Econ 522Economics of Law

Dan QuintFall 2009Lecture 2

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Chao’s office hours: Mondays, 11-1

My office hours: Wednesdays, 1:30-3:30

If you’re not registered (and want to be), see me after lecture

Logistics

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defined law and economics

saw some brief history of the common law

and the civil law

and discussed ownership of dead whales

Last week, we…

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what is efficiency?

is efficiency a good goal for the law?

Today: efficiency

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What is “efficiency”?

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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

First concept: Pareto improvementWhat is efficiency?

Vilfredo Pareto(1848-1923)

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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

Pareto superiority is not that useful a measure for evaluating a legal system

What is efficiency?

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a Kaldor-Hicks improvement is any change to the economy which could be turned into a Pareto improvement with monetary transfers

car example again your car is worth $3,000 to you and $4,000 to me government takes your car and gives it to me Kaldor-Hicks

improvement

a Kaldor-Hicks improvement may make some people better off and others worse off, but “the gains outweigh the losses” also known as potential Pareto improvements

Next concept: Kaldor-Hicks improvementWhat is efficiency?

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To check whether something is a Kaldor-Hicks improvement…

we could look for the transfers that would make it a Pareto-improvement

or, we can just count up the gains of the winners and the losses of the losers, and see which is bigger

the car example (again)

Kaldor-Hicks improvements may make some people better off and others worse off, but “the gains outweigh the losses”

What is efficiency?

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a situation is Kaldor-Hicks efficient, or just efficient, if there are no available Kaldor-Hicks improvements

(Pareto efficiency: no way to make some people in the economy better off without making some others worse off)

Efficiency: 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

EfficiencyWhat is efficiency?

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our definition of efficiency: all possible Kaldor-Hicks improvements have already been done

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’”

Some other, similar measuresWhat is efficiency?

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We can also consider the efficiency of a single action, in isolation

an action is efficient if its total social benefits are greater than its total social costs same as saying, a change is efficient if it is a Kaldor-Hicks

improvement

example: is it efficient for me to drive to work?

What is efficiency?

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What forces lead to inefficiency?

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Externalities

Barriers to trade

Monopoly power

Taxes

We can better understand efficiency by considering what forces lead to inefficiency

What forces lead to inefficiency?

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Efficiency weighs social benefits and social costs

But individual decision-makers consider only their private benefits and private costs

Externalities are whenever people not involved in making a decision are affected by it

Example: is it efficient for me to drive to work?

1. Externalities lead to inefficiencyWhat forces lead to inefficiency?

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In general, actions that impose a negative externality will tend to be done

more than the efficient level actions that impose a positive externality will tend to be done

less than the efficient level

In contract and tort law, we will try to design the law to make people internalize their externalities

1. Externalities lead to inefficiency (cont’d)What forces lead to inefficiency?

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If some guy in Canada owns something worth $100 to him, and worth $150 to me, then it’s a Kaldor-Hicks improvement for him to sell it to me

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…)

2. Barriers to trade lead to inefficiencyWhat forces lead to inefficiency?

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CS

Profit

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

3. Monopoly power leads to inefficiency

P* = 70P = 100 – Q

Q* = 30

MC = 40DWL

What forces lead to inefficiency?

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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

4. Taxes lead to inefficiencyWhat forces lead to inefficiency?

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For example we just said taxes lead to inefficiency but without taxes, there’s no way to fund public goods, and not

having public goods is also inefficient

But also, we’ve defined “efficient”, but we haven’t claimed that efficient = good

Which brings us to…

Of course, that doesn’t mean these things are always bad…

What forces lead to inefficiency?

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Is “efficiency” a good goal for the law?

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positive statements 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”

Important distinction: positive versus normative economics

Is efficiency a good goal for the law?

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Predicting behavior, and outcomes, that follow from a law or legal system is positive analysis “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 the goal of the legal system would be “Law X is better than law Y”

Posner, and many others, argue that efficiency should be that goal

Most of this class will be positiveIs efficiency a good goal for the law?

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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

Richard Posner gives us one argument why the law should aim to be efficient

Is efficiency a good goal for the law?

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Even ex-ante, bad drivers might prefer a less efficient system if it meant drivers weren’t responsible

Posner deals with heterogeneity with a different example

And of course, this consent is all hypothetical

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

Things are a little more complicated…Is efficiency a good goal for the law?

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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

Posner’s argument does have its limitations…Is efficiency a good goal for the law?

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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

This highlights some of the things efficiency is not

Is efficiency a good goal for the law?

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Cooter and Ulen (textbook ch. 1)

Efficiency should not necessarily be the goal of society

But efficiency should be 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

A more pragmatic defense of efficiency as a goal for the law

Is efficiency a good goal for the law?

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1. Taxes can target “rich” and “poor” more precisely than the legal system can

2. Distributional effects of legal changes are harder to predict

3. Lawyers are more expensive than accountants

4. More narrowly-targeted taxes cause greater distortion than broad-based taxes

Four reasons the tax system is a better way to redistribute wealth than the legal system

Is efficiency a good goal for the law?

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(Example of why narrowly-targeted taxes cause greater distortion)

Is efficiency a good goal for the law?

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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”

So, summing up… is efficiency a good goal for the law?

Is efficiency a good goal for the law?

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Next class, we’ll see some numerical examples of some of what we did today, introduce some basic game theory, and begin property law

See me if you’re not yet registered

That’s it for today