Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2013 Lecture 2

Logistics • TA sections begin this Friday • “Fake homework” for Wednesday on website • First real homework due next Thursday (Sept 19) • If you want to read ahead, look at Coase, “The Problem of Social Cost,” but we probably won’t get to it till next week

Last week, we… • defined law and economics • saw some brief history of the common law • and the civil law • and discussed ownership of dead whales

Today: efficiency • quick review of rational choice • what is efficiency? • is efficiency a good goal for the law?

Rationality, optimization,revealed preference

Most microeconomics is based on the premise of rational choice • People have preferences… • They understand their options, and how much they like each one • …and they optimize • They choose the option they like the best • This is what economists mean when we talk about rationality or rational behavior • Behavior that is consistent with someone having well-defined, consistent preferences • And this is what we’ll be assuming throughout the semester 5

This leads to the idea of revealed preference • If I see you choosing something… • …I infer you like it more than your other alternatives • We assume people succeeded in doing what they like, rather than screwing up and doing the wrong thing • And this allows us to learn peoples’ preferences from their choices (to some degree) 6

All this is useful if we want to judge what are “good” outcomes • If we assume that people have coherent preferences… • …and that we might be able to infer those preferences… • …then we can try to use those preferences to judge when one societal outcome is “better” than another 7

One way to do this: Pareto criterion • a Pareto improvement is any change to the economy which leaves… • everyone at least as well off, and • someone strictly better off • example • you prefer $3,500 to your car • I prefer your car to $3,500 • I buy it for $3,500 – Pareto improvement • an outcome is Pareto superior to another, or Pareto dominates it, if the second is a Pareto improvement over the first Vilfredo Pareto(1848-1923) 8

Pareto superiority is not that useful a measure for evaluating a legal system • Pareto improvements are “win-win” • but most new laws create some winners and some losers • so the Pareto criterion usually can’t tell us whether one policy is “better” than another • even the car example might not be a true Pareto-improvement • so we need another way to compare outcomes 9

Efficiency 10

We generally assume preferences are complete • Given any two options, I can figure out which one I like more (or else I truly don’t care) • Given two options – say, $4,000, or a 2002 Pontiac Grand Am… • Maybe I prefer the money • Maybe I prefer the car • Maybe I’m truly indifferent between the two • But one of these must be the case 11

We also assume more money is better… • If you don’t like it, you can always burn it… • …but we generally assume everyone prefers more money to less money “Everybody needs money. That’swhy they call it money.” -Danny DeVito, in Heist 12

And finally, we assume preferences are continuous • If I prefer your car to $3,000… • …but I prefer $5,000 to your car… • …then there must be some amount in between that makes me indifferent • We can say that’s my value for the car • If I’m exactly indifferent between $4,000 and your car… • …we can say I value your car at $4,000 13

So now, we build toward efficiency • next, we define a Kaldor-Hicks improvement • Informally: any change to the economy which increases the total value… • …where value is measured by everyone’s willingness to pay • going back to the car example • suppose your car is worth $3,000 to you and $4,000 to me • government seizes your car and gives it to me • I’m better off, you’re worse off • But since I value the car more than you… • …me getting the car is a Kaldor-Hicks improvement

So now, we build toward efficiency • A Pareto improvement only creates winners • A Kaldor-Hicks improvement can create some winners and some losers… • …but the winners’ gains must be bigger than the losers’ losses • If I get your car for free… • I end up better off by $4,000 (my value for the car) • You end up $3,000 worse off (your value for the car) • $4,000 > $3,000, so this is a K-H improvement 15

So now, we build toward efficiency • formally: a Kaldor-Hicks improvement is a change to the economy which could be turned into a Pareto improvement with monetary transfers • also called potential Pareto improvement • I get your car for free • If we combined this change with me giving you $3,500… • …then it would be a Pareto improvement • So even without the transfer, it’s a K-H improvement 16

Another example • You and I are neighbors, you want to throw a party • The party would make me $100 worse off… • …and make you $50 better off… • …and make each of your 30 guests $5 better off • Is the party a Pareto improvement? • No – it makes you and your guests better off, makes me worse off • Is the party a Kaldor-Hicks improvement? • Yes – because the party, combined with the appropriate money transfers, would be a Pareto improvement • (Example: you throw the party, you give me $40, each of your guests gives me $3 – that’s a Pareto improvement)

To check if something is a Kaldor-Hicks improvement, we can… • look for transfers that turn it into a Pareto-improvement… • …or, just count up the gains of the winners and the losses of the losers, and see which is bigger • a change in the economy is a Kaldor-Hicks improvement if the winners’ gains outweigh the losers’ losses • if you have the party… • I’m $100 worse off • You’re $50 better off • 30 guests are each $5 better off • – $100 + $50 + 30 X $5 = $100 > 0 • Gains outweigh losses, so party is a Kaldor-Hicks improvement • (“the party created $100 in value”)

Efficiency • we will call a change to the economy efficient if it is a Kaldor-Hicks improvement • we’ll say law A is more efficient than law B if moving from B to A is a Kaldor-Hicks improvement • and we’ll say a situation is efficient if there are no available Kaldor-Hicks improvements • an efficient situation is when there’s no way to make some people better off, without making some others worse off by more • we’re already getting maximal value out of all available resources

Is it efficient for you to have the party? • Makes you $50 better off • Makes 30 guests $5 better off • Makes me $100 worse off • $50 + $150 – $100 = 100 – party “creates $100 of value” • So it’s efficient for you to have the party • True whether or not you compensate me • Even if “my slice of the pie” is smaller, overall pie is bigger… • …which is all that efficiency is concerned with

What we’ve really done here • In a sense, what we’ve done here is created a way to add up different peoples’ utility functions… • …by equating utility with willingness to pay • We said the party made me $100 worse off • We equated my disutility from you making noise with the amount of money that would replace the inconvenience – if you threw the party and gave me $100, I’d be just as well off as before • Once we’ve done that, what’s efficient is whatever configuration of the economy “creates the most value”

Another example: is it efficient for me to drive to work instead of taking the bus? • Bus to campus from where I live is free • Driving is more convenient, but costs me $1 (gas) • Driving also imposes costs on other people: there’s more traffic, less parking, more pollution • Suppose when I drive to work, it makes 1,000 other people worse off by $0.01 each • By driving to work, I create $11 of total costs • It’s efficient for me to drive to work if the benefit I get is more than $11 • If the benefit is less than $11, it’s inefficient for me to drive

Some other, similar measures • our definition of efficiency: actions are taken when total benefits outweigh total costs • “goal” is to achieve all Kaldor-Hicks improvements • Ellickson: efficiency is “minimizing the objective sum of (1) transaction costs, and (2) deadweight losses arising from failures to exploit potential gains from trade” • Posner: “wealth maximization” • Polinsky: “Efficiency corresponds to ‘the size of the pie’”

What forces lead to inefficiency

To see whether something’s efficient… • Compare gains to everyone in society (total social benefit)… • …to costs to everyone (total social costs) • Example we already saw (me driving to work): • Total social cost = $1 (gas) + 1,000 X $0.01 = $11 • Total social benefit = whatever benefit I gain by driving to work • So we just said: it’s efficientfor me to drive to campus whenever the value I get from driving is more than $11

How do we expect people to actually behave? • When people decide how to act… • …they consider the cost and benefit to themselves, not to everyone • private benefit and private cost • Driving only costs me $1 • so I’ll drive whenever benefit to me is more than $1 • On days when value I get from driving is more than $1 but less than $11, I drive to work even though that’s inefficient

So externalities cause inefficiency • I’ll do something whenever private benefit > private cost • Efficiency depends on whether social benefit > social cost • If I was the only one affected by my choices, then social benefit = private benefit and social cost = private cost • when I’m deciding which movie to watch on Netflix, nobody else is affected by my choice, so my choice will be efficient • But when my choices affect other peoples’ payoffs… • social benefit ¹ private benefit, or social cost ¹ private cost • so actions I choose to take may not be efficient

A classic example of this: the Tragedy of the Commons • Hardin (1968), “The Tragedy of the Commons” • Picture a small fishing village on a lake • The more fish I catch, the fewerfish are left in the lake… • …and the harder it is for everyone else in the village to catch fish • So my fishing imposes an externality on everyone else • So everyone ends up fishing more than the efficient amount

Tragedy of the Commons – example • 20 fishermen • Cost of fishing is 8 fish per hour • Notation • h = how many hours I fish • H = combined hours everyone fishes • H = hours everyone but me fishes • Fishermen catch 260 – H fish per hour • What is the efficient level of fishing? How much utility does that give to each fisherman? 6.3 hours per day per fisherman; 793.8 fish/day • Left to their own devices, how much will each person fish? How much utility will each person get? 12 hours per day per fisherman; 144 fish/day Total fish caught “Maximum Sustainable Yield” H (260 – H) Efficient Level of Fishing “Equilibrium” Level of Fishing 0 3 6 9 12 Hours fishing, per day, per fisherman

What’s going on here? • Fishing imposes a negative externality on other fishermen • Each one ignores this externality when deciding how much to fish… • …so they all end up fishing more than the efficient amount • Same thing happens with other communal resources • Cattle grazing, whaling, overhunting, oyster beds • Aristotle: “That which is common to the greatest number has the least care bestowed upon it” • Elinor Ostrom, who shared the 2009 Nobel Prize in Economics, studies how different societies solve this problem • Positive externalities work the opposite way • Activities which create positive externalities are naturally done less than the efficient amount

So externalities can lead to inefficiency • Without some sort of regulation/intervention… • Activities which impose a negative externality will be done more than the efficient amount… • …and activities which impose a positive externality will be done less than the efficient amount • One recurring theme we’ll see in this class: if we want the law to lead to efficient outcomes, we can try to design the law to eliminate externalities! • “Internalization”

Other forces which lead to inefficiency

Another thing that leads to inefficiency:barriers to trade • Cuban cigars • Suppose I’d pay $15 each for Cohibas • They cost $2 each to make, and another$3 each to transport from Cuba to Madison • Clearly, it’s efficient for me to smoke Cohibas • But trade embargo on Cuba makes it illegal for me to buy them • Anything that prevents me from buying something I want can be a source of inefficiency • One approach to property law: make it as easy as possible for people to trade among themselves • (This may seem like an obvious point; but then, there are lots of things we’re not allowed to sell…)

Another thing that leads to inefficiency: taxes • I value my free time at $40/hour • Working in a factory, I can build things worth $50/hour • Clearly, it’s efficient for me to work • Each hour I work creates $10 of new value • Doesn’t matter who gets it – it’s efficient for me to work • But if income tax is 25%, then it won’t happen • Factory owner can’t pay me more than $50/hour • But $50/hour pre-tax is only $37.50 after-tax… • …and I’d rather stay home than earn $37.50 an hour • So I don’t get hired, which is inefficient

Another example of taxes leading to inefficiency • This is a new BMW that’s been cut in half • Taxes distort behavior away from efficiency

(or private information) Another thing that leads to inefficiency: monopoly • Example • Demand for some good given by P = 100 – Q • Monopolist can produce good for $40/unit • Monopoly price is 70, demand is 30 • Deadweight loss is inefficiency • Customers willing to pay more than marginal cost but unable to trade CS P = 100 – Q P* = 70 Profit DWL MC = 40 Q* = 30

But, saying these things lead to inefficiency doesn’t automatically mean they’re bad • For example • we just said taxes lead to inefficiency… • …but without taxes, there’s be far too few public goods, which is also inefficient • we just said monopoly leads to inefficiency… • …but we’ll study patents, which are legal monopolies used to get companies to innovate • But also, we’ve defined “efficient”, but we haven’t claimed that “efficient = good” • Which brings us to…

Is efficiency a good goal for the law?

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”

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

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

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…

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

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

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!

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

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

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

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

Econ 522 Economics of Law