PROFESSOR ULEN – LAW & ECONOMICS – FALL 2012
I. INTRODUCTION TO LAW & ECONOMICS
A. Law & Economics: The use of economic tools to describe how the law is working and to prescribe better laws to achieve law’s social goals
1. Positive and normative analysis. Descriptive and prescriptive.
a) Descriptive: What is the most effective way to enforce a speed limit?
b) Prescriptive: What should the speed limit be?
(1) Efficiency?
(2) Fairness or Justice?
B. Some Fundamental Tools
1. Theory, measurement, empirical studies
a) Ex: the deterrent effects of the death penalty
2. Rational choice theory
a) People are rational when it comes to making decisions. Rational people typically only assess the effect of their decisions on other people.
3. The behavioral perspective
4. Ex Ante perspective
a) Contras with ex post perspective
b) Does tort liability enduce people to behave more carefully so as to reduce the number and severity of accidents? This is what is most important from the ex ante perspective.
5. Efficiency
a) Allocative or Pareto efficiency.
b) Productive efficiency
c) Kaldor-Hicks or Pareto potential efficiency
6. Individual and social well-being
a) Private cost and benefit
(1) Happiness or “subjective well being”
b) Social cost and benefit
7. Motivation (extrinsic and intrinsic)
a) Extrinsic – things external to the person that motivates them (“do this by 5 tomorrow and I’ll give you a bonus”)
b) Intrinsic – something inside of you (study hard because that’s the kind of person you are).
(1) We are all motivated by both. There is some sort of relationship between the two that we ought to be aware of. Does extrinsic motivation crowd out intrinsic motivation?
8. Markets and other regulatory devices
a) When do we leave unregulated or lightly regulated markets to do what they can? And when and how should we regulate markets? Should we ever replace markets?
C. Downsizing Supersize
1. “Default bias” – if you offer a choice in which one option is seen as a default, most people go for that option. The soda ban makes 16oz or less the default option for soda drinkers, if they want more, they’ll have to make an extra effort.
2. Most of us don’t have a fixed idea of how much we want; instead, we look to outside cues—like the size of a cup—to instruct us. If the largest soda you can order is 16oz, a can of Coke may start to seem like more than enough.
D. Social Choice Theory
1. Why doesn’t economics pay as much attention to distributive equity as it does to efficient allocation and use of resources?
2. 2nd fundamental theorem of welfare economics: efficiency and distribution are separable.
a) Perhaps the same tools that we use to discuss efficiency could be used to discuss equity. We would have to identify social tastes and preference. Since, individuals maximize their well-being subject to an income constraint, society should maximize its well-being within its resource constraint.
3. Social welfare function: a reflection of social tastes and preferences. No easy way to ascertain social preferences. We must somehow aggregate individual preferences; one possibility is to vote on those preferences.
E. The Arrow Impossibility Theorem
1. Arrow sought to investigate the general properties of mechanisms by which society aggregates individual preferences about social matters (e.g., about the distribution of income and wealth) into societal preferences.
2. He first established some general characteristics that any method of aggregation should have and then showed that there is no method of social choice that satisfies all these general characteristics.
3. Characteristics: (1) there is no dictatorship; (2) each individual has ordered all the alternatives according to her preferences and votes for the thing/person that ranks highest; (3) if every individual unanimously agrees on an alternative, that alternative is indicated as the society’s preference; (4) each individual’s choices are complete, transitive, and reflexive; (5) the preferences between any two candidates or policies depend on how people rank those two alternatives, not on how they rank other alternatives.
4. The gist of the AIT is that even though individual preferences are complete, transitive, and reflexive, group preferences determined through majority voting may not be. There is no method of aggregating individual choices into social choices that simultaneously satisfy all five desirable general properties. The only method of guaranteeing transitive social preferences through majority voting is to violate at least one of the general characteristics.
F. Game Theory: a formal means of modeling strategic interaction.
1. Two or more players who must choose among various strategies either sequentially or simultaneously.
2. In the prisoner’s dilemma, Suspect 1 and Suspect 2 will always confess. Regardless of what the other player does, confessing will always mean less time in prison. In the jargon of game theory, confessing is the “dominant strategy.”
3. Nash equilibrium: a solution in which there is no incentive for either party to play a different strategy. Some games have no Nash solution, some have one, some have multiple
a) If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute a Nash equilibrium.
4. Perhaps we need not worry overly about how parties divide up cooperative surpluses. They seem to do it equitably. However, perhaps we need to pay attention to the fact that overreaching can cause otherwise mutually beneficial transactions to fail.
a) The Normative Hobbes Theorem
5. One shot vs. Repeated Games
a) In a repeated game, there is an incentive to develop a reputation for cooperation or trust. However, in a repeated game in which there are only a finite number of repetitions, if people think the game is about to end, it may “unravel”
(1) The creditor-debtor relationship is an example: May cut each other a little slack if it’s a repeated game. If something happens to indicate that the game is almost over, the other person may stop thinking about the long-term. Bankruptcy code provides special orderly methods of winding up the relationship w/out a grab for assets.
G. Market Imperfections
1. General equilibrium: achieved only when competitive forces have led to the equality of marginal benefit and marginal cost in the market for every single commodity and service. It is socially optimal.
2. Deviations from competitive market conditions that lead private individuals and organizations, in pursuing their own private goals, to do things that are not in the social interest (leads to market failure).
3. Individuals typically pay attention only to private costs and benefits, ignoring social costs
a) The general corrective is to align private and social goals by creating programs that induce private maximizing individuals to take all social costs and benefits into their own calculations.
H. Five Sources of Market Imperfections
1. Market power – monopoly and monopsony; imperfect competition
a) Monopoly: the condition of one seller and significant barriers to entry. A monopolist’s profit-maximizing output and price combination occurs at a point where the price exceeds the marginal cost of production. The price is too high, and the quantity supplied is too low from the viewpoint of efficiency.
(1) Corrective: replace monopoly with competition whenever possible (basis of antitrust law); regulate the price charged by the monopolist (i.e. public utilities)
b) Monopsony: the condition of one buyer and significant barriers to entry. The monopsonist pays too little for the resources that he uses and hires too few.
2. External Costs and Benefits
a) Costs that are an unintended by-product of the profit- maximizing or utility-maximizing actions of one person and that impose these unwanted costs directly onto third parties. Examples: air and water pollution; secondhand smoke.
(1) Problem: from a social point of view, there is too much of the external cost generating activity.
(2) Corrective: inducing less of the external-cost generating activity by having the creator “internalize” the external cost.
b) Benefits that are unintentionally conferred onto third parties by the profit- or utility maximizing actions of one person. Ex: elementary education; pollination services provided by beekeepers by a neighboring apple orchard.
(1) Problem: from a social point of view, there is too little of the external-benefit generating activity.
(2) Corrective: public subsidy of the external-benefit generating activity to motivate people to engage in that activity (i.e. lower price of flu shots).
3. Public Goods
a) Two characteristics:
(1) Non-excludability: the cost of excluding nonpaying beneficiaries who consume the good are so high that no private profit-maximizing firm is willing to supply the good.
(2) Non-rivalrous consumption: consumption of the good or service by one person does not leave less for others to consume.
(3) Examples: fireworks display; national defense; over-the-air broadcasting.
(4) Principle legal application: information. Information is valuable but it can have the characteristics of a public good. Can be consumed by one person or a million people. Difficult for the person developing it to identify all of the consumers of the information and charge them.
b) Problem: private providers cannot make a profit by providing a socially optimal amount of the public good or service. As a result, there is too little (from a social point of view) of the public good. “Free riding” and the holdout problem.
c) Correctives: (1) public provision of the public good (i.e. municipalities who provide fireworks displays on July 4); (2) public subsidization of the private provision of the public good or service, as when the government subsidizes fundamental research.
4. Severe Informational Asymmetries
a) Two parties to a potential transaction have very different information about some important aspect of the potential transaction. For example, consider the very different knowledge of the true
e of the vexing policy questions of capital punishment, advances our under- standing and the public debate about this matter beyond what speculation and argumentation about justification can do.
5. The most obvious cost to making empirical studies a standard part of legal scholarship is that very few lawyers have studied empirical methods. As a result, they will neither know how to read empirical work critically nor how to engage in empirical research themselves.
II. THE COASE THEOREM AND TRANSACTION COSTS
A. The Coase Theorem
1. Coase’s “Nature of the Firm”: people don’t bargain with their employers about what they’re going to do; order and direction form a hierarchical structure. Circumstances where the market/bargaining are not a particular good way to allocate resources:
a) Circumstances in which there are costs associated with bargaining.
b) Cost of using the market is something we ought to pay attention to.
2. When transaction costs are zero (or very low), an efficient use of resources results from private bargaining, regardless of the legal assignment of property rights. The theorem asserts that when property rights are involved, parties naturally gravitate toward the most efficient and mutually beneficial outcome.
3. The assignment of property rights might be crucial to the efficient use of resources when transaction costs are not zero.
a) When transaction costs are high enough to prevent bargaining, the efficient use of resources will depend on how property rights are assigned.
b) Transaction costs must be subtracted from the surplus in order to compute the net value of cooperating.
4. Criticisms:
a) Some believe that the Coase Theorem might be true in the short run but not in the long run. The efficiency of the Theorem in the long run depends on the ability of private bargaining to accommodate any additional costs of altering resource use over long time periods as relative prices and opportunity costs change.
b) Surveys and experiments reveal that people sometimes demand much more to give up something that they have than they would be willing to pay to acquire it. The divergence between buying and selling price is called an endowment effect.
c) Social norms evolve to cope with external costs, without bargaining or law.
5. Coase’s great innovation was to recognize that in many circumstances bargaining is costly – it uses up resources.
B. Transaction Costs: the costs of effectuating an exchange or transaction. Coase’s great innovation was to recognize that in many circumstances, bargaining is costly.
1. Search costs: costs of finding someone with whom to transact
2. Bargaining costs: costs of finding a mutually acceptable price, delivery date, and other terms and conditions of the transaction.
3. Enforcement costs: the post-bargaining costs of monitoring the transaction and guaranteeing that its terms are kept.
4. These costs are not fixed and can change over time. For example, the internet has lowered search costs significantly. They are also subject to legal change (laws can reduce enforcement or monitoring costs).
5. What factors cause transaction costs to be high or low?
a) The number of people involved – the fewer people, the lower the transaction costs, all other things equal. Reduce transaction costs by organizing them into bargaining groups with a spokesperson.
b) Homogenous (or fungible) vs. unique or hard-to-replace goods and services: TC are usually lower when there are many competitors selling the same good and higher when there is only one or a few selling a unique good (w/ no substitutes).
c) Timing of the transaction: spot (or immediate) transactions generally have lower TC than those that will take place at some future date.
d) The complexity of the transaction: are there many steps in the completion of the transaction or is it a simple matter? Will someone have to bear extensive monitoring costs to see if the terms and conditions have been adhered to?
e) Aside from these general factors, transaction costs are to be determined on a case-by-case basis. Look at Table 4-3 on page 91.
