Review

1
Review

• What is economics?
• What does it have to do with law?
• Economic efficiency
• The simple solution and its problems
• Externalities Pigou and Coase
• Designing legal rules Spaghetti
• Economics of risk
• Ext Post/Ex Ante
• Game Theory
• Value of Life

2
General Perspective

• Rationality
• Rules make sense
• Maybe
• And maybe my kind of sense, or not

3
In a complicated world

• Actions are interdependent,
• We all need inputs from many other people to
  achieve our goals.
• Solutions
• Decentralized violence
• Centralized controldoesnt scale
• Decentralized control with suitable legal rules
• Could arise, as norms do, with decentralized
  legal system, but
• We are mostly looking at a unified system of
  legal rules to coordinate decentralized actors.
• Why each person doing whatever he wants doesnt
  work?
• Because individuals are not rational? Rejected by
  economic approach
• Because individual rationality doesnt
  automatically lead to group rationality.
• So we want legal rules under which it does.

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Which leads both to

• Understanding existing legal rules, on the
  conjecture that they are supposed to do this, and
  
• Deciding what legal rules to create
• If group rationality aka economic efficiency is
  what we want.
• Where economic efficiency
• Is an imperfect but useful measure of the degree
  to which everyone achieves his objectives.
• Defined by summing the value of each outcome to
  everyone, defined by willingness to pay

5
Starting point

• Private Property and trade
• Should move all goods to their highest valued
  uses, but .
• Problems arise with
• Costs of enforcing property rights
• Transactions costs of trade
• Ambiguities in defining rights, and

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Externalities

• The problem
• If I do not bear all costs of my actions
• And do not have to have permission of the others
  who do to take them
• I may take actions that on net are not worth
  taking.
• The inefficiency is the net cost of such actions
• Benefit to me minus cost to you
• Which can be a loss since I ignore the cost in
  making my decision
• Administrative solution
• Usual problems of centralized control (within
  decentralized system)
• Controller needs information it cannot get, and
• Incentives it does not have.
• Pigouvian Solution
• One step more decentralizedactor does the
  calculation
• Solves part of the information and incentive
  problem
• But leaves part of each

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Coasian Critique

• Costs are jointly caused, so ..
• Pigouvian solution is unnecessary if the person
  who bears the cost is the one who can solve the
  problem at lowest cost
• Indeed, may make the situation worse
• Cannot use the Pigouvian solution unless you
  already know the lowest cost avoider
• And there may not be one.
• Inefficiency would be bargained away in the
  absence of transaction cost, so
• In deciding how to define the initial rights, you
  need to think both about who is likely to be the
  high cost avoider (give him the right, so the
  other party has to adjust) and
• How easily your initial definition of rights can
  be changed by the parties if necessary.

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Solutions to Externality Problems

• Administrativeimpose the right answer (no
  murder)
• Pigouvianimpose the cost on one actor
• Effluent fees
• Speeding tickets
• Coaseiandefine rights, bargain to the efficient
  outcome
• Coaseian2In defining rights, take account of
  transaction costs and lowest cost avoider

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Coasian2 Application

• Spaghetti diagram approach
• Consider each possible initial definition of
  rights
• The transaction costs blocking the move to each
  final outcome
• The probability of each final outcome being the
  efficient one
• Pick the initial that minimizes the sum of
• Cost of getting to the efficient outcome, plus
• Cost of not getting to the efficient outcome.
• In principle, a machinery for figuring out how
  rights should be defined, if only we knew enough.

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• Property rights vs Liability rights
• Liability rights have problems of detecting act,
  measuring damage, litigating
• Property rights problems of private transactions
• This oversimplifies because even property rights
  must be enforced.
• Takings clause
• I build a house where the highway will go through
  in five years
• Takings without compensation give government the
  wrong incentive, but
• With compensation gives me the wrong incentive
• Typically, my incentive is unimportant, because I
  face a small risk of expropriation, but
• Government, when it makes the decision, chooses
  where to put the road.
• This looks a lot like the coming to the nuisance
  defense
• When I build my pig farm, I am very unsure what
  the best value of surrounding land will be in ten
  years. So being subject to expropriation
  doesnt much improvement my incentives, doesnt
  much change my actions.
• When you build your housing development, where
  you put it will depend largely on the legal rule.
• But fact dependent.

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Economics of Risk

• Risk aversion
• Moral hazard
• Externality problem all over again
• Put the incentive where it does the most good.
• Adverse selection
• Comes from assymetric information
• Inefficient because some cars dont get sold that
  are worth selling, some people dont get insured
  who are worth insuring.
• Solve either by eliminating assymetric
  information (genetic testing example) or
• By arranging liability so that the well informed
  party bears the relevant risk
• With three different criteria
• Minimize cost of risk aversion
• Optimize incentive to prevent risk
• Minimize costs of adverse selection
• Each of which tells you how to assign risk.
• No guarantee all go the same way, so have to
  balance.
• In designing a contract, or a rule of liability
  law.

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Ex Post/Ex Ante

• General distinction
• charge for inputs to bad outcome
• or for outcome if it happens
• Ex Post utilizes actors private information
  (like effluent fee)
• Good since the actor knows more about what he is
  doing than anyone else, but
• The actor might be mistaken about the causal
  links between what he does and what happens
• But may require small chance of large
  costinefficient punishment
• Punishment for attempts a special case

13
Game Theory

• Idea General solution
• To all games, including
• Chess, poker, economics, diplomacy, war,
  courtship
• Several informative but inadequate theoretical
  approaches
• Two interesting games
• Bilateral monopoly
• Bargaining range
• commitment strategies
• Try to avoid bilateral monopoly with large
  ranges, because likely to be expensive. Hence
  liability rather than property rule in some
  nuisance situations.
• Prisoners dilemma
• Simplest case of individual rationality not
  leading to group rationality.
• Still holds with fixed number of repetitions.
• So people avoid that game where possible
• Or get their opponents into it

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Value of life

• Matters
• For tort law
• Building highways
• Punishing murderers,
• Revealed preference gives two drastically
  different answers, one arguably infinite
• Because the alternative experiments have
  drastically different values for the dollars
  value is measured in
• Use the one where marginal utility of income
  corresponds to its usual value
• Meaning a situation where the actor
• Probably survives to spend the money
• Hence choices involving only a low probability of
  dying
• Inconsistency between insurance function and
  deterrence function of tort
• So use tort for deterrence and
• Insurance for insurance
• Better insurance, but
• Have to be able to sell insurance on yourself as
  well as to buy it.

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Questions?