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Law and Economics
Rutgers University, Newark School of Law
Latin, Howard A.

I. Theory of the Consumer Product Warranty
A. Priest – Chicago School of Analysis
Ø Priest says warranties is an like an insurance policy
Ø Chicago school of Analysis –
a. Consumers are Perfect maximizers who can make well informed decisions about purchases.
b. Consumers are well informed Calculating machines
c. Latin doesn’t agree with it or Priest
d. Priest is rigid Chicago School Theory – Latin can’t stand him
Ø Priest acknowledges that consumers don’t read the warranties most of the time
a. So why does he still subscribe
Ø Consumers don’t read the warranty usually unless it breaks – unless major major purchase
Ø Why assigned – Priest is rigid but gives latin something to work off of
Ø Chic School of Analysis dominates Law and Economics

B. Basic Economic Theory
Ø Hypo – You want to buy a Car
a. Economics – You have a very high interest to Pay for a car
i. You have willingness to pay but can’t afford it
ii. You have a willingness and can Pay for it
iii. We will treat them the same in this course
Ø Economists – Redistribution of Wealth rather than Subsidizing
a. Poor people can decide what is important to them to decide to buy rather then subsidizing where the Govt decides what people needs
Ø Back to Hypo – People who want to buy a car (assume only one type of car)
a. Person 1 – You want to buy a car and willing to pay for it
b. Person 2 – Wants to buy a car but is poor
c. Person 3 – Want to buy a car but not willing to pay as much for it

(Figure 1) Demand Curve – Keep making units of that product until there is no one left who

Y axis is Value/Demand that a particular person values the product.

Cost curve

Number of Units

Supply Curve – Cost Level

Ø When does it no longer make sense to make the product – most efficient level
Ø Marginal Value = marginal price = marginal cost (which includes some reasonable profit)
a. Mfct price driven down until it is determined by the cost of the next unit and the value of the next unit
Ø Area above cost curve is cost Consumer Surplus
a. The last guy is the one whose cost is going to be equal to the value
b. Always looking/caring about the next guy down on the chart
c. Efficient approach is keep making units until the marginal value of the next guy is not worth making any more. (I,.e, until the marginal cost = the mariginal value)

Ø So how does Unit Reliablity/Warranties come into play
a. There is some expectation of unreliability of a Car for example
i. Risk of unreliability – Flaw of Priest argument
1. How can you make an assessment if you don’t know how unreliable a certain product is – priest assumes consumers know what risk of unreliability is.
b. Assume each car is equally unreliable
c. Car is less valuable because of unreliability
d. If User bares all losses – (FIGURE 2)Drops the demand curve (hypotenuse) down by amount of unreliability
e. If Strict Liability – mftr bares all loses (FIGURE 3)– cost curve goes up
f. Either way, number of units where product is making money drops.

Ø Warranty doesn’t mean anything if all losses on either Consumer or all on Manufacturer
Ø Look at it from Mftr point of view
a. How much is the first unit of reliability (one unit of reliability)
i. Mftr is going to look for the cheapest way to provide the first unit
ii. Unit 2 will be more expensive than unit 1 but also cheaper then all other units
iii. See Figure 4

C. Latin Criticism of Priest Article
Ø Priest says that consumers will gradually agree to accept some risk themselves, and pay mftr through warranty to accept other types of risks – Insurance policy
Ø Priest says Users are also influences/increases reliability of the product (Figure 5)
Ø Rational Utility Maximizing will determine whose costs of providing increased reliability is most efficient
Ø Need to accept all behavioral assumptions (people know what they need to know) in order for Priests analysis to appear coherent – Which latin does not

D. 3 Theories Presented in Priest Article

1. Exploitation Theory
– Warranties are adhesion contracts which limit consumers power due to the uneven bargaining power

2. Signal Theory
– Signaling that their product comes with some sort of reliability through the warranty and giving the people the information to decide

3. Investment Theory (Priest)
– Consumer knows risks and chooses whether to make investment in accepting/reducing risk on their own part. (people are maximum utility maximizers)

Ø Criticizes first two theories WHICH ARE BASED ON IMPERFECT COMSUMER INFORMATION REGARDING THE RISKS/RELIABILIYT (only makes senses in light of consumer imperfections)
Ø However, Priest’s theories assumes CONSUMER KNOWS RISKS/RELIABILITIES
a. ONLY MAKE SENSE if consumers KNOW everything (what they need to)
b. AND ONLY MAKE SENSE if manufactuers DON”T KNOW everything
i. If they did know everything (how each consumer uses each product) it would charge more for consumers that are higher risk.

E. Warranties Compared to Insurance Companies
Ø Insurance Companies separates people into risk categories which get charged more (smokers, etc)
Ø A warranty is an insurance policy in one respect
a. An insurance company, however, discriminates between high risk and low risk
b. Priest says that Manufact. don’t discriminate – Latin says they do
Ø Priest says if Mftr have to pay for risk, they will charge an average equal risk premium across the board
Ø Priest Does Assumes people know how risky they are
– If a person is high risk, it makes sense to get warranty since it is subsidized by low risk users
– Doesn’t make sense if low risk user
– A wash if average risk user

Ø Priest says People KNOW, so they can make the right decision (perfect decision making by consumer)
Ø Priest says Mftr DOESN”T KNOW, so they CAN”T make the right decision about how much to charge in light of consumer risks, so have to charge average amount (imperfect decision making by mftr)
Ø Priest says that normally, market decision making should determine warranties, which would mean mftrs would only provide what they want to, and consumers will bare the rest of the risk.
– Therefore the high risk consumers will subsidize the low risk users which would drop due to the lack of benefit
– But if the cosumers bore the risk, high risk and low risk consumers could each decide how much risk to bare.

– Latin says they could (look at number of children for large appliances)
– example 2 – Assume higher income people are willing to by more expensive model and may treat them more carefully or replace them more frequently so they may be considered lower risk then low income users

F. Priest – Moral Hazard (p

th people with using property for 100’s of years in their cultures

Ø Water Rights laws –
– appropriation doctrine
i. only way to get use of water had to appropriate it and reroute it, impound it, reservoir it, and use it
1. Result of it was people who benefited from natural water flow, were not appropriating it, and were just letting it go by and environmentally sensitive and enjoying the Bounty of Nature…had no right.
– Other Doctrine

Ø Promoting Development if west
– View in congress was that there is a limited amount of water, so let each person take amount of water they need…but they have to use it.
– What if there is a drought – Seniority Rules
– Very destructive from environmental rule

Ø East – Reasonable Use Doctrine
– Have right to use water as much as you need as long as it does not interfere with others use.
– Water far more abundant

Property Rights – Calabresi –
1) Property Rule – you own a resource and the only way another can use it is by paying the owner through a contractual agreement. – you get to choose
2) Liability Rule – Didn’t have right to keep them from infringing on property, just got liability from that infringement – work better for complicated transaction where unknown effects or lots of people involved – They get to choose
3) Limited category of non-alienability – Can’t do something even if you want to (drug laws, sex laws – prostitution, statutory rape)

If someone is willing to take your property and assume liability, what does that say
– In a Law and Economics analysis, then it is essentially saying that he can pay off your damages and still make a profit.

Abstract discussion with labels –

From matt
1) Property Laws – you own a resource and the only way another can use it is by paying the owner through a contractual agreement.
2) Liability Laws – if someone infringed on your property right you do not have the right to keep them from doing some, instead you have the right to damages for that infringement.
3) Anti-Alienation Laws – someone can’t do something even when that person wants to, e.g. slavery, statutory rape, prostitution.

IV. Coase Problem of Social Cost
Ø Coase article is a response to Externalities (a market imperfection)
Ø Also a response to another market imperfection (Cost Transactions)
Ø People having property rights and invading other property rights
Ø Single most widely quoted/referenced article in Law and Economics
Ø Positve and Negative Externalities

Ø Social Costs – all the costs of a given activity – overall
Ø Private costs – what the individual has to pay
Ø The External Costs is the difference between the two (Social – Private Costs)

Ø Hypo – Widget factory pollutes river affecting local fishermen