Behavioral Law & Economics Christina Maria Markowski

1. Behavioral Law & EconomicsChristina Maria Markowski

2. I. What is behavioral law & economics („BLE“)? • concerned about humans behavior (how people act/react) • effect of different norms • consistent tools and approaches to impact human behavior • explicit models of legally relevant behaviour policy makers rely on mere intuitions about human behavior to guide their decisions => systematic errors + contradiction in the law) Traditional law & economics: - models based on assumptions - strictly rational actor - self interest seeking BLE attempts to improve the predictive power of law & economics!

3. II. Bounded Rationality: Psychology of Judgment and Decision Making How do people form judgments and what impacts their decision? • deviates from strictly rational actor • intuitively instead of rational (not fully automatic/controlled) Kahneman: System I: operates automatically, quickly, with little effort an no voluntary control System II: allocates attention to the effortful mental activity that is demanded including complex computation Why?: - impossible to process every decision - don’t know all variables - use short cuts, rules of thumb, heuristics Human beings are bounded rational= face limited cognitive resources and are affected by emotions and motivations!

4. III. JDM – Beliefs and Preferences Studying the psychology of JDM in 2 ways • how people form their beliefs • peoples preferences • Beliefs = Judgment under uncertainty How do people assess the probability of uncertain events? • Tversky and Kahneman: people rely on a number of heuristics to simpler judgment operations • severe and systematic errors

5. III. JDM – BeliefsandPreferences Some of the major heuristics: • Representativeness Heuristic: “judgments by similarity” => Bias: neglect base rate (70 engineers, 30 lawyers) insensitivity of predictability (description of a company) illusion of validity (information matching stereotype) => Legal Impl.: character evidence of a defendant • Availability Heuristic: “likelihood of event depending on how easy it is to recall similar events in the past” => Bias: over-/underestimation (some events impact availability but not prob.) =>Legal Impl.: lower crime rates in cities/ fine for wrong parking deterrence: (i) increase magnitude or (ii) prob. of sanction • Affect Heuristic: “substitute the effect of an event with the likelihood” => Bias: affect-rich outcomes yield significant overweighting of small probabilities =>Legal Impl.: risk regulation for nuclear power station (excessive demand, inefficent high regulation)

6. III. JDM – BeliefsandPreferences Some other effects in the process of decision making: • Anchoring and (insufficient adjustment): “ estimates starting from a reference point” 8 x 7 x 6 x 5 x 4 x 3 x 2 x 1 = ? (2250) 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8 = ? (512; 40.320) => Legal Impl: judges effected by the plaintiff's damages demanded as anchor • Hindsight Bias: people tend to overestimate predictability of past event Why?update information automatically and employ it when having to make judgment (instead of ex ante) => Legal Impl: judges overestimate foreseeability after accident occurred tortfeaser to often negligent, excessive level of precaution • Hot vs. Cold process: judgment depends on what to reach, “wishful thinking” => Bias: self serving bias (eg.: litigation 50:50 chance to win) optimistic bias (own prob. is higher/lower compared to others)

7. III. JDM – BeliefsandPreferences 2. Preferences = peoples choice under uncertainty A. Imagine that the U.S. is preparing for the outbreak of an unusual disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. The consequences of the two programs are as follows: • 1a) If Program A is adopted, 200 people will be saved. (72%) • 1b) If Program B is adopted, there is a 1/3 probability that 600 people will be saved and 2/3 probability that no one will be saved. (28%) B. Imagine that the U.S. is preparing for the outbreak of an unusual disease, where in the best case all 600 people will be saved. The two programs to combat: • 2a) If Program A is adopted, 400 people will die. (22%) • 2b) If Program B is adopted, there is a 1/3 probability that nobody will die and a 2/3 probability that 600 people will die. (78%) Rational choices depend on value, preference and risk attitude but not on framing!

8. III. JDM – BeliefsandPreferences Utility function of a risk averse person: Traditional law and economics => people are risk averse (concave function) • only true when talking about decisions over significant sums of money to impact utility • but can not explain risk aversion for most choices in life • can not explain why in some cases people are risk seeking

9. III. JDM – BeliefsandPreferences BLE – Kahneman & Tversky: Prospect Theory (1984, American Psychologist) • instead of state of wealth => choices are reference depending (considered gains/losses) • steeper in domains of losses => status quo bias (endowment effect)

10. IV. EndowmentEffect • central point of contact for Law&Economics and behavioral economics • fundamental debate over Coase theorem • endowment effect = people attach different values depending on initial assignment Traditional Law & Economics: The Coase Theorem posits that theinitial allocation does not affect final allocation if transaction costs sufficiently low and market participants are fully informed (eg.: factory/neighbor) Behavioral Law & Economics: (empirical assessment by D. Kahneman, J. Knetsch, R. Thaler) Experiment A: “token” with assigned value => WTA = WTP

11. IV. EndowmentEffect Experiment B: Cornell University coffee mugs => WTA > WTP • 50% predicted trade did not materialize (2-4 instead of 11) • initial allocation mattered dramatically • Coase theorem no longer holds – endowment effect changes pref. • Not be confused with sentimental value endowment effect = “refusal to give up an entitlement one holds due to disutility of giving up something” Implication for L&E: unsettles bases for normative economic analysis cost-benefit analysis can not be based on WTP (function of default rule) Possible Solution: instead of parties joint welfare consider third party effects asking which rule deserves greater deference (eg.: opt in or opt out of a saving plan)

12. V. BoundedWillpowerandBoundedSelf-Interest 1. Bounded Willpower (people want something different to what they do) • people not only formulate preferences different to strictly rational actor + • choices contrary to own best interest (choosing to spend rather than save, consume desserts over salads, etc) • Why pay attention? (i) third party effect, (ii) law facilitates desired behavior – justifies legal intervention 2. Bounded Self-Interest (do not necessarily want to max. own wealth) • people care about giving and receiving fair treatment • outcomes are judged depending on reference transaction • explains some legal rules, eg.: consumer protection law

13. VI. Modern Domain of BLE Implicit bias in people’s perception of racial and other group members (conventionally not grouped with other forms of bounded rationality) • Justification for antidiscrimination policies: personal taste or prejudice • but BLE: implicit discriminatory behavior within groups = faster categorization • IAT (Implicit Association Test) • Stereotype consistent pairing: “black/unpleasant” or “white/pleasant” • Stereotype inconsistent pairing: “black/pleasant” or “white/unpleasant” • Why? Characteristics of a race or group member operate as a sort of “heuristic” (attribute substitution = answering an easier question)

14. VII. Illustrative Applicationsof BLE • “optimistic bias” Consider: A high income individual faces a 2% probability of incurring tort liability for an accident, thereby facing the risk of 500.000 € extra payment in damages or having to pay 10.000 € tax (risk neutral). • Traditional L&E: • distributive legal rule (eg governing accidents) vs. wealth max. rule + tax • work incentives are distorted the same way (i) money redistributed by legal rule or (ii) via tax system (any distributional issue can be achieved at lower cost through tax system than distributive legal rules) • Behavioral L&E: - distributive tort liability is superior - depending on an uncertain event (party to lawsuit) optimism bias: underestimate probability of being hold liable perceived cost lower than expected cost of 10.000 €

15. VII. Illustrative Applicationsof BLE • “self-serving bias” and “discovery rule” Consider: Under US Law rules require parties to disclose all relevant information • Traditional L&E: parties are better informed (full information) convergence of parties expectation facilitates out of court settlements (more accurate) • Behavioral L&E: people interpret information according to their interest more information – more prone to bias experiment: likely outcome at trial – third party/plaintiff/defendant more information might lead to divergence

16. VIII. WhatKahnemanmeansforLawyers Kahneman’spathbreaking work also provides insights for lawyers: • Importance of answering the right question at trial • Awareness that people substitute difficult question by answering simpler one • Therefore: “prepare” witness, try different questions/set of questions/style make sure they answer the right question • “Priming” – frequently used by trial lawyers • Come up with an amount (compensation for damages) first • Advantage: judge/jury might anchor, increases threshold • Not only numbers also characteristics (eg.: case Amanda Knox) • Coherent story more important than logical story • Thinking of “Steve”: people substitute plausibility for probability (neglect base rate) • Power of “stereotyping”

17. VIII. WhatKahnemanmeansforlawyers • Impact of first impression • closely related to stereotyping + anchoring • Alan: intelligent; industrious; impulsive; critical, stubborn; envious. Ben: envious; stubborn; critical; impulsive; industrious; intelligent. • Impression of lawyer during opening statement is likely to remain • Confirmatory Bias • Strong advantage when framing a problem/situation first • People have tendency to stick with the positive/negative characteristics and to like or dislike everything about the person/situation = favor of coherence • Tend to disregard information that is inconsistent with what we already belief

18. Thank you! Contacts: Mag. Christina Maria Markowski, LL.M EMLE (Bologna/Hamburg) Singer Fössl Rechtsanwälte (attorneys at law) Prinz-Eugen-Straße 30 1040 Wien email: markowski@sfr.at or ch.markowski@gmail.com