econ 522 economics of law dan quint fall 2009 lecture 23

Econ 522Economics of Law

Dan Quint

Fall 2009

Lecture 23

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Solutions to HW3 at end of lecture

Remaining lectures Today: finish “core material” of class (everything on final) Thursday: interesting digressions (not on exam) Tuesday: practice problems

Office hours Thursday instead of Wednesday this week (details by email) Extra office hours Tues and Wed next week

Final: Thursday December 17 10:05-12:05, Social Science 5206 Cumulative, more weight on second half of semester

Logistics

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Efficiencyrevisited

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Efficiency Property law: efficient allocation of rights/resources

Coase Theorem says this is easy… Contract law: efficient breach, efficient reliance, efficient disclosure

of information, etc. Tort law: efficient precaution to avoid accidents, efficient levels of

risky activities Civil and criminal law: minimize combined cost of administering

system and living with its errors

With each branch of law, we asked: What would efficient system look like? How do the rules in place measure up?

What have we done this semester?

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We could focus on final outcomes only No worries about process, procedural fairness, etc.

We could ignore transfers when considering efficiency Paying damages has no effect on efficiency ex-post So we can ignore the “direct” effect of most remedies, consider only

the impact on incentives

Goal was always to maximize total social surplus (or total wealth)

The focus on efficiency has made our lives much easier

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Is efficiency the right goal for the law?

Should we expect the common law to naturally tend toward efficiency?

This leads us back to two questions

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Posner Once you’ve already been hit by a car, you’d prefer a strict liability

rule to a negligence rule But suppose we all agree a negligence rule is more efficient Then we’d all have agreed to it ex-ante (before the accident) “Ex-ante compensation” / “ex-ante consent”


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Posner Once you’ve already been hit by a car, you’d prefer a strict liability rule to a

negligence rule But suppose we all agree a negligence rule is more efficient Then we’d all have agreed to it ex-ante (before the accident) “Ex-ante compensation” / “ex-ante consent”

Even if people are asymmetric… Landlords wouldn’t like inefficient tenant-friendly law… …but rents are set competitively, would go up to compensate… …so tenants wouldn’t like the law either

Ex ante, everyone would agree to most efficient laws


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Cooter and Ulen Society may have goals other than efficiency… …but it’s cheaper to design law to be efficient, and address the

distribution of wealth through the tax system

Why is tax system better way to control distribution of wealth? More directly targets high/low incomes, rather than rough proxies

(“consumers” vs “investors”, “doctors” vs “patients”) Effects of changes in legal system harder to predict Lawyers more expensive than accountants Redistributive laws would be like taxes on particular activities; narrow

taxes have greater deadweight loss


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Should the legal system aim to be efficient? Posner: it’s what we’d all have agreed to ex-ante Cooter/Ulen: if we want to adjust distribution of wealth, better to do

it through taxes

Second question: should we expect the common law to naturally tend toward being efficient?

That answers the first question

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Posner

Some believe government, and courts, respond to politically powerful interest groups

Landlords might be more politically connected than tenants, so might influence laws…

…but like we just saw, even landlords probably don’t want inefficient pro-landlord laws, since they’d just lead to lower rents

So well-connected groups generally won’t resist efficient rules

Should we expect common law to naturally tend toward efficiency?

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Cooter/Ulen: three ways the common law may naturally tend toward efficiency

By implementing social norms/existing industry practices Whaling example: industry norms were well-suited to each environment Common law judges enforced industry norms, making law efficient

Judges may deliberately try to make law more efficient Hand Rule: incorporated efficiency into legal standard for negligence Judges may be more willing to reverse inefficient precedents, as in

Boomer v Atlantic Cement


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Cooter/Ulen: three ways the common law may naturally tend toward efficiency

By implementing social norms/existing industry practices Whaling example: industry norms were well-suited to each environment Common law judges enforced industry norms, making law efficient

Judges may deliberately try to make law more efficient Hand Rule: incorporated efficiency into legal standard for negligence Judges may be more willing to reverse inefficient precedents, as in Boomer v

Atlantic Cement

Inefficient laws may lead to more litigation More opportunities to get them overturned


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So that’s two yeses: Posner: even politically influential will want efficient laws Cooter/Ulen: three ways common law evolves toward efficiency

But an opposing view: Gillian Hadfield, “Bias in the Evolution of Legal Rules” Cases are different, but law must be consistent So at best, courts can try to be “right on average” But courts will see a biased sample of all possible cases

Situations that lead to litigation are different from those that don’t So court will have biased view of what rules are efficient


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Hadfield, “Bias in the Evolution of Legal Rules” A given rule will have different effects on different individuals/firms Some will find it easy to follow rule: compliers Some will find it very costly to follow rule: violators (Others may drop out of market entirely) Being “right on average” means doing what’s efficient given the

true mix of compliers and violators in market But court will mostly see cases involving violators So it might choose rule that’s efficient for market containing only

violators… …which is different than the efficient rule


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Should we expect common law to naturally tend toward efficiency? EXAMPLE

$145$100$190$90$1801%High

$140$110$170$60$1205%Medium

$145$130$160$30$6010%Low

$200$200$200$0$020%None

“Average” Firm

Low-cost Firm

High-cost Firm

Low-cost Firm

High-cost Firm

Total Social Cost(Accidents + Precaution)

Cost of PrecautionProbabilityof Accident

Level of Precaution

Four levels of precaution: none, low, medium, high Accidents do $1,000 of harm Market has equal number of high- and low-cost firms

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$145$100$190$90$1801%High

$140$110$170$60$1205%Medium

$145$130$160$30$6010%Low

$200$200$200$0$020%None

“Average” Firm

Low-cost Firm

High-cost Firm

Low-cost Firm

High-cost Firm



Level of Precaution

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$145$100$190$90$1801%High

$140$110$170$60$1205%Medium

$145$130$160$30$6010%Low

$200$200$200$0$020%None

“Average” Firm

Low-cost Firm

High-cost Firm

Low-cost Firm

High-cost Firm



Level of Precaution

Efficient levels of precaution High-cost firms: low precaution is efficient Low-cost firms: high precaution is efficient One rule for all firms: medium precaution is most efficient

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Hadfield: this bias will occur in any situation where courts adjust legal rule based on what appears efficient Whatever the existing rule, there will be some “compliers” and

some “violators” Courts will mostly see cases involving violators Law will evolve toward rule that would be efficient if only

violators existed But if compliers and violators are different enough, this won’t be

the efficient rule All this requires is enough heterogeneity in cases… …and courts that can only learn from the cases that go to trial


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Posner: yes Everyone, including the politically connected, wants efficient laws

Cooter/Ulen: yes Common law courts enforce existing norms/practices Courts may be more likely to overturn inefficient precedents Inefficient laws may lead to more litigation, and have more chances to

be overturned

Hadfield: no Courts see biased sample of cases If they adjust the law based on the cases they see, this will not lead to

efficient laws

So… should we expect common law to naturally tend toward efficiency?

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Three recurring themesfrom the semester

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Determining efficient action/outcome requires comparing social cost and social benefit of each activity Activity should occur when social benefit > social cost

We expect self-interested decision-makers to consider private cost and private benefit

If private cost < social cost, activity imposes a negative externality, and will naturally occur too much Tragedy of the commons Breach on contract in a world without remedies Reckless driving in a world without liability

If we can set private cost = social cost, people will naturally take efficient actions

To get efficient outcomes, design the law to make people internalize externalities

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If we set private cost = social cost and private benefit = social benefit, people naturally choose efficient action Contract law

Breach of contract imposes externality on promisee Expectation damages = anticipated benefit = harm done by breach So then we get efficient breach

Tort law Liability causes injurer to internalize harm his actions lead to Leads to efficient precaution, efficient activity level

Nuisance law Suppose I have a legal right to quiet enjoyment of my apartment You value making noise at $100, I value quiet at $50 If rights are tradable, silence costs me $100 in opportunity cost Tradable entitlements also lead to internalization, therefore efficient allocation

To get efficient outcomes, design the law to make people internalize externalities

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A right is protected if nobody can violate it without my permission Really, if violation is punished severely Injunctive relief protects rights

An interest is protect if violation must be compensated Interests are protected by damages

Protecting a right versus an interest

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Property law generally protects rights Trespassing on my land is punished severely, as a crime Theft: if you steal my iPhone, you don’t owe me $300, you go to jail But there are exceptions

Private necessity Eminent domain

Contract law generally protects interests Expectation damages protect promisee’s interest in performance of a

promise, not their right to performance But again, there are exceptions

Remedy of specific performance protects promisee’s right to a promise, is often used for contracts to sell unique good


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Tort law generally protects interests Nobody asks permission to break your arm in a car accident Instead, they hit you, then have to compensate you

Key difference between criminal law and civil (tort) law Crimes are intentional, so we may want to deter them Give you a right not to get stabbed, protect that right with

severe punishment for assault Torts are accidental, impossible to eliminate them Just want to reduce them to efficient level So we price them, to get injurer to internalize externality This is same as protecting an interest


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Designing efficient legal system means maximizing social surplus

Which is same as minimizing social costs Think about starting at most efficient outcome Costs are any deviations away from that

Costs typically take two forms: Direct costs of implementing some part of legal system Indirect costs: any flaws in system lead to imperfect incentives, and

therefore inefficient outcomes (“Administrative costs” and “error costs”)

Often tradeoff between cheaper/simpler system, and more costly/extensive system giving better incentives

Tradeoff between cheaper/simpler rule and better incentives

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Demsetz: private land ownership among native Americans Private ownership has higher direct costs: boundary maintenance Public ownership has high indirect costs: inefficient use of land

(overhunting)

Whaling “Fast fish/loose fish” simpler rule, fewer disputes

Lower direct costs “Iron holds the whale” creates more efficient incentives for

faster/more violent whales Lower indirect costs

Which is more efficient depends on situation


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Injunctions versus damages Damages more costly for court to calculate – higher direct costs Injunctions rely on bargaining – inefficient outcomes (high indirect costs)

if transaction costs are high

Filing fees to initiate a lawsuit Higher filing fees fewer lawsuits lower direct costs But more harms “unpunished” weaker incentives to avoid higher

indirect costs

Crime Catching more criminals is more costly (higher direct costs) But deterrence leads to fewer crimes (lower indirect costs)


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The semesterin review

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Coase: when there are no transaction costs: Just define property rights and make them tradable… …then sit back and let people trade till we get efficient allocation

But with transaction costs, this won’t work; we can either: try to reduce transaction costs, or… …try to get the allocation right to begin with

Some sources of transaction costs Search costs Private information Large numbers of parties Hostility Enforcement costs

Begin with Coase

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Property/nuisance law Clarify peoples’ rights/entitlements so they can enter into voluntary exchange Initial allocation matters when transaction costs are high enough that

efficiency isn’t reached “automatically”

Contract law Costs of ex-ante negotiations not too high… …but renegotiation costs enough that we want to avoid it

Tort law Accidental situations, strangers – costs of ex-ante negotiations prohibitively

high

Criminal law Ex-ante negotiations impossible for other reasons “Public bad” – many parties harmed, so transaction costs are high

Branches of the law and transaction costs

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Why do we need it? Without private property, publicly-owned resources will be

overutilized (tragedy of the commons)… and people will waste resources on “possessory acts”

Four key questions: What can be owned? What can/can’t owners do with their property? How are property rights established? What remedies are provided when rights are violated?

Property Law

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What can be owned? For efficiency: private goods should be privately owned Tradeoff between efficiency gain and boundary maintenance costs Intellectual property (patents, copyrights, trademarks, trade secrets),

organizations versus corporations

What can/can’t owners do with property? For efficiency: maximum liberty Even with externalities, low transaction costs initial allocation affects

distribution but not efficiency High transaction costs initial allocation (and remedy) do impact

efficiency – Normative Coase versus Normative Hobbes Limitations: inalienability; unbundling; perpetuities; private necessity;

eminent domain; government regulation

Property Law

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How are property rights established? Examples: fugitive property (whales, foxes, underground gas) Tradeoff between simple “bright-line” rule versus rule that’s harder to

enforce but gives better incentives First possession versus tied ownership Proving ownership; losing ownership (adverse possession, estray)

What remedy is provided when rights are violated? Injunctive relief (property rules) versus damages (liability rules) Calabresi and Melamed: injunctions more efficient when transaction

costs are low; damages when transaction costs are high Temporary versus permanent damages Public versus private nuisances

Property Law

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Agency game, contracts as a way to enforce promises and enable cooperation

Bargain Theory – offer, acceptance, consideration Efficiency: a promise should be enforced if both parties

wanted it to be when it was made Contract law can promote efficiency by…

Enabling cooperation Encouraging efficient disclosure of information

Contract Law

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Agency game, contracts as a way to enforce promises and enable cooperation

Bargain Theory – offer, acceptance, consideration Efficiency: a promise should be enforced if both parties

wanted it to be when it was made Contract law can promote efficiency by…

Enabling cooperation Encouraging efficient disclosure of information Securing efficient breach Securing efficient reliance Providing efficient default, and regulations Encoruaging enduring relationships/repeated interactions

Contract Law

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Remedies: expectation damages, opportunity cost damages, reliance damages, specific performance

Effect on breach, reliance, threat points for renegotiation Paradox of compensation, foreseeable reliance Formation defenses and performance excuses

Incompetence (but not drunkenness); duress and necessity; unconscionability; derogation of public policy; bad information

Contract Law

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Remedies: expectation damages, opportunity cost damages, reliance damages, specific performance

Effect on breach, reliance, threat points for renegotiation Paradox of compensation, foreseeable reliance Formation defenses and performance excuses

Incompetence (but not drunkenness); duress and necessity; unconscionability; derogation of public policy; bad information

Efficient default rules Impute terms parties would have chosen Allocate risk to low-cost avoider Unite knowledge and control Ayres and Gertner: penalty defaults

Contract Law

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Traditional theory: harm, causation, breach of duty Simple model of precaution and incentives Various negligence rules Effect of rules on activity levels

Tort Law

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Traditional theory: harm, causation, breach of duty Simple model of precaution and incentives Various negligence rules Effect of rules on activity levels Hand Rule for required level of care Effect of errors Tort law with sellers and consumers in competitive market

Tort Law

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Traditional theory: harm, causation, breach of duty Simple model of precaution and incentives Various negligence rules Effect of rules on activity levels Hand Rule for required level of care Effect of errors Tort law with sellers and consumers in competitive market Irrationality, judgment-proofness, regulation, insurance, litigation

costs Vicarious liability, joint and several liability, evidentiary uncertainty McDonald’s coffee cup case, punitive damages

Tort Law

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Efficient legal process minimizes sum of administrative costs and error costs Error costs depend on whether errors affect production or only

distribution

Out-of-court settlement, pre-trial exchange of information Nuisance suits

Legal process itself

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Efficient legal process minimizes sum of administrative costs and error costs Error costs depend on whether errors affect production or only

distribution

Out-of-court settlement, pre-trial exchange of information Nuisance suits Who pays costs of trials, fee-shifting rules Burden of proof, standard of proof Appeals process

Legal process itself

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Differences from civil law: intent; cases brought by state; public harms; higher standard of

proof; punishment vs. civil remedies

Punishments generally inefficient Are crimes always inefficient? Marginal cost of deterrence could be positive or negative Optimal level of deterrence (optimal level of crime)

Criminal law

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Differences from civil law: intent; cases brought by state; public harms; higher standard of proof;

punishment vs. civil remedies

Punishments generally inefficient Are crimes always inefficient? Marginal cost of deterrence could be positive or negative Optimal level of deterrence (optimal level of crime) Social stigma Fines varying with wealth Incapacitation and rehabilitation “Efficient” criminal system, and arguments against efficient

punishments

Criminal law

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Should the law aim to be efficient? Posner: yes, ex-ante consent Cooter and Ulen: yes, better to handle distribution through taxes

Will common law naturally tend toward efficiency? Posner: yes, even the politically influential want efficient laws Cooter and Ulen: yes

Common law enforces norms and industry practices, which are likely efficient

Judges may be more likely to overturn inefficient precedents Inefficient laws may lead to more litigation

Hadfield: no Court gets biased sample of cases, leading to “biased” laws

Today, back to efficiency

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That’s basically the class

End of material on final exam

Lecture on Thursday: Behavioral economics and the law Some other fun stuff Kind of a digression – not on final exam

To wrap up the “core material”, a few final thoughts…

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Economics is a set of tools, not a set of answers Friedman: “Economics is neither a set of questions nor a set of answers;

it is an approach to understanding behavior”

Point of class Not to memorize which liability rules leads to efficient injurer activity …but to understand why To understand how people respond to incentives, and be able to predict

how a law or policy will affect peoples’ behavior

Santa Monica, CA City Council banned ATM fees in 1999 They were shocked the next day, when ATMs stopped giving money to

other banks’ customers I’d like to think you all would have been smarter than that

What I hope you’ll remember after December 17

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Thank you allfor being here

econ 522 economics of law dan quint fall 2009 lecture 23

Documents

efficient system

common law

law eitherex ante

criminal law

easycontract law

tort law

efficiencyproperty law

branch of law