preceding week, deus volenti. You're reading it.
    • 4. An optional supplementary text by Posner. This is a big book, covering a huge range of material, by one of the leading scholars in the field.
  • B. I have a web page for the course at http://www.best.com/~ddfr/Econ154.html. My EMail address is DDFr@Best.com
  • C. There will be a midterm at about 10/24.
  • D. The final will cover everything, and be mostly or entirely essay.
  • E. last year's lecture notes and exams, from when I taught this course at Santa Clara University, are or will be available on the web page and in the library.
• II. Sketch of course:
  • A. This week--introduction
  • B. Part I: Economic Analysis of Law, organized by ideas.
  • C. Part II: Organized by legal field.
• III. What is economics? [For a longer discussion, see chapter 1 of Price Theory ]
  • A. An approach to understanding behavior, based on the assumption that Individuals have objectives and tend to choose the correct way of achieving them. "Rationality."
  • B. Some Examples:
    • 1. Why have locks on doors?
      • a. A sufficiently determined burglar can get into anything short of a bank vault, with a sledgehammer and crowbar or through the window.
      • b. A lock makes it harder, thus more work and a greater chance of being caught, thus a less profitable project.
      • c. So we put locks on our doors because we believe that burglars are rational.
    • 2. A policeman has evidence that will convict a criminal; what does he do with it?
      • a. Convictions costs the criminal $50,000, benefits the policeman's career by $10,000
      • b. Dragnet answer: arrest the criminal.
      • c. Economics answer: Sell the evidence to the criminal for some price between $10,000 and $50,000
      • d. To keep this from happening, some of the policemen have to be watching the other policemen instead of the criminals.
      • e. The solution proposed by Becker and Stigler was a bounty system, where the policeman receives as salary the fine paid by the convicted criminal. If he takes a bribe, he is merely cutting out the middleman.
      • f. Which is how our civil system works--we call the "bribe" an out of court settlement.
    • 3. Civil forfeiture
      • a. Under Federal law and the law of many states, property used in certain crimes can be seized by the government, without proving that the owner was guilty of anything.
      • b. In at least some states, the value of the seized property goes to the police department that seized it.
      • c. Which gives police departments an incentive to look for rich people they can find (or create) evidence against, rather than criminals in general.
      • d. A similar problem exists with punitive damages.
    • 4. If we impose the maximum possible penalty for armed robbery, the additional penalty for murder if you are already committing armed robbery is zero, so we have made it in the interest of armed robbers to kill their victims.

     

• IV. 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, ...
      • a. The implication is not necessarily that we shouldn't do it--it will deter some armed robberies
      • b. But increase the number of armed robberies with murder
      • c. And we should take that into account in deciding whether to execute armed robbers.
    • 2. Plea bargaining:
      • a. It seems as though it should weaken punishments, since a defendant will only accept a plea bargain if he thinks it is a better deal than the risk of being tried and convicted.
      • b. 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, since prices, or other terms in the contract, shift to compensate.
    • 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.
  • B. Second Project: Predicting legal rules.
    • 1. The Posner Conjecture: Common Law tends to be economically efficient.
    • 2. One basis for this conjecture might be a plausible mechanism by which efficient law would be generated. In my opinion, Posner has never provided 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--and might be able to do so for whichever alternative the law chose.
    • 4. An alternative approach to predicting legal rules--legislated ones--is public choice theory, which tries to apply economics to the political marketplace. We will probably not be covering that in this course.
    • 5. 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.
    • 1. Controversial, but ...
    • 2. Economic efficiency is a value, and maybe the one law can best achieve
    • 3. Allocation vs distribution
• V. What is economic analysis of law good for? Why should people study it?
  • A. One attraction of the economic analysis of law, from the standpoint of legal scholars (or potential legal scholars) is that it ties together diverse areas of law, providing a common theoretical structure.
  • B. It is also useful for understanding economics, because you learn about ideas by trying to concretise them.
    • 1. "Property" sounds like a simple idea--and isn't.
      • a. Does ownership of land include the air above--to what height? The earth underneath? Oil in the earth underneath?
      • b. What can you do to protect your ownership? Physically keep people out (build a high wall)? Shoot trespassers? Sue trespassers--but only for damage actually done?
    • 2. "Cause an externality" seems like a simple concept--and isn't. When I play loud music while my roommate wants to sleep, there is a resulting cost--but it would be eliminated either by my turning off my music or by my roommate deciding to get up and party.
    • 3. Coase revolutionised our understanding of externalities, market failure, etc., in part by looking at how the common law of nuisance treated such problems.
    • 4. "Cause" is also a difficult concept more generally. Consider the case of two hunters simultaneously shooting a third--one in the head, one in the heart. Who caused the third hunter's death? Neither--and both.
  • C. The law is also useful to economists as a vast pool of interesting puzzles.
  • D. And as data.
    • 1. How people do things is a fact--evidence.
    • 2. When you prove they would be better off doing things differently, you have probably demonstrated a flaw in your theory--since people generally know what actions are in their interest.
• VI. I have been offering a broad definition of economics, one that goes far beyond prices, unemployment, and the like. What is the relation between economics defined in that way and economics more narrowly defined--what you find in the typical micro text?
  • A. The latter has been worked out in more detail.
  • B. and it helps us understand economics in the broader sense.
    • 1. To understand marriage, use ideas developed in explaining long term contracts between firms. Talking about a marriage market is not merely a metaphor--it is a real market, even if the prices are not explicit or in money.
    • 2. To understand your three year old's apparently irrational behavior ("I want icecream and will throw a tantrum if I don't get it, even though you will then send me up to my room without any icecream") think about the logic of commitment strategies in ordinary economics. If he persuades you that he has committed himself strongly enough, next time you may give him the icecream to avoid the tantrum.
  • C. The broad approach helps us intuit the narrow. We do a lot of rational choosing in our daily lives, and can apply the intuitions developed there to understanding the behavior of firms, workers, etc.
• VII. What is economic efficiency? (Posner calls it "Wealth Maximization") [For a longer discussion, see Chapter 15 of Price Theory .]
  • A. The problem--evaluating different systems of rules, their outcomes, etc.
    • 1. By whose values?
    • 2. How aggregated?
  • B. The economic solution.
    • 1. Revealed preference: 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. How valuable? It is worth to him the maximum amount he would be willing, if necessary, to pay for it.
    • 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.
    • 3. Note that value measured in dollars is not the same thing as pieces of green paper. If I am willing to pay $400 for a new printer and buy it for $300, I end up with $300 less money--but I am $100 better off than before the deal.
  • C. Defense of the economic solution.
    • 1. If we wish to describe behavior, it is revealed preference, not "value as known in the mind of God," that 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--to decide how society should be organized?
      • 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 available 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, 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 discussing--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. [I didn't get to this part in class]
    • 1. Pareto:
      • a. An improvement is a change that benefits someone, hurts nobody. This definition avoids interpersonal comparison, but ...
      • 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).
      • c. Because if there are net benefits, then the gainers gain enough to compensate the losers, and if the gainers gain enough to compensate the losers, then there are net benefits.
      • d. Actually, there is an exception to this apparently obvious conclusion, explained in my article "Does Altruism Produce Efficient Outcomes? Marshall vs Kaldor" on my academic web page.
    • 3. Both the Kaldor and Pareto approach 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.
  • E. 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.
• VIII. Law
  • A. Where it comes from:
    • 1. Constitution
    • 2. Legislature
    • 3. Courts
      • a. On their own--Anglo-American common law.
      • b. Interpreting the constitution to constrain the legislature
      • c. Interpreting legislation.
    • 4. The hierarchy of courts, appeals.
      • a. District to Circuit to Supreme
      • b. Each level can refuse to hear appeal
      • c. Appeal on the law, not the facts, which the appeals court accepts as determined by the lower court.
    • 5. Why courts matter--the inherent ambiguity of English. You cannot write laws clearly enough to leave no hard cases, so the courts (at least) fill in the details.
  • B. Consistency/inconsistency.
    • 1. In many areas, state laws differ.
    • 2. Federal laws are the same everywhere in the U.S., but different circuits may differ in their interpretation of them until the Supreme Court hears the issue and settles the disagreement.
    • 3. In the case of patents on software, a specialized lower court with expertise in the field gradually pulled the Supreme Court into interpreting the law the way the lower court thought it should be interpreted.
    • 4. In interpreting new issues on the basis of old court decisions, courts frequently argue by analogy.
    • 5. Which raises the interesting question--is it analogy, or function, or interest, or ... that determines the development of the law.
  • C. How are cases decided.
    • 1. Adversary system
      • a. That means that each party is in charge of finding and presenting the evidence for his side of the case.
      • b. As opposed to an "inquisitorial" system where the judge is in charge of finding out what the facts are.
      • c. Real systems, American or European, have elements of both, but American is more adversarial, European more inquisitorial.
    • 2. Jury is available for both criminal and civil (U.S. only)
    • 3. Judge decides law, jury facts--supposedly.
      • a. But consider the incentive for a juror who disapproves of the law to "interpret" the facts so as to get what he considers the just verdict, or ...
      • b. For a judge who has a strong opinion on the facts to "interpret" the law so as to push the jury towards the correct verdict.
  • D. We have multiple legal systems
    • 1. Federal, state
    • 2. Criminal/Civil
      • a. The difference being whether the state or the victim controls what happens
      • b. And collects damages, if any (damage/fine; injunction/punishment)
      • c. Different standard of proof.
      • d. Civil law includes property, contracts, and torts.
    • 3. Administrative law.
    • 4. Property law:
      • a. What rights do you have when you own something?
      • b. What can you sell? Land, but not your kidney.
      • c. How else can you lose the rights? Under the doctrine of adverse possession, if someone else acts openly as if he owns the land, or some right such as the right to cross over it, and you do nothing to object, he owns it.
    • 5. Contract
      • a. What suffices to form a contract
      • b. What terms will be enforced
      • c. What terms will be read in--resolving ambiguity
      • d. How will breach be treated?
    • 6. Tort law: What determines liability
      • a. strict, negligence, comparative negligence
      • b. Causality--what does it mean for someone to cause an injury?
  • E. Some interesting issues include ...
    • 1. Why do civil and criminal law
      • a. Exist in their current form. Each is a particular bundle of legal rules
      • b. Apply to the particular things they apply to
    • 2. Adversarial vs Inquisitorial systems for trying cases
    • 3. Who pays the cost of litigation
      • a. English (loser pays) vs American (each party pays his own litigation expenses) rule for civil cases.
      • b. Should we reimburse criminal defendants who are acquitted for their defense expenditures?
      • c. What about defendants who are convicted and later found innocent?
    • 4. Enforcement strategies
      • a. How to punish criminals
      • b. How hard to try to catch them

http://www-leland.stanford.edu/~ddfr1/Econ154.html

Second Week: Externalities

Pigou, Coase, Railroads, Candy Makers, and All That

• I. Externalities: The conventional Analysis
  • A. The simple argument for efficiency:
    • 1. If people who take actions receive the benefits and pay the costs of those actions
    • 2. Then they will take those actions and only those actions for which net benefits>net costs
    • 3. Which is the efficient rule
    • 4. And this condition is met in the ideal competitive market (for explanation, see a Price Theory text--preferably mine)
  • B. The problem:
    • 1. If I can take an action some of whose costs are born by other people
    • 2. For example, produce both steel and pollution, sell the steel, pay wages and the cost of input, but not pay the cost of the pollution
    • 3. Then I will produce steel even if total costs, including pollution, are > total benefits for at least some of my output--i.e. produce more than the efficient quantity
    • 4. And I will produce steel in the way that minimizes my total cost, not all total cost--for example, will not do costly things to reduce pollution, even if they are, on net, worth doing.
  • C. Simple solution--direct regulation.
    • 1. The EPA or equivalent decides who can pollute how much where, what methods of pollution reduction have to be used, etc.
    • 2. The problem is that do do that right they would have to know both the damage done by pollution and the cost of all the alternatives--which they probably don't
    • 3. And it is not in the interest of firms to tell them, since a firm that can persuade the EPA that there is no way of reducing its pollution at any reasonable cost gets to keep on polluting.
  • D. Fancier solution--effluent tax.
    • 1. Charge each firm for the damage done by its pollution.
    • 2. It can decide whether to pollute and pay, control pollution, or stop producing.
    • 3. And it is in its interest to choose the most efficient alternative.
  • E. There is still an informational problem, since the taxing authority has to estimate the damage done by polluting in order to set the tax--but at least it does not have to estimate the cost of not polluting. It can trust the firms to solve that problem in their (and our) interest.
  • F. Both solutions face a further problem--how to make it in the interest of the regulator/taxing authority to make the rules that produce an efficient outcome.
    • 1. It might be more politically attractive to sell out to the polluters in exchange for campaign contributions.
    • 2. Or impose very stringent rules in order to be bribed not to enforce them.
    • 3. We will be mostly ignoring this class of problems at this point.
• II. Externalities in the law
  • A. Direct regulation of pollution--EPA
  • B. Laws as effluent fees: Speeding tickets.
    • 1. If we wanted to eliminate all speeding, we would hang speeders--or confiscate their cars.
    • 2. If we believe that speeding imposes some, but not infinite, cost on others, we try to impose a penalty sufficient to deter speeding--except when speeding is worth enough so that the driver is willing to pay the price.
  • C. Damage payments as effluent fees: Tort law.
    • 1. One way of inducing drivers to take precautions is to make them liable for the cost of the damage they do to others if they don't.
    • 2. By allowing their victims to sue them for damages.
  • D. Criminal punishments as effluent fees.
    • 1. Crimes impose costs on their victims.
    • 2. By making the criminal pay a punishment equal (on average) to those costs, we deter crimes, except
    • 3. When the benefit to the criminal is greater than the cost to the victim, so the criminal is willing to pay the price. Example: Hunter lost and starving in the woods who breaks into a cabin, steals food, phones for help.
    • 4. In other words, we deter inefficient and only inefficient crimes.
    • 5. An alternative approach, if we think the court can tell when offenses are efficient, is to special case them--to punish only the inefficient crimes. The lost hunter is excused from punishment under the "doctrine of necessity."
    • 6. Note that criminal punishments are typically costly. When I pay a damage payment, someone receives it. When I am executed, nobody gets the life I lose. When I am imprisoned, nobody gets my liberty and the taxpayers have to pay for the prison.
    • 7. We should modify our rules to take account of this. There may be some offenses that are inefficient--we would like to deter them if we could do so costlessly--but cost more to deter than it is worth.
  • E. Some of these examples involve a payment to the "victim" and others involve payment to the state. We will see shortly that this difference is sometimes important.
• III. Coasian critique of externality theory: An argument in three acts.
  • A. Nothing works: Two sided causation.
    • 1. A doctor builds a new consulting room onto his house, adjacent to where a neighboring candy maker is operating machinery. The machinery was no problem previously, but is vibration now prevents the use of the consulting room. The doctor sues.
    • 2. As this example shows, "external costs" are typically due to joint actions.
      • a. Polluting and breathing
      • b. Using the same lake for a summer resort and a place where a factory dumps chemicals
      • c. Operating a recording studio next to a fraternity house that has parties
    • 3. Making either one party liable to the other eliminates the other party's incentive to solve the problem.
    • 4. A railroad throws sparks that start fires in the adjacent grain fields. One solution is for the railroad to put on a spark arrester that will prevent the sparks. An alternative is for the farmers to plant some non-inflammable crop (hereafter "clover") along the rail line.
  • B. Everything works: The Coase Theorem
    • 1.The doctor wins his his case, but the efficient outcome is to move the consulting room, not the factory. So the candy maker pays the Doctor to move the consulting room and let him continue to operate his factory.
    • 2. As long as there are net gains from changing the outcome, there is some way of allocating the gains that makes everyone better off, so the change should occur. More precisely:
    • 3. The Coase Theorem: If transaction costs are zero, any initial allocation of property rights will lead to an efficient outcome.
    • 4. Here "transaction costs are zero" means "if there exists a transaction that benefits all parties, it will happen."
  • C. It all depends--on transaction costs.
    • 1. 1 Railroad and 1 farmer--fine. Whatever the legal rule is, they bargain to the efficient outcome.
    • 2. Railroad, 100 farmers, railroad has the right to throw sparks.
      • a. And should... no problem. sparks
      • b. And shouldn't--public good problem. Still sparks, even if the spark arrester is less costly
      • c. A public good problem occurs when a good, if produced, will be available to all the members of a pre-existing group. In this case, if someone pays the railroad to install the spark arrester, all of the farmers will benefit--whether or not they helped pay. So each farmer may try to be a free rider--get the benefit without paying for it.
    • 3. Farmers have the right to enjoin.
      • a. And should...no problem. No sparks, and that is the efficient outcome.
      • b. And shouldn't...holdout problem. Suppose that the cost of a spark arrester is $200,000, the cost of switching to clover is $100,000 ($1000/per farmer). RR offers each farmer $1100 to switch. One farmer notices that if everyone else agrees, his agreement will let the RR save a lot of money--but if he blocks the settlement (i.e. insists on enjoining the RR from throwing sparks) they will have to pay for a $200,000 spark arrester. So he tries to hold out for much more than $1100. So do others. No agreement. No sparks. No clover.
    • 4. Farmers have the right to sue--for $3000 damages each:
      • a. If no sparks is the efficient solution, you get it immediately--the RR installs the spark arrester instead of paying damages.
      • b. If sparks +clover is the right solution, get it after bargaining. A farmer can try to hold out--but the RR can settle with the other farmers, and pay the holdout $3000 for the fires in his fields. The holdout loses out on whatever premium the RR was paying above the cost of switching to clover.
      • c. If sparks without clover is the efficient solution, that happens immediately too. The RR is only willing to pay the farmers up to $3000 each to switch to clover--but switching costs them more than that (that is why clover is not the efficient solution in this case).
      • d. So the damage rule appears to be the best solution--if damages are easily and cheaply measurable by the court. We have so far ignored both the cost of litigation and the risk of court error.
• IV. Some further implications:
  • A. We should include other alternatives:
    • 1.the fourth option--RR has the right, but a liability rule. That means that any farmer can enjoin sparks--but is then liable to the railroad for the cost of putting on the spark arrester.
    • 2. Which gives a public good problem if no sparks is the right solution. No individual farmer wants to enjoin, because he will then pay for the spark arrester while everyone else gets the benefit of no sparks.
    • 3. And we could consider still more possible legal rules, including one where the RR can force the farmers to switch to clover--but owes them damages for doing so, and rules where the damage payments go to the state instead of the other party.
  • B. How we would figure out the optimal property rules, if we knew just barely enough: The spaghetti diagram.
    • 1. We start with three possible legal rules, four possible outcomes (one, spark arrester + clover, is uninteresting here, although one could imagine situations where we wanted both parties to take precautions).
    • 2. We are going to apply our legal rules to a lot of different situations in the future, and the courts will not know enough to revise the legal rule for each situation. In other words, we can't say "in any situation where the efficient outcome is sparks, give the railroad the right to throw sparks, in any situation ... ." We need a single legal rule to cover many future cases.
    • 3. We have some estimate of how likely different situations (sparks efficient, clover efficient, etc.) are to arise in the future.
    • 4. So we consider, for each initial rule, how hard it is to get from that rule to each of the possibly efficient outcomes. We then choose the least costly rule, allowing for how likely it is that each outcome will be the most efficient (and how much is at stake, and how costly getting to that outcome from that initial rule will be).
    • 5. Note that the costs coming from problems that block the move from initial rule to final outcome are of two sorts.
      • a. The cost of organizing a transaction--bargaining out a solution to the public good problem.
      • b. The cost of failing to organize such a transaction, and thus ending up with an inefficient outcome.
• V. Damages vs fines:
  • A. The strategic case: suppose the RR owes a fine to the government for each fire; further suppose that the spark arrester is the efficient solution, but clover is better than fires.
    • 1. The RR keeps throwing sparks, pays fines for a while, knowing that ...
    • 2. The farmers, who are suffering from the fires and not collecting the fines, will eventually switch to clover
    • 3. Note that this depends on a particular asymmetry--one RR, many farmers.
      • a. With one of each, the RR has no bargaining advantage. The farmer might refuse to switch to clover in order to get the RR to put on the spark arrester.
      • b. With many of each, no strategic behavior. Consider the case of auto accidents. It doesn't make sense for me to drive recklessly in the belief that everyone else will be very careful to compensate--because I am only one one-millionth of their driving environment.
  • B. The non-strategic case with bargaining:
    • 1. There is a factory polluting a small lake; preventing the pollution will cost the factory $1,000,000/year.
    • 2. The pollution does $700,000/year worth of damage to the resort at the other end of the lake--ruins the fishing, people don't want to swim in water that smells bad, etc.
    • 3. Efficient outcome--keep polluting, since prevention costs more than it is worth.
    • 4. The government imposes a Pigouvian tax--every year, the factory must pay $700,000 in fines to the EPA for its pollution. The factory keeps polluting. The resort keeps losing money.
    • 5. The resort owner offers the factory $400,000/year to stop the pollution--which is a good deal for the resort, since stopping the pollution is worth $700,000 to it.
    • 6. The factory accepts. It saves $700,000 in fines and gets an additional $400,000 from the resort, so it is worth paying the $1,000,000 cost.
    • 7. The result is inefficient.
    • 8. Coase + Pigou is too much incentive. "Incentive" is not automatically a good thing; what we want is the right incentive, neither too much nor too little.
    • 9. Note that the problem will not arise if the $700,000 is a damage payment to the resort instead of a fine--now the resort doesn't care whether or not the factory pollutes (and pays for it).
  • C. The non-strategic case without bargaining--auto accidents.
    • 1. The probability of accidents depends on precautions by both parties.
    • 2. We want each to take any precaution whose payoff in decreased accidents is greater than its cost.
    • 3. To give them an incentive to do so, we must make each party liable for all of the costs--double liability in total.
    • 4. At which point they have an incentive not to report the accident.
• VI. Fines vs Damage Payments in summary:
  • A. Strategic argument for damage payment--where parties are identifiable and one side has a big commitment advantage.
  • B. "Coase+Pigou is too much" argument for liability.
  • C. Joint cause argument for fine--adding up to double liability.
  • D. Liability has the advantage (and disadvantage) of private enforcement.
    • 1. An incentive to report the accident
    • 2. But also an incentive to sue when you have not been injured--in order to collect.
• VII. Other Coasian stories:
  • A. Suppose rights with regard to polluting the lake are well defined but for some reason the factory and the resort find it hard to bargain to the efficient solution. Perhaps there are many resorts. Perhaps it is hard for the resort to tell how much pollution the factory is putting out.
  • B. One solution is for the factory to buy the resort, or vice versa. Once they belong to the same firm, there is no longer an externality--the cost of pollution and the cost of pollution control are being paid by the same people.
  • D. Generalizing the argument provides an explanation of why we have firms--which was the subject of Coase's other famous article:
    • 1. If you have taken an intermediate micro course, you know that trade on the market provides the perfect system for decentralized coordination. So why have firms? Why not do everything by contract?
    • 2. Suppose we do it that way (the "Inside Contracting System," which was widely used in the 19th century). Each stage of production is being done by a separate firm or individual, with contractual agreements among them. "I will deliver ten assembled rifle actions per day for you to put into the stocks you are making, and I will get $7 per action from what he eventually sells them for."
    • 3. Something goes wrong. One party fails to fulfill his contract, imposing costs on everyone else up and down the line, which he may not have the resources to reimburse.
    • 4. More generally, the market solution to coordination is limited by transaction cost problems of various sorts, while the hierarchical solution (the ordinary firm) is limited by the problem of controlling people by command (the worker's objective is to maximize his welfare, not the firm's profits--only if the worker owns the firm, as he does in a system where every worker is his own firm contracting with other such firms, are the two objectives the same), the informational problems of centralized authority, etc.
    • 5. Think of the firm as a balance between the problem of transaction costs and the problem of hierarchical control. The bigger the former problems are the larger firms will be, the bigger the latter problem, the smaller firms will be.
• VIII. Coase vs Pigou--a summary:
  • A. In some contexts, such as traffic accidents and much pollution, we have large numbers on both sides, so no Coasian negotiation is practical.
    • 1. So property rights will end up where they start,
    • 2. So we want the "right" Pigouvian solution--which requires an opinion on who can best adjust.
    • 3. And might mean fining both parties to make both adjust--the auto accident case.
  • B. In some contexts, it is obvious who is the lowest cost avoider--so the Pigouvian solution is correct. But watch out for the Coase+Pigou problem if transaction costs are low.
  • C. In contexts where transaction costs are low and it is not obvious who is the lowest cost avoider, the Coasian solution is best--define rights clearly and let the parties bargain to the efficient solution.
  • D. The Coasian approach gives the same double incentive on the margin as does the double liability solution I described for auto accidents. My incentive to take a precaution that saves both me and you costs is the sum of my savings plus what you will, if necessary, pay me to take it--and similarly for your taking precautions. So on the margin, each of us takes account of all costs and so takes all precautions that are worth taking.
• IX. Property rules vs liability rules:
  • A. The difference:
    • 1. Property rule: If I want to use your property I have to get your permission, and if I use it without your permission I receive a punishment which may be much larger than the damage I actually did. In effect, the rule pushes people into coordinating by mutual agreement, rather than by unilateral action followed by litigation.
    • 2. Liability rule: I can use your property without your permission and then pay (in the form of a damage judgement when you sue me) for the damage done.
  • B. A liability rule requires the court to measure the value of what has been taken, damaged, etc., so the harder it is for courts to measure value, the greater the advantage of a property rule.
  • C. Under a property rule, the only way someone other than the owner of the property gets to use it is via a transaction with the owner, to get his permission. So liability is more attractive the harder it is for parties to transact.
  • D. Consider ordinary private property. A property rule is clearly superior to a liability rule. If I want your property, labor, etc. I buy it. The alternative would be a system where I get groceries by going into the store, taking them, and having the owner sue me for their value.
  • E. Consider pollution, or risk of airplane crashes--liability is clearly a superior rule. I can't contract, before taking off, with all of the people through whose roofs my airplane might conceivably crash if enough things go wrong.
• X. Another take: Its all a matter of information
  • A. Consider the RR/Farmer situation with a fully informed court.
    • 1. If you scrape my car and instead of having it repainted I wait a year until it has rusted through then sue you for the value of the car, I will lose; the victim of a tort is obliged to take reasonable care to minimize the damages.
    • 2. So if the court knows that clover is cheaper than fires, farmers who have fires due to sparks will only be able to sue for what it would have cost them to switch to clover--that being the reasonable way of minimizing the damages.
    • 3. The reason this usually does not work in practice is that the court can observe the fires and the damage done, but is unlikely to have enough information to figure out the cost of all the alternative precautions the farmer could have taken.
  • B. More generally, if a court knew everything relevant to figuring out how people ought to ask (i.e. what action--spark arrester, clover, checking your car brakes, driving at exactly 43 miles an hour, operating a candy factory only for seven hours a day, having a party at the frat house this Saturday but not next Saturday because next saturday is the best time for the recording studio next door to tape a new album, ...) it could solve all legal problems by telling everyone to do the right thing and hanging those who didn't. Everyone will obey, nobody will be hanged, so we get the perfect outcome with no litigation and no punishment.
  • C. This is analogous to the central planning solution to running a society--or the direct regulation solution to pollution problems. Figure out what everyone should do and make them all do it.
  • D. But since in practice the various parties to the dispute have private information that the court does not have, we try to use an incentive system instead--Pigouvian taxes, Coasian bargaining, or whatever--to make it in their interest to use their private information to choose the correct action.
  • E. Why don't we solve the whole problem this way--set up legal rules under which the court does not have to know anything, because it is in the interest of all parties to use their information to produce the right outcome?
  • F. Because we don't know how to do it for the hard cases.
  • G. For ordinary markets that is just what we do. All measures of value are determined by market transactions reflecting the values of the participants. But when we have to deal with externalities, public goods, transaction costs, etc. it becomes hard, and perhaps impossible, to set up institutions that work this way.

   

• Third Week: Insurance
•  
• I. Insurance: why it is interesting:
  • A. Because one recurring legal issue is who will bear the costs if something goes wrong-i.e. who is insuring whom. For example:
    • 1. Contracts. Something changes, so either I don't want to produce what I agreed to or you don't want to buy it. Who bears the costs resulting from such problems?
    • 2. Auto accidents: Who pays for them?
    • 3. Product defects and the associated costs. When a coke bottle explodes, injuring someone, is Coca Cola liable for the resulting medical costs?
    • 4. Wider political issues of welfare, unemployment insurance, health insurance, etc.
  • B. All of these involve the same set of issues, as we will see.
  • C. Starting with straightforward private insurance, which provides the simplest introduction to the analysis.
•  
• II. Why insure?
  • A. In expected value terms, insurance is a losing deal for the customers-on average, they pay out more in premiums than they collect in claims. If that were not true, insurance companies would go broke, since they not only have to pay claims but also other expenses (salaries, rent, advertising, ...).
  • B. But a dollar is not a dollar is not a dollar. Insurance may be a bad deal if you are calculating in dollars paid out and collected on average, but a good deal in terms of what those dollars buy.
  • C. Consider two futures:
    • 1. 50/50 chance of $10,000/year or $90,000/year
    • 2. or a certainty of $50,000/year
    • 3. Which do you choose?
    • 4. Why?
  • D. Consider the goods you would buy in each case. The goods you would give up if your income dropped from $50,000 to $10,000 are probably a lot more important to you than the goods you would buy if it rose from $50,000 to $90,000.
•  
• III. The economics of risk aversion:
  • A. On average, an additional dollar is worth less to you, in terms of the importance to you of what you use it for, the more dollars you have. This is the same reason we were not entirely happy with the solution to interpersonal comparisons that we used in defining efficiency-compare value measured in dollars-but this time in an intrapersonal context.
  • B. Where revealed preference solves the problem of how to measure the difference
  • C. And people buy insurance
    • 1. because a dollar in the future where their house burns down is worth more to them
    • 2. than a dollar in the alternative future where it doesn't.
  • D. This argument implies that you will insure against large risks but not against small risks, since the difference in value to you between the goods you would buy with an extra dollar if your income was $49,990 and the goods you would buy with an extra dollar if your income was $50,010 is small.
•  
• IV. Von Neumann and Morgenstern formalized this argument as Von Neumann utility-which is defined in such a way that individuals, in choosing among alternative gambles, maximize expected utility rather than expected income.
  • A. The varying value of a dollar shows up as declining marginal utility of income.
  • B. Also known as "risk aversion."
  • C. Which does not mean "fear of uncertainty" but simply "declining marginal utility of income."
  • D. Someone could perfectly well be risk averse in money (he prefers a certainty of income X to a lottery whose expected value is X-where X was $50,000 in our earlier example) yet risk preferring in years of life (he prefers a 50/50 gamble of zero or 20 years to a certainty of 10 years). He has declining marginal utility of income, increasing marginal utility of years of life.
  • E. the figure below shows that declining marginal utility of income (the slope of the utility function becomes flatter as income gets higher) implies risk aversion (the utility of the average payoff from a gamble is higher than the average of the utility of the possible outcomes). In the example shown, the gamble is a 50/50 chance of $10,000 or $90,000. The utility of the average outcome ($50,000) is greater than the average of the utilities of the outcomes .
  

• V. One problem with insurance: Moral Hazard.
  • A. I insure my factory for 100% of its value, then stop taking (costly) precautions to make sure it won't burn down. If it does burn, that is the insurance company's problem, not mine.
  • B. Solution-only insure for 80%.
    • 1. The result is still inefficient.
    • 2. If I can reduce the expected loss from fires by $100 at a cost of $10, I will-since I am saving myself $20.
    • 3. But if it costs $30 I won't-and should.
  • C. Or have the insurance company mandate precautions.
  • D. We have been here before:
    • 1. Moral hazard is another name for an externality-voluntarily adopted.
    • 2. It results in the usual inefficiency
    • 3. Mandated precautions are the regulatory solution-but by someone with a private interest in mandating the right precautions, which might not be true for the EPA.
  • E. Presumably risk aversion gains are worth inefficiency cost, or the customer wouldn't buy the insurance policy, but ...
    • 1. Not if others bear some of the moral hazard's cost.
      • a. Consider auto accidents. If I am carrying liability insurance, the risk of having to pay for the damage done by my risky driving will not deter me, so I will drive more carelessly-harming others.
      • b. That does not matter if the legal rule is such that I end up paying the full cost of my dangerous driving, but ...
      • c. Maybe we should ban auto insurance if we don't have adequate internalization via damages, fines, etc.
      • d. And, in the case of criminal punishments, we do. It is illegal to insure against them.
    • 2. And not if insurance is not the result of a voluntary transaction:
      • a. Either mandatory-as in assigned risk pools. Auto insurance companies are required to insure the very bad risks at a high price, but not high enough to make the insurance companies willing to do it voluntarily.
      • b. Or implicit in the legal system, as in legal rules that you may not contract out of (non-waivable contract rules) or cannot (tort rules for auto accidents).
  • F. In some cases, "moral hazard" is a feature, not a bug, either because
    • 1. We want people to engage in risky behavior that produces positive externalities. Give cops life and medical insurance. Or ...
    • 2. Because we are transferring the risk to someone more competent to deal with it:
      • a. Insurance company vs employee of large firm.
        • i. Company has more expertise
        • ii. and better incentives, due to inadequate bonding of the employee.
        • iii. The employee in charge of keeping the building from burning down skimps on precautions. Ninety-nine times out of a hundred nothing happens, and he gets a raise for keeping costs down. One time out of a hundred the company loses a ten million dollar factory-and fires the employee. A better gamble for the employee than for the firm.
      • b. I read an article arguing that the failure of this mechanism was the reason that nuclear reactors have poor safety design:
        • i. In other risky fields, safety engineering research is produced by the insurance companies that insure chemical factories etc. and want to know how to make sure they don't end up paying out a lot of money due to major accidents.
        • ii. Nuclear reactors are largely insured by the Federal government.
        • iii. Their concern is not convincing experts-safety engineers working for insurance companies-that they are safe, but convincing amateurs-mayors and city councils and citizens of towns where a reactor is to be located-that the reactor is safe.
        • iv. Which is done by having big switches, big dials, the sort of engineering that is well suited for science fiction movies but makes it hard for the guy on duty to actually keep track of what is happening.
      • c. Sharecropping-in the case where the landlord is also providing inputs of capital, expertise, etc.
      • d. Note that this is the double incentive problem again-ideally we would like each of the two (landlord and sharecropper) to receive 100% of any increase or decrease in output.
      • e. We could do it via a third party risk bearer-but landlord and sharecropper would then conspire to produce an inefficiently high output.
    • 3. A different way of putting this is that we have been implicitly assuming that the person who bears the cost if the legal system does nothing (lets costs lie where they fall) is also the person best able to control the cost, so transferring it to someone else increases the inefficiency. Sometimes it might be the other way around.
      • a. Suppose the only way of preventing the problem of exploding Coke bottles is better quality control by the manufacturer.
      • b. If so, transferring the cost to the manufacturer solves a moral hazard problem instead of creating one.
•  
• VI. The other problem with insurance: Adverse Selection.
  • A. The market for lemons.
    • 1. There are two kinds of used cars-cream puffs and lemons. The potential seller knows which he has; the potential buyer does not.
    • 2. Both would rather own a creampuff, so the price a buyer will pay for a creampuff (if he knows that is what he is getting) is higher than for a lemon, as is the price an owner will require before he is willing to sell.
    • 3. Since buyers don't know which they are getting, they offer a price representing a weighted average of the value of the two.
    • 4. Suppose a cream puff is worth $4000, a lemon is worth $2000, half of the potential sellers have cream puffs.
    • 5. Buyer offers up to $3000, but ...
    • 6. That is a good price for a lemon, so all owners sell,
    • 7. A bad price for a creampuff, so few owner sell
    • 8. So buyers, anticipating that problem, change their weights and offer only $2500, and ...
    • 9. Even fewer cream puffs sell.
    • 10. We could end up with only lemons selling-at lemon prices.
    • 11. This is inefficient-because cream puffs are worth more to potential buyers than to potential sellers, yet are remaining with the latter.
  • B. Possible solutions:
    • 1. If everybody knows, no problem.
      • a. Require repair records?
      • b. Permitting repair records will do, if they can be authenticated. It is in the interest of someone selling a creampuff to produce the records that prove it is a creampuff.
      • c. The analogous approach to the AIDS problem is a reliable ID card, certifying that the bearer was HIV negative as of a recent test. People who are negative have an incentive to get tested and show the card-people who are positive can't.
    • 2. If nobody knows, no problem. Not an option here, but might be in other cases.
    • 3. So the problem is asymmetrical information.
    • 4. Another solution is for the seller to guarantee the car.
      • a. Which brings us back to insurance
      • b. And double causation. Now that breakdowns are insured against, the owner has less incentive to take precautions against them.
      • c. Ami Glazer's solution to the lemons problem: Find a car you like; ask the dealer if, for an additional sum, he will guarantee it. Repeat until someone says yes. Then buy the car-without the guarantee. The fact that he was willing to guarantee the car is evidence that he doesn't expect it to break down-unless he has correctly guessed your strategy.
  • C. Selling life insurance.
    • 1. If someone comes into your office and demands to buy a large life insurance policy right now, you don't sell it to him
      • a. because you suspect he knows something about his odds of collecting that you don't.
      • b. Someone has just taken out a contract on him
      • c. Or he tested HIV positive
      • d. Or his girlfriend jilted him, and he is planning to fall off a cliff this afternoon.
    • 2. More generally, the customer has some private information relevant to how likely he is to collect.
    • 3. His decision to buy signals you that the private information is in the direction of making him a bad risk, so you adjust the price accordingly.
    • 4. Note that we apply exactly the same logic when we say "If you're so sure, what will you bet?" Putting your money where your mouth is is a form of signalling.
    • 5. And betting that you are going to die early (i.e. buying life insurance) signals that that is what you believe.
  • D. Or health insurance
    • 1. You know whether your hobby is reading science fiction or kickboxing or jumping out of airplanes
    • 2. Which is relevant to how good a risk you are
    • 3. And your buying signals that you are a poor risk.
  • E. Or anything else with asymmetric information.
  • F. Again, the problem disappears if everyone knows or if nobody knows
    • 1. Suppose we can identify people prone to various medical problems by genetic testing (as, increasingly, we can).
      • a. If nobody knows, there is no adverse selection problem-both buyer and seller of insurance treat the buyer as a random individual.
      • b. If everybody knows, there is no adverse selection problem-and people with unhealthy genes pay more for their insurance.
      • c. In the latter case, having unhealthy genes is an uninsurable risk-because you know how the gamble turned out before you buy the insurance.
    • 2. This is analogous to the economic argument for welfare. Risk aversion is normally dealt with by market transactions-buying insurance. But you can't insure against being born poor, because by the time you are there to buy the insurance, you already know how the gamble turned out.
    • 3. Suppose we forbid insurance companies from discriminating by gender in the price of life insurance-they must sell at the same price to men and women, even though women on average live longer.
      • a. Men and women can still use their information about life expectancy to decide whether to buy.
      • b. So we get adverse selection. Men buy too much life insurance, since they are getting it at less than its real cost (given their greater chance of collecting early) and women buy too little.
      • c. In this case, we have the effect of asymmetric information because one side of the transaction is forbidden from using information that both sides have.
  • G. Note also that this is an efficiency problem, not (only) a fairness problem.
    • 1. If you have a cream puff that is worth $3000 to you and $4000 to me, but it does not get sold because of adverse selection (I only offer $2000 because I believe that it is probably a lemon) we are on net $1000 worse off.
    • 2. If I get insured at too high a price (because the insurance company thinks I am a bad risk) that is only a transfer, but ...
    • 3. If I don't get insured because the price the insurance company charges (knowing that people who buy insurance are likely to be bad risks) is more than the price I will pay (knowing that I am a good risk) that is a net loss.
•  
• VII. Application to product liability. Who is liable for damage done by exploding Coke bottles?
  • A. Consider two alternative legal rules:
    • 1. Caveat Emptor (latin for "let the buyer beware"): You take your good as it is, defects and all. If the coke bottle explodes, the injured consumer pays his own bills.
    • 2. Caveat Venditor ("let the seller beware"): If something goes wrong with the product, the seller is liable for the damage.
    • 3. I am treating the distinction as sharper than it really is. If your wife shoots you with your gun, something has gone wrong, but the fact that a gun shoots the person it is pointed at does not generally count as a product defect even if it happens to have been pointed at the wrong person. So implicitly we are talking only about some subset of "things going wrong" that are plausibly associated with something wrong with the product.
    • 4. But that can still be a large and hazy category.
  • B. The Coke company can self-insure, the customer cannot.
    • 1. If Coca-cola is selling ten billion bottles a year, of which one in a million will blow up, they can count on almost exactly 10,000 exploding coke bottles per year. It is still a cost, but not much of a risk, since the size of the cost can be predicted with accuracy.
    • 2. So transferring the cost to Coca-cola reduces the risk aversion part of the cost. Before the change, the customer faced a very uncertain cost. After the change, neither party faces a very uncertain cost.
    • 3. This only works if the events in question are independent. One bottle blowing up does not affect the probability that another one will.
    • 4. On the other hand, Coke cannot self-insure against the risk that legal rules will shift against them. If courts decide to award much larger damages to consumers injured by exploding Coke bottles, that will apply to all of the bottles. Coke (in the U.S.) cannot "average out" futures in which the courts become more pro-plaintiff against ones in which it becomes less, the way it can average bottles that do and bottles that don't explode. It might be able to do some averaging across jurisdictions-but a very large fraction of its potential liability is in the U.S.
  • C. Moral hazard argument:
    • 1. If the relevant margin for control is care in manufacturing, then liability (caveat venditor) reduces the moral hazard problem.
    • 2. If the relevant margin is careful use by the buyer, then caveat venditor increases the problem.
  • D. Adverse selection argument:
    • 1. What do we assume about consumer information?
    • 2. If consumers cannot observe quality or judge it by firm (or product) reputation, then we have a lemons problem with caveat emptor-everybody produces a below optimal quality, because a higher quality, being unobservable, cannot command a higher price.
    • 3. A different way of saying this is to consider a situation where the seller knows how safe the coke bottle is, the buyer does not.
      • a. If he sells me a coke bottle, I don't know what I am buying (since I don't know the risk of explosion and do care), so don't know whether it is worth the price.
      • b. I buy too much if it is riskier than I think (since I am underestimating the true price-or, if you prefer, overestimating the true value), too little if it is safer than I think.
      • c. If he sells me a coke bottle with a guarantee, he knows what he is selling, since he knows the chance that he will have to pay off on the guarantee.
      • d. And I know the value to me of what I am buying. I don't know the chance of an explosion-but I don't care, since he has insured me against that risk.
    • 4. If consumers are well informed about average quality by firm, then caveat emptor is fine from both an adverse selection and a moral hazard standpoint. No moral hazard, because Coke has an incentive to provide good quality control so that consumers will want to buy their product.
    • 5. Adverse selection can also apply on the customer's side. Under caveat venditor, I don't want to sell a car to someone who will use it for drag racing, then sue me when there is an accident.
  • E. So far it looks as though we can simply balance risk aversion, moral hazard, and adverse selection to choose the optimal rule.
    • 1. Either the optimal broad rule- "producers are always liable," "producers are never liable"
    • 2. Or have the court look at the product and decide which rule is preferable for that product.
    • 3. The conclusion seems to be that if consumers are well informed about average product quality by firm, or can judge individual products, the optimal rule is caveat emptor.
    • 4. Ditto if the main risks comes from decisions by consumers (shaking a warm coke bottle up and down while making a point in an argument-you can't idiot-proof everything because idiots are so damn ingenious).
    • 5. Caveat venditor is the optimal rule if the consumer is poorly informed both about the individual product and about the average quality of products produced by each firm, and the important decisions relative to accidents are decisions by the firm.
    • 6. And the advantage tilts towards caveat venditor if the loss is large and the producer is much better able to self insure than the consumer. Note that not all imaginable cases involve a small buyer and a big seller-consider GM as a buyer of labor.
    • 6. But ...
  • F. Litigation cost and insurance:
    • 1. So far, we have not been talking about insurance in the literal sense-we have a Coke company, a customer, but no insurance companies.
    • 2. Why not? Instead of asking whether people want protection against risk, why not ask whether tort liability is the cheapest way to produce it? What about ordinary insurance?
    • 3. It has two big advantages, one disadvantage.
      • a. An insurance company wants a reputation for paying out readily; a firm may well want the opposite reputation. A reputation for being tough might make consumers less willing to buy the product-but in order to justify caveat venditor, we must assume that consumers are poorly informed. A reputation for being tough makes injured consumers (and their attorneys) less willing to sue-and tort attorneys may be well informed about the litigation reputation of the firms they consider suing.
      • b. Risk aversion doesn't depend on whose fault it was, so product liability is lousy insurance. What if you get hurt and it wasn't due to a faulty product? You are better off buying insurance that covers injuries from a wide range of causes.
      • c. Disadvantage-product liability may put the incentive somewhere useful (on the firm that could take greater precautions not to make defective products), insurance doesn't (except to the extent that your health insurer mails you medical tips, etc.)
    • 4. One advantage of letting the loss lie where it falls is that nobody has to sue anybody, so you don't have any litigation cost.
•  
• VIII. We have been running through arguments about how to decide whether or not the law should force Coke to "insure" its customers against exploding Coke bottles. Why doesn't the law make these calculations for ordinary insurance, deciding for you whether you are insured or not?
  • A. Because under ordinary circumstances, you have the right incentive to make the right decision for yourself. You get risk protection, pay moral hazard plus administrative costs in the price of the insurance.
  • B. Where that is not true, there is an argument for government involvement:
    • 1. Mandatory auto insurance-to make sure that if you cause an accident, you can pay for it.
    • 2. National health insurance-if we believe that the rest of us won't let you die in the street, so if you are uninsured and sick we end up paying.
    • 3. Or if we think that the adverse selection problem, which gives an inefficient outcome on the private market, is sufficiently serious.
    • 4. This is a public approach analogous to a group policy, which is a private way of controlling adverse selection.
•  
• IX. Why not apply the same analysis to tort liability?
  • A. Instead of asking "when should the firm be liable"
  • B. Ask "when will the firm choose not to be liable although it should be, or vice versa?"
  • C. In other words, the alternative to both caveat emptor and caveat venditor is freedom of contract.
  • D. Under freedom of contract, the court sets a default rule, which applies if the parties do not specify some other rule of liability. But the parties are free to contract around the default rule, thus setting their own terms:
    • 1. If the default is caveat emptor, the seller can offer a guarantee, thus shifting the rule (for whatever sorts of defects the guarantee covers) to caveat venditor.
    • 2. If the default is caveat venditor (malpractice liability), the buyer can agree to sign a waiver of liability committing him not to sue, thus converting the rule to caveat emptor.
    • 3. Under current U.S. law, guarantees are normally enforceable but waivers often are not. You can agree not to sue your physician for malpractice, perhaps in exchange for a lower price of service-but if something goes wrong you can change your mind and sue anyway.
  • E. This is an issue that will appear again and again.
    • 1. One reason for legal rules is to fill in gaps that parties cannot, or do not bother, to fill in themselves.
    • 2. A different reason is to compel rules different from the ones that parties would choose.
    • 3. Different sets of arguments apply to the two cases:
      • a. "What is the rule that maximizes their joint benefit?" Make that the default-because if you don't, you are merely putting them to the trouble of contracting around the default rule.
      • b. "Why is it not in their interest to take the optimal rule?" That tells you what direction you want the mandatory rule to alter their behavior in.
    • 4.When you are writing waivable rules, "fixing" inefficiencies due to externalities etc. isn't really an option, because if you try the parties will contract around your rule.

     

• Week 4: Ex Ante/Ex Post, Strategic Behavior, Etc.

   

• I. Review: Marginal vs average.
  • A. The diamond water paradox--marginal value vs average value.
    • 1. Marginal Value: Value of having one more gallon given what you have
    • 2. MV times quantity is not total value
    • 3. In other words, the value to you have having water is a lot more than 1000 times the value of one more gallon used to water the lawn.
  • B. What is the cost of cooking dinner for one person?
    • 1. Very low, if it means nine people instead of eight.
    • 2. Pretty high (in labor) if it means one person instead of none.
  • C. Two hunters in the woods. If either or both shoot the third, he is dead.
    • 1. So the marginal cost imposed by B shooting C (given that A was already doing so) is zero.
    • 2. As is the marginal cost of A shooting C (given that B was doing so)
    • 3. But the cost of A and B shooting C is one life.
    • 4. The marginals don't add up to the total.
  • D. Two drivers--takes two to tangle.
    • 1. There are only two drivers in the world.
    • 2. If A drives and B doesn't, or B does and A doesn't, or neither does, zero collision cost.
    • 3. If both drive, $100 expected accident cost.
    • 4. So the marginal cost of one more driver (two instead of one) is $100--whichever driver it is.

   

• II. Ex Ante, ex Post:
  • A. Consider two different approaches to preventing auto accidents:
    • 1. Ex Ante--laws against speeding, required brake inspections, laws against DUI, etc.
    • 2. Ex Post--tort liability, criminal penalties for drunk drivers in accidents, etc.
  • B. Consider the question of attempted murder:
    • 1. If we are punishing ex post, according to damage actually done, attempted murder is not a crime since nobody was killed. The bullet went into a nearby tree--which is doing fine.
    • 2. If we are punishing ex ante, according to the effects we predict behavior will have on average, then attempted murder is a crime--shooting at people results, on average, in killing some of them.
    • 3. For a further puzzle, consider the (moral?) question of why we punish murder more severely than attempted murder. If punishment reflects desert--what the crime tells us about the wickedness of the perpetrator--shouldn't the punishment be the same? Being a bad shot is not a moral virtue.
    • 4. What about the case of impossible attempts--trying to kill someone by sticking pins in a voodoo doll? Should that be a crime?
  • C. What are the advantages of ex post ?
    • 1. Ex post has some of the advantage of effluent fees over regulation. The court must measure damage done, but doesn't have to know the relationship between precautions and accidents--the driver provides that.
    • 2. Nor does the court have to be able to monitor behavior in order to punish its consequences, and thus deter it.
    • 3. The driver has a lot of private information about costly activities that are hard to monitor. Driving when sleepy, angry, paying attention to the conversation instead of the road, ...
    • 4. On the other hand, both methods use the driver's private information about how costly the precaution is (in that respect, both are analogous to effluent fees), since with speed limits, a driver can still violate them-and pay the ticket-if he thinks doing so is important.
    • 5. Ex post has the further advantage that measuring the costs easier after they have happened.
  •  
  • D. Advantages of ex ante ?
    • 1. Popular wrong answer: "ex post doesn't prevent accidents." Sure it does--by deterring them.
    • 2. Risk aversion--do you want to lose your house, all your property, and be indentured for five years if you make a mistake driving?
    • 3. Other punishment costs--can't collect ten million dollar fines.
    • 4. What can we do that is equivalent in deterrent effect to one chance in a million of a ten million dollar fine?
    • 5. Maybe one chance in a million of execution, or life imprisonment, or ...
    • 6. None of which pay us anything.
    • 7. So ex post forces us to use punishments which are large, and as a result inefficient.
  • E. Implication:
    • 1. People are risk averse only for large losses. So small ex post punishments are unambiguously superior to ex ante.
    • 2 So an entirely ex ante system, with no ex post costs, cannot be the right answer
    • 3. We want ex post at least equal to the largest fine you can pay without serious risk aversion costs.
    • 4. Plus possibly some ex ante if that isn't large enough.
  • F. Freedom of contract solution?
    • 1. Require insurance for appropriate amount.
    • 2. Permit insurance company to impose ex ante rules as a condition of insuring you.

   

• III. "Impossible attempts": Should there be a penalty for attempting to kill someone by a method that cannot work?
  • A. Argument against--we don't mind if people stick pins in voodoo dolls, so why impose costs on us and the attempted murderers to prevent it?
  • B. Argument for: The legal rule isn't about voodoo, it is about methods that don't work. There must be some uncertainty about what methods work, or nobody would use the ones that don't.
  • C. Consider a rational murderer choosing between voodoo and poison:
    • 1. Rational believer in voodoo?
    • 2. Why not--we all believe in, and under some circumstances trust our lives to, things we don't really understand, and trust because people we trust tell us they work.
    • 3. If he knows it doesn't work, he won't use it.
    • 4. If he is certain it works, our legal rule (punishment for impossible attempts) has no effect, since he is certain it does not apply to him--and the rule is costly, so why do it?
    • 5. But if he thinks either method might be the one that works, penalizing him either way helps to deter him. When he decides whether to try to commit murder, he must take into account the risk that he will choose an impossible method and not only will fail, but might be caught and punished.
  • D. Of course, another way of providing the same additional deterrence might be by raising the punishment for success. But what if raising the penalty on methods that do work is not an option--we can't hang him twice. We can hang him once if he succeeds, and lock him up if he fails--even by an impossible method.
  • E. My article on Payne v Tennessee discusses the ex post , ex ante issue in a somewhat different context.
    • 1. Should murderers be punished more severely (for example, execution instead of life imprisonment) for killing particularly valuable victims--for example, a mother with young children?
    • 2. If the answer is "yes," that is a form of ex post punishment--punishment by the damage actually done.
    • 3. The alternative is to punish according to what the court thinks the murderer knew when he committed the murder--a sort of ex ante punishment.
    • 4. In other words, punishing you particularly severely if the court thinks you knew the victim was likely to be a particularly valuable one, but independent of whether the victim actually was particularly valuable (you get the death penalty for killing someone, because the court believes that you didn't notice the empty bottle of sleeping pills next to her).
    • 5. The article (not the part assigned) also discusses some questions about the relation between punishment and moral desert which are outside the subject matter of this course but which some of you may find interesting.

   

• IV. Strategic behavior: The problem (see my Price Theory chapter)
  • A. Bilateral monopoly.
    • 1. Economic example: I have the only apple, worth $1 to me. You are the only customer, and value it at $2. If we can agree on a price, there is a net gain of $1 to be divided between us, with the division implied by the price.
    • 2. My six-year-old threatens to throw a tantrum if she doesn't get her way. Doing so imposes net costs, so there is a gain to finding some mutually acceptable outcome. Don't assume you can simply be firm and always win. You may have thought out the logic of bilateral monopoly bargaining better than she has, but she has a hundred million years of evolution on her side--during which offspring who succeeded in getting a larger share of parental resources were more likely to survive to reproduce.
    • 2. Doomsday machine.
      • a. The idea. Lots of very dirty bombs buried under the Rockies. If the Russians attack, the bombs go off and the fallout kills everyone on earth. So the Russians won't attack, and we don't need to pay for nuclear arms.
      • b. The reality: Our (and their) nuclear systems were doomsday machines, with human triggers. They worked, and therefore were not used--fortunately.
    • 3. Bully: If you train yourself to punch out anyone who gets in your way, and people know it, they will stay out of your way, and you don't have to fulfill the commitment--until you run into someone else following the same strategy, and one of you ends up dead. A doomsday machine on the individual level.
    • 4. In general, the outcome of such games depends largely on issues of commitment and reputation, which are hard to include in our analysis.
  • B. Prisoner's Dilemma
    • 1. Simple: Both prisoners are better off if both keep their mouths shut, but given what one does, the other is always better off confessing. So they both confess.
    • 2. Iterated. If we play the game multiple times, you might think that a prisoner would keep his mouth shut one time, for fear his partner would betray him next time in revenge.
    • 3. Why it doesn't work:
      • a. On the last play, no further threats of retaliation remain, so we are back with the original game--and both players betray.
      • b. But since I know you are going to betray me on the last play, there is no cost to me to betraying you on the play before last.
      • c. Repeat. The whole series of plays unravels, and we both betray every time.
      • d. It seems intuitively wrong, but logically right.
    • 4. Why it does work:
      • a. In the real world, we are playing such games an indefinite number of times
      • b. And want a reputation for being people who don't betray their partners, so that people will be willing to work with us, and ...
      • c. Not betray us, since they want a reputation for not betraying honest partners.
      • d. All of which is hard to model.
    • 5. Plea bargaining and armies running away are examples of multiplayer prisoner's dilemmas.
      • a. The defendants would all be better off if none of them copped a plea, since the prosecutor would have to divide his limited resources among many cases, and would get few convictions.
      • b. But, given what everyone else is doing, it is in my interest to accept a plea bargain if it is a little better than my expected result at trial.
      • c. Almost everyone accepts, leaving the prosecutor enough resources to make the expected result at trial pretty bad for the defendant.
  • C. Economics avoids including strategic behavior in its analysis wherever possible.
  • D. But can't always:
    • 1. RR example: throw sparks, despite fines, to get the farmers to switch to clover.
    • 2. Punitive damages example: Beat people up, despite fines, to get them to do what you say next time (there are complications which will get discussed later).
    • 3. Why do some cases get tried instead of settling out of court, and thus holding down litigation costs?
      • a. one reason is because the two sides disagree about the likely outcome.
      • b. But another is because each side is trying to get a settlement on its side of the bargaining range--and the result is no settlement.
    • 3. Nuisance suits: Sue in order to settle.
    • 4. Strategic imposition of costs: Threaten that if they don't settle, you will make the trial costly for them--by requiring the company president to spend three days answering your questions.
  • E. "Solutions." These are discussed at much greater length in Chapter 11 of Price Theory . The basic problem is to come up with a clear definition of what a "solution" to a game is.
    • 1. Von Neumann solution to two person, fixed sum game. A pair of strategies and a value V for the game, such that if player A follows his strategy he will get at least V whatever B does (and maybe more), if player B follows his strategy he will lose at most V whatever A does (and maybe less).
    • 2. Von Neumann solution & the Core are solution concepts for multi-person games: Each is a solution concept where one solution can include many outcomes--perhaps an infinite number. There may be multiple Von Neumann solutions. There is at most one core--but may not be any.
    • 3. Nash equilibrium: Given what everyone else is doing, I am doing the right thing--and the same is true for every other player.
      • a. Unstable against cooperation
      • b. What the equilibrium is depends on how you define a strategy.
      • c. In the case of oligopoly, does "I adjust, keeping what everyone else is doing the same" mean "when I change my output, everyone else keeps his output the same and sells it for what he can get" or "when I change my price, everyone else keeps his price the same and sells what he can at that price?"
      • d. The two different definitions of strategy--quantity and price--give very different predictions for the workings of an oligopoly.
    • 4. Subgame perfect equilibrium. Assume away commitment. If at any point in the decision tree, someone at that point would never find it in his interest to make a particular choice, eliminate that choice from the tree. This is how we proved that repeated prisoner's dilemma gave the same result as a single play of prisoner's dilemma.
    • 5. None of these solutions is very satisfactory, with the possible exception of the first--which only applies to a situation where there really is no strategic behavior.

       

• V: What is property?
  • A. we take the institution for granted--for familiar things
  • B. But it is a specific kind of rule and concept, as you can see by applying it in less familiar contexts. My obligations to you are good only against me, but your ownership of property is good against the world--everybody is legally obliged to respect it.
  • C. You ask a friend to borrow his bicycle. Implicit is:
    • 1. he can have it back when he wants
    • 2. If you give it to someone else, the owner can still claim it.
  • D. You ask a friend for information on a good dentist.
    • 1. He has no right to have it back--to have you stop using the dentist unless you pay him for the information. Or even to demand that you give him the dentist's name if he forgets.
    • 2. He has no right against third parties.
  • E. A gives you a business idea; you sign a non-disclosure agreement, etc. You tell it to B who tells it to C, who uses it. A can sue you, but he has no claim against C to "have his idea back," assuming C did not induce the breach.
  • F. There is a very partial exception to this in trade secret law, discussed below.
  • G. And a partial exception to the idea that you can always reclaim your property in the legal rule of "adverse possession," which implies that if someone else treats your land, or some right with regard to your land (such as the right to walk across it) as his for long enough (about seven years, varying by state) and you do nothing to indicate that it is yours, it becomes his.
  • H. So a recording system becomes important for maintaining property rights, especially for valuable items such as land.
  • I. And how fancy the property rights are--to what degree you are free to unbundle them and sell only part of the bundle--may depend on how easy it is for innocent third parties to figure out what they are getting. If you unbundle the tires from a car, the purchaser can learn it by inspection. But what if you unbundle mineral rights from the land? The right to decide what color your front door is from a house?
  • J. So for most forms of property other than land, the bundle of rights is fixed.
    • 1. You can sell me your car, along with an agreement that I will not drive it on Sunday or sell it to anyone who will.
    • 2. But if I resell without requiring the buyer to sign such a contract, you have no claim against the new owner--he got the full bundle of rights to the car
    • 3. only a claim against me for violating the contract.

   

• VI: Determining property rules really involves a set of questions:
  • A. How rights should be bundled (Coase article, next week)
  • B. How should you be allowed to defend your property rights (property vs liability)
  • C. What should be property?
  • D. We are concentrating on the last at the moment.

   

• VII. Property rules--including Intellectual Property (I.P.), primitive societies, et multae caetera:
  • A. Property vs commons.
    • 1. Argument for property is obvious. Why plant if you can't harvest? Tragedy of the commons.
    • 2. Argument for commons? Cost of enforcing and/or transacting over property.
    • 3. English language as a commons. We could give ownership of every new word to its inventor, and there would be some advantages to doing so--but less than the costs.
    • 4. From primitives to cyberspace.
      • a. When does it pay to define and enforce property rights in land? Not if you are hunting large animals across it--the rights you want are in the animals. Yes if you are planting on it.
      • b. Giving away information on the internet vs charging for it. Porn does the latter, almost everything else does the former.
      • c. A lot EMail is transmitted on an "I'll forward your packets, you'll forward mine" basis.
      • d. All you can eat restaurant as a commons. An Internet Service Provider with a fixed monthly charge is a commons too--no charge for additional use. These are voluntary commons in the middle of private property, so it can't be just a case of "it didn't occur to them to treat it as property."
  • B. Boundaries. Floating islands story:
  • Stack island, which belonged to someone, floated down the Mississippi (erosion at the upstream end, deposition at the downstream end), into a strip of the river where all islands belonged to the owner of the land on the west bank of the river. Who did it belong to?
    • 1. Property rights would be hard to work with in a world where that was the norm instead of the exception--where the boundaries that defined land ownership kept moving in unexpected and inconsistent ways. Arguably, in intellectual property it is the norm.
    • 2. In patent law--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 was for all ways of using the electromagnetic force to transmit signs or images to a distance. That includes the fax machine, the internet, the telephone, .... . The court denied it.
    • 3. 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 using 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.
    • 4. Wild animals are generally not private property, because the cost of keeping track of which animal belongs to whom is too difficult.
    • 5. Underground petroleum moves around as you pump some of it out.
      • a.If I pump long enough, and you don't have not drilled your own oil well and started pumping, I may end up pu mp out all of your oil as well as mine.
      • b. So each of us has an incentive to drill too early andpump too fast, in order to (at some cost) get the oil before the other does.
      • c. The usual solution is "unitization," a legal rule under which some fraction, often 2/3, of the owners of land above a common oil pool can vote to have the oil treated as a common resource, belonging to all the land owners.
  • C. Defending. Dogs and property rights. The bionic burglar alarm.
    • 1. Changes in technology change what rights can be enforced.
    • 2. Consider a primitive people trying to decide whether land should be private property or a commons. The cost of private property includes the cost of guarding it--there is no point in my planting wheat if my neighbor is going to come by at night and harvest it for himself. That cost was substantially lowered by the domestication of dogs, since dogs, being territorial can learn to identify their master's property and bark at trespassers. Perhaps that was what tilted the balance in favor of private property. If so, we may owe most of human civilization to the dogs.
    • 3.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.
    • 4. One approach to dealing with enforcement issues in I.P. 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 by using the chemical in the patent way. The patent holder sued the firms selling the chemical for contributory infringement and won, there being no other substantial uses for the chemical.
    • 5. Sony v Betamax is a famous case that went the other way--making a VCR is not contributory infringement. The argument was that, while a VCR can be used to tape a movie off TV, infringing the copyright owner's rights, it can also be used for time shifting programs, so there are substantial non-infringing uses, so the manufacturer of the VCR is not responsible for the infringing uses.
  • D. Transaction costs
    • 1. 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.
    • 2. 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 it.
    • 3. All you can eat restaurants. Cost of monitoring is higher than the efficiency loss--for spaghettti, lettuce, but not steak. The more expensive something is, the greater the net cost due to consuming an inefficiently large amount of it.
  • E. Creation of Property rights: Rent seeking problems.
    • 1. Homesteading. If I get ownership of 160 acres of government land by being the first person to farm it for X years, there is an incentive to start farming prematurely--losing money on the farming in exchange for obtaining ownership of valuable land. If I wait until the land is worth farming, someone else will already be there.
    • 2. Patent races. If I make my invention a day before you do, I get all the rights to it, you get none. So there is an incentive for an inefficient competition to be first.
    • 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. It eliminates a valuable opportunity (to homestead that piece of land or make that invention) that others 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 this year; if it will cost a tenth as much to invent it a year later, 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.
  • F. 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 having 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 your "deliberately beautiful" (or at least "desirable in some way") is my "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.
    • 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.

• VIII. Intellectual Property Law: What the law is.
  • A. Copyright Law
    • 1. Applies to expression, not idea.
    • 2. Applies mostly against literal copying
      • a. A bit vague at the edges--Superman (or at least his copyright owner) won an infringement suit against another superhero that was too similar to him.
      • b. Is Superman an expression of the idea of a superhero, or is a particular Superman comic book an expression of the idea of Superman? On the former reading, Superman is copyrightable, on the latter he is not.
      • c. A movie derived from a book would violate the book's copyright even if there was very little verbatim copying.
      • d. In computer law, the issue of non-literal copying has become an important one.
    • 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.
    • 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 assassination 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 synthesize a chemical with no known uses is not useful, thus not patentable.
    • 4. Bounds of the invention are set by the claim.
      • a. If the claim is too broad, you don't get your 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. 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, ... . That was his idea, the telegraph he had invented was simply one implementation of that idea. The court didn't buy it.
      • 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. Patents provide relatively short protection.
  • C. Trade Secret law:
    • 1. Almost entirely deals with the consequences of acts that would be banned anyway, such as:
      • a. An employee violating his obligation of loyalty to his employer by selling a competitor secret information.
      • b. Breaking into a lab at night and photographing the working model.
      • c. etc.
    • 2. Trade secret law allows the victim to sue for sums based on the value of the secret.
    • 3. And gives some rights against an innocent third party who has received the secret.
  • D. Trademark/trade dress law: In effect, this body of law propertizes a limited part of the language. If a particular restaurant design has come to mean your chain in the minds of consumers, you may be able to prevent another restaurant from copying the design. Similarly for a trademark--a word that has become closely associated with your product.

• IX. The Economics
  • A. Why have protection?
    • 1. Traditional answer: Incentive to produce writings and inventions.
      • a. But is it the right incentive?
      • b. The more people will pay to license your patent or buy your books, the greater the value you have produced, and the greater the reward you get, hence the incentive.
      • c. The longer it will be before someone else would have produced the same intellectual property independently, the greater the value you have produced. And Copyright accordingly gives longer protection than patent.
      • d. But patent is still a "one size fits all" system--it is not likely that all patented inventions would hae been independently reinvented in exactly 17 years.
    • 2. To discourage secrecy
      • a. A patent make secrecy unnecessary, since if someone copies your idea you can sue him.
      • 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 use it.
    • 3. Kitch homesteading alternative--the objective is to propertize ideas.
      • a. Once a range of ideas has been converted into private property by a patent, the owner can develop it, coordinating future research
      • b. 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. Why not use contract instead of intellectual property?
    • 1. The originator of a work or invention could transfer 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.
      • a. Instead of suing someone for violating your patent or copyright you sue him for violating his contract with you.
      • b. But when you find copies being sold, how do you know which of the people who bought it from you andsigned the contract is the source of the original that is being copied?
    • 2. Copyright: The problem is how to enforce it against innocent 3rd parties.
      • a. It 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. In effect, copyright law creates such a system, with respect to removing that one item from the bundle.
      • 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 to protect trade secrets. The rule on innocent 3rd parties who get a trade secret through someone else's violation of his obligation, without knowing they 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 in the context of computer networks, where new technology may make the enforcement of intellectual property law very difficult.
    • 4. One solution for copyright would be to somehow tag every copy of the computer program you sell, so that if a pirate copy appears you can prove which buyer is responsible--and sue him for violating his agreement not to allow others to copy the program.
  • C. Why do we have different patent and copyright rules, and why are they applied to the things they are applied to?
    • 1. The 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--quite often, several people are trying to make the same invention.
      • c. So we have much tighter rules and shorter protection for patents than for copyrights.
    • 3. Costs of fighting over fuzzy boundaries are an argument against protection.
      • a. Literal copying is easy to spot and prove.
      • b. Copying of ideas is much harder.
      • c. So we have easier and longer protection for copyright.
  • D. Copyright Protection for software.
    • 1. A program is not a writing, since it is intended to control a machine, not be read by a person (more like a cam--some courts got that right).
    • 2. But it 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. The 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 of writing programs is low compared to the cost of making machines, the sort of thing patent law was designed for, so the incentive of patent may be unnecessary. Lots of programs were written and lots of progress made before the Supreme Court started recognizing software patents.
  • F. Why doesn't patent law pre-empt trade secret law?
    • 1. Sears vs Steiffen says it sometimes does--a state cannot give the equivalent of patent protection to things that do not qualify for a federal patent.
    • 2. But in general it does not. Kewanee v Bicron says that states are allowed to have trade secret law, even though it deals with some of the same things as federal patent law, and does so in a different way.
    • 3. Trade secret helps fill in some of the gaps left by patent law, since ...
    • a. Patent is one-size-fits-all; either you get it or you don't.
    • b. You can use trade secret law to protect secrets that are not sufficiently important or non-obvious or whatever to qualify for patent protection but are still worth something.
    • c. You can use trade secret to protect secrets too important for patent--ones that you believe you can keep secret much longer than 17 years (the formula for Coca-Cola, for example).
    • d. You can use trade secret to protect ideas that you think are non-obvious but the patent examiner thinks are obvious. If he is right, someone else will invent the idea, making your secret worthless. If you are right, you get some of the protection you deserve.
    • e. And trade secret law has the right incentive pattern with regard to timing--it is not worth spending a fortune to invent something this year that will be easy to invent next year, since your trade secret will only last a year.

Fifth Week

• I. Contract Law:
  • A. We need enforceable contracts to permit transactions over time.
    • 1. Why not do everything as a spot transaction--here is the money, there is the apple?
    • 2. Building a house.
      • a. If I pay and then you build, you can cheat me by stopping work as soon as my check clears.
      • b. If you build and then I pay, I can cheat you by deciding to "renegotiate" when the house is finished. Nobody but me is willing to bid for a house sitting on my land, so you accept a price below what we agreed to rather than losing everything.
      • c. Even if you build on your own land, then sell me house and land, you can cheat me if I cannot fully measure quality. So you might want to insure your work--especially if you don't have a reputation.
    • 3. The loss from not being able to enforce contracts is not cheating but inefficiency due to the possiblity of cheating. Because we anticipate these problems, the house never gets built--even though it it is worth building.
  • B. One issue is how to allocate unexpected losses. We have been here before:
    • 1. By who can best insure.
    • 2. By who can best control.
      • a. I can take precautions to make sure my factory doesn't burn down, my workers don't go on strike.
      • b. And my decisions (I might be buyer or seller--or some other role) may affect how much is at risk. Do I take actions that will cause me serious problems if the contract somehow falls through--or do I take precautions "just in case."
      • c. Reliance expenditures are costs born in reliance on the other party performing his part of the contract--costs that will be wasted if the contract falls through. An example would be modifying my factory to produce the goods I am making him at lower cost--where the modification is useless if he decides he doesn't want the goods.
    • 3. By who best knows the risk, so can include it in the contract price.
    • 4. The allocation of such losses might be included in the contract ("if the producer is unable to fulfill his obligation due to forces beyond his control, ...") or it might be done by a court after the fact.
  • C. In many contexts, 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. Imaginary example: UCLA hires me for $50,000/year. I move there from Virginia.
      • a. I am losing money on the first two years, because of moving costs etc. So are they--because of my having to learn the ropes.
      • b. After two years, they tell me they are cutting my wage to $45,000. I wouldn't have come at that price--but it is too late to get back my moving costs.
      • c. I tell them that I will quit if they don't raise my salary to $55,000. They wouldn't have hired me at that, but there is no way they can get back the money they lost on me while I was learning the ropes.
      • d. We are now stuck in bilateral monpoly bargaining. We need a long term contract, signed before I come, to solve such problems.
    • 2. So the courts should enforce contracts against opportunistic breach.
    • 3. With some mechanism to deal with breach due to changed circumstances. What?
  • D. There is never enough fine print to specify the terms in full, so where the contract does not say what to do, the court fills in what it thinks the parties would have agreed to.
    • 1. Parties will try to construct contracts that are efficient for the mini-society consisting of the parties to the contract, since increases in the size of the pie make it possible for everyone to have more.
    • 2. If I see a way of changing the terms of the contract we are negotiating that benefits you by $2000 and hurts me by $1000, I point it out to you and propose that we incorporate the change and shift the contract price by $1500 in my favor, thus making both of us better off than if I had kept my mouth shut.
    • 3. So if the court wants to fill in the terms the parties would have written, it should figure out what terms were in the interest of the parites.
    • 4. One reason to do this is to maximize economic efficiency--but this only applies if the terms don't have significant effects on other people, since the parties will only take effects on themselves into account. We don't want to make assassination contracts "more efficient" in the sense of making them better serve the interest of the contracting parties.
    • 5. Another reason is that if the courts don't try to do what the parties would have done, the parties have an incentive to write more detailed contracts, so as to get their preferences rather than the court's preferences. That is costly. By filling in the blanks as the parties would have when unlikely eventualities occur, the court reduces the cost of drafting contracts.
  • E. One way of dealing with changed circumstances is for parties to break or renegotiate the contract. We then need legal rules specifying what happens if one party fails to fulfill his contractual obligations (breaches the contract).
  • F. These questions arise both in the context of negotiating a contract (the parties want to find the efficient terms) and filling in the blanks (parties would have chosen the efficient terms, so the court adds them).
  • G. It also arises where a court is trying to modify the terms agreed to by the parties
    • 1. Of course, if the court disagrees with the parties about what the efficient terms are, the court may be wrong.
    • 2. And one consequence of courts modifying contract terms in ways the parties don't like will be the parties writing more detailed contracts in order to stay out of court.

• II. But contracts can be enforced in other ways than by law--and are.
  • A. Within our society:
    • 1. Reputation. Why our exterminator kept coming back (after trying, repeatedly and unsuccessfully, to eliminate our fleas).
    • 2. 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.
    • 3. Why do countries pay off on their debts?
  • B. Limitations to such enforcement methods:
    • 1. A "one time killing" --someone might make enough by one violation of an agreement to make up for the reputational costs (countries do occasionally default).
    • 2. Some firms are not dependent on reputation, so can't use it to guarantee contracts. But such firms 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.
    • 3. Individuals may not have a reputation outside of their local area, so reputational enforcement may work in Ellickson's context of neighbors, but not for forcing me to pay back a loan from a bank in the next state.
  • C. 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 ...
    • 1. Either a society of neighbors, where people can judge reliability for themselves, or ...
    • 2. Specialist courts, producing the information and relying on their own reputation to certify it.
  • D. What is the Mafia--or, more generally, "organized crime?" Perhaps it is mainly such a court system, authorising the use of force against people in the criminal market who have broken their contracts.

   

• III. Damages
  • A: Two extremes
    • 1. No damages. Either party can walk away from the contract at any time. This is the rule we follow for most small contracts--a dinner engagement, ordering a computer that they don't have in stock yet, etc.
      • a. To prevent opportunistic breach requires precise timing of performance by each party, making it unprofitable for either party to breach at any time.
      • b. For example, as you build the house I pay you, week by week, in such a way that there is no point at which either of us is better off backing out of the contract than fulfilling it.
      • c. But one of us might still use the threat of breach strategically--if breaching hurts me a little and you a lot, and I think you will agree to change the terms of the contract in my favor if I threaten to breach.
      • d. And timing performance does not solve the problem when something changes that alters the gains to one or both parties.
      • e. But it does help if everything goes as planned, so you want to do it so far as practical, thus eliminating at least one source of breach.
    • 2. No unilateral breach permitted--either party can enforce specific performance (i.e. you must do what you agreed to, under threat of very large punishments).
      • a. This does not mean that the contract will actually get performed--just that the party who wants to breach must first get the other party to agree.
      • b. Which he won't give unless he is at least fully compensated, but ...
      • c. If a change makes performance very costly, there is now a huge bargaining range--since if I have to perform doing so will cost me a fortune, even if it only benefits you a little.
      • d. And you might end up with bargaining breaking down, and performance
      • e. The two parties are stuck in an expensive bilateral monopoly game.
  • B. 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, my tooling up to make the custom widgets that you have agreed to buy from me--which is a waste of money if you decide you do not want them.
  • C. 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.
  • D. Two ways of preventing breach
    • 1. Expectation damages gives the right incentive to breach or not 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. It matters if the potential breaching party knows the odds
      • c. Just as in the insurance, adverse selection case.
    • 3. 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 the probability of breach 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).
  • E. What about having the damages set by the contracting parties?
    • 1. Liquidated damages--the parties specify damages for breach in advance.
      • a. Solves the reliance problem.
      • b. But it only solves one of the other two problems if the parties can figure out in advance what the correct expectation (or reliance) damages would be.
    • 2. Generally liquidated damages agreements 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.
    • 5. A penalty clause serves the same function here as a property rule--instead of "pricing" unilateral breaches it tries to eliminate them, forcing the party that wants to breach to negotiate to get the permission of the other party.

   

• IV. Consumer fraud, liability, etc.
  • A. Distinguish the argument for default rules
    • 1. Who can more cheaply control
    • 2. And has better information
      • a. A photographer spends $10,000 and six months photographing African wildlife, then sends his film to a mass market developer--which loses it.
      • b. Should the developer be liable?
      • c. No. The developer does not know, and the photographer does, that losing these films costs $20,000, instead of the $20 or so cost of losing an ordinary roll of film.
      • d. The cheapest way of solving the problem is not for the developer to take extraordinary precautions with every roll, to protect the one roll in ten million that is worth such precautions, but
      • e. For the photographer to send the films to a custom developer, and warn the developer how important they are, so that that developer can then take special care with those films.
    • 3. And can more easily bear the risk
  • 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?
    • 1. Better tailored to the facts, but ...
    • 2. Less predictable.
    • 3. Did you buy the lawnmower under a rule of caveat emptor or caveat venditor? Only the Supreme Court knows.

• V. Duress
  • A. Real duress: A mugger points a gun at you and demands your money or your life. You write him a check for $500 and he lets you go. Should you be able to stop payment on the check? In other words, should contracts made under duress be binding?
    • 1. Argument for: If you can stop the check, you can't give him the money (assuming you don't have much on you) so he shoots you.
      • a. Worse still, you write the check and then he shoots you--to keep you from stopping payment.
      • b. Anticipating such, you don't write the check, since writing it actually gives him more of an incentive to shoot you, in a world where you can stop payment.
    • 2. Argument against: In a world where such checks can be stopped, there is less incentive to be a mugger, so you are less likely to have people point a gun at you and demand your money or your life.
    • 3. Here, as in many other cases, you have to consider the effect of the rule not only on what happens once you are in a situation, but on the effect that the knowledge of that has on your getting into the situation. In this case the analysis has three levels:
      • a. After you have written the check, gotten home, and had a drink, calling up the bank to stop payment clearly benefits you, but ...
      • b. Because the criminal anticipates that you will do so, in a world where you can stop payment on such checks, he doesn't accept your check and shoots you instead (or accepts and then shoots you), so being able to stop payment makes you worse off, but ...
      • c. Because the criminal anticipates that you won't be able to pay very much for your life (in a world where you can stop payment on such checks), he doesn't threaten you in the first place, so being able to stop payment might make you better off.
    • 4. And in fact, contracts made under duress are not enforceable. This makes sense, since the combined act "he puts you under duress, you sign the contract" does not in general produce a desirable outcome (economic improvement), in the same sense that the combined act "he offers you a contract, you sign it" in general does.
  • B. Form contracts ("contracts of adhesion")
    • 1. Consider the sort of contract that a consumer faces when he rents a car or an apartment, buys a computer program, ... .
      • a. It is drawn up by the other party in a standard form, applied to many transactions, and ...
      • b. Although he may have a choice as to some optional terms, the consumer's basic choice is to sign or not to sign.
      • c. Does this count as a sort of "duress," since one party cannot bargain about the terms?
      • d. And does that imply that the arguments for freedom of contract do not apply to such contracts?
    • 2. Innocent explanation: Form contracts reduce drafting costs, eliminate the problem of the firm having to control the employee who negotiates the individual contracts.
    • 3. The argument for freedom of contract still applies, since the firm, in drafting the contract, will take account of benefits and losses to its customers. Anything that makes the terms of the deal more attractive to the customer will also increase the amount he is willing to pay.
    • 4. The freedom of contract argument even applies to a 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. Although a monopolist has no competitor, his customers still have the alternative of not buying the good at all--which is why monopolists to not charge an infinite price.
    • 5. Although the argument does not always hold 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 those consumers who will still buy at a higher price.
    • 6. Courts sometimes refuse to enforce the terms of form contracts on the grounds that they represent a sort of duress. These arguments suggest the courts are wrong.
    • 7. Although we have not considered the separate issue of contracts sufficiently complicated so that the consumer does not really know what he is signing.
  • C. "Duress" due to nature, not to the other party
    • 1. A ship is sinking, another ship shows up, and the two captains start bargaining over how much the latter will be paid to rescue the former. Is the "duress" any more real than other cases?
    • 2. This is not analogous to the mugger case--the tug didn't sink the ship.
    • 3. 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 ...
    • 4. 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.
    • 5. So there is no simple price that gives the right incentive to both parties--just like the auto accident problem. The salvor should receive 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.
    • 6. 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 the ship.
    • 7. 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.
    • 8. That is an argument against freedom of contract, but does not tell us where, between the value of the ship and the cost of saving it, the court should set the price.
    • 9. The actual legal rule is that the salvor is entitled to a reasonable fee, but that contracts made while the ship is going down are not in general enforceable.

• VI. Information and Incentives: Laidlaw v Organ
  • A: Organ, with advance news of the treaty of Ghent which ended the war of 1812, ordered lots of tobacco from Laidlaw, at a low price reflecting the effect of the war on tobacco prices.
    • 1. When the news of the end of the war--and the end of the blockage of New Orleans--became public, Laidlaw tried to cancel the contract.
    • 2. The Supreme Court didn't let him.
    • 3. Did Organ, by not telling Laidlaw why he was buying the tobacco, commit fraud? Should the contract have been enforced?
  • B. The argument for the court's position is that producing information is a useful activity, and you can't make money doing it if, once the information is produced, you have to give it away.
  • C. Consider the more general case of speculation.
    • 1. 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 low and sells high.
    • 2. By buying grain before other people anticipate the coming shortage he drives up the price early, giving other people an incentive to use less grain (slaughter hogs early, for example, to save their feed for human consumption), produce more food of other sorts, etc.
    • 3. So when the shortage hits and the speculator puts the grain he bought back on the market, the famine is less severe and the price does not go up as high as if he had not intervened.
  • D. This only works if the speculator has secure property rights.
    • 1. If, when the famine happens, a mob seizes his barn full of grain, or the government confiscates it, speculation won't pay and won't happen.
    • 2. And when there are bad harvests, people will starve
    • 3. Which suggests that the belief that speculators cause famine may be one of the most lethal errors in human history.
    • 4. It is a result of applying a useful rule of thumb in an inappropriate context.
      • a. The rule is "cui bono"--to find out who is responsible for something happening, first figure out who benefits by it.
      • b. It doesn't work in the case of production, since producers benefit by high prices but the act of producing increases supply and so makes prices lower than they would otherwise have been.
  • E. The successful speculator produces a benefit and gets a reward, but the latter is not equal, or even closely related to, the former. The relation between the private value of his activity and the social value of his activity is correct qualitatively (if he makes money he is also doing good) but not quantitatively (he might do a little good and make a lot of money, or vice versa).
    • 1. 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.
    • 2. So we might get inefficient speculation--spending $1000 dollars to get information whose private value is $1100 but whose social value is only $100.
    • 3. aka rent seeking

• VII. 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. Two important (and closely related) issues in designing the efficient contract are who should bear the risk if something goes wrong amd what happens if one party breaches the contract.
  • D. Another important issue is whether the contract was formed in a fashion that leads to a valid (and presumptively efficient) contract--i.e. the issue of duress.
  • E. We have omitted some other important legal issues, such as:
    • 1. One sided contracts. What if I make a general offer (a reward for whoever finds my dog) and you act in reliance on it, even though there is no contract between us? Am I bound to fulfill my offer?
    • 2. What defines whether a contract exists and ...
    • 3. What the terms are if parties disagree as to what they were agreeing to (I thought the price was $100, you thought it was [[sterling]] 100).

Family Law

 
• I. 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: If we knew the right terms, and everything was observable and enforceable, perfect solution. but ...
    • 2. 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.
    • 3. 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 breach--and pay the penalty!

       

• II. 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 the potential for serious bargaining costs
      • 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 efficient.
  • 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.
  • These issues are also discussed in chapter 21 of my Price Theory textbook

   

• III. The economics of wedding rings-argument from an article by Margaret Brinig (not in the packet):
  • A. Fact: diamond engagement rings became common only starting in the 30's, peaked in 50's, declined since.
  • B. Men preferred wives who have never slept with anyone else.
  • C. Men and women like sex.
  • D. This creates a problem for those not yet married:
    • 1. For woman, who knows that sex lowers her value on the marriage market
    • 2. For men, who can't find women willing to sleep with them, because ...
  • E. Solution?
    • 1. Each generation believes it invented sex, despite the evidence, but previous generations managed somehow.
    • 2. Part of the solution is sex after engagement but before marriage.
    • 3. Which creates a problem of opportunistic breach. Seduce and abandon.
  • F. One way of controlling this used to be the legal action for breach of promise of marriage. The victim could collect damages, in large part for her reduced marital opportunities.
  • G. Between 1935-1945 the action was abolished in U.S. states containing half the U.S. population; it has now entirely vanished.
  • H.The custom of the male giving a valuable engagement ring, which the woman could keep if he walked out on her, arose--arguably to solve this problem. Think of it as a performance bond.
  • I. More recently, the custom has declined--along with the importance of virginity on the marriage market.

   

• IV. Adoption market:
  • A. Currently, it is illegal for the adoptive parents to pay the natural mother for her consent to the adoption. It is legal to pay the lawyers who arrange the adoption, the mother's medical costs, etc. One consequence seems to be high transaction costs (as potential adopters bid via lawyers), and a market that shifts between surplus and shortage.
  • B. One argument against payments by adopting parents to the natural mother in exchange for her giving up her child to them for adoption 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?
    • 3. Is it better for the (richer, on average) adoptive parents to get the child from the (poorer, on average) biological mother, and not pay her?
  • C. 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 violate the first amendment.
    • 3. As one student pointed out, a similar argument would seem to apply to laws that impose special penalties for "hate crimes." If you punish a crime more because, in addition to doing injury, it also conveys the message "group X are bad people who should be hated," isn't the additional punishment a punishment for speech? After all, you couldn't punish someone (in the U.S.) for a speech or a book arguing that "group X are bad people who should be hated."

     

• V. 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 from my having another child is. Positive externalities include:
    • 1. My child may 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. This argument is one example of an error common in political discussions in many areas. You calculate net externalities considering only the externalities of one sign (negative if you want to ban something, positive if you want to subsidize it) and ignoring those of the other sign.
  • C. 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.

       

• VI. 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 enforce the marraige contract by making it harder for husbands to break it.

     

    ---

Tort Law

• I. Tort Law:
  • A. What it is: a private action for a wrong, typically for damages, although injunctions are also possible.
  • B. Differs from criminal law in being a private rather than a state action.
  • C. And from contract law in not being based on any contract between the parties.
  • D. Four issues arise:
    • 1. What makes it wrongful: Competition is not a tort. Some system of rights assumed.
    • 2. Causation: What does it mean to say A caused the harm.
    • 3. Liability--strict liability, negligence, contributory negligence, etc.
    • 4. Damages--how calculated?
  • E. One can think of all these issues in terms of economic efficiency, although whether doing so describes how the law actually works is an open question.

• II. "Wrongful"
  • A. Tort damages are a version of a Pigouvian tax, so ...
    • 1. We want to treat as wrongful only acts that impost a net externality.
    • 2.And are worth the trouble of dealing with through the legal system.
      • a. We can use injunctions or punitive damages to enforce a property rule, where it is the injured party who owns the property.
      • b. Where the injuring party owns the property and is using it within his rights, we solve the problem by a transaction.
    • 3. And can be dealt with better in this fashion than by a property rule.
  • B. Should competition be a tort?
    • 1. When I become the 101st physician in San Jose, the wages of the first 100 physicians fall--should they be able to sue me?
    • 2. No, because their loss is their patients' gain.
    • 3. So I have imposed only a pecuniary externality--a transfer between two other people, not a net injury to other people.

• III. 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.
      • There is a real case along these lines.
      • A tree fell on a bus.
      • The plaintive demonstrated that in order for the bus to be where it was, the driver had to have been driving above the speed limit, and ...
      • Breaking the law is per se negligence, meaning that it automatically classifies as negligent even if it isn't really.
    • 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. This puzzle is based on a somewhat less dramatic real case: Summer v Tice.
    • 2. The benefit of 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. Probabilistic injury.
    • 1. Suppose a radiation leak increases the number of cancer cases in the surrounding area over the next 20 years from 100 to 110. Is the reactor liable, for what, to whom?
      • a. If we must show that it is more likely the death is due to the radiation leakage than that it is not, the defendant 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, most of which it did not cause.
    • 2. One 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.
    • 4. Real world equivalent--DES cases.
      • a. DES was a fertility drug which turned out to have serious side effects.
      • b. By the time the effects were discovered, it was no longer possible to determine which pharmaceutical company had manufactured the DES that a particular patient had used.
      • c. So if a victim sued a company, the company could (correctly) claim that it had probably not been responsible for that woman's injury.
      • d. Solution--divide the liability among the companies in proportion to what fraction of DES each had produced.

• IV. Liability
  • A. Optimal supply of accidents: The accidents we would get if everyone took all and only cost-justified precautions.
  • B. Strict liability gives you the right answer with unicausal accidents.
  • C. Negligence applied to unicausal accidents.
    • 1. Negligence is defined (by economists, but not necessarily by legal scholars) by the Hand formula (named after Judge Learned Hand, who applied it in a famous case) (T.J. Hooper)
      • a. Hand says that you are negligent if you failed to take a precaution whose cost was less than the expected benefit in accident reduction, in other words ...
      • b. If you failed to take all cost justified precautions.
    • 2. The rule "you are liable if negligent" gives the right answer if everything is observed by the court,since:
      • a. Either you take all cost justified precautions and are not liable, or ...
      • b. You don't take all cost justified precautions and are liable, and since you are liable you bear the full cost of the accident, and since you bear the full cost of the accident it is in your interest to take all cost justified precautions.
      • c. So you do take all cost justified precautions, which is the outcome we want, but ...
    • 2. What if the efficiency of some classes of precautions is observable by the actor but not the court?
      • a. The usual 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 to 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. Negligence 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 result in lawsuits--the plaintiff has no claim.

   

• V. Complications in tort damage analysis.
  • A. Double sided injury in a literal sense--both cars are dented.
    • 1. True of auto torts, but ...
    • 2. Not of most others--pollution, nuisance, ....
    • 3.We could include the problem by treating each such collision as two torts, one each way.
    • 4. We will avoid this problem for the moment by considering collisions between a tank and a car--in which only the car is injured.
  • B. While literal double injury is a special case that applies to auto collisions but not to most other torts, it is generally true that there are possible harms to both parties in a very different sense--avoiding injury to you is costly to me.
  • C. Double sided causation--a much more fundamental problem.
    • 1. We can solve the problem by a legal rule of negligence or strict liability with contributory negligence--provided the court knows enough to properly implement such a rule.
    • 2. Or we can avoid it by having each party bear the full cost--i.e. A fine rather than a damage payment, so the tank pays the cost of the damage done to the car, but the owner of the car doesn't get the money, and must pay fir his repairs himself.
    • 3. In which case the tank owner bribes the car owner not to report the accident--and we have left tort law for criminal law, where enforcement is by the state rather than the victim.

• VI. Liability alternatives
  • A. No liability--the tank pays nothing, the car owner pays for his own repairs.
  • B. Strict liability--the tank pays for fixing the car it ran over, whether or not its driver was negligent.
  • C. Negligence liability--the tank pays if its driver was negligent (i.e. Did not take all cost justified precautions), but not otherwise.
  • D. Strict liability with contributory negligence--the tank pays unless the car driver was negligent.
  • E. Note that A and B are really the same rule, with tank and car exchanged.
  • F. As are C and D.

• VII. Summary of implications:
  • A. Assume one dimension (care) is observable by the court, another (activity level) is unobservable.
    • 1. Note that "care" and "activity level" are merely convenient examples.
    • 2. The real categories are "activities with regard to which the court can tell whether or not the actor was negligent" and "activities with regard to which the court cannot ... ."
  • B. A sketch of the implications of the alternative rules.

• C. Why are there accidents? In general, because our assumption that both courts and individuals have perfect information is not true.
  • 1. The court might be wrong about either what precautions the tortfeasor took or what precautions he should have taken, and so find him negligent when he was not.
  • 2. The tortfeasor might be wrong about what precautions he should have taken, and so really be negligent. Or ...
  • 3. The tortfeasor might gamble on the court thinking he wasn't negligent when he really was--and lose.
• D. The "reasonable man" standard.
  • 1. One form that imperfect information by the courts takes is the rule that negligence is judged according to what precautions would be cost effective for an imaginary "reasonable man" rather than for the actual tortfeasor, since the court doesn't know whether the tortfeasor has better or worse reactions, higher or lower alcohol tolerance, etc. than the average.
  • 2. Suppose you have much better reflexes than the average:
    • a. One half of the argument for keeping down to what the court considers a safe speed is that if you don't, you will be liable for damages if you run into someone. That argument still applies to you.
    • b. The other half is that if you are liable, it is then in your interest to take all cost-justified precautions. But keeping down to what the court considers a safe speed is not cost-justified for you.
    • c. So you either keep down to the court's speed, in order to make sure that if there is an accident you won't have to pay for it, or
    • d. Drive at the efficient speed, which is faster than the court things, knowing that you will be liable if there is an accident.
• E. Effects of court error depend on the form of the error:
  • 1. Suppose the court correctly measures your precautions but sometimes overestimates or underestimates the efficient level of precautions. The higher the level of precautions you take, the greater your chance of not being found negligent, hence liable. This tends to push you to a greater than optimal level of precautions.
  • 2. Suppose the court simply makes mistakes at random--a third of the time it decides that the tortfeasor was not negligent, whether or not he actually was. The result is like a strict liability rule, with a punishment equal (on average) to 2/3 of the damage done. So tortfeasors are underdeterred, and take less than the efficient level of precaution.
  • 3. So it is hard to work out a theory that takes account of court error--the effect depends on the details of what sort of mistakes the court makes.

• VIII. Amount of damage payment awarded:
  • A. "Enough to make good the injury." Or in other words, enough to make the victim as well off as if the tort had not occurred.
    • 1. This is the right rule if we catch, sue, and win every time.
    • 2. Otherwise it gives too little expected punishment since sometimes tortfeasors don't end up paying damages, so there is too little deterrence.
    • 3. Why is this the standard rule in tort damages?
  • B. Punitive damages--more than enough to make good.
    • 1. Very uncommon until recently.
      • a. N.H. Supreme Court, and others, argued that "punitive damages" were ...
      • b. A misunderstanding of damages for non-pecuniary injuries.
    • 2. They are supposed to be awarded for a "deliberate or reckless" tort, and the amount is up to the court.
    • 3. Old examples:
      • a. King's messenger case:
        • i. The King's messengers forced their way into someone's house, held him prisoner while they searched his papers in an (illegal) attempt to find out if he was the author of articles in a newspaper they considered subversive.
        • ii. He sued, they argued that they only owed him for actual damages, which were small.
        • iii. He got punitive damages.
      • b. Insult case.
        • i. One landowner swore he would shoot birds on his neighbor's property without permission
        • ii. And did
        • iii. And the neighbor was awarded punitive damages.
  • B. Non-economic explanations:
    • 1. To express condemnation
    • 2. Punitive damages are really just compensation for hard to measure injuries--reputation, etc. Shooting on your enemy's land without his permission shames him, makes him unhappy, lowers his reputation, ... .
  • C. Other people's economic explanations.
    • 1. Punitive damages are a probability multiplier. If so, why not base punitive damages on how large a fraction of those who commit a particular tort get away with it, rather than on whether the tort was "deliberate or reckless?" A reckless tort should be very likely to result in a successful suit.
    • 2. Punitive damages are a way of playing safe if damage is hard to measure but efficient torts are unlikely.
      • a. A deliberate tort requires a positive cost to commit. So the optimal level is likely to be zero. But it doesn't have to be--there might be a large benefit.
      • b. An accidental tort requires a cost to avoid, so the optimal level is likely to be >0.
      • c. A deliberate tort, unlike an accidental one, can usually be replaced by a market transaction--the tortfeasor knows who he is going to injure and should be able to buy permission if the tortfeasor's gain is more than the victim's loss.
      • d. Or in other words, punitive damages are a way of enforcing a property rule within the legal framework normally used to enforce liability rules.

• IX. My Explanation 1: Punitive damages are for very deterrable torts.
  • A. Economic theory of optimal damages with litigation etc. costs
    • 1. Without such costs, expected punishment (<P>) should = damage done. In civil law, <P> is the damage award times the probability that the victim will sue and win.
    • 2. Deterring the marginal tort at that point does no good, so ...
    • 3. If detering it is costly, don't do it.
    • 4. Cost depends on elasticity, because increased award decreases nbr of cases but increases cost per case.
    • 5. If supply very inelastic, there is a positive cost to deter. So you only want to deter very inefficient offenses, so you set <P> < damage done
    • 6. If supply is very elastic, you want to deter even offenses that are (slightly) efficient, in order to avoid the cost of prosecuting them, so you set <P> > damage done
    • 7. So the optimal expected punishment is below or above the damage done according to how elastic the supply of offenses is.
    • 8. This is worked out in more detail in my punitive damages piece and my Payne v Tennessee piece.
  • B. A deliberate tort is very deterrable, so the supply of offenses is elastic, so you should overpunish.
  • C. An accident may be not very deterrable, so the supply of offenses is inelastic, so you should underpunish.
  • D. The case where it is efficient to overpunish a lot, deterring almost all offenses and leaving almost none to be punished, brings us to a property rather than a liability rule.

   

• X. My explanation 2: Punitive damages are for strategic torts.
  • A. Why did I beat him up, even though I knew I would have to pay damages?
  • B. To deter other guys from going out with "my" girl.
  • C. This only works if ordinary damages undercompensate, since otherwise he doesn't mind being beaten up--and paid damages.
    • 1. But they do undercompensate.
    • 2. Since they have no probability multiplier and ignore pain and suffering (until recently)
    • 3. And they should undercompensate, since ordinary damages are for offenses with an inelastic supply curve (or so I have just argued above).
  • D. So we want extra damages in such cases, to deter strategic torts.
  • E. This makes sense where the tortfeasor is a repeat player.
    • 1. The insult cases--maybe the two landowners were really fighting over local political control and the like. Perhaps one of them was trying to shame the other so as to prove to other locals that they had better support his candidate for parliament--or else.
    • 2. The real first case--king's messenger, North British Enquirer. The crown wanted to discourage people from writing for subversive newspapers.
    • 3. But it does not work against our equivalent of the king's messengers--law enforcement agents.
      • a. Governments are protected from tort liability by the principle of Sovereign Immunity
      • b. The federal torts act waives sovereign immunity in some cases, but not to the extent of permitting punitive damages.
•  
• XI. 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 affect the incentives of the victim?
    • 1. That is a good reason in the strategic 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.
    • 3. Note the difference between anonymous tort (auto accident, many small players) and named tort (deliberate trespass, conversion)
      • a. Named tort introduces strategic problems, but also ...
      • b. Possibility of Coase Theorem bargaining
      • c. Moving us towards a property rule instead of a tort rule.

• XII. One way of thinking of the problem of controlling accidents-Three steps to an efficient world:
  • A. If only we knew what everyone should do, we could command them to do it. Direct regulatory solution.
  • B. If we knew the consequences of all actions, we could use a full system of Pigouvian taxes on actions (driving fast, for instance) to internalize all externalities and let individuals use their private information on their costs to choose what actions to take.
  • C. Since we don't, one solution is to evaluate by results. If my dangerous driving does not cause an accident I don't get punished, if it does cause an accident I pay the full cost.
    • 1. The expected social cost of my dangerous driving is the probability it will cause an accident times the damage done.
    • 2. The private cost to me of my dangerous driving is the probability it will cause an accident times the amount of punishment if it does.
    • 3. So if we set punishment equal to damage done (i.e. the victim sues me for his costs--I am already paying for my own injuries), my private cost equals the social cost, so it is in my private interest to make the right decision.

   

• XIII. The problem of measuring and compensating damages for loss of earning capacity, death, injury. [For a much more detailed discussion, see my article on this subject]
  • A. Lump sum vs periodic payments
    • 1. A lump sum reduces disincentive effect, but
    • 2. By the same token lowers the cost of fraud. Once the money is paid 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.

     

• I. The nature of the criminal law:
  • A. Crimes are enforced by police, prosecuted by the D.A. The case takes the form of "The state of California vs X."
  • B. Punishment: fine, imprisonment, execution, to and by the state.
  • C. High level of proof required ("beyond a reasonable doubt").
  • D. Why have criminal law? Why not do everything with tort law? Some possible answers:
    • 1. Crimes do damage to the "society" as well as the victim
    • 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. For some offenses, a fine gives the right incentives, damage payments give the wrong incentive.
    • 5. We will return to these questions.

     

• II. Economist's view of what should be a crime and why.
  • A. Actions that impose costs on others.
  • B. We don't want to eliminate all such--consider the lost hunter breaking into a cabin in the woods to get food and use the phone.
  • C. We could either "regulate" such behavior, permitting it when we think it is efficient (the defense of necessity in tort law) or
  • D. Price it--impose a fine that reflects the costs imposed by the crime. Let the offender choose whether to commit the crime and pay, or not commit it.
  • E. If we set the expected punishment (<P> defined as probability of being punished times amount of punishment)=damage done, then efficient crimes will occur, since committing them is worth more than the expected punishment for doing so, and inefficient crimes will not occur.
  • F. This assumes criminals are rational--and they are. Football players rarely get mugged

     

• III. If this is how we set our punishments, then the reason we do not make them higher is that we are afraid of deterring efficient crimes. Can that be right? Is the reason we do not increase the punishment for murder that we are worried that we would then have too few murders? [This set of issues is discussed in more detail in my "Payne v Tennessee" and "Punitive Damages" articles]
  • A. In the case of speeding, perhaps, but ...
  • B. In the case of murder and other serious crimes, surely not.
  • C. Some crimes, such as theft, have a superior market substitute.
    • 1. If my car is worth more to you than to me you don't have to steal it--you can buy it.
    • 2. So the only transfers prevented by making theft illegal are the inefficient ones--stealing a car that is not worth enough to make you willing to buy it.
    • 3. So we don't have to worry that making the punishment too high will deter efficient thefts.
    • 4. The obvious exception to this argument is the case where the market transaction is not possible--such as the lost hunter.
  • D. And there are other crimes where there is no market substitute, but where we believe efficient offenses are rare to nonexistent.
    • 1. Murder may be an example. Although one can imagine ...
    • 2. A market transaction for murder. A wealthy hunter who believes that human beings are the only game dangerous enough to be worth hunting offers ten adventurers $100,000 each in exchange for their agreeing that he may choose one of them at random and try to kill him.
    • 3. Should such a transaction be legal? It appears to be efficient, since the victims are receiving enough compensation to make them willing to accept the deal.
    • 4. If not, why not?
  • E. What limits our punishment of such offenses is cost--we permit offenses that are inefficient in that we would like to eliminate them, but efficient in that the cost of eliminating them is more than the benefit.

     

• IV. The cost of crime control.
  • A. We are choosing a combination of a probability of punishing an offender (p) and an amount of punishment (P).
  • B. We want to get a particular level of expected punishment aka deterrence at the lowest cost, where the cost is punishment cost plus enforcement cost.
  • C. Enforcement cost is obvious, and increases with number of offenses and with the fration of offenders to be apprehended.
    • 1. It costs more to catch twenty criminals out of two hundred than to catch ten out of a hundred.
    • 2. And it costs more to catch eleven criminals out of a hundred than to catch ten.
  • D. Punishment cost--cost to the convicted criminal minus gain to others from the punishment.
    • 1. Costlessly collected fine. Punishment cost =0
    • 2. Execution: punishment cost = 100% of punishment. One life is payed, none received
    • 3. Imprisonment: cost is more than 100%. The criminal loses his freedom and we must pay for the prison.
  • E. Why not go to the corner of infinite punishment with infinitesimal probability? As long as we hold expected punishment constant, deterrence and cost to criminal are constant, and catching fewer offenders costs less.
  • F. Because as we shift to more severe punishments we must use less efficient ones--criminals can pay a $100 fine but not a $100,000 fine.

     

• V. If punishment were costless, the optimum level would be expected punishment equal to damage done, deterring all and only inefficient offenses. How do we calculate the optimal punishment taking account of the cost of imposing it?
  • A. For each expected punishment (=level of deterrence), find the lowest cost combination of p,P that produces it.
  • B. Start at zero, keep raising the expected punishment as long as the gain in offenses deterred>= cost in additional expenditure.
  • C. Gain = (nbr of offenses deterred)x(damage that an offense does to the victim - gain that the offense produces for the offender)
  • D. Offender's gain, for marginal offense (an offense deterred by a slight increase in expected punishment) equals the expected punishment.
    • 1. Because if his gain were less than that, the offense would already have been deterred before we increased the punishment.
    • 2. And if his gain were more than that, the current expected punishment would not deter him.
    • 3. So the offense just barely deterred at the current level of expected punishment is one for which the offender's gain equals that expected punishment.
  • E. So at any level of <P>, gain=nbr deterred x(damage-<P>)
  • F. So if an extra $X deters one more offense and we are at the optimum:
  • $X=D-<P>,
  • <P>=D-$X (Equation 1)
  • G. Intuition for that: It is worth deterring offenses as long as the benefit from deterring is greater than the cost, so we increase expected punishment until we reach the point where the benefit of deterring one more offense (cost to victim-benefit to offender) just equals the cost in increased punishment and enforcement costs of deterring it.
  • H. The argument still works if $X<0, i.e. the cost of deterring one more offense is negative.
    • 1. The reason that can happen is that as you increase the expected punishment you decrease the number of offenses--so there are fewer offenders to be apprehended and punished. You are spending more per offense, but spending it on fewer offenses. So an expected punishment of $1000 might cost less to impose than one of $900.
    • 2. In the case where the marginal cost of deterrence is negative, equation 1 above implies an expected punishment higher than damage done. You are deterring some efficient offenses--in order to save the cost of punishing them.
    • 3. Two intuitions: "Enough to deter" vs "equal to damage done."
    • a. "Equal to damage done" is the right intuition if catching and punishing criminals is costless.
    • b. "Enough to deter" is the right intuition if there is some level of punishment below which you have lots of offenses and above which very few. You keep increasing expected punishment until you reach the point where the payoff to additional increases becomes very low because there are very few offenses left to be deterrred.
  • I. The mathematics of this are worked out in an appendix to my punitive damage article and in my Payne v Tennessee article. The latter also has a verbal discussion of the argument.

     

• VI. 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.
  • A point discussed in my Punitive Damages article.

     

• VII. 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 richer 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.
  • D. The issue is discussed in part of my Payne v Tennessee article.

     

• VIII. Marginal deterrence: My article (with William Sjostrom) is accessible from the web page.
  • A. If armed robbery gets the maximum possible punishment, then the additional punishment to an armed robber for killing the victim is zero.
  • B. More generally, in setting optimal punishments we must allow for the possibility that we may deter someone out of one crime and into another.
  • C. Which makes the calculation of an optimal set of punishments more complicated.

     

• IX. The Paradox of Efficient Punishment:
  • A. 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. No imprisonment for serious crime.
      • d. Costs of slave labor too high to make imprisonment an efficient crime... 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. The English didn't use galleys, because the Atlantic is too rough for them. So their only cheap imprisonment option was transportation. For more details, see my article on 18th c. English law.
    • 4. If the sort of efficient system of punishments I have described is a bad idea, as most people believe, why?
  • B. 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 if those are the legal rules?"
      • b. In other words, the government was being treated as a philosopher king rather than as a human institution controlled 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, who is collecting it.
      • 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, biological and economic capital is up for grabs all the time.
      • 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.

     

• X. Some more points involving crime:
  • A. Why have criminal law? Since the central difference between criminal law and tort law is in who enforces the law for what reason (government employees or victims and their agents), the answer should 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 systems we call "criminal" and "civil."
      • b. Why sort offenses as we do into criminal or civil
      • c. Or, more generally, "How should we bundle rules and sort offenses ?" Our Criminal and Civil are not the only possible alternatives.
      • d. Who controls prosecution? Who owns the offense? Does conviction result in moral stigma?Is our ultimate objective (if we could afford it) to prevent offenses or to regulate offenses--i.e. price them so that only the efficient ones occur..
      • e. 18th c. English example. Medieval English. Traffic ticket.

• 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. The civil law uses more efficient punishments, so false positives (convicting innocent defendants) 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 to have evidence, and uniting ownership of evidence and claim reduces transaction costs of prosecution.
  • f. But ownership by the victim reduces his incentive to prevent the crime--if it occurs, he gets a (possibly valuable) claim. Consider the simple case with costless enforcement and punishment, pollution vs burglary.
    • 1. A fine gives the right incentive for pollution, auto accident, sound pollution, ... because a damage payment would eliminate the victim's incentive to prevent or reduce the cost. If I soundproof my house I can't collect damages any more.
    • 2. A damage payment gives the right incentive for robbery--since it does no net damage, we don't want to give the victim an incentive to prevent it.
    • 3. The essential difference is that in the first set of offenses, the victim, by protecting himself, does not make the tortfeasor worse off--the airline doesn't want your living room to be noisy.
    • 4. But the burglar does want to succeed in stealing from you, so the victim's defensive expenditures do make the burglar worse off.
  • g In an article on private enforcement, I show that (given some simplifying assumptions), a system of privately enforced criminal law (i.e. the equivalent of tort law for burglary) gives victims the optimal incentive to protect their houses.
  • h. In fact, our legal system gets this one backwards! We use tort damages where we should use fines, and vice versa.
  • i. But remember, this is true only in terms of one of the relevant arguments--the effect on the damages/fine choice on victims' incentives to protect.

• B. Economics of drug laws? Does making it harder to smuggle drugs into the country 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 due to attempts 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.
• C. 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 description, they succeeded only by a certain amount of fraud against the jury, which was sympathetic to the norms and the defendants.
  • 4. Note that the argument for why cannibalism is taboo under ordinary circumstances in all or almost all societies parallels my argument for why we might not want efficient punishments.
    • a. Eating corpses instead of burying them seems, on the face of it, an obvious net gain--just like harvesting the organs of the people we execute.
    • b. The problem is that it gives us an incentive to kill each other, which raises the costs of both potential victims, who have to avoid giving other people an opportunity to kill and eat them, and to potential murderers, who spend time looking for such an opportunity.
    • c. So the costs of rent seeking in both direction may greatly outweigh the gains from the more efficient disposal of corpses.
    • d. Which may explain why cannibalism is such an unpopular form of behavior.

     

• XI. Criminal law summary:
  • A. Most broadly, criminal law exists to control inefficiency due to externality ...
  • B. It differs from tort in being enforced by the state.
  • C. One line of analysis: What would the optimal pattern of enforcement and punishment be for a philosopher king government?
    • 1. Pick the combination of probability and punishment that minimizes the sum of enforcement and punishment costs for any level of deterrence.
    • 2. Find the level that minimizes all costs, including net costs of crime.
    • 3. The effect of including enforcement and punishment costs may be to increase or decrease optimal expected punishment.
  • C. Another line--how is this modified by considering the enforcers' incentives?
    • 1. Efficient punishment has problems.
    • 2. Low probability of conviction leads to judgement proof defendants (and fake offenses) if we scale up the punishment to match, and leads to underdeterrence if we don't.
    • 3. Or in other words, we have to worry about problems of both too much incentive to prosecute, and too little.
  • D. Another: Why do the legal rules we have exist?
    • 1. Criminal law requires a higher standard of proof for conviction because it employs more inefficient punishments, making the cost of errors higher.
    • 2. Intent is much more important in criminal law than in tort law:
      • a. is this act a coerced transfer, hence almost certainly inefficient? Yes if you intended to steal the umbrella, no if you took it by accident, thinking it was your own.
      • b. How deterrable is the act? It is costly to avoid accidents ("unintentional acts"), but easy to avoid deliberately running someone down.
      • c. Defense of insanity exists for criminal law, not for tort law--because it is hard to deter someone who is insane.
      • d. Premediated murder vs act of rage is again a distinction of intent.
      • e. Intent may also affect probabilityof apprehension. If you did it on purpose you probably also took precautions not to be caught, so we need a higher punishment to make up for the lower probability of imposing it.
    • 3. This pattern makes some sense. If criminal law typically has higher punishment and enforcement costs, we only want to use it where the payoff from deterrence is sufficient to justify those costs, so we don't try to use criminal law to deal with acts that are hard to deter.
    • 4. Giving the victim ownership of the claim reduces his incentive to prevent the cost, which is a good thing in some contexts, a bad thing in others--and we don't seem to get it right.

     

I. The Issue of Monopoly [See Chapter 10 of Price Theory for a more detailed explanation of much of this.]

• A. Why does a monopoly exist?
  • 1. A natural monopoly exists because the cost curve keeps falling--average cost is lower for a firm producing the entire amount demanded by the market than for any smaller firm.
  • 2. A government monopoly exists because it is against the law to compete with it.
  • 3. An artificial monopoly exists because it has somehow driven out and kept out competitors even though their costs are as low as its are. It is not clear if there are any such cases.
  • 4. A cartel is an "almost natural monopoly" situation where the efficient size of the firm is so large that there are only a few such, and they get together to act like a monopoly--restrict output and raise price.
• B.What is wrong with monopoly?
  • 1. Classical welfare triangle (aka "deadweight loss" from monopoly):
    • a. The monopoly maximizes its profit at the quantity where MR=MC, and
    • b. Since MR<Price, that is a quantity where P>MC, hence
    • c. Some consumers who value the good at more than the cost of producing one more unit don't get it.
    • d. Producing that unit and giving or selling it to such a consumer would produce a net benefit, so ...
    • e. The outcome of a private single price monopoly is inefficient.
  • 2. Rent seeking argument from Tullock
    • a. If there are monopoly profits to be made
    • b. Firms will compete to become the monopoly and make them
    • c. Competing away the monopoly profit, perhaps in wasteful ways such as starting the industry early, losing money in the early years, in order that, when the monopoly develops, you will be it.
  • 3. But not commonsense inefficiency
    • a. It pays a monopoly to produce the goods at the lowest possible cost, since a reduction in cost is an increase in profit.
    • b. Remember that "monopoly" is not equivalent to "big firm." Some very big firms (MacDonalds) are only a small part of their industry, and some monopolies (the one general store in a small village fifty miles from the next town) are small firms.
    • c. So the question of whether big firms are inefficient is separate from the question of whether monopolies are.
• C. Price discrimination.
  • 1. A monopoly can both reduce the deadweight loss and increase its profits if it can find a way to sell at a lower price to customers not willing to buy at the high price, while maintaining a high price for those willing to pay it.
  • 2. Such discriminatory pricing provides a possible explanation for a lot of things: Cheap theater tickets for children, lower prices for old people, hardcovers costing a lot more than paperbacks (arguably more than the difference in production cost), selling a book for a lower price in England than in the U.S., ... .
  • 3. It might increase or decrease the inefficiency of monopoly.
    • a. It decreases it by "filling in" the welfare triangle--moving towards the efficient quantity by selling goods at a low price to the low demand customers.
    • b. It increases it by allocating a given quantity of output less efficiently. The American willing to pay $20 for the book doesn't get it (U.S. price $25), the Englaishman willing to pay $18 does (U.K. price $15--in [[sterling]] s.)
    • c. And firms may do costly things in order to transfer money from their customers to themselves via discriminatory pricing.
• D. What can we do about monopoly?
  • 1. Natural monopoly:
    • a. leave it alone, regulate it, or have the government own it.
    • b. Turning it into a competitive industry isn't an option, since it exists because small firms can't produce as cheaply as big firms.
  • 2. Government monopoly: Could abolish it, since a competitive industry is an option (assuming it isn't also a natural monopoly)
  • 3. Artificial monopoly. We could (do) have legal rules designed to make it harder to create and maintain such.
    • a. Such as rules that sometimes forbid large firms in the same industry from merging, and
    • b. Laws against "predatory" pricing.
    • c. How much sense this makes depends in part on whether artificial monopolies are really a problem or not.
  • 4. Cartel. We can:
    • a. Make cartel agreements illegal (we do)
    • b. Refuse to enforce them (we do, some European countries don't)

     

• II. The Efficiency and Inefficiency of Discriminatory Pricing: A XMas Tale
  • A. Having recently moved to California from Chicago, we have lots of friends east of here, and complicated vacation plans: SJ-Denver-Boston-DC-Chicago-SJ.
    • 1. The cost of doing it that way is about $1800/person, for two adults and a child.
    • 2. The cost of one round trip SJ-Denver-Chicago-SJ and one Chicago-Boston-DC-Chicago is about $1100.
    • 3. The cost of SJ-Denver-SJ + Denver-Chicago-Denver + Chicago-Boston-DC-Chicago is about $800+
    • 4. So we are taking the third option.
  • B. Why are the prices like this?
    • 1. No airline has anything close to a U.S. monopoly, but on a given route there may be one or only a few, so there is a fair amount of monopoly power in the system.
    • 2. As well as other complications associated with joint costs, which I will ignore.
    • 3. And airlines engage in a good deal of discriminatory pricing
    • 4. Much of it intended to charge high prices to business customers with inelastic demand, low prices to vacationing families with elastic demand (less tight schedules,tighter budgets).
  • C. Producing a deadweight cost, for me, consisting of the cost of doing things in ways that don't save the airlines money, but do make me look like a vacationing family (which, as it happens, I am) rather than a business traveller.
    • 1. Flying Denver-Chicago-Boston instead of Denver-Boston direct, and ...
    • 2. Chicago-Denver-SJ instead of Chicago-SJ direct
    • 3. With two small children
    • 4. Some of which might happen anyway due to scheduling, hubs, etc., but might not.
  • D. And an efficiency gain, inasmuch as a single price covering the airlines costs might price many vacationing families off of the airline into cars.
  • E. Note that I am probably not part of that efficiency gain, although I am a beneficiary of the discriminatory pricing (after readjusting my flights slightly).

• III. Solving the efficiency problem of natural monopoly by regulation:
  • A. The obvious solution:
    • 1. Compel a monopoly to act efficiently, which means ...
    • 2. Charge marginal cost
    • 3. And exist if at that price it produces net gains.
  • B. The obvious problem:
    • 1. If it has to charge marginal cost, the monopoly can't cover is fixed cost and goes broke.
    • 2. So subsidize the difference between AC and MC.
    • 3. At which point the monopoly has no incentive to minimize its costs, since whatever it loses is being made up by the treasury.
    • 4. So subsidize the difference between MC and what you have calculated that AC should be.
    • 5. But how do you get the information needed to estimate what AC should be?
    • 6. You could see what production cost last year, but ...
      • a. If they knew you were watching, last year was a very expensive year, and ...
      • b. In any case, things change over time.
  • C. Rate of return regulation of utilities as an example of regulation of natural monopoly. The theory is to allow them to charge a price which gives the investors a fair rate of return on their capital.
    • 1. This is average cost pricing, not marginal cost pricing (except to the extent that the regulator permits discriminatory pricing), so there is still some efficiency loss, although not as much as at the profit maximizing price.
    • 2. How do you measure the amount of capital?
      • a. By the amount initially invested? But some investements don't pan out and are lost, so how do you figure out how much to give to the ones that succeed as compensation?
      • b. Replacement cost of the physical plant? But there may be some generators that would not be worth building today, even though, having built them twenty years ago, they are still worth operating.
      • c. By the market price of the utility's stock? But this is a circular argument--what is determining the market price of the utility's stock is how much the market believes the regulators will let the utility charge.
    • 3. If the regulators control the price the utility sells its output at, one way the utility can evade the regulation is by lowering the quality of its output.
      • a. In the extreme case, one way of doubling the price of milk is to sell the bottles half full. That can be prevented, but it is harder to detect cheating on subtler quality dimensions, ...
      • b. Such as how fast a repairman shows up, how often restrooms are cleaned, how likely a power failure is.
  • D. Similar problems exist with state ownership
  • E. Note that we have now gotten back to the sort of inefficiency we rejected in I B 3 above. We would expect inefficient management and poor quality not in a private monopoly but in a badly regulated private monopoly.
  • F. In addition to these problems, there is also the problem of how to make it in the interest of the regulators of a private monopoly (or the officials running a state monopoly) to try to produce the efficient outcome:
    • 1. The regulators might find there was more to be gained, politically and economically, by allying with the regulated industry and helping it prevent competition, both within the industry and from outsiders.
    • 2. While claiming to be protecting the customers against the industry. The industry, after all, is going to be much better informed about what is really happening than the average consumer.
    • 3. A phenomemon that has become known as "regulatory capture."
    • 4. Similarly, a government run monopoly might find its best policy was to make lots of monopoly profit and use it to give good jobs to people who spend part of their time getting out the vote for the politicians who appointed them.

• IV. What about legal rules to discourage monopoly?
  • A. Regulate mergers:
    • 1. You would like to permit mergers that allow firms with complementary assets to join, thus producing goods more efficiently
    • 2. While banning mergers designed simply to create a firm big enough so that it can reduce output, drive up prices, and make monopoly profits, at least until other firms have time to enter the industry.
    • 3. But how do you tell which is which?
    • 4. One solution proposed, not entirely seriously, is to judge by the response of competitors:
      • a. If the purpose of a merger is to form a monopoly and drive up prices, competitors should be all in favor of it--they can expand their output and make lots of money.
      • b. If the purpose is to create a new firm that can produce at lower cost, competitors should disapprove.
      • c. So if two firms propose a merger and competitors complain, permit the merger. If competitors don't complain, forbid the merger.
      • d. Of course, this depends on the competitors not realizing what your policy is.
  • B. Cartels: Don't enforce contracts in restraint of trade--i.e. agreements by the firms in a cartel to keep prices up, or allocate markets, or ...
  • C. What about predatory pricing?
    • a. The strategy. Big firm cuts prices below cost, drives out little firm, can then raise prices and make monopoly profits.
    • 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. Ban resale price maintainance--contracts by which a wholesaler sets a minimum price his goods may be retailed at. The first question is why the wholesaler would do so.
    • 1. To provide monopoly revenue for the wholesaler? But he can push prices up by pushing up the price he sells at, and let the retailers compete down their profit margins. Why should he share his monopoly profit with the retailers?
    • 2. To provide an incentive for retailers to offer 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. With a fixed price higher than the competitive price would be for firms that don't provide sales services, firms will compete for customers in non-price dimensions
    • 5. By, for example, providing sales related services--which is what the wholesaler wants.
    • 6. But why are such services bundled with sales of the good, instead of priced separately?
  • E. Restrictions on tie-ins, vertical integration, et. al.
    • 1. Tie-ins: If you by your computer from IBM, you have to use IBM punchcards.
      • a. Why would IBM want to insist on that?
      • b. In order to make a monopoly profit on cards as well as on computers? But ...
      • c. the high price of punchards lowers the amount customers are willing to pay for the computer.
      • d. You are taking money out of one of your pockets to put it in another--at some cost.
      • e. So why do they do it?
        • 1. Perhaps they want to control the quality of inputs, in order to maintain the reputation of their computers for reliability, hold down the cost of repairs that they have agreed to provide.
        • 2. Or perhaps it is a device for price discrimination. High demand customers also use lots of cards. So by selling expensive cards and (somewhat cheaper) computers, IBM is charging a high price to the customers willing to pay a high price (on average, the ones using a lot of punchcards) and a low price to the customers who are not willing to pay a high price (and are not using a lot of punchcards).
    • 2. Vertical integration: cars and distributors, refineries and gas stations.
      • a. The argument is that the steel company, by using its monopoly of steel to gain a monopoly of the auto industry, can now collect monopoly profits on both industries, but ...
      • b. Why not just sell steel, let the auto companies compete down their profit margin, and collect the "monopoly profit" on the auto industry in the form of high steel prices?
      • c. One possible answer is that vertical integration might reduce the 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.

• V. As these examples show, imprecise verbal arguments about monopoly behavior, or economic behavior in general, often produces the wrong answer. There is something to be said for precision--and for formal mathematical models.
  • A. Predatory pricing--we expect the big firm to win.
    • 1. There is an implicit analogy to a battle, where the bigger army wins
    • 2. But in predatory pricing, being bigger also means losing money faster
    • 3. So it turns out that the small firm has the advantage.
  • B. Resale price maintanance--we think that the wholesaler can produce extra monopoly profits by helping the retailers keep their prices up. But he can do that, at more profit to himself, by simply charging a high wholesale price.
  • C. Tie-ins--we think the computer company is now collecting monopoly profits on two markets--computer cards and computers. But the first profit is coming out of the second.
  • D. Vertical integration similarly.
  • E. General lessons:
    • 1. Making money at artificial monopoly is harder than it seems
    • 2. You need to be careful about verbal arguments
    • 3. And you need to fig ure out why the behavior is happening.

     

• VI. The English vs the American Rule
  • A. Query: What is the effect of the choice of rule on litigation expenditures? On amount of litigation?
  • B. Stylized version of the English rule: Loser pays winner's legal costs.
    • 1. It leads to larger litigation expenditures on cases that are litigated because if you win you won't have to pay for your legal costs.
    • 2. And because the stakes are higher.
    • 3. But it reduces the incentive to do things intended to increase the other side's legal costs--since you might end up paying for them--, and ...
    • 4. it discourages low probability suits (suits that you expect you will probably lose), encourages high probability suits.
  • C. Real version of the rule: Loser pays what the judge things winner's legal costs ought to have been.
    • 1. Leads to larger expenditures because the stakes are higher.
    • 2. Still discourages low probability suits
    • 3. Is that a feature or a bug?
      • a. Prevents harassment, extortion, via the legal system, but ...
      • b. Also suits that might push the envelope of legal rules, by getting a court to rule that previous courts were wrong.

       

• I. Looking at how other societies did it.
  • A. The general problem--using legal rules to control the sorts of behavior that tort law and criminal law control.
  • B. Other societies help us in two ways:
    • 1. They expand our ideas, by showing us alternative approaches that we might not have thought of.
    • 2. They give real world evidence on how problems get dealt with.
  • C. Can civil law absorb criminal law? If it does, how does it deal with:
    • 1. Judgement-proof defendants
      • a. how to collect, or ...
      • b. how to motivate prosecution when you can't collect.
    • 2. Poor victims who can't afford a lawyer.
    • 3. Dangers of overenforcement
  • D. Three different solutions:
    • 1. Saga period Iceland--pure civil system, without any government enforcement.
    • 2. 18th century England--Criminal law privately prosecuted.
    • 3. Shasta County, CA today--norms as a substitute for law.

• II. Iceland. History. Harald's unification of Iceland. [This is given in much greater detail in my article "Private Production and Enforcement of Law: A Historical Case" which you have, and which is also on the web]
  • A. How the system was organized.
    • 1. Four quarters, each with 9 Godar (chieftains). The godord, the right to be a Godi, was a property right--it could be inherited, sold, lent.
    • 2. Anyone could be the thingman of any Godi.
    • 3. Court determined by the location of the Godord of the plaintiffs.
    • 4. Legislature consisted of the Godar
    • 5. Court gives a verdict, goes home.
  • B. Why it worked:
    • 1. If a convicted defendant does not pay his fine he gets outlawed.
    • 2. Killing an outlaw is legal, defending him is not.
    • 3. Stability. Njalsaga episode. Even when the system seems to be breaking down, the participants expect to eventually have to pay for anyone they kill.
  • C. How do the poor and powerless get protected? Legal claims are transferable, so they can sell them to someone with the power to enforce them.
  • D. What about judgement-proof defendants?
    • 1. The probability of catching an offender is high, because concealing the crime is itself a serious crime (and considered shameful). A high probability means that fines do not have to be enormous in order to get a reasonably high expected punishment.
    • 2. Informal coalitions existed for enforcing legal claims, and could also pay fines for a member in exchange for his obligation to do favor in the future.
    • 3. Someone who could not pay his fine could become a temporary slave--a debt thrall.

     

• III. 18th century England. [This is given in much greater detail in my article on 18th century England]
  • A. Puzzles: pattern of punishment, prosecution.
  • B. Punishment--for a serious offense, the only punishment the court could impose was hanging. In practice, some convicted defendants were then pardoned, some were pardoned on condition of transportation, some (if there was a war going on) were pardoned on condition of joining the army or navy.
    • 1. Transportation did not work in the 17th century, without a subsidy, because many convicts were not worth enough as indentured servants to cover the cost of transporting them.
    • 2. It worked with a subsidy of about 3 pounds per convict starting about 1719 (for a 14 year sentence--the convict was taken to the New World and sold as an indentured servant for 14 years).
    • 3. The cost of maintaining a prisoner in a French prison at the time was about 4 pounds/year.
    • 4. So transportation was a much cheaper alternative, assuming that the cost in England was similar.
    • 3. Why not use penal slavery?
      • a. Because for most activities, guarding, feeding, clothing potentially violent criminals cost more than they could produce?
      • b. The French had galley slaves, presumably because that was an activity particularly well suited for slavery--hard to escape, easy to monitor output.
      • c. The English had no galleys--so used transportation as the cheapest available alternative to hanging.
      • d. But both are lumpy punishments. You can't hang someone just a little, and it isn't worth transporting him for six months.
      • e. Which leads you to a high punishment/low probability system, where the probability is low mostly because you don't get caught, partly because you might get pardoned.
  • C. Private prosecution. Why bother to prosecute when you don't get a damage payment?
    • 1. Vengeance?
    • 2. Private deterrence. Prosecution associations..
      • a. Note that vengeance can be seen as a version of private deterrence
      • b. I want a reputation as someone who is vengeful in order that people won't injure me in the future.
      • c. So I train myself to be the sort of person who feels bad if he hasn't gotten back at someone who injures him.
      • d. Other people observe what sort of person I have made myself, and take appropriate precautions.
      • e. Of course, I don't want to overdo it--or the appropriate precaution might be shooting me in advance for fear that some day you would accidentally step on my toe and I would kill you.
    • 3. Compounding? You start a prosecution in order to be paid to drop it.
      • a. This was illegal in the case of felonies, although legal and approved of for misdemeanors
      • b. I offer some, but not very much, evidence that it happened anyway, and the rules against it were not very well enforced.
  • D. Problems with bounties. Bounties were introduced in order to help solve the problem of inadequate incentive to prosecute.
    • 1. Very large bounty for highway robbery--100 pounds+
    • 2. This led to scandals involving entrapment or framing.
    • 3. Juries didn't believe the witnesses--with cause, since the witnesses could get a share of the reward.
    • 4. They abolished most of the bounty system in mid-century.
  • E. Pardoning: A significant minority of felons got pardons. They were given out by a royal official, based both on the judge's recommendation and on petitions.
    • 1. Price discrimination on that market.
      • a. Enough to deter. If five months waiting to be tried plus the scare of being condemned to hang provides a enough deterrent for a "good lad led astray," it is unnecessary to hang him.
      • b. Avoiding costly punishment: If hanging him means that his family go on the parish (their equivalent of welfare), maybe better not.
    • 2. "Selling" pardons. Friends of the convict could "buy" pardons by incurring obligations to local politically influential people, whose petitions had a good chance of getting a pardon.
    • 3. These are all possible interpretations of what was happening.
    • 4. And they both have an efficiency element. Selling pardons both means that people are less likely to hang if they are of value to others, and converts execution into the more efficient punishment of a fine.
  • F. Did the system work?
    • 1. They didn't think so--it was eventually converted into something more like ours, but ...
    • 2. Despite talk of rising crime rates, there is some evidence against, none I know of for.
  • G. Medieval Appeal of Felony. Indictment of felony.
    • 1. 1208 story.
      • a. Pre -1208, a private party prosecuting an appeal of felony--a private criminal suit--could drop charges in exchange for compensation.
      • b. Post-1208, if he dropped charges the grand jury could take the case up as a royal suit--an indictment of felony.
      • c. The result was a sharp reduction in the fraction of cases prosecuted as appeals of felony.
      • d. Presumably because it reduced the incentive to start such cases, since you could not guarantee the defendant freedom from prosecution if he settled.
    • 2. Medieval pardon selling. The crown sold pardons for cash.
  • H. Why the shift towards public enforcement during the Middle Ages. In the 19th c.?
    • 1. Because we learned more about how to enforce the law?
    • 2. Because conditions changed, and private deterrence doesn't work in large, mobile societies, where many crimes are anonymous?
    • 2. A revenue grab by the crown, which wanted the revenue from enforcing the criminal law--in cash (medieval) or influence (19th century--when the crown still controlled pardons)--for itself?
  • I. Ideological reasons for keeping private enforcement, as seen by 18th century Englishmen.
    • 1. If the crown controls criminal prosecution, the King's friends can get away with murder.
    • 2. Better if any Englishman can prosecute any crime.
    • 3. A system of public police and prosecutors is tyrannical--just look at the French.
  • J. France in the 18th century had a "modern" system of professional police and public prosecutors. England had an obviously unworkable system of private prosecution of nominally public criminal cases. At the end of the century it was the French system that collapsed.

• IV. Twentieth Century California. [This is discussed in more detail in my review "Less Law Than Meets the Eye," and in much more detail in Ellickson's book]
  • A. Coase and Shasta County.
    • 1. Do ranchers and farmers behave differently in open than in closed range?
    • 2. Coase says "no" because of transactions between them.
    • 3. Ellickson observes that the answer is right but the explanation is not--no side payments are happening.
  • B. Informal norms, not laws, are determing behavior with regard to trespassing cattle and many other things.
  • C. Trespassing cattle and inefficient punishments.
    • 1. If your cattle trespass and do damage, you are expected to apologize, make up for serious damage.
    • 2. If you don't, the victim retaliates by spreading true gossip--the fact that you are not behaving in a neighborly fashion. You start getting the cold shoulder from other neighbors.
    • 3. If that doesn't work, next time the victim retaliates by driving your animals far away, where it is going to take you time and trouble to find and retrieve them.
    • 4. The victim does not go to court.
    • 5. And does not use efficient punishment (slaughtering one of the cattle)
      • a. That would be more efficient than driving the animals away, but ...
      • b. Produces a temptation to overuse such a punishment--since doing so is profitable.
      • c. Locke: Every man is a biased judge in his own case.
      • d. We are back with the inefficiency of efficient punishment.
  • D. Fence building--the same story.
  • E. But not accidents with motorists who run into cattle. They are strangers, hence not a part of the system of norms of neighborly behavior.
  • F. Other norms Ellickson discusses: Whaling. Photocopying.
  • G. The economics of norms.
    • 1. Locally efficient.
    • 2. But not globally efficient.
      • a. Whalers efficiently hunted one species after another into near extinction.
      • b. They would probably have been better off limiting their catch so as to preserve their prey, but ...
      • c. Any whaler or group of whalers who did so would be bearing the cost of catching fewer whales, while sharing the benefit of more whales in the future with everyone, including the whalers who did not restrict their catch.
  • H. Implications. Crime rates?
    • 1. The facts about U.S. murder rates.
      • a. Most of the U.S. has murder rates comparable to those in European countries.
      • b. The high national average reflects very high rates in the inner cities.
    • 2. Explanation? Perhaps ...
      • a. Crime control is mainly by norms and reputation.
      • b. And they break down in a society without marriage or jobs.

       

• V. Summary:
  • A. We looked at three+ different systems for doing what we do with tort and criminal law:
    • 1. Iceland: Private enforcement, full civil
    • 2. 18th c. England: Private prosecution, punishment at the extremes
    • 3. Shasta county: Norms as a substitute for law.
    • 4. A little on medieval England.
  • B. Some of what we learned:
    • 1. Different allocations to tort/crime are possible: Iceland, (Shasta), Medieval
    • 2. Different bundling of legal rules, not fitting our tort/crime distinction, are possible. Some of the relevant choices are:
      • a. Who controls prosecution
      • b. Who collects the punishment
      • c. Price or prohibit behavior
      • d. Moral stigma?
    • 3. For example, we observed:
      • a. Privately prosecuted law with "criminal" punishments and government collection of the punishment (it was the crown, not the victim, that could pardon the convicted offender, transport him, etc) in 18th c. England.
      • b.Privately prosecuted law with criminal punishments and private collection in the medieval appeal of felony.
      • c. Publicly prosecuted law with "civil" punishments (plus criminal) in the medieval indictment of trespass.
    • 4. Incentives to prosecute privately include not only
      • a. Collecting damages, but also
      • b. Reputation as a private good (18th c. England, probably Iceland, Shasta County, Medieval England)
      • c. Possibility of out of court settlement (Medieval--there is evidence that the appeal of felony declined in popularity after it became impossible for the plaintiff to guarantee the defendant immunity in exchange for a settlement. Probably 18th c. England)
    • 5. Too much incentive can be a problem for private prosecution:
      • a. 18th c. reward system
      • b. Why Shasta county uses inefficient punishments
      • c. Note that b works precisely because it applies to offenders unwilling to pay damages--or settle out of court.
      • d. 18th c. England, at both the public and private level, may have converted inefficient to efficient (compounding a felony, selling a pardon)
    • 6. Some of the ways of solving problems with private enforcement that might not have occurred to us if we had not observed them are:
      • a. Punishing the offense of concealing an offense, thus raising the probability of convictions, which reduces the efficient punishment and thus the risk that defendants will be judgement proof.
      • b. Temporary slavery (Icelandic debt thralldom) as a solution for judgement-proof defendants.
      • c. Or giving them an incentive to raise the fine from their friends and relations.
      • d. Marketable torts as a way of making it possible for poor people to get their rights enforced.
    • 7. Distinction between locally efficient and globally efficient.
      • a. Why norms give only local efficiency.
      • b. This is related to the issue of efficiency of common law. The law may embody pre-existing norms--and their efficiency characteristics. Also, getting individual judges to take account of the influence of their precedents on people not before them is a problem analogous to getting groups of individuals to take account of the influence of their norms on people not in the group.
      • c. So is the problem of getting governments to take account of the influence of what they do on people other than those controlling the government.
      • d. Was the shift from private law (common in lots of primitive societies, not just Iceland--including Anglo-Saxon England) to public law
        • i. Improved form of law enforcement?
        • ii. Adapting to changing circumstances (urbanization might make private deterrence less practical)?
        • iii. Or a revenue grab by the crown at the expense of victims?

   

• VI. Efficiency and the common law:
  • A. What is efficiency? For a detailed answer, see my webbed Price Theory chapter on efficiency.
  • B. Efficiency as a normative, or at least normatively interesting, criterion.
    • 1. A large part of the course has consisted of asking what legal rules would be efficient in various circumstances.
    • 2. Which makes sense if we consider maximizing the size of the pie a disideratum, although not the only one.
    • 3. And is an interesting lens through which to look at law.
  • B. Efficiency as accurately descriptive: Mixed verdict
    • 1. If this were a law school class, and I was a legal scholar instead of an economist, we might have spent more time on the details of U.S. law in 1996, instead of more general issues.
    • 2. Some fairly clear evidence in favor of the efficiency of our legal rules:
      • a. Property rules in general (transferable, bundling, etc.) seem to make economic sense.
      • b. As do liability rules.
      • c. Our crime/tort distinction makes some sense in terms (at least) of judgement-proof defendants.
      • d. As does the general rule of freedom of contract.
      • e. And many detailed rules
        • i. defense of necessity,
        • ii: different levels of proof for civil and criminal law
        • iii. Only liable for reasonably foreseeable damages (photo case)
        • iv. No bargaining as the ship goes down
        • v. Strict liability for ultrahazardous activities.
        • vi. Many more in Posner.
    • 3. Some fairly clear evidence against the efficiency of our legal rules:
      • a. Retreat from freedom of contract, as for instance:
        1. "Contracts of adhesion" etc.
        2. Refusal to enforce penalty clauses
        3. Refusal to enforce waivers re first party product liability, etc.
      • b. Lack of transferability of torts (existed 1000 years ago in Iceland!) and inchoate torts.
    • 4. Lots of fuzzy evidence:
      • a. Crime/tort distinction is backwards with regard to incentives to avoid by victim. To justify that you have to argue that other considerations, such as judgement-proof defendants and wanting to provide victims incentives to report offenses, outweigh that consideration.
      • b. Negligence, contributory negligence, strict liability. The rules vary from state to state, and the advantages of the different rules depend on things, in particular what sorts of mistakes courts make, that we don't know much about.
• C. Are there good reasons to expect efficiency?
  • 1. Efficiency is important to people, including judges, so judges seek to maximize it. but ...
    • a. There is a large public good problem to doing so, since most of the benefit of efficient law goes to people other than the judges who produce it, and ...
    • b. not all economics is easy, so figuring out what rule is efficient is sometimes hard, so why would judges bother?
  • 2. Judges want to do good, and since the alternative values are controversial and hard to produce, efficiency is the only kind of good they can readily do. In particular, redistribution is hard to do as a judge
    • a. But you can do it for the particular case you are ruling on, between that plaintiff and that defendant, and ...
    • b. Inability to do it in general is far from obvious.
    • c. If some classes of plaintiffs or defendants are consistently people that judges want to help you might get legal rules that "favor" those classes--for instance, rules favorable to tenants, or poor people, or purchasers of consumer goods, or ...
    • d. Which is likely to be not only inefficient, but against the interest of those classes of people, who can now less able to sign binding contracts, since the other party knows that the court may not enforce them.
  • 3. Expenditure on litigation argument--the more the outcome is worth, the more you spend to get it, so the efficient outcome tends to win out in the long run, but ...
    • a. The litigant only gets his gain, not the whole gain of the new legal rule to all who benefit, so the amount each side is willing to spend to get the precedents they want is weighted by that side's ability to solve its internal public good problem (raising money for litigation to extablish precedents that will benefit everyone on that side), which will be different for different sides, giving you inefficient outcomes.
    • b. Thus legal rules will tend to favor more concentrated interest groups at the expense of less concentrated interest groups.
    • c. Consider, as an example, the conflict between the interest of the plaintiff's bar (in legal rules that produce lots of litigation) and the interest of the consumers who ultimately bear the cost of that litigation.
  • 4. Fossilized efficiency?
    • a. Norms have some efficiency characteristics.
    • b. As does a competitive court system where both parties can opt in or out of a court's jurisdiction. To some extent, the common law is based on such systems (Fair courts, church/state, royal/baronial).
    • c. So might retain some of their efficiency
  • 5. Which suggests that common law should have some tendency towards efficiency--but it might be declining over time, as the law changes, and the efficient bits erode away.

    ---

• I. What is economics?
  • A. Rationality. Individuals have objectives and tend to choose the actions that best achieve them.
  • B. Examples:
    • 1. Rational criminals consider costs and benefits of crime, commit only if there is a net gain.
      • a. Gives you the argument for using punishment to deter.
      • b. And the argument for punishment equal to damage done in the simple case.
      • c. And for value of marginal offense = <P> in the complicated case.
    • 2. Rational Enforcers, private or public, use legal rules if they gain by doing so
      • a. Which gives you a problem with efficient punishments.
      • b. Since they benefit someone, someone has an incentive to impose the punishment, whether or not the defendant is guilty.
    • 3. Flip side:
      • a. Rational enforcer do not prosecute if the gain is not worth the trouble.
      • b. So private prosecutors do not go after judgement-proof victims
      • c. Unless they can privatise deterrence.
      • d. And ditto for private prosecution of criminal law (18th c. problem)
      • e. Or, in our system, private individuals bothering to press criminal charges.
    • 4. Why does the victim own the claim?
      • a. Justice--but not in the criminal context.
      • b. Because he owns the evidence, and ...
      • c. Has the private deterrence incentive.
      • d. Hence in English case, crimes were typically prosecuted by the victims.
    • 5. Contract breach: Parties will breach if it is profitable to do so, so ...
      • a. Use damage rule to control inefficient breach (expectation), and
      • b. Inefficient contracting (reliance)

• II. What is economic analysis of law?
  • A. Consequences of legal rules:
    • 1. Easy divorce ->opportunistic breach, and women taking precautions against it.
    • 2. Marginal deterrence problem--the additional punishment for an armed robber who kills his victim.
    • 3. Risks of efficient punishment issue.
    • 4. When the law changes one term of a contract in favor of one party, that shifts the contract price (or other terms) against that party, which makes redistribution via law difficult.
  • B. Predicting (post-dicting?) legal rules:
    • 1. Posner's efficiency conjecture.
      • a. Explains some of the distinction between criminal and civil law.
      • b. And different standards of proof in criminal and civil law.
      • c. And lots of detailed legal rules (see Posner's book)
    • 2. My market for norms.
      • a. Predicts local but not global efficiency.
      • b. In particular, efficiently inefficient punishments.
  • C. Recommending legal rules: Efficiency as a norm.
    • 1. Argument for freedom of contract.
    • 2. Analysis of optimal liability/contract rules for product defects.
    • 3. Optimal punishment arguments.
  • D. What kind of knowledge does economic analysis of the law give us?
    • 1. None of this gets to the point of a set of equations where you can expect to fill in the numbers and turn the crank.
    • 2. But it tells you how you would do so if you had enough information, and thus tells you what factors are relevant why.
    • 3. We can't prove "the right liability rule for lawnmowers is X"
    • 4. But we can give good reasons to believe that the argument for caveat emptor is stronger for some goods than for others.
    • 5. Which is the kind of knowledge we have for most things--getting married, betting on ballgames, choosing a career.
  • E. Why is it an interesting subject?
    • 1. Provides a single theory to make sense of the diversity of law.
    • 2. Pushes economists into thinking about theory by concretizing it.
    • 3. Provides puzzles
    • 4. And data. Resale price maintainance, etc. After we have proved that it isn't happening, we have to rethink the question to figure out why it is happening.

• III. Allocational vs distributional issues: At the heart of many political arguments, including the preception of economic analysis of law as conservative.
  • A. Allocation is how to make the pie, Distribution is how it gets cut.
  • B. Distributional effect of restraints on contract tend to be wiped out by price shifts.
  • C. A judge can benefit a particular tenant at the cost of his landlord, but it is much harder to create legal rules that benefit tenants in general at the expense of landlords in general--because the parties know about the rules when the decide whether to build apartment buildings, what price to rent them at, etc.
  • D. Similarly, rules making it hard to fire minorities make it costly to hire them.
  • E. An economy is a complicated system, and ...
    • 1. The effect of regulating one dimension may well get wiped out by another
    • 2. Regulating all of it is hard, for the same reasons that running a centrally planned economy is hard.
  • F. Lesson for political discourse: A lot of disagreements that seem to be distributional aren't, since the parties do not agree what the distributional consequences would be.

• IV. Economic efficiency
  • A. Size of the pie, loosely speaking.
  • B. But how do we add up a "pie" consisting of many very different things consumed by many people?
  • C. Marshall's answer: Measure value by how much someone would be willing to spend to get or keep something (i.e. to cause or prevent some change), add up by dollars (actually pounds in Marshall's case) across people.
  • D. Critique:
    • 1. We might reject individual values as a basis for judging what is good.
    • 2. Or reject revealed preference as a way of determining what people really value
    • 3. Or reject interpersonal comparison by dollar-measured value.
    • 4. But can you do better? Is there an alternative criterion that is both closer to what we want and operationally usable?

• V: What is Law?
  • A. Where it comes from:
    • 1. Constitution
    • 2. Legislature
    • 3. Courts
    • 4. The hierarchy of courts, appeals.
    • 5. Why courts matter--inherent ambiguity of English. You cannot write laws clearly enough to leave no hard cases, so the courts (at least) fill in the details.
  • B. Consistency/inconsistency.
    • 1. In many areas, state laws differ.
    • 2. Federal laws are the same everywhere in the U.S., but different circuits may differ in their interpretation of them until the Supreme Court hears the issue and settles the disagreement.
  • C. How are cases decided.
    • 1. Adversary system (vs European inquisitorial system)
    • 2. Jury is available for both criminal and civil (U.S. only)
    • 3. Judge decides law, jury facts--supposedly.
  • D. We have multiple legal systems
    • 1. Federal, state
    • 2. Criminal/Civil
    • 3. Administrative law.
    • 4. Property law:
    • 5. Contract
    • 6. Tort law
  • E. Some interesting issues include ...
    • 1. Why do civil and criminal law exist, and have the form they do
    • 2. Adversarial vs Inquisitorial systems for trying cases
    • 3. Who pays the cost of litigation
    • 4. How should law be enforced
    • 5. ...

• VI. Essential economic concepts:
  • A. Externalities:
    • 1. The problem--inefficiency due to the existence of externalities. Some goods worth producing don't get produced, some pollution worth preventing doesn't get prevented.
    • 2. Conventional solutions
      • a. regulation
      • b. pigouvian tax (aka effluent fee).
      • c. b requires much less information than a--but still more than the regulators are likely to have.
    • 3. Coaseian three step critique: "Victim" is not well defined. If I can play my stereo, you are the victim of my noise, if I can't, I am the victim of your desire to sleep.
      • a. Nothing works--because we might be imposing the Pigouvian tax on the wrong party.
      • b. Everything works--because parties can negotiate to the efficient outcome.
      • c. It all depends on transaction costs--which sometimes block the agreements necessary to get to the efficient outcome.
    • 4. As we will see, for some legal problems the conventional approach is still the most useful way of thinking of them, for others not.
    • 5. Lots of examples as we went through the law.
  • B. Property rules vs liability rules.
    • 1. Not "property vs not-property" but "property protected by ... rule."
    • 2. Property rules are best if market transactions are the best way of allocating (including the possibility that the best outcome is leaving the property with the original owner, which requires no transaction.).
    • 3. Liability rules if "take and then be sued" is the best way of allocating. Sounds odd, but consider pollution, traffic accidents.
  • C. Insurance is useful for thinking through some relevant issues--because it is a context in which we are deciding who will bear a particular cost.
    • 1. Risk aversion--let whoever can best bear the risk have it. Not an egalitarian argument, since you pay for your insurance, but based on the same principle (declining marginal utility of income) that generates the utilitarian argument for egalitarianism.
    • 2. Moral hazard argument: Starts as "insurance causes moral hazard cost." But generalizes to "let whoever can best control the occurence of the cost bear it," which really means" "put the incentive where it will do the most good in reducing the moral hazard inefficiency."
    • 3. Adverse selection argument: With assymetric information, efficient transactions don't happen.
      • a. You can solve the problem by nobody knowing, or
      • b. Everybody knowing, or
      • c. Insurance so that the knowledge is only needed by the person who has it.
    • 4. Litigation cost--an argument for leaving damage where it falls. One reason to have a policy with a deductible is that, for small losses, making and investigating an insurance claim cost more than the small reduction in risk is worth.
  • D. Ex ante/ex post enforcement
    • 1. Ex post uses the actor's information about what he is doing and what its consequences are, but ...
    • 2. My involve a low probability of a high cost, which gets into risk aversion and inefficient punishments ...
    • 3. And assumes that the actor's information really is better than the cop's.
  • E. Strategic behavior:
    • 1. Threats, commitments, coalitions, etc. become important
    • 2. When I am acting to influence your action and vice versa
    • 3. Which makes the analysis very hard, dependent on an (unknown) technology of commitment.
    • 4. Which is why we try to set up problems in ways that avoid such things, as by perfect competition.

• VII. Property.
  • A. The idea: People control scarce things. They trade to get to the optimum--move goods to their highest valued use.
  • B. So why not solve all problems that way?
    • 1. Propertise everything that is scarce and leave it to the market to allocate it?
    • 2. Because costs of creating, defining, protecting, and transacting over property can be high.
      • a. Propertise the atmosphere, gas by gas?
      • b. Or the English language, word by word?
    • 3. So some things should be left as commons, despite the costs of treating them that way.
  • C. Also--what we own are not things but rights with regard to things.
    • 1. How do you bundle them?
    • 2. What rules protect the owner?
    • 3. How do you get ownership?
  • D. Contexts:
    • 1. Property in land. What do you own?
    • 2. Selling partial bundles of other things
      • a. You can't sell a thing minus the right to use it in certain ways.
      • b. So to get that result, you have to use contract, not property law.
      • c. But you can sell a piece of land minus some of the associated rights--for example with an easement allowing a neighbor to cross it, or a restrictive covenant limiting the ways it may be used.
    • 3. Primitive peoples seem to establish pretty sensible property rights, propertizing things roughly when they ought to, from the standpoint of efficiency.
    • 4. Intellectual property.
    • 5. All involve the same set of issues. Worked out in most detail for intellectual property in my article on standards.
  • E. Coase as one approach to all of this.
    • 1. You can allocate your property either by using your property or selling it.
    • 2. So bundle the rights in the way that minimizes the cost of doing so.
    • 3. The simple property argument generalized to the fine points--the individual rights within the bundle.
    • 4. With attention paid to the transaction cost problem.

• VIII. Contract Law:
  • A. Need enforceable contracts to permit transactions over time.
    • 1. Building a house.
      • a. If I pay and then you build, you can cheat me.
      • b. If you build and then I pay, I can cheat you (nobody but me is willing to bid for a house sitting on my land, so you accept a price below what we agreed to rather than losing everything).
    • 2. Loss from not being able to enforce contracts is not cheating but inefficiency due to the possiblity of cheating. The house never gets built.
    • 3. Enforcement mechanisms other than law exist, but law is the one we are most interested in.
  • B. There is never enough fine print to specify the terms in full, so we solve by either ...
    • 1. Court fills in what the parties would have agreed to (efficient terms)
    • 2. If circumstances change, parties can break or renegotiate the contract. We then need rules specifying the result of breach.
  • C. One issue is how to allocate unexpected losses.
    • 1. By who can best insure.
    • 2. By who can best control.
    • 3. By who best knows the risk, so can include it in the contract price.
  • D. Another issue is what happens if one party breaches the contract.
    • 1: Nothing. No enforceable contract.
    • 2: Specific performance: No breach without the permission of the other party.
    • 3. Expectation damages: The breaching party must make the victim as well off as if there had been no breach. This gives the right incentive to breach, since the breaching party bears all of the costs, and receives all the benefits, of breach.
    • 4. Reliance damages: The breaching party must make the victim as well off as if there had been no contract. If the party that will breech is the one best informed about the likelihood of events leading to breach, this gives the right incentive to sign such contracts--the party with the superior information is insuring the other party against the loss from signing and then being the victim of breach.
    • 5. Both of these give the wrong incentive to rely.
    • 6. Liquidated damages: The parties agree in advance on what the penalty for breach will be. This gives the right incentive to rely; whether it gives the right incentive to sign or to breach depends on how the agreed upon payment compares to what expectation or reliance damages would be.
    • 7. Courts will enforce liquidated damages if they think they are reasonable, but not if they think they are a "penalty clause."
    • 8. Note that a penalty clause serves the same function here as a property rule--instead of "pricing" breaches it tries to eliminate them, forcing the party that wants to breach to negotiate to get the permission of the other party. To put it in contract language, the parties are agreeing to a modified version of specific performance--up to some maximum cost of performance (party can breach without permission if he is willing to pay the penalty).
  • E. These questions arise both in the context of negotiating a contract (the parties want to find the efficient terms) and filling in the blanks (the parties would have chosen the efficient terms, so the court adds them). It also arises where a court is trying to modify the terms agreed to by the parties--subject to the argument that if the court disagrees with the parties about what the efficient terms are, the court may be wrong.
  • F. Distinguish the argument for default rules from the argument for non-waivable rules:
    • 1. Default is what you think they would have agreed to--and if you get it wrong, they will contract around you, at some cost in additional negotiation.
    • 2. Non-waivable is what you insist that they must be bound by--whether or not they agree.
    • 3. Consider fine print rules re fraud. If the contract says even terms in four point type are binding--and that passage is in four point type, hidden in the ornamental border--it isn't binding.
  • G. What is duress? Gun? No good alternatives? Sinking ship?
    • 1. Courts won't enforce contracts signed under real duress so people won't point guns.
    • 2. Contracts of adhesion are not a reason not to enforce, since it is in the interest of the party who draws up a form contract to take account of its cost for the other side--it will show up in the price he will be willing to pay.
    • 3. Sinking ship might be--because bargaining costs are high.

     

• IX. Family law:
  • A. The problem with no fault divorce (Cohen article):
    • 1. If women perform early and men late
    • 2. There is an opportunity for opportunistic breach by men.
    • 3. Women will adjust by performing later (postponing childbearing, for example) and investing less in relationship-specific capital (work and hire a nanny).
    • 4. All of which is costly--in foregone opportunities, and middle aged people trying to cope with energetic children.
  • B. But there are serious problems with the alternatives.
    • 1. No divorce locks partners into their early mistakes, is hard to enforce, and may produce costly bargaining within marriage, since there is no exit option to limit the stakes.
    • 2. Divorce with fault gives one partner an incentive to perform his or her obligations badly in order to force the other to request the divorce.
    • 3. Part of the problem is that it is a complicated contract, making it hard to specify all the relevant terms, and much of the performance is difficult for an outside party to observe.
  • C. Why has marriage become less stable over time? Because falling infant mortality and increasing replacement of household production by market production greatly reduced the amount of relationship-specific capital required. [Other economic explanations are also possible--for example, that improved medicine has virtually eliminated death in childbearing, substantially increasing the ratio of women to men in the relevant ages and thus weakening women's ability to insist on economic support as a condition for sex or childbearing.]
  • D. The economics of engagement rings. Arguably they became popular when states stopped awarding damages for breach of contract, and served as a performance bond for the promise to marry, reducing the "seduce and abandon" risk to pre-marital sex by engaged partners.
  • E. The adoption market: Why not allow payments to natural mothers for their consent?
    • 1. "Commodification" argument--doing so makes us think of children as commodities.
    • 2. Should it be illegal to do things that affect how other people think about things?
    • 3. Isn't making that illegal in violation of the first amendment?
  • F. Do people have too many children?
    • 1. Argument: By having a child I impose costs on others (for his schooling, resources he uses, ...)
    • 2. Counter-argument: If my child uses resources he (or I) must pay for them--they aren't given away. There are some negative externalities, but some positive externalities too, and one must count both.
    • 3. How in principle do we define the optimal level of population? How do we apply ideas such as Pareto or Marshall efficiency when we are comparing alternative futures with different numbers of people in them?
  • G. Why do we have laws the regulate sex--laws against prostitution, adultery, fornication, ... ? To help enforce the marriage contract? Protect children? Avoid externalities associated with transmission of disease? Avoid the "esternality" of A doing something B disapproves of?

   

• X. Tort law:
  • A. What it is: Private action for a wrong done to you.
  • B. What is a wrong?
    • 1. An act that causes harm
    • 2. Is worth dealing with through the legal system
    • 3. And can be dealt with better by a liability rule than by a property rule (although punitive damages can be seen as a property rule within tort law).
  • C. What does it mean to say I "caused" the harm?
    • 1. It would not have happened "but for" my act runs into coincidental causation problem--the falling safe.
    • 2. Probabilistic injury (reactor leak) means nobody caused anything (less than 50% chance that any given cancer was due to the leak) or that total liability is many times total damage.
    • 3. Two people might cause together but neither singly (three hunter story)
    • 4. The right answer is "it means that holding me liable creates desirable incentives for me to modify my actions." i.e. my action affects the expected cost to others calculated with probabilities I do or reasonably might know.
  • D. Liability: The law should be designed to produce the optimal number of accidents--which, for bicausal accidents, means the optimal precautions by both sides.
    • 1. Strict liability--but that eliminates the victim's incentives.
    • 2. Negligence--requires the court to know if you are taking efficient precautions (if not you are negligent and liable).
    • 3. Both parties liable? Correct incentives--but it no longer works as a tort, since neither party has an incentive to prosecute.
  • E. Amount of damages.
    • 1. Enough to make good is the usual rule. But as the law is applied damages are less than that, since they do not include attorney fees, may not include non-pecuniary injuries, etc.
    • 2. Punitive damages provide an indefinite amount more than enough to make good, and are awarded for "deliberate or reckless torts."
    • 3. Why do we want to deter apparently efficient torts? Several answers were discussed. Mine involved the problem of optimal punishment with costly enforcement, discussed at greater length in the context of criminal enforcement.
  • F. Why pay damages to the victim instead of to someone else?
    • 1. Incentive to sue
      • a. Best given to him, who has the evidence (typically)
      • b. And the additional incentive of deterrence.
    • 2. But it reduces his incentive to prevent the injury.
  • G. Compensating for death or injury: Loss of both utility and of the ability to convert damage payment into utility.

   

• XI. Criminal Law.
  • A. Enforced by the state.
  • B. Again we want all and only efficient offenses, but ...
  • C. Not at any price of getting them.
    • 1. Expected punishment equal to damage done would be right if catching and punishing criminals were costless, but ...
    • 2. It involves enforcement and punishment costs
    • 3. So the right rule is to produce an expected punishment with the least costly combination of punishment and probability, yielding a total cost curve for deterrence (enforcement+punishment cost for producing any level of deterrence via the least costly probability Punishment pair)
    • 4. And then to calculate the optimal expected punishment, taking account of the cost of imposing it.
    • 5. Detailed version of this in punitive damage and Payne v Tennessee papers.
  • D. Why do the criminal's costs count? We don't know what is a crime until we know what it is efficient to punish.
  • E. Should rich and poor pay the same punishment? In general no.
  • F. Why not punish with an efficient suite of punishments?
  • G. One reason is that efficient punishments provide enforcers with an incentive to punish even the innocent, since someone collects what the victim loses.
  • H. Why have criminal law?
    • 1. Diffuse costs--doesn't explain the law.
    • 2. Low probability+judgement proof defendant
    • 3. Low probability+problem of fake offenses. In other words, optimal fine for deterrence is more than for enforcement.
    • 4. To give the victim the right incentive--but that mispredicts the pattern of what is a crime and what a tort.

   

• XII. Monopoly.
  • A. Produces an inefficient outcome
    • 1. Because a single price monopoly produces too low a quantity.
    • 2. Discriminatory monopoly solves some of this, but may allocate inefficiently
  • B. One approach to solving is to prevent monopolies from existing.
    • 1. Not workable for a real natural monopoly.
    • 2. But perhaps for preventing monopoly-by-merger or preventing cartels
    • 3. Or artificial monopolies? But that assumes that predatory pricing works, and it probably doesn't.
  • C. Another is to regulate monopolies (public utility regulation and the like) to try to make them behave more efficiently. This has problems.
    • 1. To make them produce the efficient quantity, you need to know their cost curves, and don't.
    • 2. You need a way of covering their losses to keep them in business.
    • 3. And we need a way of making it in the regulator's interest to try to produce the efficient outcome.
  • D. Some behavior has been regarded as monopolistic, but perhaps incorrectly.
    • 1. Resale price maintanance.
    • 2. Vertical integration.
    • 3. Tie-in sales (you have to use our punch cards with our computer).

   

• XIII. The English vs the American rule:
  • A. The English rule gives an incentive for more expenditure on cases
  • B. But fewer cases. In particular, it makes low probability cases less attractive
  • C. Which might be a good or bad thing.

   

• XIV. Some interesting historical cases:
  • A. Iceland.
    • 1. All offenses treated as torts.
    • 2. Tort claims transferable, so a weak victim could sell his claim to someone with the power to enforce it.
    • 3. Enforcement was entirely private.
    • 4. Concealing an offense increased the punishment (and was considered shameful)
    • 5. Loans within groups, and temporary slavery, to keep defendants from being judgement-proof.
  • B. 18th century England.
    • 1. Hang, transport, or pardon
      • a. Why no imprisonment for serious crime? Because too costly?
      • b. Why a system where pardoning was common?
      • c. A form of discriminatory pricing, or ...
      • d. Selling pardons for non-pecuniary payments, thus converting execution to a (more efficient) fine.
    • 2. Crime privately prosecuted. Why bother--no damage payment to collect.
      • a. Deterrence as a private good: Associations for the prosecution of felons.
      • b. Out of court settlements to convert hanging to a cash payment.
    • 3. Rewards for successful prosecutions let to a problem of entrapment, framing, perjury.
  • C. 20th century Shasta County, California.
    • 1. Norms substituting for laws.
    • 2. Self enforced.
    • 3. Avoiding efficient punishment that would give "victims" an incentive to find other people guilty when they weren't.
    • 4. Locally efficient, but not necessarily globally efficient.

   

• XV. Summary of Summary:
  • A. We have a small number of central ideas:
    • 1. Efficiency
    • 2. Externalities as a problem for efficiency
    • 3. Solutions such as Pigouvian taxes and property rights to eliminate the inefficiency
    • 4. Problems such as transaction costs and imperfect information, by courts as well as actors, to prevent the solutions from working
  • B. We apply the analysis to a wide range of problems, including:
    • 1. Solving the problem with legal rules, so far as practical, in many contexts.
    • 2. Individual choices, such as contracts, designed to do the same thing privately.