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Law and Economics
University of Iowa School of Law
Miller, Robert T.

Robert T. Miller Law & Econ Outline Fall 2012
I.                   Foundations of the Economic Analysis of Law
2 types of economic analysis:
–          Positive: describes how humans will behave (“what is”)
–          Normative: how people should act
o   When making laws: USE POSITIVE ANALYSIS
o   Legislature often experiences “slippage” from positive to normative analysis: what economists tell law makers is not always what they want to hear
A.      Positive Economics Analysis: RATIONALITY ASSUMPTION
–          Example: Seatbelt problem. Decrease in deaths per crash, but also incentivizes more reckless driving (cost decreases) and therefore more crashes result. àNet effect: not sure if it saves lives or not (immediate effect in real life was more deaths)
–          Rationality assumption is best to predict a LARGE group of behavior, NOT INDIVIDUAL behavior
o   Predictable irrationality: optimism bias, regression to the mean, if you hear something a lot, you think it happens a lot (ex; in the news you hear a lot about child abductions)
o   In order to apply the rationality assumption, you need to do 2 things
§  Assume Motives (example of incorrectly predicting motives: Princeton professor says his students go to Goldman Sachs, not the military àhe incorrectly assumed the motive for everyone was to make money, not true) àAgent/Principle problem (divergent motives) Miller thinks its overblown
§  Predict Means to achieve motives
o   Opposite of predicting: look at behavior that seems irrational, and find why it is really rational.  Examples:
§  Why do you give gifts instead of money? àValue in showing you know/care about the other person
§  Why are Taylor Swift concert tickets so much cheaper than Opera tickets? à type of crowd, merchandising, create T-Swift sensation so people buy her CD
§  Celebrity endorsements: it’s a status symbol (i.e., signaling device), often has little to do with quality, although celebrities don’t want to endorse “loser products”
§  Why are department stores so generous with return policies? àLong term greedy, they want repeat customers àDifferent than car dealerships
–          In class incentive problems:
o   Welfare Reform Act does not award more money for more children. (↓pregnancies, ↑abortions when there are pregnancies: similar to seatbelt problem)
o   Salvage at sea: $50 million worth of treasure, people will pay up to $50 million to find; this causes over-investment; solution àsell the right to look for the treasure (similar to a patent law problem)
–          Posner: spendthrift trusts that limit creditors from collecting from a trust’s beneficiary limits the beneficiary’s ability to borrow. It doesn’t hurt creditors (as normal intuition would think) instead it hurts spendthrift trust beneficiaries.  àThis applies to bankruptcy laws too. Creditors are hurt by laws that are too stringent (creditors can kill borrowers; borrowers are afraid to borrow) and also if they are too lenient (creditors can’t collect, they make less loans)
–          Know the limits of your predictive capabilities:
o   When evidence is presented to you, but there is very little of it, people tend to over-invest in that evidence (ex; A class had to predict how good a teacher would turn out to be based on 10 minutes of that teacher their sophomore year. THE BEST ANSWER would be that the teacher would be average; not enough evidence to form a prediction)
B.      Normative economics: How things “should” be
–          This gets very philosophical, economists say to hell with philosophers (they can’t figure it out)
–          Economists use two properties: (1) What the majority thinks “should” happen; (2)Apply empirically
Ordinal Preferences: We assume that, for every person, and for any two states of the world S1 and S2, the person either prefers S1 to S2, or S2 to S1, or is indifferent as between S1 and S2.
Pareto-Improvement; Pareto-Superior: A transition from state of the world S1 to state of the world S2 is a Pareto-improvement, and S2 is said to be Pareto-superior to S1, if at least one person prefers S2 to S1 and no one prefers S1 to S2.
–          Very few opportunities for pareto-improvement (Cartman has 10 toys, 9 other kids want 1 toy. 9 kid favor the move from S1 to S2, but Cartman objects, so there is no pareto-improvement)
Pareto Efficient: A state of the world is Pareto-efficient if it cannot be Pareto-improved, i.e., there is no state Pareto-superior to it.
Cardinal Preferences Assumption: We assume that, for every person, they prefer one state (S1 or S2) over the other by a certain amount. Function: F such that, for every person p and any two states of the world S1 and S2, F(p, S1, S2) = x, a real number. If x > 0, then p prefers S2 to S1 by x, and if x < 0, then p prefers S1 to S2 by x, and if x = 0, then p is indifferent as between S1 and S2. -          Changes in Cardinal Preferences: a change in the world makes you value certain products more o   Buy a car, you now value gas more. o   Decrease wealth, you now value inferior products more and superior products less Kaldor-Hicks Improvement: The “winners” win more than the “losers” lose  Kaldor-Hicks Efficient: When the state of the world cannot be Kaldor-Hicks improved. -          If we have make Kaldor-Hicks improvements in every transaction, everyone is better off in the long run: You have a reverse Casino -          Bias towards the rich? àRich v. poor family: medicine worth $350,000 to the rich, while the poor family can’t afford it. Efficient to give to the rich. o   At the same time, rich people buy new products, and the cost is then reduced for the secondary purchasers (TV’s, microwaves, computers were all much more expensive when they first hit the marketplace) àThe money the rich spend is reinvested to create more efficient productions and therefore cheaper products -          Kaldor-Hicks doesn’t fare well in “non-commercial” settings when you can’t put $ amount on preference Revealed Preferences: When data is available to display preferences. (Price of stuff i.e., stub-hub) Market failure: the free market fails in terms of efficiency. (Public goods like national defense, roads) -          These have 2 characteristics: (1) Non-competitive & (2) Non-excludable (results in free riders) Rent Seeking: When real time and resources are invested to transfer wealth. HIGHLY INEFFICIENT -          Robbery: robber scopes building, buys tools, obtains wealth -          Murder: murder rich uncle to inherit estate: real loss is estate + life -          Government: lobbying, bribing, or coercing government policies that transfer wealth   II.                 Economic Analysis of Property Law Property right: ownership interest to stuff in the world -          This right is limited: you can’t conduct criminal activity on your land, zoning laws prohibit what you can build on your land, easements, tort liability with nuisance laws, etc. Common law creates default rules for what “rights” are in the bundle. We want efficient rules -          Again we use the Rationality Assumption to achieve efficiency o   Make rules where Benefits to society > Costs to society (Bs > Cs)
o   With the rationality Assumption, we assume individuals will make transactions where their benefits exceed their costs (Bi > Ci)
§  Problems arise where the costs/benefits to society do not align with costs/benefits to the indi

ources is invariant to the assignment of property rights.
–          Invariance rule is not true when the right represents a high fraction of wealth to the person the right is assigned to
For most goods, in most situations, the amount you paid for it is the same amount you would pay to avoid losing it
–          Our case book was $20, we would pay $20 to avoid losing it
–          This is not always the case: you would pay anything for water when stranded in a desert
o   The difference is the percentage of wealth
Coase Theorem: Strong version:
–          If transaction costs are zero, no wealth effects, and parties do not value it equally, then assignment of the right is irrelevant and will always go to the HVU
Property rules vs. Liability Rules
–          Property: you can sue and get an injunction       
o   Huge costs imposed on violators of property rules
o   Patent law is a property rule: Apple hammered Samsung for violating their Patent
o   Can lead to criminal prosecution
–          Liability: example is eminent domain. The government can take your house, and they have to pay you fair market value, but you cannot stop them from taking it
o   Someone can “take” your liability right, but must pay you damages
§  Polluter may be able to pollute your air, but pays you damages for it
§  You may take be able to take polluter’s liability right to pollute, but you must pay for him to either move or install something that fixes the pollution
Intentionally destroy a car àproperty rule (jail)
Unintentionally destroy a car àliability rule (fine)
–          Why the difference? In accidents, the parties don’t know each other before the transaction. But if you want to destroy a car, you can negotiate with the owner to buy it and get that right. Also seems that we want to deter intentional harm; also a chance the offender gets away with it so we must increase punishment for optimal deterrence.
In choosing either property or liability rules we use whichever produces the least amount of transaction costs
“Bargaining costs” àWhen someone wants to buy a PROPERTY right (search costs, negotiating)
“Litigation costs” àWhen someone takes a LIABILITY right, another party sues
–          Whichever costs are higher determines whether to use liability or property rights
–          Friedman: “Property rules are attractive when the cost of allocating rights by market transactions is low. Liability rules are attractive when the cost of allocating rights by litigation is low.”
When approaching problem, ask:
–          What are the real world solutions?
–          How much does each of these cost?
–          What are the transaction costs?
–          What are the litigation costs?
–          There are 4 possibilities, go through each case and see which rule gives you the efficient solution in each case. For example:
o   Property right for polluter
o   Property right for farmer
o   Liability right for polluter