Law & Economics

1. Law & Economics Fall 2008 Dr. Delemeester

2. What is Law & Economics? • Three Strikes Laws? • No-Fault Divorce Laws? • Kelo v. City of New London (2005)? • Good Samaritan Laws?

3. Review of Microeconomic Theory • Rational man model • An individual seeks to maximize his or her utility. • For social optimality the rule is: This involves taking actions till the marginal private cost of further action equals the marginal private benefit of that action. Taking action till the marginal social cost of further action equals the marginal social benefit of that action

4. Market Model Price • Free Market Outcome: P*, Q* • Maximizes social welfare: SW = CS + PS Supply CS Deadweight Loss P* PS Demand Q* quantity

5. Competitive Firm Profit Maximization rule: P = MR = MC $ MC ATC AVC P1 MR1 ATC1 quantity q1 What happens to the market price in the long run?

6. Consumer optimum Consumer Choice • Budget Line • I = PC*C + PAOG*AOG • Indifference Curves • Shows all (C, AOG) pairs that provide same level of utility AOG Ex: I = $1000 PC = $2 PAOG = $1 1000 AOG* U1 = 40 500 coffee C*

7. Market Imperfections • Market power • monopoly and monopsony • imperfect competition • Externalities • Public goods • Severe informational asymmetries • Coordination and collective action problems

8. Market Power • Monopoly • The condition of one seller and significant barriers to entry. • A monopolist charges too high a price and sells too little of the monopolized good or service. • Corrective: antitrust and regulation. • Monopsony • The condition of one buyer and significant barriers to entry. • The monopsonist charges pays too little for the resources that he uses and hires too few of them.

9. Externalities • Unintentional Costs imposed on third parties by the profit-maximizing actions of one person. • Examples: air and water pollution, secondhand tobacco smoke. • Unintentional Benefits that are conferred onto third parties by the profit-maximizing actions of one person. • Examples: elementary education, pollination services provided to beekeepers by a neighboring apple orchard.

10. Externalities in a Graph Ssocial • Free Market: P1, Q1 • Optimal Outcome: P2, Q2 $ Sprivate P2 P1 External cost D1 Q2 Q1 steel Free market overproduces goods that generate a negative externality

11. A consequence of a positive consumption externality is that social benefits are ______ than private benefits, and the socially optimal level of output is ______ than the private level of output. • greater; greater. • greater; less. • less; less. • less; greater.

12. Public goods • Two characteristics: • Non-excludability • Non-rivalry • Free rider problem • Corrective: • Public provision • Public subsidization • Examples: • Fireworks display • Radio broadcast • National defense • Information

13. Severe informational asymmetries • Two parties to a potential transaction have very different information about some important aspect of the potential transaction. • Example: consider the very different knowledge of the true quality of a used car as between the buyer and the seller. • Why is this a problem? • Because fear of uncertainty about the unknown attributes may prevent otherwise value-maximizing transactions from taking place. • Corrective • Compelling information disclosure by punishing failures to disclose

14. Coordination and collective action problems • Traffic congestion • Drivers make decisions about using the roads independently with the sometime result that the roads are terribly congested. • How can drivers coordinate their decisions so that the roads are not too crowded? • Congestion pricing • London now charges £8 for cars to come within the central business district on weekdays. • Traffic is down 20 percent since early 2003. • Public goods present a collective action problem • Free riders • Corrective: compulsory contribution.

15. Game theory • A formal means of modeling strategic interaction involving: • 2 or more players • Strategies • Payoffs • Types of games • Cooperative vs Non-cooperative • Sequential vs simultaneous move • Single play vs repeated play • Solution strategies and Nash Equilibrium

16. -5, -5 -1, -10 -10, -1 -2, -2 Prisoners’ Dilemma Prisoner B Confess Don’t Confess Confess Prisoner A Don’t Confess What strategy would you choose in a single shot game?

17. Solution Strategies • Dominant Strategy • One that is optimal no matter what opponent does • Nash Equilibrium • No player has a unilateral incentive to change their strategies Prisoner A: Confess Prisoner B: Confess (Confess, Confess) is a Nash Equilibrium

18. -5, -5 -1, -10 -10, -1 -2, -2 PO, but not NE Prisoners’ Dilemma Prisoner B Confess Don’t Confess NE Confess Prisoner A Don’t Confess Pareto optimal outcome maximizes joint payoff What if you play a repeated prisoner’s dilemma?

19. Player 2 Don’t Contribute Contribute 30, 30 5, 35 Contribute Player 1 Don’t Contribute 35, 5 10, 10 Consider the voluntary contribution game below. What is the Nash Equilibrium for this game? • (C, C) • (C, DC) • (DC, DC) • (DC, C)

20. Hunter 2 Stag Hare Stag 10, 10 0, 8 Hunter 1 Hare 8, 0 8, 8 Stage Hunt

21. Decision-making under uncertainty • How to evaluate future outcomes when there are multiple possibilities? • Calculate the expected value • Weight each possible outcome by its probability and then add them How much would you pay to play this game? Flip a coin gamble: Heads = $100 Tails = $500 EV = 0.5 ($100) + 0.5 ($500) = $300

22. Consider a lottery with three possible outcomes: $125 will be received with probability .2, $100 with probability .3, and $50 with probability .5. What is the expected value of the lottery? • $60 • $80 • $90 • $105

23. Decision-making under uncertainty • Now suppose that there are two uncertain courses of action • Should one always choose the course of action with the higher expected value? • People have different attitudes toward risk or uncertainty and these attitudes may influence how they behave when facing uncertain outcomes • Risk neutrality • Risk aversion • Risk seeking • A1: EV = $300 = 0.5 (100) + 0.5 (500) • A2: EV = $400 = 0.99 (0) + 0.01 (40,000)

24. Utility when healthy PH = probability of being healthy PS = probability of being sick PH + PS = 1 Utility when sick Expected Utility Theory: Risk Aversion Assumes diminishing marginal utility of income Utility U 90 86 E(U) = PHU($40,000) + PSU($20,000) = PH•90 + PS•70 Let PS = .20 E(U) = (.80)90 + (.20)70 = 86 E(Y) = (.80)(40,000) + (.20)(20,000) = $36,000 70 Income (thousands) $20 $36 $40

25. Any risk-averse individual would always • take a 10% chance at $100 rather than a sure $10 • take a 50% chance at $4 and a 50% chance at $1 rather than a sure $1 • take a sure $10 rather than a 10% chance at $100 • take a sure $1 rather than a 50% chance at $4 and a 50% chance at losing $1

26. Decision-making under uncertainty • Insurance • Allows risk-averse individuals to convert uncertain outcomes into certain outcomes • Two problems: • Moral hazard • Adverse selection • Corrective: • Co-insurance and deductibles.