Efficiency in Law: Balancing Social Costs for Optimal Outcomes

1. Econ 522Economics of Law Dan Quint Spring 2014 Lecture 3

2. Logistics • First homework due at noon next Thursday • Feel free to work together, but write up your own answers! • If you want to read ahead for Monday… • Ronald Coase, “The Problem of Social Cost”

3. Lecture notes – try View  Notes Page

4. Monday, we defined efficiency • Efficiency: “all available Kaldor-Hicks improvements made” • roughly, maximizing total value, or total surplus, or total payoffs, to everyone in society… • …where everything is translated into dollars, so we’re able to add/compare across people • Means that… • each scarce resource is owned by whoever values it most • goods are produced whenever their value is greater than their cost • and so on

5. Also Monday, we discussed some forces that lead to inefficiency • Externalities • People make choices based on private cost and private benefit • Efficiency is based on social cost and social benefit • When social cost > private cost, negative externality people will do something more than efficient amount • When social benefit > private benefit, positive externality people will do something less than efficient amount • Barriers to trade, taxes • Monopoly/private information

6. Finally on Monday, we posed the question: • Is efficiency a good goal for the law? • …and then we ran out of time

7. Is efficiency a good goal for the law? 6

8. Important distinction: positive versus normative economics • positivestatements are statements of fact • can be descriptive: “in 2007, U.S. GDP was $13.8 trillion” • can be theoretical predictions: “if prices rise, demand will fall” • “economics of what is” • normative statements contain value judgments • for example, “less inequality is better” • or, “government should encourage innovation” • “economics of what ought to be” 7

9. Most of this class will be positive analysis • Predicting behavior, and outcomes, that follow from a law or legal system is positiveeconomics • “Law X will lead to more car accidents than law Y” • “Law X will lead to more efficient outcomes than law Y” • But in the background, we’d like some sense of what is the normative goal of the legal system • “Law X is better than law Y” • One candidate for that normative goal is efficiency 8

10. Friedman gives a few arguments for studying efficiency “The central question [in this book]… is a simple one: what set of rules and institutions maximize the size of the pie? What legal rules are economically efficient? There are at least three reasons why that is the question we ask. The first is that while economic efficiency… is not the only thing that matters to human beings, it is something that matters quite a lot to most human beings. The second reason is that there is evidence that considerable parts of the legal system we live in can be explained as tools to generate efficient outcomes… It is a lot easier to make sense out of a tool if you know what it is designed to do. A final reason is that figuring out what rules lead to… efficient outcomes is one of the things economists know how to do – and when you have a hammer, everything looks like a nail.” - Friedman, Law’s Order, p. 312 9

11. But… • This answers the question, “Why is it interesting to study efficiency?” • Not the question, “Should the law be designed with the goal of achieving efficiency?” • To answer this latter question… 10

12. Posner gives us one argument why the law should aim to be efficient • Richard Posner (1980), The Ethical and Political Basis of Efficiency Norm in Common Law Adjudication • Starts with the observation: if you buy a lottery ticket and don’t win anything, you can’t complain • Imagine before we all started driving, everyone in the world got together and negotiated a liability rule for traffic accidents • If one rule is more efficient than another, we’d all vote for that rule ex-ante – ex-ante consent 11

13. Ex-ante consent – simple example • Suppose there are two candidate rules for accident liability • One favors pedestrians, one favors drivers • The one favoring car drivers is more efficient • Posner’s point: before we know who we’ll be, everyone would unanimously agree to the second rule Expected payoff, drivers Expected payoff, pedestrians Expected payoff if you don’t know which one you’ll be Strict liability rule -100 0 -50 Negligence rule -20 -60 -40 12

14. Things are a little more complicated… • People without cars would prefer a less efficient system if it meant drivers were responsible • Posner deals with heterogeneity with a different example • Landlord-friendly versus tenant-friendly laws • Might think tenants would prefer pro-tenant laws • But rents are determined competitively • If laws become more tenant-friendly, rents might go up to compensate • And if tenant-friendly law is less efficient, it could make both sides worse off! 13

15. Example: new law requiring landlords to pay for their tenants’ heat • Suppose tenants get $1000 value from apartment, minus rent • Landlords pay $100 for heat, $600 in other costs • Without this law, tenants would pay for their own heat • They’d heat apartment less, get $980 value and pay $60 for heat • Might think tenants would prefer inefficient tenant-friendly law… • But rents are set competitively, would go up to compensate… • So both landlords and tenants do better under the old law! Tenants’ payoffs Landlords’ payoffs Tenants Landlords Landlord pays for heat 1000 – rent rent – 600 – 100 1000 – 850= 150 850 – 600 – 100= 150 Tenant pays for heat 980 – 60 – rent rent – 600 980 – 60 – 760= 160 760 – 600= 160 14

16. Ex-ante consent, ex-ante compensation • Posner’s basic argument: if we choose the most efficient legal system, everyone is “compensated ex-ante” for the choice, and should willingly accept the outcome they get • Of course, all this consent is hypothetical… • …and it does have certain limitations 15

17. Limitations to Posner’s argument • The “lottery ticket” analogy requires risk neutrality • 50% chance at $1,000,000 is just as good as 50% chance at $900,000 and 50% chance at $100,000 • If $100,000 is “worth more to you” when you’re broke than when you already have $900,000, this argument doesn’t work • Counterpoint to Posner: Hammond (1982) • Efficiency is really a special case of utilitarianism, and subject to the same limitations • “Value” = “willingness to pay” • $1 worth the same to everyone 16

18. This highlights some of the things efficiency is not • efficiency is not equity • efficiency is not fairness • efficiency is not maximizing happiness “Suppose that pituitary extract is in very short supply… and is therefore very expensive. A poor family has a child who will be a dwarf if he doesn’t get some of the extract, but the family cannot afford the price [or borrow the money]. A rich family has a child who will grow to normal height, but the extract will add a few inches more, and his parents decide to buy it for him. In the sense of value used in this book, the pituitary extract is more valuable to the rich family… because value is measured by willingness to pay, but the extract would confer greater happiness in the hands of the poor family.” - Posner, Economic Analysis of Law 17

19. A more pragmatic defense of efficiency as a goal for the law • Cooter and Ulen (textbook ch. 1) • Efficiency should notnecessarily be the goal of society • But efficiency shouldbe the goal of the legal system • If redistribution is desirable, it’s better to make the legal system efficient, and address distribution through taxes • Cooter and Ulen offer four reasons why the tax system is a better way to redistribute wealth than the legal system 18

20. Four reasons the tax system is a better way to redistribute wealth than the legal system 1. Taxes can target “rich” and “poor” more precisely than the legal system can • Distributional effects of legal changes are harder to predict • Lawyers are more expensive than accountants • More narrowly-targeted taxes cause greater distortion than broad-based taxes 19

21. To make this last point, an example Two goods: beer (x), pizza (y) One consumer, with $60 and utility u(x,y) = x0.5 y0.5 a. Given prices p for beer and q for pizza, calculate demand. (x,y) = (30/p, 30/q) Beer and pizza are produced at $1 per unit, and perfectly competitive markets So without any taxes, p = q = $1 b. Calculate demand, and utility, with no tax. (x,y) = (30, 30) u(x,y) = 300.5 300.5 = 30 c. Calculate demand and utility with $0.50 tax on beer. (x,y) = (20, 30) u(x,y) = 200.5 300.5 = 6000.5» 24.49 d. How much revenue does $0.50 tax on beer raise? 20 X $0.50 = $10 e. Calculate demand and utility with $0.20 tax on both goods. (x,y) = (25, 25) u(x,y) = 250.5 250.5 = 25 f. How much revenue does $0.20 tax on both goods raise? 25 X $0.20 + 25 X $0.20 = $10 g. Which is the better way to raise revenue? 20

22. So, summing up… is efficiency a good goal for the law? • We’ve seen two arguments in favor • Posner: it’s what we all would have agreed on ex-ante • C&U: if you want to redistribute, it’s better to do it through taxes • But there are definitely some problems with efficiency • Distribution matters; not everything is monetizable; people might care about procedural fairness • My take • In this class, we’ll mostly focus on the positive questions • But in the background, I think of efficiency as a “pretty good”, but definitely imperfect, measure of “goodness”

23. A nice blog post about why policy evaluation should at least start with efficiency… Let’s first dispense with the straw man. I’ve never heard of an economist who believes that every efficient policy is good, and I’ve heard of very few who believe that every inefficient policy is bad. It’s true that most economists do seem to believe that any good policy analysis should start by considering efficiency. That doesn’t mean it should end there. I think economists are right to emphasize efficiency, and I think so for (at least) two reasons. First, emphasizing efficiency forces us to concentrate on the most important problems. Second, emphasizing efficiency forces us to be honest about our goals. – Steven Landsburg http://www.thebigquestions.com/2010/08/30/efficiency-experts

24. “Emphasizing efficiency forces us to be honest about our goals” Politician: Here’s my program to make the health care system work better by subsidizing health care for the poor. Economist: Your program costs a billion dollars and delivers half a billion dollars worth of benefits. That’s inefficient. Politician: So what? Economist: Well, the “so what” is that maybe you could take that billion dollars and deliver a full billion dollars worth of benefits instead if you spent it a little differently. Why not just hand the cash out to poor people? Politician: Because I don’t want to help all poor people. I only want to help sick poor people – and this is the only way I can think of to do that. Economist: Ah. So your goal here is not to make the health care system work better at all. Instead it’s to transfer resources to sick poor people. Politician: I guess so. Economist: That’s fine. Now we can have a healthy debate about whether that’s what we want to do.

25. A quickdigression

26. Before we move on, a quick digression… • I don’t have many “absolute beliefs” about economics • Some people do • I hope that doesn’t make things too confusing

27. Before we move on, a quick digression… • I don’t have many “absolute beliefs” about economics • Some people do • I hope that doesn’t make things too confusing • Relatedly, if I don’t see economics as a set of rules to memorize, how do I know what I know? • I need to see a model, or an example, that demonstrates it 26

28. Rest of today: • introduce some basic game theory • begin property law (if time allows)

29. Some basicgame theory

30. A brief introduction to game theory • Today, we focus on static games • Also known as simultaneous-move games • A static game is completely described by three things: • Who the playersare • What actions are available to each player • What payoff each player will get, as a function of • his own action, and • the actions of the other players • Any complete description of these three things fully characterizes a static game

31. A classic example: the Prisoner’s Dilemma • (Story) • Players: player 1 and player 2 • Two actions available to each player: rat on the other, or keep mum • Payoffs: • u1(mum, mum) = -1 • u1(rat, mum) = 0 • u1(mum, rat) = -10 • u1(rat,rat) = -5 • Same for player 2

32. In two-player games with finite actions, one way to present game is payoff matrix Always Player 1 Player 2’s Action Mum Rat -1, -1 -10, 0 Mum Player 1’s Action 0, -10 -5, -5 Rat Player 1’s Payoff Player 2’s Payoff

33. Nash Equilibrium • We solve a game by looking for a Nash equilibrium • Nash equilibrium is a strategy profile (an action for each player) such that: • No player can improve his payoff by switching to a different action… • …givenwhat his opponent/opponents are doing

34. A strategy profile is a Nash Equilibrium if no player can gain by deviating • If any player can improvehis payoff by changing hisaction, given his opponents’actions, then it is not a Nashequilibrium • Is (Mum, Mum) an equilibrium? • No, if player 2 is playing Mumplayer 1 gains by deviating Player 2’s Action Mum Rat -1, -1 -10, 0 Mum Player 1’s Action 0, -10 -5, -5 Rat

35. In two-player games, we find Nash equilibria by highlighting best responses • My best response to a particular play by the other player is whichever action(s) give me the highest payoff • To find Nash Equilibria… • Circle payoff from player 1’sbest response to each action by his opponent • Circle payoff from player 2’sbest response to each action • Any box with both payoffscircled is an equilibrium • Because each player is playinga best-response to his opponent’s action… • …so neither one can improve by changing his strategy Player 2’s Action Mum Rat -1, -1 -10, 0 Mum Player 1’s Action 0, -10 -5, -5 Rat

36. Some games will have more than one equilibrium • Another classic: Battle of the Sexes • (Story) • Circle player 1’sbest responses • Circle player 2’sbest responses • We find two equilibria: (ballgame, ballgame) and (opera, opera) • Game theory usually doesn’t have that much to say about which equilibrium will get played when there are more than one Player 2’s Action Baseball Game Opera 6, 3 0, 0 BaseballGame Player 1’s Action 0, 0 3, 6 Opera

37. Sometimes, there will be a “good” and a “bad” equilibrium • Growth model • (Story) • Circle player 1’sbest responses • Circle player 2’sbest responses • Two equilibria: (invest, invest)and (consume, consume) • Some papers explain differences in growth across countries by saying some are in “good” equilibrium and some are in “bad” one Player 2’s Action Invest Consume 2, 2 0, 1 Invest Player 1’s Action 1, 0 1, 1 Consume

38. Some games don’t have any equilibrium where players only play one action • Scissors, Paper, Rock for $1 • Look for Nash Equilibria by circling best responses • No square with both payoffs circled • No equilibrium where each player plays a single action • In this class, we’ll focus on games with a pure-strategyNash equilibrium Player 2’s Action Scissors Paper Rock 0, 0 1, -1 -1, 1 Scissors -1, 1 0, 0 1, -1 Player 1’s Action Paper 1, -1 -1, 1 0, 0 Rock

39. That’s a very quick introduction to static games • Now on to… Skip

40. Property Law

41. To begin, a story

42. Why do we need property law in the first place? • We already saw one reason • Tragedy of Commons – overuse of land is held in common • For another example, imagine two neighboring farmers • Each has two choices: farm his own land, or steal crops from his neighbor • Stealing is less efficient than planting my own crops • Have to carry the crops from your land to mine • Might drop some along the way • Have to steal at night  move slower • If I steal your crops, I avoid the effort of planting and watering 41

43. Why do we need property law in the first place? • Suppose that planting and watering costs 5, the crops either farmer could grow are worth 15, and stealing costs 3 • With no legal system,the game has the following payoffs: • We look for equilibrium • Like Prisoner’s Dilemma • both farmers stealing is the only equilibrium • but that outcome is Pareto-dominated by both farmers farming Player 2 Farm Steal 10, 10 -5, 12 Farm Player 1 12, -5 0, 0 Steal

44. So how do we fix the problem? • Suppose there were lots of farmers facing this same problem • They come up with an idea: • Institute some property rights • And some type of government that would punish people who steal • Setting up the system would cost something • Suppose it imposes a cost c on everyone who plays by the rules

45. So how do we fix the problem? ORIGINAL GAME MODIFIED GAME Player 2 Player 2 Farm Steal Farm Steal 10, 10 -5, 12 10 – c, 10 – c -5 – c, 12 – P Farm Farm Player 1 Player 1 12, -5 0, 0 12 – P, -5 – c -P, -P Steal Steal • If P is big, and c is not too big, then 12 – P < 10 – c • In that case, (Farm, Farm) is an equilibrium • Payoffs are (10 – c, 10 – c), instead of (0, 0) from before

46. So the idea here… • Anarchy is inefficient • I spend time and effort stealing from you • You spend time and effort defending your property from thieves • Instead of doing productive work • Establishing property rights, and a legal process for when they’re violated, is one way around the problem

47. Overview of Property Law • Cooter and Ulen: property is “A bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others” • Property rights are not absolute • Appendix to ch. 4 discusses different conceptions of property rights • Any system has to answer four fundamental questions: • What things can be privately owned? • What can (and can’t) an owner do with his property? • How are property rights established? • What remedies are given when property rights are violated?

48. Answers to many of these seem obvious • BUT… source: http://www.msnbc.msn.com/id/21088150/

49. Monday: Coase • Take a look at Coase, “The Problem of Social Cost” • Have a good weekend – see you Monday