Econ 522 Economics of Law

1. Econ 522Economics of Law Dan Quint Spring 2017 Lecture 23

2. Logistics • HW4 due Thursday • MT2 will be returned after lecture • This week is end of new material • Next Monday: I’ll solve some old exam questions – email me if there are particular problems you’d like to see • Next Wednesday: no class, extra office hours instead, times TBA • Final exam is Sunday May 7 • Online course evaluations open

3. Models inEconomics

4. Imagine you’re a physicist (Not drawn to scale)

5. Imagine you’re a physicist (Not drawn to scale)

6. Economists (at least theorists) work the same way • The world is too complicated to study “as is” • So we make a simple model • Try to leave in the “important parts” for studying a particular question • Realize that our results follow from the assumptions that we made, and may or may not be relevant to the real world

7. Important to remember: all models are massive simplifications of the real world • “All our science, measured against reality, is primitive and childlike – and yet it is the most precious thing we have.” – Albert Einstein • “All models are wrong, but some are useful.” – George Box (Statistician)

8. What does it take to “do” economic theory? Reduce asituation toa tractablemodel Solvethemodel Interpretthemodel • Judgment • (Which assumptions to make) • Technical ability • Judgment • (How much to “trust” results, given the model/ assumptions behind them)

9. Many assumptions get made differently in different situations • “Are people risk averse?” • Ask a sociologist, you get an answer • Ask an economist, he’ll say, “It depends on what type of problem you’re studying” • For some questions, risk aversion is important • How people choose investment portfolios • How people save for retirement if they don’t know how long they’ll live • For other questions, risk aversion plays no role • Including risk aversion complicates model, without adding insight • So we assume agents are risk neutral – not because they are, but because we’re focusing on something else

10. The idea of a “standard” model • So, some assumptions get made differently in different settings • Other assumptions get made so consistently that they become a part of the “standard way” that economists look at the world… • …almost become a part of conventional wisdom • And then we start to forget that they were assumptions in the first place

11. Basically all mainstream microeconomics is based on two premises • People have preferences • Allowed to like whatever they like… • …but assumed to understand all their options, and how they rank them • And people optimize • People pick whichever option they like most… • …subject to what they can afford • To put it another way, people are rational

12. We’ve been assuming this throughout the semester • “People respond to incentives according to what they correctly perceive to be their own rational best interest” • Property/nuisance law • each knows own threat point, can bargain with each other to transfer ownership of entitlements to whoever values them most • Contract law • can negotiate efficient contracts, courts can enforce them correctly • Tort law • people know effects of their actions, react rationally to incentives • courts can assign liability and assess damages correctly • Criminal law • even criminals react rationally to incentives, commit crimes when benefit outweighs expected cost

13. Rationality is a strong assumption • Very useful assumption • Led to lots of predictions about how laws affect behavior… • …and therefore what types of laws would lead to efficient outcomes • But conclusions are only as valid as the assumptions • Today: • How these assumptions sometimes fail in real life… • …and therefore why we may be skeptical about some of the semester’s conclusions • But, you’re still being tested on those conclusions! • Think of today as a digression

14. Behavioral Lawand Economics

15. Behavioral economics • How peoples’ actual behavior differs from predictions of “standard model” • Started out ad-hoc • Take a prediction of the standard model, e.g., expected utility maximization • Do an experiment – put a bunch of undergrads in a room and make them play a game • Or look for instances in real world where prediction was violated • Over time, generated some fairly robust conclusions • Systematic ways behavior differs from perfect rationality in a number of different situations

16. Behavioral economics • What’s important is that deviations from standard predictions of economics are not random • Not random errors • But consistent, systematic biases • At its best, behavioral economics holds itself to a “higher standard” than traditional economics • Traditional economics: makes assumptions (rationality and optimization), derives predictions • Asks whether predictions seem right, but doesn’t spend much time questioning the assumptions • Behavioral economics looks to justify the assumptions as well

17. Behavioral economics – sources • Some good recent “pop econ” books on behavioral econ: • Effect of behavioral economics on law and econ:

18. Jolls/Sunstein/Thaler discuss three different “uses” for economics • Positive • “Increase in expected punishment will lead to decrease in crime” • Or, an explanation for the laws that do exist, as outcomes of some process (evolutionary, legislative, etc.) • Prescriptive • “To achieve efficiency, the law should specify injunctive relief when transaction costs are low, and damages when TC are high” • Normative • What should be the goal of the legal system? • (For this class, we’ve assumed it’s efficiency)

19. Behavioral economics has implications for all three of these • Positive • Goal of any positive model is to mirror actual behavior • Prescriptive • If people respond differently than standard model predicts… • …then the law should be designed differently to account for this • Normative • If people seem to make “incorrect” choices, should we force them to choose “correctly”? • If people do not optimize based on stable preferences, even the definition of efficiency becomes unclear

20. The goal of behavioral law and economics • To give a more accurate model of how people actually behave… • …and use that model to reconsider the positive, prescriptive, and normative conclusions of law and economics

21. So, how does behavior typically differ from the standard model? • Bounded rationality • We make mistakes… • …and use simple heuristics or “rules of thumb” to make choices • Bounded willpower • Even when we know what we “should” do, don’t always do it • Means commitment devices can have value

22. So, how does behavior typically differ from the standard model? • Bounded rationality • We make mistakes… • …and use simple heuristics or “rules of thumb” to make choices • Bounded willpower • Even when we know what we “should” do, don’t always do it • Means commitment devices can have value • Bounded self-interest • We aren’t totally selfish, even in anonymous situations with strangers

23. Behavioral biases in how we evaluate alternatives

24. Trading experiment from Cornell • Similar to an experiment I ran in this class • 44 students in an advanced undergrad Law and Econ class • Half were given tokens • Each was given a number – how much they could exchange a token for at the end of the experiment • Given an opportunity to trade • As you’d expect, people with high token values bought them from people with low token values • This was with tokens – which had objective, artificial value • Reran experiment with coffee mugs • Half the students were given Cornell mugs • Then they were given opportunity to trade

25. Trading experiment from Cornell • Since the mugs were given out randomly… • If each person knew exactly what a mug was worth to them… • …we’d expect half the mugs to change hands • Since half the mug owners would have above-average values, and half would have below-average values • Instead, only 15% of the mugs were traded • On average, people who got a mug asked more than twice as much money for them as people who didn’t get a mug were willing to pay • And the effect remained if the experiment was repeated

26. Endowment effect • Conclusion from the Cornell experiment: having something makes you value it more • If you have a mug, you value mugs more than if you don’t • “Endowment effect” • Existence of this bias seems robust • One of the chapters in Sunstein book shows 12 studies where Willingness To Pay for something is compared to Willingness To Accept an offer for something people already have • Every time, people who have something value it more than people who don’t – typically by 3X or more!

27. Endowment effect – so what? • Contradicts Coase Theorem • Coase: without transaction costs, initial allocation shouldn’t affect final allocation, since whoever starts with something, it will get traded to whoever values it most • But endowment effects mean initial allocation does matter in predicting final allocation • Plus, if preferences depend on who starts with the object, it’s not even clear how to define efficiency!

28. Endowment effect – so what? • Using injunctive relief for private nuisances • When TC small, clarify threat points and let parties bargain • Endowment effect: initial allocation effects preferences, outcome • Calculating damages • Suppose someone with two arms thinks losing one would be a catastrophe, like a $10,000,000 loss • Someone with one arm realizes he’s OK that way, thinks damage done was $500,000 • What should construction company owe a worker who lost an arm? • Should they take precautions that cost $3MM per lost arm saved?

29. Context dependence best good ok bad 67% 33% 53% 47% 0% 10% 90% 0% 80 70 60 Quality rating 50 40 30 $3.50 $3.00 $2.50 $2.00 $1.50 Price per six-pack • “Second-cheapest wine” effect

30. Behavioral biases in how we perceive probabilities

31. Hindsight bias • Once something happens, people overestimate what its likelihood was • One year before 2008 election, what was chance Obama would win? • In November 2007, Intrade had Obama at 7% • Famous study (Baruch Fischhoff) • Nixon’s historic 1972 visits to China/USSR • Students asked to assign probabilities to outcomes • After visit, asked to recall the probabilities they reported • For the things that happened, 78 of 103 students gave higher probability estimates after than they gave before • (For things that didn’t happen, only 58 of 102)

32. Hindsight bias – so what? • Determining negligence (Hand Rule) requires figuring out the probability something would happen, after it happens • Example: risk of factory fire is 1 in 1,000, harm is $1,000,000, company chooses not to install $10,000 sprinkler system • Fire occurs, jury thinks risk was 1 in 50, finds company negligent • Publicly-owned companies must disclose “material risks” to investors

33. Hindsight bias – so what? • Determining negligence (Hand Rule) requires figuring out the probability something would happen, after it happens • Example: risk of factory fire is 1 in 1,000, harm is $1,000,000, company chooses not to install $10,000 sprinkler system • Fire occurs, jury thinks risk was 1 in 50, finds company negligent • Publicly-owned companies must disclose “material risks” to investors • Judges/juries will find negligence more often than “should” • Jolls/Sunstein/Thaler suggestions for dealing with this • Keep jury in the dark about what happened • Raise standard of proof for finding negligence

34. Similar bias – perception of probability skewed by availability and salience • People overestimate probability of a certain type of accident if they’ve recently observed a similar accident • “Availability” – memory of a recent accident is available in your mind, colors your judgment • “Salience” – how vivid the memory is • Explains environmental/safety regulations covering “hot topic” without regard for cost-benefit • Made worse because some people may deliberately keep the accident available for private gain • “Availability entrepreneurs” – think of U.S. politicians after 9/11/01

35. “Self-serving bias” • Relative optimism when both sides have same information • Example • Loewenstein, Issacharoff, Camerer and Babcock (1993), “Self-Serving Assessments of Fairness and Pretrial Bargaining”, Journal of Legal Studies • 80 students asked to negotiate settlement for tort case • Some chosen at random to represent plaintiff, others defendant • Given facts of actual case from Texas – car hit motorcyclist, who was suing for $100,000 • Actual (retired) judge examined case and gave ruling (secret) • Students would negotiate a settlement (or fail to reach an agreement and accept judge’s ruling minus costs) • Before negotiations started, students asked to predict how judge had ruled, and what they thought was “fair” settlement

36. “Self-serving bias” • What happened? • So what? • Pre-trial settlements may be hard to reach… • …and sharing information may not be solve the problem(all students had exactly same information) Students representing plaintiff Students representing defendant What do you think is a fair settlement? $37,028 $19,318 How do you think judge ruled? $38,953 $24,426 Actual judge’s ruling $30,560

37. Boundedwillpower

38. How people discount the future • People discount future events… • …but not in the way standard model predicts • Standard model: if discount factor is 10%, • $100 today = $110 in a year = $121 in two years = $132 in three… • In reality: drop in value between “now” and “later” seems more severe than between two future times • Example: $100 today versus $125 in six months… • …or $100 in six months versus $125 in a year • So what? • Longer prison sentence may have weak deterrence effect • (Also, people may not save enough for retirement)

39. Boundedself-interest

40. “Ultimatum game” • Player 1 proposes a way to divide up $10 • Player 2 says yes or no • Yes: they each get the proposed share • No: they both get nothing • Backward induction: only equilibrium is for 1 to keep almost everything, 2 to say yes • Experiments: offers less than $3-4 are often rejected, many people offer fairly even split • Shocking to economists, obvious to everyone else: • People sacrifice their own well-being to help those who are being kind to them • And sacrifice their own well-being to punish those who are unkind

41. One interpretation of bounded self-interest • People care not only about their own payoff, but also about “fairness” • But fairness is not objective – not all offers < $5 rejected • Preference for fairness could explain lots of rules we see: • Rules against scalping tickets • Rules against predatory pricing during emergencies • Rules against usury (very high interest rates) • Any voluntary transaction should be a Pareto-improvement… • …but prices which are too “unfair” are sometimes illegal

42. Jolls/Sunstein/Thaler prescriptive and normative

43. Jolls/Sunstein/Thaler • Lots of interesting stuff on positive aspects • Less on prescriptive and normative

44. One prescriptive suggestion • How people respond to information depends on how it’s presented • Example: choosing between safe and risky retirement investments • So if government is putting out information, should think about how “framing” changes its effect • Safe driving ads used to be, “Drive carefully, or you’ll kill someone” • But everyone believes they’re a good driver • Ads became more effective when message changed to,“Drive carefully, there are other BAD DRIVERS out there you have to watch out for!”

45. Jolls/Sunstein/Thaler’s conclusion: the case for “anti-antipaternalism” • Antipaternalism • Government shouldn’t tell people what to do • J/S/T stop short of advocating paternalism • If behavioral bias leads individuals to make mistakes, could also lead government bureaucrats to make mistakes in telling people what to do! • “Anti-antipaternalism” • We shouldn’t automatically reject paternalism, since it may have a role sometimes

46. On the other hand… • For a counterpoint, see R. Posner (2002), “Behavioral Law and Economics: A Critique”. For example: • Rachlinski argues for a behavioralist interpretation of the rule of contract law that penalty clauses are unenforceable: parties to contracts are excessively optimistic about their ability to perform and therefore underestimate the probability of having actually to pay the penalty for nonperformance. • Even if the psychological premise is correct, that people are prone to overoptimism, the conclusion does not follow, at least with regard to enterprises (a qualification… [he] does not suggest). • The problem is self-correcting, without need for legal doctrine. Enterprises that find themselves paying heavy penalties for failure to perform their contracts will either be driven out of business or refuse to agree to penalty clauses in their contracts. • [His] failure even to consider this possibility is symptomatic of a general failure of behavioral law and economics to generate feasible proposals for legal reform.

47. One other funny thing from three years ago

48. Cards Against Humanity and Black Friday source: Business Insider (link in notes), via Marginal Revolution

49. Second midterm

50. Second Midterm • This was a hard exam! • Average 75, median 76, so don’t panic when you see your score! • Not assigning letter grades till end of semester, but… • to give a rough idea of how you’re doing, • think of 70s as B range, low 60s and even high 50s as C range Last namesA-J K-N O-Z