Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2011 Lecture 2

Logistics • If you’re still trying to get into the class, see me after lecture • TA sections begin this Friday • Office hours: • Me: Tuesdays, 2-4, 7428 Social Sciences • Fran: Wednesdays, 10:50-12:50, 6443 Social Sciences • “Fake homework” for Wednesday on website

Last Wednesday, 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 • what is efficiency? • is efficiency a good goal for the law?

What is“efficiency”?

First concept: Pareto improvement • a Pareto improvement is any change to the economy which leaves… • everyone at least as well off, and • someone strictly better off • example of a Pareto improvement • your car is worth $3,000 to you, $4,000 to me • I buy it for $3,500 • 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)

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

Next concept: Kaldor-Hicks improvement • a Kaldor-Hicks improvement is any change to the economy which could be turned into a Pareto improvement with monetary transfers • also called potential Pareto improvement • car example again • 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 • combined withme giving you $3,500, it’s a Pareto improvement • so me getting your car is a Kaldor-Hicks improvement • a Kaldor-Hicks improvement may create winners and losers, but gains outweigh the losses • I’m $4,000 better off, you’re $3,500 worse off, $4,000 > $3,500

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

So… • A Kaldor-Hicks improvement is any change that“creates value…” • …where value is equated 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 • By equating utility with money, we create a way to compare utility across individuals

Efficiency • a situation is Kaldor-Hicks efficient, or just efficient, if there are no available Kaldor-Hicks improvements • In other words, efficiency is when there’s no way to make some people in the economy better off, without making some others worse off by more • we’re already getting maximal value out of all available resources • We’ll also say A is “more efficient” than B if moving from B to A is a Kaldor-Hicks improvement

Example: is it efficient for me to drive to work instead of taking the bus? • Bus to school 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 • If the benefit to me of driving to work is at least $11, it’s efficient for me to drive; if it’s less than $11, it’s not

Some other, similar measures • our definition of efficiency: all possible Kaldor-Hicks improvements have already been made • Ellickson: “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 just saw (me driving to work): • Total social benefit = whatever the benefit is to me • Total social cost = $1 (gas) + 1,000 X $0.01 = $11 • So we just said: it’s efficientfor me to drive to campus whenever the value I get from driving is more than $11

But what do people actually do? • 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 in gas – so I’ll drive whenever value to me is more than $1 • On days where my benefit 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’m the only one affected by my choices, then social benefit = private benefit and social cost = private cost • so my choices 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 • This means everyone ends upfishing more than the efficient amount

Tragedy of the Commons – example • Suppose the town has 20 fishermen • The cost (disutility, effort) of fishing is 8 fish per hour • Notation • h = how many hours a day I fish • H = combined hours a day everyone in town fishes (including me) • H = combined hours a day 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?

Tragedy of the Commons – example • Suppose the town has 20 fishermen • The cost (disutility, effort) of fishing is 8 fish per hour • Notation • h = how many hours a day I fish • H = combined hours a day everyone in town fishes (including me) • H = combined hours a day 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

Tragedy of the Commons – example H (260 – H) Total fish caught Efficientlevel offishing “Maximum sustainable yield” “Equilibrium”fishinglevel 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 intervention… • Activities which impose a negative externality will be done an inefficiently high amount… • …and activities which impose a positive externality will be done an inefficiently low amount • One 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!

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 someone with a factory to hire me • But if income tax is 25%, then it won’t happen • Factory owner can’t pay me more than $50/hour • I won’t accept less than $53.33/hour pre-tax

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

Most of the analysis in this class will be positive • Predicting behavior, and outcomes, that follow from a law or legal system is positiveanalysis • “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

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

Friedman has his own take on why we should study 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… • These both answer the question of, “Why is it interesting to study efficiency?” • But not the question of, “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

Posner’s argument does have its limitations… • 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

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

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

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”

For Wednesday… • One argument from C&U for why law should focus on efficiency, redistribution should be done through taxes: “narrow taxes cause more distortion than broad taxes” • Wednesday, we’ll work through an example of this • “Optional homework problem” • If you want to read something for Wednesday: Ronald Coase, “The Problem of Social Cost” • See me if you’re not yet registered That’s it for today – see you Wednesday

Econ 522 Economics of Law